Preparing for a Physical Workers Comp Audit

For A Smoother Audit, Organize Your Documents in Advance

Mr. LaBuano & accountant at desk, Southern California, 1940

Like many business owners, you may dread the thought of a physical workers compensation audit. The prospect of an audit may seem less daunting if you know what records the insurer will need and organize them ahead of time. Some advanced preparation on your part will help ensure the audit goes quickly and smoothly.

Scheduling the Audit

If your worker's compensation insurer plans to conduct a physical audit it should notify you by letter or telephone shortly after your worker's compensation policy has expired. The audit should be scheduled for a date that is convenient for you. You will need adequate lead time to collect the information needed. Ask the insurer for a list of the data the auditor will require for the audit. 

Note that your assigned auditor may or may not be an employee of the insurer. Some insurers maintain an in-house audit department staffed with their employees. Others outsource the audit function to an independent auditing firm. The process should be the same whether the audit is performed by an employee of the insurer or a contractor.

Records You Will Need

The auditor will need financial data for the time period covered by the policy being audited. Here is the type of information you may be asked to provide:

  • Accounting ledger
  • Tax forms, particularly form 941 and 944, Employers Federal Tax Return (quarterly and annual, respectively)
  • Records of cash disbursements
  • Payments for services provided by independent contractors. The auditor will need to verify that these workers are not your employees.
  • Payments for services provided by subcontractors
  • Certificate of insurance for each subcontractor you hired
  • W-2 and 1099 forms
  • Job description for each worker. Make sure it accurately describes the worker's duties.
  • Description of your business operations

Once you have collected the necessary data, you'll need to organize it. Put all of your payroll records (such as W-2 forms, pay stubs, and overtime records) together so that the information is easily accessible. Likewise, place all information related to subcontractors, including payment amounts and certificates of insurance, in one place. Your efforts will pay off, making the audit easier and faster.

Meeting With the Auditor

When the auditor arrives, direct him or her to a quiet location where the individual can work without being disturbed. Try to be cooperative and answer the auditor's questions as well as you can. If you ask a trusted employee to meet with the auditor on your behalf, be sure he or she:

  • knows your business well
  • understands all phases of your firm's operations
  • knows what tasks are performed by each employee
  • understands your company's workers compensation policy, including the classifications it contains
  • understands your firm's financial records, including payroll data, so that he or she can answer questions from the auditor

If your company utilizes an offsite bookkeeping firm to handle your accounting and payrolls functions, can you send the auditor to your bookkeeper's office? No! Your bookkeeper can provide the financial records the auditor needs but a physical audit must be conducted at your premises.

What's Included in Payroll?

The basis of worker's compensation premiums is remuneration (payroll), the monetary value of the services your employees provide to your organization. Your insurer calculates your premium by multiplying a rate times your remuneration and dividing the result by 100. The NCCI and some state workers compensation authorities provide a written definition of remuneration. While the definition varies from state to state, it generally includes the following:

  • Gross salaries and wages, including retroactive salaries and wages
  • Total commissions received by a worker including any draws against them
  • Bonuses including stock bonus plans
  • Vacation, holiday, and sick pay
  • Overtime pay. In most states, overtime pay is calculated at the straight time rate. For example, if a worker's hourly rate is $20 and he is paid $600 for 20 hours of overtime, only $400 of the overtime pay would be included as remuneration.
  • Payments made by you that would otherwise have been withheld from employees' pay as required by law for Social Security, Medicare or a pension plan
  • Payment to workers on a basis other than time worked. Examples are piecework, profit sharing or incentive plans.
  • Payment or allowances for hand tools or hand-held power tools that workers use to perform their jobs
  • Rental value of an apartment or house provided to an employee. Also, the value of other lodging and meals received by a worker as part of his or her pay
  • Payments deducted from workers' gross pay for retirement, cafeteria, or savings plans
  • Payroll for employees of uninsured subcontractors (see comments below)

    What's Excluded From Payroll?

    The meaning of remuneration typically excludes certain costs. While the exclusions vary from one state to another, most states exclude the following:

    • Tips and other gratuities received by employees
    • Payments by the employer to group insurance or pension plans
    • Severance pay (other than for time worked)
    • Discounts on goods purchased from the employer
    • Reimbursed business expenses
    • Pay for active military duty
    • Uniform allowances

    Classifications

    One of an auditor's primary tasks is to ensure your business is properly classified. To make this assessment, the auditor will review your company's operations and then determine whether the classifications on your policy are appropriate.

    The auditor typically begins by evaluating your basic classification. This is the classification that best describes your overall business. It is often the same as the governing classification, which is the classification assigned the most payroll. For example, suppose you operate a machine shop. Some of your employees work with lathes while others operate drill presses or stamping machines. The activities performed by your employees vary from worker to worker but all fit your basic classification, Machine Shop.

    Since most of your payroll goes to machine shop workers, Machine Shop is your governing classification.

    Some employees may perform tasks that require separate classifications. For example, suppose your machine shop employs a clerical worker who performs his job in an enclosed office away from other workers. This employee will likely be assigned the classification Clerical Office Employee rather than Machine Shop.

    Workers compensation classification systems are based on complex rules that can be difficult for policyholders to comprehend. If your auditor reclassifies your business or calculates your premium in a way you don't understand, ask him or her for a simple explanation. If you are still confused, ask your agent or broker for assistance.

    Subcontractors

    Many states have laws that impose liability on contractors that hire uninsured subcontractors. These laws will apply to you if your business operates as a contractor, and it subcontracts work to others.

    For example, suppose that your company, ABC Construction, hires a subcontractor called P&J Plumbing to do piping work at a building you are refurbishing. An employee of P&J is injured on the job and attempts to collect workers compensation benefits from his employer. The worker is unsuccessful because P&J has not purchased workers compensation coverage. In most states, the injured worker can seek benefits under your worker's compensation policy.

    Insurers are required by law to provide benefits injured employees of uninsured subcontractors hired by their policyholders. Thus, your auditor will review your tax documents, including all 1099 forms you issued to subcontractors. He or she will verify that you obtained a certificate of insurance from each subcontractor you hired. If any subcontractor did not provide evidence of workers compensation insurance, the auditor will charge you an additional premium for that contractor's insurance coverage.

    The rate charged for an uninsured subcontractor depends on the type of work the subcontractor performed. For example, if the subcontractor performed roofing work, then the rate for the applicable roofing classification will be used. The rate will be applied to all or a portion of the cost of the subcontracted work. If the money you paid to the subcontractor was for labor only, then the entire cost (divided by 100) will be used as the basis of the premium.

    Contractor Versus Subcontractor

    If your business is not a contractor, are you responsible for injuries sustained by employees of independent contractors you hire? The answer is generally no. A contractor operates an independent business and is responsible for providing workers compensation benefits to its injured employees.

    For example, suppose you own a retail store. You hire a Fabulous Flooring, a flooring contractor, to tear out an old floor in your store and replace it with a new one. You outline the result you want (a new floor), and Fabulous does the job. A Fabulous supervisor oversees the work, setting work schedules and dictating how employees perform their jobs. If a Fabulous employee is injured while installing your new floor, Fabulous (not your firm) will be obligated to provide benefits.

    There are some situations where a company could be held liable for injuries to employees of an independent contractor. Thus, you should insist that all independent contractors provide a certificate of insurance stating that they have purchased workers compensation insurance.