Watch out for state unemployment audits

When you think of tax audits, the IRS probably jumps to mind. But different state agencies also conduct tax audits. For example, state labor departments conduct state unemployment audits. So what's the purpose of an unemployment audit? To make sure that your calculation of state unemployment tax is correct based on an employee's wages and the taxable wage base, and that you've used the appropriate tax rate.

Gary I. Glassman

During this type of audit, state unemployment auditors will look at the people you've paid for services and who can be considered independent contractors. They'll ask to review your 1099 recipients. Auditors want to be sure these recipients are truly independent contractors or if they should be reclassified as employees. If they're reclassified as employees under the state's definition, you'll owe additional state unemployment tax.

If this happens to you, you'll probably look at your audit result and see that you don't owe much. Wages subject to the tax are limited and the tax rates are low. But beware. Twenty-nine states, such as Ohio, New York, California, and Michigan, have information-sharing agreements with the IRS. If you agree with the state's audit result and settle for a small dollar amount, the state may turn your information over to the IRS—which starts a second audit with a much larger bill. For example, a practice I consulted with was audited by the state unemployment agency and wound up with a $300 state audit bill that turned into an $8,000 tab with the IRS. Both agencies benefit from this agreement. The IRS turns over its audit results to the state so it can send the taxpayer a bill for state taxes based on the federal audit.

Service providers who create the greatest audit risk for practices are groomers and relief veterinarians. The problem arises when a relief veterinarian wants to be treated as an independent contractor but wants to work a regular schedule at your hospital—say two-and-a-half days every week. And let's assume she doesn't offer her services to the general public, doesn't bill you, and charges by the hour. So why isn't she a part-time employee? It's the same with groomers. A groomer who works exclusively in your practice is an employee of your practice. If you offer any benefits to these providers, then they're definitely employees. Service providers often want to be considered independent contractors so they can deduct 100 percent of their business expenses. If they're employees, they can deduct their business expenses only as itemized deductions subject to a 2 percent adjusted gross income limitation.

A relief veterinarian who is classified as an independent contractor will work in many hospitals. She'll give you a copy of her license and malpractice insurance, 1099 reporting information, and a bill for her services on letterhead with the name of the relief practice. Her business cards will include the same information. She should also be able to document the fact that she provides services to the general veterinary population.

With your tax advisor, discuss the specific independent contractor rules and how they apply to you. The fact that someone you hire wants to be treated as an independent contractor isn't enough to keep you out of trouble with the IRS.

Gary I. Glassman, CPA, is a partner with Burzenski and Co. PC in East Haven, Conn., and a Veterinary Economics Editorial Advisory Board member.