Best Approach to State and Federal Labor Audits

Arizona businesses are required to cooperate with both federal and state agencies when such agencies perform audits and investigations related to an employer’s compliance with labor and employment laws. Such audits are generally performed at the federal level by the United States Department of Labor or the Internal Revenue Service. At the Arizona state level, such audits and investigations are generally performed by the Industrial Commission of Arizona and the Arizona Department of Economic Security. In order to assist employers in dealing with the stressful audit and investigation process, this article both defines the agencies charged with investigating labor and employment claims and breaks down how to successfully approach each audit.

Business Audit

What is the United States Department of Labor?

The Unites States Department Labor (“DOL”) is a department of the federal government that is in charge of occupational safety, wage and hour standards, unemployment insurance benefits, reemployment services, etc. According to its website, the DOL’s mission is “[t]o foster, promote, and develop the welfare of the wage earners, job seekers, and retirees of the United States; improve working conditions; advance opportunities for profitable employment; and assure work-related benefits and rights.” Given the fact that most of the country’s population works for a living, the breadth of the DOL’s power is huge.

What is the Internal Revenue Service?

We all dread getting a call from the IRS. The IRS “is the nation’s tax collection agency and administers the Internal Revenue Code enacted by Congress.” While their power and responsibilities are quite broad, one responsibility they have been given is making sure employees are not misclassified by employers.

What is the Industrial Commission of Arizona?

The Industrial Commission of Arizona (“ICA”) was created by the state in 1925 in order to watch over compliance of workplace safety and workers’ compensation laws.1 Among other responsibilities, the ICA “is responsible for labor related issues regarding occupational safety and health, youth employment laws, resolution of wage-related disputes, minimum wage, vocational rehabilitation, and worker’s compensation coverage.”

What is the Arizona Department of Economic Security?

The Arizona Department of Economic Security (“DES”) was established in 1972 to help “Arizonans reach their potential through temporary assistance for those in need, and care for the vulnerable.” As a primary component of reaching Arizonans’ potential, the DES oversees our unemployment benefits, employment services, apprenticeship programs, rehabilitation services, etc.2

United States Department of Labor Audit

To say that it is stressful to receive a letter from the DOL informing you that your company will be audited is an understatement. DOL audits are dangerous because they can hit you at any time and without any significant prior notice. By understanding the DOL and the process it takes for audits, you can be more prepared to take on the audit and pass with confidence.

How does the United States Department of Labor decide who to audit?

Perhaps the better question is “why me?” In reality, you may never know why you were selected to be audited, but there are several possibilities.

  • A present or former employee filed a complaint based on personal experiences with your company.
  • A third-party (e.g., competitor, agency, labor union) filed a complaint based on a belief that you were not in compliance with the law.
  • You have been found to be noncompliant in a previous audit and the DOL is following up to ensure that such violations have been corrected.
  • Your business is part of an industry that the DOL is concentrating its effort on to find out the extent of compliance across the industry.
  • You have been randomly selected and chosen.

Can you prepare for a United States Department of Labor audit ahead of time?

YES. In fact, this is what you should do as an employer. Because the DOL only gives you a short period of time between notice and the actual audit and investigation, you will not have much time repair any noncompliant behavior. If you want to pass the DOL’s audit, it is critical that you take steps now and every day to ensure that your workplace is compliant. Here are some self-auditing steps from the Society for Human Resource Management that every employer should take to prepare themselves for an investigation before receiving an actual notice:

  • Understand the differences between federal and state laws and ensure that the laws are correctly applied to employees.
  • Ensure that Fair Labor Standards Act (“FLSA”) classifications are correct.
  • Keep accurate payroll records.
  • Apply policies consistently.
  • Make sure all records are complete and work to resolve any inconsistencies.
  • Determine how to address any areas of concern identified via the self-audit.

Commonly Vulnerable Areas for Investigation

Areas that employers frequently make mistakes in are also frequently audited. So look at your practices in these areas to best protect yourself in case of an audit:

  • Are you paying your employees at least minimum wage?
  • Are you paying your employees overtime hours properly?
  • Are you recording employees’ hours properly?
  • Do your employees meet the minimum age requirements?
  • Do you pay employees fairly regardless of gender, race, age, or any other Title VII protected characteristic?
  • Have you falsified any personnel, payroll, or time keeping records?

After receiving a notice of an upcoming audit, what should you do to prepare for and assist the DOL?

  • Make sure all required labor law posters and notices are visible and posted in common areas for employees
  • Maintain up-to-date policies.
  • Review all time-tracking procedures and devices to ensure that time reporting by employees is recorded accurately.
  • Make sure all payroll records are organized and accurate, especially records from the last several years.
  • Swiftly take action to remedy any mistakes or willful violations that have been made by you or other management.
  • Set apart a private room for the auditor to conduct business in and conduct any necessary interviews.
  • Familiarize yourself with everything you should know, including job titles, job categories, payment practices, how employee-wage garnishments are calculated, whether employees are paid for training, etc. The auditor will interview you and gauge how well you know the workplace, especially with regards to how your employees are paid and how they work. By impressing the auditor with your knowledge, you will set the tone for a straight-forward and easy investigation.

The DOL wants you to pass the audit and succeed in complying with all labor laws. While noncompliance is a serious matter and can lead to unwanted newspaper publicity, large penalties and fines, and permanent injunctions, if the DOL finds that you care about complying in order to protect your employees’ rights, then they might be more flexible with you. In this case, the punishing agency can become more like a partner to you as you get your business back on track with federal labor standards.

Internal Revenue Service (IRS) Audit

Do you classify any of your employees as independent contractors? If so, are they in fact independent contractors? The IRS remains determined to stop the misclassification of workers as independent contractors as opposed to employees. Generally, employers withhold income taxes and pay certain taxes on behalf of the employees. By classifying your employees as independent contractors, you become relieved of all of these obligations and place the responsibility to pay taxes on the employee, which usually causes the IRS to lose money.

What if I have a misclassified employee?

Like the DOL, the IRS wants to work with you in order to help everyone become compliant with federal laws. It follows that the IRS has provided two common methods to avoid or mitigate liability for misclassification: “Section 530 Relief” and the Voluntary Classification Settlement Program.

  • Section 530 Relief is designed to protect employers who have had a reasonable basis for classifying an employee as an independent contractor and have consistently treated them as such. Even if the IRS might not classify an individual as an independent contractor, if an employer does so following judicial precedent, common practice within the industry, prior IRS examination, etc. then the employer might be able to escape liability altogether.
  • The Voluntary Classification Settlement Program (“VCSP”) can allow employers to receive partial relief from federal employment taxes as well as reclassify independent contractors to normal employees. Here, as long as the employer follows several steps outlined by the IRS, the employer can avoid all liability and penalties for misclassification of employees.

If you have any questions or concerns about classification of your employees, including misclassification and remedial measures, or if you have received a notice that you are being audited by the IRS, please contact our office to speak with an experienced labor and employment attorney.

Industrial Commission of Arizona – Labor Department

Like the DOL, the Industrial Commission of Arizona (“ICA”) also has broad power over multiple issues related to workplace safety and workers’ compensation. Specifically, the ICA is tasked to oversee “labor related issues regarding occupational safety and health, youth employment laws, resolution of wage-related disputes, minimum wage, vocational rehabilitation, and worker’s compensation coverage.” While the ICA might select you randomly as a part of a routine audit, it is often more likely that the audit has come as a result of a complaint to the ICA by a past or current employee or a third party.

Because the audit is being performed by a state agency, it will probably be more focused in nature. For example, the ICA commonly audits to determine why an employer is not paying workers’ compensation premiums. Other than that, the audit will be quite similar to the DOL investigation described above in this article. To help you comply with an ICA before you even receive actual notice, here are a few compliance subjects that the ICA has taken special interest in over the last couple of years due to recent changes in Arizona law:

Earned-Paid Sick Time

In November 2016, the Fair Wages and Healthy Families Act was passed through a ballot initiative. In addition to establishing an increasing state minimum wage and stronger paid sick leave laws, the act created retaliation provisions for employers who failed to comply. Under the paid sick leave laws, an Arizona employee is entitled to accrue one hour paid sick leave for every thirty hours worked.3 Given that this law is new, the ICA is likely to heavily prioritize paid sick time and minimum wage in their auditing in the near future. If you are not giving your employees the paid sick time they are entitled to under Arizona law, then you will likely be subject to penalties and fees by the ICA.

Minimum Wage

Arizona workers who are not otherwise exempt from the state’s minimum wage requirements have been required to pay their employees a new minimum wage from 2017 on and is overseen by the ICA. The Fair Wages and Healthy Families Act implemented incremental increases to the minimum wage as follows:

  • $10.00 per hour from January 1, 2017 and on ($7.00 per hour plus tips for tipped employees);
  • $10.50 per hour from January 1, 2018 and on ($7.50 per hour plus tips for tipped employees);
  • $11.00 per hour from January 1, 2019 and on ($8.00 per hour plus tips for tipped employees);
  • $12.00 per hour from January 1, 2020 and on ($9.00 per hour plus tips for tipped employees); and,
  • Continued incremental increased based on the cost of living on January 1st of each following year.

If you are a non-exempt employer and you do not follow the minimum wage requirements above, then you are not in compliance with Arizona law and likely have a high chance of being audited.

Tipped Employees

Under the Fair Wages and Healthy Families Act, employers are allowed to pay tipped employees no less than $3.00 an hour less than non-tipped employees as long as the tipped employees earn at least minimum wage for all hours worked each week with tips included. According to the ICA website, if an employer elects to exercise this provision, he or she must:

  • “Provide written notice to each employee prior to exercising the tip credit.”
  • “Be able to show that the employee received at least the minimum wage when direct wages and the tip credit are combined.”
  • “Permit the tipped employee to retain all tips, whether or not the employer elects to take a tip credit for tips received, except to the extent the employee participates in a valid tip pooling arrangement.”

When an employer fails to comply with Arizona laws, such as The Fair Wages and Healthy Families Act’s, through bad recordkeeping, posting, or other requirements, then that employer is subject to civil penalties, special monitoring, and further inspections. For more information on how to comply with Arizona law with regards the ICA, visit the ICA website. If you have any additional questions regarding potential noncompliance or auditing, give our office a call today to speak with an experienced labor and employment attorney.

Arizona Department of Economic Security

Some employers are surprised when they receive a call or a letter regarding an intent to audit from the Arizona Department of Economic Security (“DES”). Such audits are routinely conducted on Arizona employers on a random basis in order to “investigate issues regarding the status of individuals as employees and the designation of payments as wages to ensure proper payment of taxes.”4

If you are selected to be audited by the DES, the auditor will first interview you as the representative of the business to verify ownership and learn more about the type of services performed there. The auditor will then review the financial records of the previous year in order to find discrepancies or instances where unemployment taxes have been fully paid. Being audited by the DES is perhaps the clearest investigation of all, however, it will not end well if you are not properly paying your taxes. For more information about audits by DES, visit the DES website or give our office a call today.

We get it, no one likes to be audited. Regardless of your distaste for agency audits, it will happen to you and your business at some point and noncompliance with major provisions of federal or state law could ruin your reputation and empty your wallet. Our advice to you is to prepare for an audit today like it is coming next week. If your business is being investigated or audited by the DOL, the IRS, the ICA, DES, or any other agency (even if the acronym is more or less than three letters long!), contact our office today to strategize with one of our experienced labor and employment attorneys.


1 See A.R.S.§§ 23-101 et seq., 23-201 et seq., 23-901 et seq., and 23-521 et seq.
2 In addition to certain employment benefits, the DES is also responsible for much more: nutrition assistance, health insurance, financial support, etc
3 The law applies to all employees who are full-time, part-time, temporary or on-call with a small business concession. While large employers with at least 15 employees can’t cap accruals until they reach 40 hours, smaller employers may impose a 24-hour accrual cap.
4 See Arizona Department of Economic Security Website.

Approved By:

Brad Denton, Business Lawyer
Denton Peterson, PC

1930 N Arboleda #200
Mesa, AZ 85213

Office: 480-325-9900
Email: [email protected]

Title VII of the Civil Rights Act of 1964