Government Panhandling: The Department of Economic Security’s recent uptick in unemployment insurance audits

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– by Paul J. Valentine & Steven M. Brechner.

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ccording to the Department of Economic Security’s (“DES”) Annual Report, the total amount of employer’s contributions in 2012 to the unemployment fund was $434 million. But, unemployment benefits paid out that year were $1.05 billion. That means that in 2012, DES paid $620 million more than it collected. When you consider that DES Unemployment Insurance’s fund balance is a measly $4 million, DES’s enthusiasm for worker reclassification audits makes sense. Obviously no one can certainly say whether DES’s uptick in audits and reclassifications is driven by these dire financials. However, what is clear is that DES is aggressively reclassifying workers from independent contractors to employees. Such a reclassification can have catastrophic ripple effects with the Internal Revenue Service and the Department of Labor.  Whatever DES’s motivations, practitioners should be aware of the applicable laws and regulations when handling worker classification audits, appeals, administrative hearings and beyond.

A. DES’s Two Main Strategies to Reclassify Independent Contractors as Employees

      DES is generally a two-trick pony when it comes to reclassification audits. It either reclassifies workers as employees under a relationship of the parties’ test that is similar, but not the same, as the IRS’ twenty-factor test. Alternatively, DES tries to establish unemployment insurance liability under the temporary service employer statute. Occasionally it pursues both.

a. DES Determines Whether the Workers Were Under the Direction, Rule or Control of the Hiring Party

      When examining the relationship of the parties test, DES’s first step is usually to make certain demands including copies of the parties’ agreement(s), interviews with the owners / workers / both, and on rare occasions a site visit. The hiring party is then caught between a rock and a hard place. On the one hand, most business owners want to cooperate with DES. On the other hand, agreeing blindly to DES’s demands may lead to an inaccurate classification. For instance, the agreement may not accurately represent the parties’ business dealings (thank you Google); or the business owner and/or worker get flustered during the DES interview and give incorrect or incomplete information.

      Of course it is important to cooperate with an audit; however it is just as important to ensure that DES receives complete and accurate information. To that end, this section outlines relevant Arizona law and then provides some practice pointers on how to defend an audit.

      “Employee” is defined by statute A.R.S. § 23-613.01 as individuals that are subject to the hiring party’s direction, rule, or control as to the method of performing the task.  The statute then provides four exceptions, three of which are not discussed in this article since most audits focus on the first exception– whether the worker is an independent contractor.

      Under this exception, DES does not indicate whether the hiring party classified the worker as an independent contractor. Instead, DES will focus on the substance of the parties’ relationship. In other words, DES examines the hiring party’s degree of direction, rule or control.

      There are twelve indicia of direction, rule or control, which are: (1) Authority over individual’s assistants; (2) Compliance with instructions; (3) Oral or written reports; (4) Place of work; (5) Personal performance; (6) Establishment of work sequence; (7) Right to discharge; (8) Set hours of work; (9) Training; (10) Amount of time; (11) Tools and materials; and (12) Expense reimbursement. DES’s regulations identify additional factors that show independent status, which are: (1) Availability to the public; (2) Compensation on a job basis; (3) Realization of profit or loss; (4) Obligation; (5) Significant investment; (6) Simultaneous contracts.

      A memorandum that outlines the hiring party’s business practices with regards to the above factors provides DES an accurate, complete picture of the hiring party’s business and its relationship with its workers. Just as important is to carefully guard communications between the hiring party and DES. Audits and even appeals have been decided solely because of an incorrect or incomplete statement made by a worker or business owner. In order to avoid confusion, request that DES provides written questions, instead of live interviews, so that the client may provide accurate and complete responses. Additionally, such a request provides a written record of all communication between the client and DES.

      Establishing a written record is critical, as many of these audits are resolved several administrative steps after the initial audit. Each administrative step can take years, so it is important to document each conversation to ensure there is no subsequent contradiction. If the appeal continues, requesting a public records request of DES’s file may provide valuable information about DES’s case file.

b. DES Reclassifies Workers as Temporary Service Employees

      A Temporary Service Employer is an employing party that contracts with clients to supply workers to perform services for the client and who performs all of the following:

  • (a) Negotiates with clients or customers for such matters as the time of work, the place of work, the type of work, the working conditions, the quality of services and the price of services.
  • (b) Determines assignments or reassignments of workers, even though workers retain the right to refuse specific assignments.
  • (c) Retains the authority to assign or reassign a worker to other clients or customers if a worker is determined unacceptable by a specific client or customer.
  • (d) Assigns or reassigns the worker to perform services for a client or customer.
  • (e) Sets the rate of pay of the worker, whether or not through negotiation.
  • (f) Pays the worker from its own account or accounts.
  • (g) Retains the right to hire and terminate workers.

      DES’s position is that an independent contractor can also be a temporary service employee. As a result, the hiring party would have to contribute to the unemployment insurance fund, even though DES concedes that the worker is an independent contractor. This tortured reading of the statute provides an example of the lengths DES is prepared to take to reclassify workers.

      However, this paradox is likely short lived. The statute was amended in 2013 and the amendment explicitly excludes independent contractors from the definition of temporary service employees. The author’s position is that the temporary service employer statute has always excluded independent contractors and the amendment is simply a clarification. However, DES maintains that the amendment was not a clarification, but rather a change. Thus DES is attempting to reclassify independent contractors as temporary service employees for any audits involving individuals that worked prior to the statute’s amendment. The author is currently litigating this matter and would be happy to discuss further with any interested practitioner.

B. Conclusion

      Disputing DES’s classification of workers is a lengthy process. DES has created a system whereby the odds are stacked in its favor and the lengthy appeal process weeds out all but the most determined of clients. Clients should be advised of the long and difficult process from the beginning. Nevertheless, it is critical that practitioners protect the record at audit for subsequent appeals.

      Arboleda Brechner’s tax group is well versed in the consequences of a DES audit. They are happy to work with practitioners to assist them best represent their clients.

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