Whenever the Internal Revenue Service starts sniffing around a particular area, it pays to take preventative action. One area the tax agency is poking around these days: How businesses go about classifying workers as independent contractors. In particular, the IRS is looking into the practices of small and midsize businesses.

Earlier this year, the IRS launched a national research program into the matter and how it impacts the U.S. tax gap – the difference between how much the government collects in taxes each year, and how much it thinks it should be collecting. By auditing 6,000 randomly-selected businesses across the country over a three-year period, the program is designed to measure the level of compliance with respect to worker classification within that group.

The audits will focus on whether a company's independent contractors should actually be treated as employees. If you misclassify an employee as an independent worker, you're on the hook for unpaid income taxes, federal unemployment taxes, and FICA withholdings.

The government will then use that data to compute the employment tax gap and to focus its audit efforts on the most noncompliant employment tax areas, according to Edward Froelich and James Merritt, attorneys in the Washington, D.C., office of law firm Morrison & Foerster.

The last time the IRS conducted a similar audit was 25 years ago when the agency concluded that the share of the tax gap that could be attributed to misclassification was roughly $1.6 billion. 'There is a sense that [misclassification tax gap] is a lot bigger now because of time and because of the way that technology has changed the worker relationship,' says Froelich. 'There are a lot of new ways of doing things, ways to be at home and work.'

Indeed, independent workers constitute a growing part of the U.S. workforce.

The audits are expected to be thorough and time-consuming and may run concurrently with an income-tax audit—or could result in an income-tax audit if the IRS finds something worth a closer look.

Here are some best practices when it comes to classifying independent contractor and what to do if you end up the target of such an audit:

Worker Classification Tax Audits: What You Can Do Now

1. Review Your Contracts. Unless you're dealing with someone that's a well-recognized independent contractor – such as a lawyer, accountant, or building contractor – you'll want to execute a written contract with each independent vendor that spells out that he or she is a contractor, advises Merritt. Additionally, you'll want to require him or her to file all the appropriate tax returns that an independent contractor should.

The IRS uses a 20-factor test to size up whether a worker is an employee or an independent contractor. Unfortunately, the test is vague at best. Still, it's a useful guideline for requirements you might include in a contract.

For example, the contract could specify that the worker is expected to pay his own expenses or that he doesn't have to work at a particular location. You should set out the goals the contractor is expected to accomplish, but let him or her figure out how the work will get done. All of these elements will factor into the test, Merritt says.

A contract alone won't protect you, however, as the IRS and tax courts don't accept the written contract as being determinative. Just because a contract says something doesn't mean that's the actual relationship.

2. Employ Experienced Contractors. Another way to protect yourself, Merritt says, is to avoid providing the worker with any training. That is, you should hire people who already know what they're doing. Also, you should have the contractor bill you on a regular basis to create a paper trail. Finally, one small symbollic gesture: make sure your  contractor has his or her own business cards, too.

3. Document Why You're Treating a Contractor as Such. The safe harbor provisions of section 530 of the Internal Revenue Act of 1978 provide the best defense against an audit. According to these provisions, a taxpayer must satisfy three criteria to be eligible for safe harbor treatment:

  • There was a reasonable basis for treating a worker as an independent contractor. (Reasonable basis can be shown through judicial precedent; past IRS audit treatment; long-standing industry practice; and other reasons, including reliance on the advice of a qualified tax professional.)
  • Workers with substantially similar positions must be treated consistently.
  • A taxpayer must have filed all required federal tax returns consistently with its treatment of the workers.

If you can show that the 530 safe harbor applies, you're done with an audit most of the time. Documenting the information that leads you to conclude that a person is an independent contractor is a smart move. A written letter or opinion from an adviser, such as a lawyer or accountant, stating the reasons why the worker qualifies as a contractor should suffice. Having a file on hand containing correspondence with advisers, the legal precedents relied upon, and even what you know about industry practices can go a long way in heading off an audit.

Worker Classification Tax Audits: What You Should Do During

1. Be Timely. If you do get audited, hopefully you've taken some of the aforementioned steps. If not, put on your bravest face and push forward. 'A best practice is to try to get off on a good foot with the agent when there is an examination,' says Merritt. 'Be timely and get your act together.'

If you've got a big mess of documentation, you're probably not going to get back to the IRS agent in a timely fashion, which will lead him or her to believe you're stalling for time. Instead, you ideally want to convey the impression that  your documentation is in order and that you knew what you were doing when you classified a worker a particular way. In short, take a confident approach.

2. Have Worker Contacts Ready. In the event of an audit, an IRS agent is going to want to talk to your workers to see if they confirm what you say. 'The reason is, many worker classification audits in the past originated when somebody that was an independent contractor wasn't working anymore so they filed for unemployment benefits, which you only get if you're an employee,' says Merritt. 'So they file forms saying that I was in fact an employee and that can trigger an audit.'

Of course, getting information from a worker at the beginning of an audit can be a tricky thing. They might not be timely or want to get involved, sometimes due to immigration status concerns. Take a moment right now to decide which one or two workers would be good witnesses for you, and include information from and about them in your file.

3. Be Ready For What They Already Know. Has your company been sued by employees over benefits in the past? If so, be prepared to answer questions about the litigation. 'It's very likely that [the IRS agent] has already done some research and maybe has a certain view of how you do things in terms of your workers,' Froelich says.

4. Remain Calm. This is going to take awhile and be a distraction, and losing your cool won't help. Because these audits are part of a research project, the agent is going to pursue the audit until all the data required is collected, even if it looks like you've correctly classified your workers. And since the audit is likely to last six to seven months, you'll probably want an intermediary like a tax adviser or lawyer to handle the probing.

Merritt says: 'Be patient and bear in mind that you may be okay, but they're going to get all the data anyway, so you might as well do everything you can to make it less painful for yourself.'