California businesses should be cautious about how they classify their workers. Whether a worker ought to be classified as an independent contractor or an employee can be a tricky business that is carefully scrutinized by the IRS during audits. It is explicitly stated in the IRS's Audit Techniques Guide that worker classification is an area auditors are expected to check into.
If an independent contractor is required to be reclassified as an employee due to an audit, the business owner could potentially end up owing additional taxes to the IRS, not to mention penalties and interest. It would be wise for California business owners to ensure they do not classify a worker as an independent contractor instead of an employee solely to save money. Unfortunately, the difference between an independent contractor and an employee is not clearly defined by the IRS tax code. Auditors will likely take this into consideration and look at each case independently.
There are certain things that alert auditors to look more closely. One thing that may raise a flag is the case of a business rehiring a previous employee as an independent contractor. While it may be a completely legitimate re-hire, it could be interpreted as a warning sign during audits and cause an auditor to look into the matter more closely.
If using independent contractors, companies should ensure that 1099s are always issued and that the contractors offer a different service than what the company provides. Auditors will look at how much supervision is involved and whether or not hiring independent contractors is common practice for whatever industry you are in.
Business owners in California should make certain they are prepared to defend their classification choices during an audit. Having an IRS determination letter approving an independent contractor hire is always helpful. And if penalties are assessed, then having proof that your 1099s were sent out and that you truly "acted in good faith" when making your classifications will go a long way.
Source: Fox Business, "What Auditors Look for: Independent Contractor vs Employee," Bonnie Lee, June 8, 2012