(FORTUNE Magazine) – After more than a decade as an executive publishing computer magazines, Jay Whitehead, now 34, in October 1985 suddenly found his world falling apart. That's when the state of California launched the first of six employment audits of the magazines he worked for. Alerted by California, the IRS soon joined the chase. Between them the state and the feds have slapped the publications, among them PC Magazine and Computer Register News, with fines and penalties totaling $2.85 million -- so far. As a principal of three of the hunted firms, Whitehead personally faced liabilities of over $300,000. ''It was a life-shattering experience,'' he says. Could this happen to you? You bet. Like many in his industry, Whitehead and his colleagues relied on a regular stable of temporary writers, art directors, and photographers. Their sin wasn't trying to hide the income they paid out to these people. They reported every dime. Their mistake was using the wrong form, the 1099s sent out to independent contractors rather than the W-2s mailed to regular employees. To the taxmen, who collect withholding and other employment taxes from W-2s but not from 1099s, hiring part-timers to do jobs also filled by permanent workers -- but accounting for them differently -- is a tax error that costs the federal government alone $2 billion a year in lost revenues. Aware of the growing market for temporary and freelance work and eager to get its due, the IRS since the mid-1980s has been cracking down hard on companies that misclassify contingent workers. The tally so far: $678 million collected in fines and back taxes, and some 439,000 independent contractors recategorized as full-time employees. Any business, large or small, can be at risk. But the IRS is especially interested in temp-intensive industries such as publishing, entertainment, telecommunications, advertising, software, and construction. How can you avoid getting hit? The law can be pretty vague, but here's one handy rule to remember: Send 1099s only to people who truly work out of the office. Provide a phone and a desk for more than a few days to someone who does tasks similar to those your regular staff perform, and you'd better withhold taxes and send that person a W-2. Another red flag: hiring back former employees or retirees on a contract basis. Again, consider those folks employees, not freelancers. Still uncertain about a worker's true tax status? Here's another solution: hire part-time or self-employed staff only through an outside agency. That hoists the risk onto someone else's shoulders -- and lets him deal with the hassle of distributing paychecks and paying income and employment taxes. Convinced by his own unfortunate experience that such a service could prove a booming business, Jay Whitehead in early 1993 reinvented himself as head of a new division at Uniforce, a California temp agency. Known as Payroll Options: The 1099 Compliance System, Whitehead's operation promises to make any company IRS-audit-proof -- at least when it comes to misclassifying workers. His toll-free number is -- what else? -- 1-800-291-1099.