If they were audited, a large percentage of the salon owners in the beauty industry today could not pass the tests determining their workers’ tax status imposed by the IRS or by their individual state, says our expert. As tax time approaches, know the facts. The financial fall-out from misclassifying your staff can be devastating.
Employees, booth renters, or independent contractors — how do you choose? More importantly, have you made the right choice? And what are the consequences if I have placed your workers into the wrong categories? Most people in the nail industry are categorized as self-employed. (According to NAILS 2004-2005 Big Book, more than 70% of nail techs categorize themselves as salon owners or booth renters.) The real question is, which category do they belong in as far as the IRS is concerned? Consider that, if you have placed these individuals into the wrong category, it can affect you from a business and personal perspective.
Here are some facts that affect the life of every salon owner who has a staff, especially if you call them booth renters or independent contractors. In a meeting with the IRS in North Carolina (the head office of written educational compliance) some months ago, the message was clear to this salon management consultant: The IRS is, and will be, concentrating on auditing the beauty and barbering industry after April 15, 2005. The reason is clear. The government is broke and is out to collect as much unreported income as it can from every industry — especially the beauty and barbering industry because of the amount of cash our industry deals with. The bottom line is the IRS would prefer to see everyone in an employee/employer relationship rather than so many self-employed individuals because employees tend to pay a higher proportion of their income in taxes than self-employed individuals.
The most common mistakes most salon owners are making are in regard to creating titles for their staffs. The reality is the IRS and your individual state do not care what you call them. These agencies are interested in one thing and one thing only: Who has the ultimate tax responsibility? (Who is going to have to pay the money that is justly owed?) So let’s look at the distinction between an independent contractor and a booth renter from an owner’s perspective. There are guidelines available in each category that will protect all parties involved if the business relationship is set up correctly. Otherwise the results can — and will — be devastating financially and emotionally.
There is a major difference in how these two business categories should be set up and run as a business. So let’s break each category down to its simplest form to help you understand how each structure is different so you can choose which one is best for you. Or restructure your business to protect your investment before it’s too late.
Booth renting, as it is known in our industry, is a completely different structure than had existed in any other industry. In the past, the IRS only had tax auditing guidelines in the area of contract labor for non-employees. Each year, the IRS does more research and is becoming more aware of how we operate our salons, spas, and barbering businesses. They have settled on three factors to determine if someone is actually an employee or a booth renter and who has the tax responsibility: 1. Who has financial control? (Does the technician have s significant investment in her work and can she realize a profit or incur a loss?) 2. Who has behavioral control? (Does the salon owner have the right to tell the tech how to do her work?) and 3. What is the relationship between the parties? (Does the tech receive any benefits? Is there a contract for her services?) Your written contract should make that separation clear in all three categories. This is where 90% of the beauty industry is in trouble without even realizing it.
I believe that most owners/landlords and renters could not pass an audit today because of the lack of any written structure that makes the separation between the owner/landlord in these three crucial areas. Most salon owners set up their own businesses based on how the people they previously worked with did it, duplicating the same potentially costly mistakes, especially when it comes to the day-to-day operations of running a business.
Here’s the major difference between a booth renter and an independent contractor: A booth renter usually works in one business location even though she could work outside of the salon. She pays a flat rate of rent, usually monthly. She collects her own income for services rendered to clients. And at the end of the calendar year, the booth renter provides the owner/landlord with a tax form 1099 for rent paid, assuming the rent was $600 or more. This would be for all rent paid to the nail owner during the tax year unless the owner is incorporated. This booth rental structure is completely different than an independent contractor situation.
No salon, spa, or nail business should enter into this kind of agreement without having a contract that very clearly creates the separation of the two parties tax-wise.
The contract labor category — and independent contractor status — was created out of the need to categorize someone who did not fit the traditional employee category in order to track the payment of income for tax purposes. In general, people in a contract labor position provide services that are NOT on ongoing projects at the same location. The service they provide is usually for a short period of time. They have no regular set hours or days in performing those services. At the end of the calendar tax year, the salon owner provides a tax form 1099 for the amount of money paid to the independent contractor (if the amount was more than $600 within that given tax year). The independent contractor (like a booth renter) would then be responsible for paying her own income tax and self-employment taxes.
The first step in these types of business relationships is to set up a legal, industry-related contract that is dated and signed by both parties. Every smart business owner knows that the contract, if drawn up correctly, will in fact prove who has the ultimate tax responsibilities and in what areas. Beyond tax issues, a contract will resolve a lot of potential problems in many areas. If the independent contractor is working on site for a temporary period of time, the contract should set out the business hours and days the establishment is open.
Another important issue in the contract is insurance. Every contract between a salon owner and an independent contractor should include a clause that the independent contractor must show proof of insurance. This is yet another way to show the separation of the two different business entities.
According to the IRS, a business owner can collect all the revenue at the front desk for services that an independent contractor provides for the salon. That means that in the contract there needs to be a clause that clearly shows how the independent contractor will be compensated for providing those services. The negotiation process could be a flat dollar amount for services provided or a percentage or commission. What you need to remember is the government agencies are looking at this relationship as short-term.
The most common mistake we see in the beauty industry is making someone an independent contractor to avoid tax responsibilities and reduce operating overhead. The problem with this is most of the people categorized as such are actually in the salon on a regular, ongoing basis. This would lead the IRS and the state to believe you, as the nail salon owner, in fact have employees. If this happens, the salon owner could be stuck paying back taxes for the period of time for which they where audited. On top of that, there would most likely be penalties and interest added on.
Remember, the real issue is that an independent contractor is a temporary arrangement with a start date and an end date specified within the contract. In other words, with no legal written contract, you probably have employees. And that means past tax obligations will be due.
From the IRS Perspective
Eight years ago, the IRS created a division to oversee cash-based businesses, including the beauty industry. Now the IRS has a tax compliance division solely for the salon, spa, and barbering industry and it has organized several areas of that compliance. First, it has been teaching tax compliance workshops at all the major trade shows to make us aware of our tax responsibilities as employers, employees, and self-employed booth renters or independent contractors.
Several years ago the IRS created a manual to audit the beauty and barbering industry. Did you know most audits occur three years behind the current tax year? The auditing agents do not care what hat you are wearing or what title you have given yourself or your staff. In an audit, they will ask three main questions: 1) How many hours and days of a week are you open? 2) What do you charge for services? 3) How much time do you allow for an appointment? They will retrieve your banking records to uncover, among other things, the tip percentage and any other income you should have declared. From the booth rental and contract labor side, all of the same rules apply with the exception that the IRS wants to see a clear-cut separation between the business owner/landlord and the booth renter —meaning a copy of your contract. Using the issue of tips to open the doors, the IRS can use the same information to determine if a tech has been improperly classified and to determine who has tax responsibility.
So here is their plan of action. The IRS and most states are looking to have you declare anywhere from 7.5% to 20% of your income as having been derived from tips or gratuities. The IRS thinks they are losing between $17-$20 million from unreported income based on a study several years ago. They believe a large portion of that revenue loss is derived from unreported tips and other sources that are unreported regardless of one’s title.
Our industry shifted into the booth rental market in the early 1990s because of two distinctive reasons — the economic recession and the major shortage of people entering the beauty industry. This booth rental explosion caught on so fast because it was a way to save salon owners from losing everything they had worked so hard for financially in their lives. The high commissions paid to employees and the taxes that an owner had to pay left very little revenue for survival.
Today, many business owners may have their staff misclassified tax-wise. Not only can this be financially devastating in terms of the amount of money owed in back taxes, penalties, and interest that would occur from an audit, the government agencies will demand that you make all those misclassified individuals employees immediately. What do you think most of those staff members will do? Our educated view is that they will leave your establishment because they also can and will be audited.
From a business point of view, there is no wrong choice when it comes to staffing your salon. Depending on the individual salon, having employees, independent contractors, booth renters, or a combination, can be appropriate. But when it comes to the IRS, you can make the wrong choice if you don’t structure you business relationships in accordance with the tax laws.
Ken Cassidy is president of Kassidy’s Management Consulting Company, based in Long Beach, Calif.
He welcomes your questions and comments. You may reach Kassidy’s Salon Management Consulting Company at (562) 432-4462, fax (562) 439-6692, e-mail [email protected], or visit kassidys.com.
A Plea to the IRS
This management educational consultant has traveled all around the United States and found that in all levels of our industry most people want to do things correctly. Salon professionals are good, law-abiding citizens. They just need to know what the rules are so they can comply. We have repeatedly requested in writing from the IRS what is meant by the confusing statements they have published. Agents of the IRS, isn’t it time you did your part as leaders so we can be clear how to follow? We need to understand the rules. Is that to much to ask for? Almost all current written material in the area of booth rental and contract labor is misleading or unclear.
As an industry we need to be united. The best way is through great organizations nationally and through your own state. Get involved in the political movement or donate funds to help support the people who are trying to support you and our industry, such as TSA, Professional Beauty Federation (especially the California chapter), NCA, and your own state chapters. - by Ken Cassidy
If you are an employee…
Your employer must withhold social security and Medicare taxes. Also, your employer is responsible for paying Social Security, Medicare, and unemployment (FUTA) taxes on your wages. Your employer must give you a Form W-2, showing the amount of taxes withheld from your pay.
You may deduct unreimbursed employee expenses on Schedule A of your income tax return, but only if you itemize deductions and they total more than 2% of your adjusted gross income.
If you are an independent contractor or booth renter …
You are responsible for paying your own income tax and self-employment tax (SECA). The business does not withhold taxes from your pay. You may need to make estimated tax payments during the year to cover your tax liabilities.
You may deduct business expenses on Schedule C of your income tax return.
- The Government Accountability Office, the investigative arm of Congress, has estimated that 38% of employers examined by the IRS have misclassified workers as independent contractors.
- In recent years, the IRS, courts, and state agencies have focused on one key issue in determining worker classification: how much control the company exerts over the day-today activities of the worker. A worker is likely to be considered an employee if he or she works set hours, is required to follow instructions on how to do the job, receives training from the employer and works on the employer's premises.
- Self-employed contractors tend to pay less tax relative to their income. Some fail to report what they earn, or reduce their taxable income with deductions that company employees normally couldn't claim.
- The IRS estimated that in 2001, sole proprietors failed to pay $81 billion in taxes they owed.
Source: Wall Street Journal (Jan 7, 2005)
For more information on this topic, you can download the following publications from the IRS website at irs.gov or call (800) 829-3676.
- Publication 3518, Beauty, Barber, & Cosmetology Industries
- Publication 4143, Federal Taxation Curriculum for Cosmetology Students
- Publication 4161, Federal Tax Guidelines for the Cosmetology and Barbering Industry
- Publication 1779, Independent Contractor or Employee?
- Publication 531, Reporting Tip Income
- Form SS-8, Determination of Employee Work Status