Misclassifying workers as “independent contractors” can trigger serious IRS scrutiny. The IRS now closely monitors companies for red flags – for example, a business that issues multiple Form 1099s while issuing relatively few W-2s may invite a high-risk employment tax audit. The IRS’s common-law “control” test (roughly the traditional 20-factor analysis) and the Department of Labor’s broader “economic realities” test often lead to the same result: if a worker looks like an employee, treat them as one. Under the IRS test, if the company dictates how and when work is done, the worker is likely an employee & thus subject employment taxes and income tax withholding. (The DOL’s FLSA standard is even broader – most workers end up classified as employees under that test.) In light of aggressive enforcement by both federal and California state tax agencies, businesses must carefully follow the rules. This involves understanding the law, documenting your relationships, and structuring contracts and pay practices to minimize the risk of worker misclassification. The goal is to avoid employment tax audit triggers in the first place; however, if an employment tax audit arises, to be prepared with strong documentation and experienced representation.
It would be helpful to understand the following legal tests:
IRS Common-Law Test (3-factor approach)
The IRS looks at three categories of evidence – behavioral control, financial control, and the nature of the relationship – when classifying workers. Behavioral control asks whether the company controls or has the right to control how the worker does the job (schedules, instructions, training). Financial control considers who pays the worker’s business expenses, who provides equipment, and how the worker is paid (project vs. salary, significant investments, etc.). The type of relationship is determined by written contracts or benefits, whether the relationship is permanent or project-based, and whether the work is a key aspect of the business. No single factor is decisive; IRS examiners weigh all relevant factors together and expect employers to document their analysis. (In short, if you tell a worker exactly how to do the work, require full-time hours, train them like an employee, and pay them a salary, the IRS will likely treat them as an employee.)
California ABC Test (AB-5/AB-2257)
California presumes almost all workers are employees unless all three of the following are true: (A) the worker is free from the hirer’s control both under contract and in fact, (B) the work is outside the usual course of the hiring entity’s business, and (C) the worker is customarily engaged in an independently established trade or business of the exact nature as the work performed. In practice, that means a delivery driver working for a restaurant is an employee (the work is part of the restaurant’s business). In contrast, a plumbing contractor hired ad hoc is independent (plumbing is outside the restaurant’s business). California’s test (established in Dynamex and codified in AB-5/2257) is rigorous – most workers are considered employees unless they are clearly independent. Notably, California still recognizes the older Borello multifactor test in certain exceptions. S.G. Borello & Sons v. DIR (1989) treated employee status as the default and used a “totality of circumstances” analysis with no single controlling factor. Under AB-2257, Borello’s multifactor test now applies in limited categories (certain licensed professions or actual business-to-business relationships), but outside those exceptions, the stricter ABC criteria prevail.
Voluntary Classification Settlement Program (VCSP)
The IRS offers a prospective relief program called the VCSP for employers who realize they need to reclassify contractors as employees. By applying for the VCSP (Form 8952) and paying a modest penalty (usually 10% of the employee’s FICA taxes for past years), a company can avoid the full payroll tax liability that a routine audit would impose. This is a valuable option before an audit, but it requires the company to reclassify workers and meet the eligibility rules promptly. Likewise, California has a voluntary “catch-up” program for AB-5 (Labor Code § 2753) that allows limited remission of payroll taxes if certain conditions are met (for qualifying worker groups up to $10,000 per worker).
Form SS-8 and Form 8919
When classification is unclear, IRS Form SS-8 (“Determination of Worker Status”) may be filed. If you file Form SS-8, the IRS will eventually issue a determination – but be aware it can take 6+ months, and any determination can expose misclassification to audit. (Proactively filing SS-8 is a double-edged sword: it provides official clarity but invites scrutiny.) Likewise, if a worker believes they were misclassified, they can file IRS Form 8919 to report the uncollected employee-side Social Security and Medicare taxes on their return. An 8919 filing or an SS-8 request by a disgruntled contractor usually triggers an IRS look at the employer’s records, so the best defense is to ensure the classification is correct before any worker complains.
These federal tests and programs are supplemented by California state tax enforcement. For example, the Employment Development Department (EDD) treats any unemployment or workers’ compensation claim by a contractor as a red flag. A contractor claiming UI or SDI benefits essentially signals to the EDD that they were, in substance, an employee, as contractors generally aren’t eligible for these programs.
Avoid Audit Triggers: Common Red Flags
IRS and California state tax agents don’t audit companies at random. Certain “triggers” often draw attention. To avoid an audit, businesses should carefully avoid these pitfalls:
Mixed Tax Forms (W-2/1099 Confusion)
Paying the same person sometimes as an employee (W-2) and sometimes as a contractor (1099) in the same year invites scrutiny. If someone is doing the same work but the paperwork is switched, the IRS will ask, “Why weren’t they always on payroll?” Similarly, paying workers “under the table” (i.e., without a W-2 or 1099) and later having them apply for benefits raises criminal tax red flags for aiding and abetting the income tax evasion of a worker. In short, consistency is key: classify and report each worker’s status consistently.
Contractor Benefit Claims
As noted above, any claim by a purported contractor for unemployment, disability, or workers’ compensation benefits can spark an investigation. These claims often prompt state agencies to conduct audits of the company. Contractors cannot collect unemployment or workers’ comp if they truly worked as contractors, so if they do, auditors assume misclassification.
Worker Complaints and Whistleblowers
Disgruntled workers are among the most common sources of audit complaints. If a worker feels underpaid or deprived of benefits, they may report the issue to the IRS, the Department of Labor (DOL), or their state labor board. Whistleblower complaints will lead DOL or state labor investigators to examine the business’s records. The IRS may also get involved if back taxes are at stake.
Analytical Anomalies
The IRS uses data analytics (like DIF scores) to detect unusual patterns. Some examples of risky patterns: a company reporting substantial contractor payments relative to wages (especially in roles that seem integral to the business) or inconsistencies between expenses deducted and reported employment taxes; Paying many individuals in cash with no tax reporting is a notorious red flag. If you run any of these scenarios, expect heightened IRS attention. Moreover, remember that federal and state agencies share information: a misclassification finding by California’s EDD can trigger an IRS audit and vice versa.
To avoid these triggers, businesses should take a proactive approach. For example, if you hire a long-term worker who fits an employee profile, seriously consider issuing a W-2 and properly withholding taxes – especially in California under AB-5. If the work is truly a one-off project, ensure your relationship meets all the contractor criteria (see below) and maintain documentation to prove it. Maintain consistent tax filings (don’t flip between W-2s and 1099s without good reason). And never ignore a contractor’s benefit claim – if one arises, address it immediately (ideally by consulting experienced dual-licensed tax attorneys and CPAs) rather than waiting for the tax agency to start investigating.
Document, Contract, and Report with Precision
Solid paperwork is your first—and often best—defense against a worker classification audit. For every independent contractor, maintain a complete file: signed IC agreement, Form W-9 (with EIN), proof of business license or liability insurance, and the contractor’s invoices, payment records, and project correspondence. Store these documents under a consistent naming convention so they can be produced instantly if an IRS or EDD examiner calls. At least once a year, run an internal compliance audit: pull every 1099 vendor, verify that written agreements exist, and confirm each contractor operates a bona fide business (own tax ID, outside clients, independent tools). A cross-functional team—comprising HR, legal, finance, and compliance—should vet new engagements and flag potential red flags, such as long-term, full-time contractors who appear indistinguishable from employees. Use a standardized contract template that (1) defines deliverables, not hours; (2) states the contractor controls how work is done; (3) requires the contractor to pay all self-employment taxes and carry insurance; and (4) mandates a W-9 before the first payment. A clear, well-drafted agreement will not override reality, but it shows intent and can tip the scales in a close audit.
On the payroll and reporting side, maintain consistent treatment. Pay contractors by discrete invoice or milestone, never through your payroll system. Avoid time-clock requirements, fixed schedules, or exclusive-service clauses. Issue Form 1099-NEC for every contractor paid $600+ by January 31 and withhold and report taxes on a W-2 for anyone who belongs on payroll. Never switch a worker back and forth between W-2 and 1099 status for the same services. If you are unsure, classify as an employee—extra payroll tax today is cheaper than penalties tomorrow. Remember: the IRS’s analytics will compare your wages, 1099 totals, and business deductions year-by-year. Inconsistent or missing filings are an immediate trigger for an audit.
Finally, know and assert Section 530 Safe-Harbor protection if it applies. This provision can erase employment-tax liability even when workers were technically misclassified—but only if you meet all three prongs:
- Reporting consistency: All required 1099s were filed for the worker each year.
- Substantive consistency: You (and any predecessor) have never treated a substantially similar worker as an employee since 1977.
- Reasonable basis: You relied on prior IRS audit results, established industry practice, published authority, or competent professional advice.
If you can document those elements, raise Section 530 at the start of any audit; examiners are required to consider it, and it can shut down back-tax assessments and penalties entirely.
If a High-risk Tax Audit Looms: Preparation is Key
Sometimes, despite best efforts, an IRS employee-classification audit notice arrives. If that happens, respond quickly and calmly:
Gather Records Immediately
Collect all documents relating to the workers in question and similar positions: contracts, signed W-9s or W-4s, invoices, expense reimbursements, bank statements showing payroll deposits, canceled checks, and your bookkeeping ledgers. Be prepared to show Forms 1099 and W-2 for the relevant years. The more complete your documentation, the better you can tell your side of the story. At the tax law offices of David W. Klasing, we emphasize having all employment records ready: “financial statements, bank records, income tax returns, credit card statements, [and] copies of checks” may be requested. Keep them well-organized by year and by employee or contractor.
Designate a Single Point of Contact
Handle the audit through one knowledgeable person (or hire counsel). Multiple uncoordinated responses can look chaotic. Having a dual-licensed attorney & CPA liaise with the IRS can help ensure nothing important is missed and deadlines are met. Failing to respond promptly to IRS inquiries may give the impression that you are seeking to hide information. A professional representative knows exactly what information to provide and can negotiate scope where appropriate.
Cooperate with the Auditor
Literally “make it easy” for the examiner. Provide the requested documents promptly and in the requested format. Be honest about your policies and any mistakes. If the auditor requests to interview workers, suggest scheduling convenient interviews rather than stonewalling. Hiding records from an auditor (for example) will only cause more trouble. In contrast, full cooperation can sometimes earn the IRS or auditor’s good-faith consideration.
Consult a dual-licensed Tax Attorney & CPA Right Away
Once the audit notice arrives, get professional help immediately. Tax attorneys (especially those who are also CPAs) can help formulate a strategy – for example, whether Section 530 or VCSP applies or whether to concede specific points. They can question improper audit demands and ensure you invoke all legal defenses (such as safe-harbor relief). Above all, experienced counsel can prevent statements or actions that inadvertently exacerbate matters.
Even after an audit begins, remember that you have rights and options. You can appeal any unfavorable IRS findings, including going to IRS Appeals or Tax Court if necessary. Having a dual-licensed attorney-CPA on your side ensures someone understands both the law and the numbers.
Contact the Tax Law Offices of David W. Klasing to Avoid an IRS Worker Classification Audit
At the tax law offices of David W. Klasing, our team is composed of award-winning dual-licensed tax attorneys and CPAs having earned advanced tax degrees. David W. Klasing himself is part of an elite group of an estimated 3,000 professionals nationwide who hold both a law license and a CPA credential, having also earned a master’s degree in taxation. This dual expertise enables us to understand both the tax accounting implications and the legal standards governing worker classification.
We proactively help clients avoid classification audits in the first place. We can review your worker policies and contracts, advise on borderline cases, and assist in designing the documentation program outlined above. If we identify any problem areas, we recommend taking corrective steps (such as applying for VCSP or adjusting future hiring practices). Our firm stays current on both federal and California law (including AB-5/2257 and Borello exceptions), so we can guide you in structuring roles that meet all applicable criteria. Crucially, we also help implement compliance controls: for instance, we might provide training to your HR staff on classification red flags or templates for independent contractor agreements.
If a high-risk tax audit does occur, our attorneys swing into action. We assist with preparing for the audit by examining your employment records to determine any errors or noncompliance that are very likely to become the focus. In practice, this means we gather and analyze the same documents that an auditor would want, and we advise on how to explain any gray areas. During the audit, we work to present your case clearly to the IRS or California state tax agents. Our dually-licensed attorneys-CPAs have extensive experience working with clients who were facing audits or far worse criminal tax investigations. We negotiate on your behalf to limit penalties (for example, by qualifying for Section 530 relief or reaching an abatement agreement if possible). By combining legal strategy with accounting precision, we aim to minimize any assessment and protect your personal liability.
Call the tax law offices of David W. Klasing at (800) 681-1295 or book a confidential, reduced-rate consultation online HERE.
