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Risk of audit for issuing 1099 and W2 to former employee in same year

If an employee is let go or quits and is immediately rehired sillydood06/21/18
? Who knows. If there is no illegal activity going on, who lawyer197206/21/18
Yes, big red flag unless there’s a substantial change in p alphadog1506/22/18
What if the employee is legitimately setting up a business t sillydood06/22/18
Actually, that happened with me a few years ago. I went fro patenttrollnj06/22/18
I think he's talking about the risk of an audit of the emplo onehell06/22/18
TY, this is exactly what I'm worried about. sillydood06/22/18
Ha! If that jerk former employer that put us on a 1099 coul patenttrollnj06/22/18
never mind, onehell just covered it. wutwutwut06/22/18
sillydood (Jun 21, 2018 - 7:01 pm)

If an employee is let go or quits and is immediately rehired as an independent contractor, that's a major red flag for an audit, correct?

If the employee sets up a registered business, is the risk of audit reduced?

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lawyer1972 (Jun 21, 2018 - 11:28 pm)

?
Who knows. If there is no illegal activity going on, who cares about an audit, right?

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alphadog15 (Jun 22, 2018 - 4:56 am)

Yes, big red flag unless there’s a substantial change in position and duties of the employee that warrants treatment as an independent contractor.

Setting up a “registered business” is irrelevant unless the above can be proven, the IRS will look past that and consider substance over form. If the plan is to try to obscure the identity of the employee with that or the name of the business it won’t work as the employee will eventually have to claim the income on their own return, and can potentially act as another red flag.

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sillydood (Jun 22, 2018 - 6:18 pm)

What if the employee is legitimately setting up a business that offers the same services to multiple clients? I guess that doesn't really prevent the audit initially....

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patenttrollnj (Jun 22, 2018 - 12:42 pm)

Actually, that happened with me a few years ago. I went from a W2 to a 1099 within the same calendar year. It happened to other lawyers I've worked with too.

I've never heard of it being a problem, so long as you pay the estimated taxes as required.

I think the "red flag" is more in what you claim as a deduction, rather than merely going to a 1099. If your deductions don't look too unusual, you should be OK.

Be carful of the "home office" deduction. That one has very strict guidelines.

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onehell (Jun 22, 2018 - 3:47 pm)

I think he's talking about the risk of an audit of the employer, not the individual, because the company can get in trouble both with IRS and DOL as well as state workers comp and unemployment authorities for misclassifying an employee as an independent contractor.

A lot of employers think (erroneously) that there's some kind of bright line like "oh if they don't work more than X number of hours or if I make them set up an LLC and get an EIN then it's ok to 1099 'em" when in reality it's more subjective tests like behavioral control, whether the contractor supplies their own tools and works on their own schedule or one set by the employer, and economic dependence.

What employers should do is make sure they pay attention to the "independent" in independent contractor. If you're telling the person that they're supposed to be at their desk from A to Z time on X days of the week, that's "behavioral control" and they could be found to be an employee. If you're the only customer of their supposedly independent business, that's a problem too as it may indicate "economic dependence" characteristic of an employer/employee relationship. If they're getting company email and business cards and phone extension, that's another possible problem. But it's a multifactor test with no single factor being dispositive.

Honestly though, the IRS is pretty short on resources right now, so I don't know that they're doing much auditing of classification as opposed to just being reactive. Besides, it's pretty common (for example) for people to retire and set up a consulting business and for their first customer to be their former employer. That can be entirely fine and the raw data the IRS computers see is not going to distinguish the one from the other without a more in-depth human review. So it can feel like the IRS may be more reactive than proactive on this, basically investigating employee classification issues when someone complains more than looking for flags in the data such as a W2 and a 1099 from the same employer in the same year.

Individual people who think they've been misclassified can complain about it by filing form SS-8, so it may be that the biggest risk turns on situations where the "contractor" is unhappy with the arrangement. When it comes to very senior people leaving the company and the company contracting with them in a desperate bid to hang on to their expertise for awhile longer, that usually comes with the elimination of the obligation to go into the office on any kind of regular basis, and they're usually happy to lose unemployment and comp coverage and employer-side payroll tax coverage in exchange for that flexibility.

So there's the theoretical answer, and then there's the practical one. The theoretical answer is to get comfortable with applying multifactor tests and living in gray areas. The practical answer is to make sure the contractor is happy with the arrangement, which usually means giving them a large amount of flexibility in scheduling that they never could have had or expected as an employee. And make sure the contractor has their own resources to live on; if they're depending on you to make rent and things go south, they may very well complain to IRS or file for unemployment or something like that, and those things are much more likely to lead to an investigation than the odds of being flagged for an audit.

In fact, if I were to point to one single factor that is more important than all others, I think it's the economic dependence issue. Not because the factor is legally dispositive (it isn't), but because it is most predictive of whether the individual might file a complaint if the contract is ever terminated or significantly reduced, or if they get pissed off at the company for any other reason such as if they were too unsophisticated to understand the implications for their own taxes or lived hand-to-mouth such that they didn't save up for the self-employment tax liability.

Many hand-to-mouth types who get paid 1099 love not having withholdings, at first. But then tax season comes around and they get hit with a huge bill and all of a sudden they're saying you never should have called them an independent contractor in the first place.

Never 1099 someone who would primarily rely on the money you're paying them to survive. If I could give employers one easy tip, it would be that.

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sillydood (Jun 22, 2018 - 6:19 pm)

TY, this is exactly what I'm worried about.

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patenttrollnj (Jun 22, 2018 - 9:45 pm)

Ha! If that jerk former employer that put us on a 1099 could get in trouble, one of us would have reported him at the time.

I think small law is full of shady stuff like that.

One of my friends was sacked after returning from a medical leave, and nothing happened to them. Lawyers are good at covering their bases so they can toy with people.

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wutwutwut (Jun 22, 2018 - 3:48 pm)

never mind, onehell just covered it.

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