There is no statute of limitations on fraud so if the 1099 was fraudulently issued, you very well may have an action. And regarding the IRS and State, those issues can be resolved but will likely take some time. This is something you should retain counsel for. Both CA and IRS won't stop until they're satisfied with these size of amounts. Would also strongly recommend you not provide any further information via this public forum. Call or email if you want to discuss further.
Evan A. Nielsen is licensed to practice law in California and handles federal tax matters throughout the U.S. The information provided here is for educational purposes only and is not intended as legal advice for a particular matter. This response does not create any attorney-client relationship with the author. For specific advice about your particular situation, please consult an attorney.
Mr. Nielsen has given you good advice: retain experienced counsel and do not give more details over an internet site. The information you have provided is far too specific to you.
You now face a large problem of proof. First, the state of California, as I am sure you have read, is having severe financial difficulties. The very nice people at the California Franchise Tax Board are forced to take days off, without pay. As you can imagine, that does not make them happy. As you can imagine, the California Franchise Tax Board does not easily give up on the idea that people owe taxes. You will find out that you will not prevail in an audit, because you have already had your chance at an audit, as far as the FTB is concerned. You will probably not get a chance to go to the level above the audit, which is Protest. In any event, you would have a tough time there. You probably do not want to go to Settlement, because all you could get is 50 cents on a dollar, even if you had a very strong case. Although, if you have a case that they can't collect, settlement is a possibility. You will not be able to get to the State Board of Equalization, which is a place where you might have a decent shot if you can develop the facts. So, you are left with a collection matter, which will be unpalatable if you have significant assets. Or you have to figure out some way to reopen the matter administratively. For that it is not what you know, but whom you know.
It is somewhat easier to deal with the IRS. If you didn't have a chance to argue about this in the first place, you may get your chance now. Do not delay another day. Give us a call now and start working on these problems. It it is going to take a year at least to put these two to bed - and possibly twice that long. And it is going to cost more than $100.