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Subcontracting Lessons Learned from a Department of Labor Audit


Several years back, I led a GPA conference session on subcontracting, which included a section on labor laws. I discussed classifying subcontractors as independent contractors versus employees and the legal risks of worker misclassification (i.e., paying past payroll taxes, interest and penalties). So it was ironic when, six months later, my state's Department of Labor (DOL) determined I was in violation of employee labor laws and wanted me to pay three years of back payroll taxes!

 
I had been operating my own consulting firm for over 18 years and subcontracting for 17 of those.  Lucky me – I was randomly selected by my local County Department of Labor office to be audited. My accountant pulled out the 1099s for ten individuals who I contracted with during the previous three years and had me pull together copies of all their contracts and 36 months' worth of invoices and proof of my payment. (The five-inch stack of paperwork cost me $38 to overnight to his office!)
 
The DOL auditor spent a couple hours combing through the piles and left his office on a cheery note. Phew!  But three weeks later, I get the determination letter stating that my grant writing subcontractors should have been considered employees, I should have been withholding taxes and issuing them W2s, and I had to pay the back taxes and a penalty.
 
Since failure to pay fines could result in jail time and I wouldn't look good in an orange jumpsuit, I vowed to fight this injustice. To make a long story short, over the next three months I contested the determination twice and presented formally to a DOL supervisor who eventually agreed that my subcontractors were indeed independent contractors and not employees subject to payroll withholdings. (I could once again walk in the sun with my head held high!)
 
Whether you subcontract, are a subcontractor yourself, or are considering subcontracting, I hope my experience will help you better operate according to the law, survive a DOL audit, and/or spare your client grief if they are called in for an audit regarding subcontracting to you.
 
Behavioral control, financial control and relationship of the parties
For over an hour, I was asked questions in order to determine the amount of behavioral control, financial control, and relationship between the parties the IRS 3-category test to determine whether a business exerts undo control over the manner and means by which the individual performs his/her service. She started with “What is involved with grant writing?” and “Why do you outsource?” and continued to ask questions for the next hour.  
 
Do you give them directions?
Do you give them deadlines?
Do you edit their work?
Have they refused work?
If they weren't available, what would you do?
Where do they work?
Have they ever worked in your office?
Have you ever paid their travel or education? 
Do they have other clients?
Who are their clients?
How do they get clients?
And then some.
 
Regarding behavior, she wanted to determine how much control I exerted over where, when, and how the job was being done. You cannot demand that a consultant work at your office or on certain days and specify the order of how things must be done.  You cannot require certain tools or equipment be used or purchased. You cannot provide training.  You are hiring them for their expertise and should not provide excessive instruction. You cannot give the person an evaluation. In short, you do not manage a consultant. 
 
There should not be any financial control.  The rate of pay must be negotiated between the two parties. You cannot provide a compensation and benefits package (health, dental, pension) or pay their expenses (e.g., travel, office supplies). They should have multiple clients, make an investment in their own businesses (e.g., own their own equipment like laptop, printer, and typewriter), and have the opportunity for profit or loss.
 
The relationship between the parties should be specified through a written contract, which helps prove that the worker considers herself to be a contractor. If she is incorporated, you will bring a smile to the auditor's face! Short term projects are more indicative of a contractor versus steady, year-round work. The questions regarding core work are a bit trickier; technically, if the service they provide is an integral aspect of the company's regular business activity, they are more an employee. However, if you can say that the contractor provides your business with new services (e.g., knowledge of a particular industry, strong government grant writing experience, new avenues for research), they are providing an “expertise” you need and are a consultant.
 
This chart from my PowerPoint three years ago still holds true: 


 
I was better prepared for my audit hearing than any defense lawyer on SVU and presented extensive “proof” that each subcontractor operated her own business.  My “show and tell” included our signed contacts and their resumes, business cards, brochures and press kits, swag with their company logo, copies of their website, ads, incorporation papers, bank statements and liability insurance, a sampling of other client contracts and invoices, and whatever else they could send me.  While grant writers often tout their LinkedIn profiles, it was not considered acceptable “proof” of business operation.  It was music to my ears when she stated that my subcontractors were indeed independent consultants. BAM! (I could put that orange jumpsuit back in my closet!)
 
Since laws vary by state, the above should serve as a general guideline regarding independent contractors and employee classification.  Adhering to federal and state labor laws is your responsibility if you subcontract or are a contractor. While you cannot escape or lower your chance of being audited, you can increase your chances of “passing” an audit by understanding applicable labor laws, classifying properly, operating correctly, and being prepared for that dreaded DOL audit.
 
Lydia S. Howie, MS, GPC, is a grant consultant operating in New York and the eastern shore of Maryland/Delaware.  Contact her at HowieMarketing1@gmail.com.

Comments

 
By: Shelley
On: 07/30/2019 19:09:44
Lydia, I attended your conference session on this topic. I'm so glad the end result was positive for you! Are you doing anything differently now to avoid or be more prepared for a similar situation in the future? Many thanks for sharing your experience.
 
By: Diane
On: 07/31/2019 10:27:10
Great article! Thanks for sharing your experience with a good sprinkling of humor.
 
By: Charise Whitt
On: 07/31/2019 16:00:44
This was helpful. Thank you.

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