Preparing for a Workers Compensation Audit

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Image courtesy of [Katrina Charmatz] / Getty Images.

Is your company about to undergo a workers compensation audit? Preparing for an audit can seem daunting, especially if your insurer plans to conduct a physical audit at your premises. This article will outline some steps you can take that will help make the process easier and faster.

Scheduling the Audit

Your workers compensation insurer will likely initiate the audit process soon after your workers compensation policy expires.

You may receive a letter from your insurer or a phone call from the person assigned to conduct your audit. Your assigned auditor should schedule the audit at a time that is convenient for you. The date should be far enough into the future that you'll have adequate time to collect the information the auditor will need. Ask the auditor to provide you a summary of the data he or she will require to perform 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 own 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 various financial information 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 forms 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
  • Payroll records for the term of the policy. The auditor will need to verify all sources of pay provided to each worker (salary, bonuses etc.).
  • Payroll limitations applicable to executive officers, partners, sole proprietors etc. that are covered under the policy
  • Your experience rating worksheet

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.

What's Included in Payroll?

Your workers compensation premium is calculated by multiplying a rate times your payroll, and then dividing the result by 100. The NCCI and most state workers compensation authorities refer to payroll as remuneration. These terms are often used interchangeably. Both mean the monetary value of the services your employees provide to your organization.

The costs that are included in remuneration vary somewhat from state to state. However, they generally include the following:

  • Gross salaries and wages, including retroactive salaries and wages
  • Commissions. This includes total commissions received by a worker and any draws against commissions.
  • Bonuses, including stock bonus plans
  • Vacation, holiday and sick pay
  • Overtime pay. In all but a few states, remuneration includes overtime calculated at the straight time rate. For example, suppose a worker's normal hourly rate is $20 per hour. If the worker was paid $600 for 20 hours of overtime, you would include only $400 of the overtime pay.
  • 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?

There are a number of costs that are typically excluded when payroll is calculated for the purpose of rating workers compensation insurance. While these vary by state, they often include the following:

  • Tips and other gratuities received by employees
  • 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 that the insured business is properly classified. Workers compensation classification systems are designed to categorize businesses, not individual employees. The auditor will review your company's operations to determine whether the basic classification listed on your policy is correct.

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

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

Workers compensation classification systems are extremely complex. Your auditor may reclassify your business in a manner that you don't understand or that doesn't make sense to you. In this event, ask the auditor for an explanation. If you are still confused about the changes, ask your agent or broker for assistance.

Meeting With the Auditor

To conduct the audit, the auditor will need to meet with you or a trusted representative of your firm. If you delegate this task to someone else, be sure that 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

When meeting with the auditor, you or your designee should be cooperative and answer the auditor's questions as well as you can. Don't offer information that wasn't requested.

Like many businesses, your firm may hire an offsite bookkeeping firm to handle your accounting and payrolls functions. Should your bookkeeper meet with the audit on your behalf? The answer is no. Your bookkeeper can provide the auditor the financial records he or she needs to do the audit. However, the auditor will need to visit your premises to conduct a physical audit.

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 file a workers compensation claim. However, P&J has not purchased workers compensation coverage. In most states, the injured worker can seek benefits under your workers compensation policy.

Insurers are required by law to provide benefits to employees of uninsured subcontractors. Thus, your auditor will review your tax documents and look for 1099 forms issued to subcontractors. He or she will check to see whether you obtained a certificate of insurance from each subcontractor you hired. If any subcontractor you hired 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. The contractor operates a business that is independent from yours. Thus, the contractor is responsible for providing workers compensation benefits to its own injured employees.

For example, suppose that you own a retail store. You hire a Fabulous Flooring, a flooring contractor, to tear out an old linoleum 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 flooring workers. The supervisor sets work schedules, and dictates how employees perform their work. If a Fabulous employee is injured while installing your new floor, Fabulous (not your firm) should be liable to the worker.

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 contractor's you hire provide evidence that they have purchased workers compensation insurance.