Spin the Wheel: Playing the Classification Game — In the salon industry, workers most often operate in one of three ways: as employees, booth renters, or independent contractors. But for years many salons have incorrectly labeled their independent contractors and may have put themselves at risk of having the IRS reclassify their workers. Find out if you're doing things correctly or if you're just spinning the wheel and seeing where it lands.
Since the nail industry is relatively new (having only been around for the last 30 years or so, since the advent of acrylic nails), business models are evolving and changing. A common practice that salons use is to hire technicians as independent contractors. But it turns out that many, if not most, of the independent contractors in the nail industry have been incorrectly labeled, and this can cause serious problems for both the salon owner as well as the worker who has been mislabeled.
According to the Professional Beauty Association (PBA), 87% of the workforce in the salon industry (hair, skin, and nails) is comprised of non-employee workers, with booth renters and independent contractors making up the majority of this percentage.
Since booth renters, independent contractors, and employees are all taxed differently by the IRS, the issue of classification makes a difference on how much money the IRS collects from each. As a result, the IRS has certain criteria for classification; and when workers are mislabeled, the IRS can impose penalties, fines, and back taxes during an audit.
The IRS has recently stated that they are targeting mid- to small-size businesses, especially those that file incorrect 1099s and deal in cash.
So why the confusion on classification? It is often difficult to get clear and concise information from the IRS on this subject, and even then it is still a rather complicated issue, filled with all kinds of gray areas and exceptions. It’s no wonder we’re all scratching our heads.
Currently, the nail industry is in the habit of hiring technicians as independent contractors when they should actually be employees. This happens in many industries because hiring workers as independent contractors lowers the owner’s operating costs. But it is difficult to know how to classify workers, and many find out only when it is too late — when the IRS comes knocking at your door.
Ken Cassidy, president of Kassidy’s Salon Management Consulting Company in Long Beach, Calif., says he regularly deals with salons that have misclassified their workers. “It’s usually not a case of someone doing something they know is wrong. A lot of times it’s just people doing business the same way they were taught when they were first coming up in the industry,” says Cassidy.
Misconceptions are common, and many do not know that payment method (commission, salary, or a combination) and contracts do not themselves classify a worker as an independent contractor. But whether or not an owner knows that their workers are misclassified, an audit will have the same results — penalties, fines, and back taxes.
There is literature available at www.irs.gov to help explain the differences between booth renters, independent contractors, and employees — and the different tax -implications for each. But we’ll break it down for you here.
> Employees are defined as anyone who performs a service for a company/business owner, where the owner has direct control over when and how the worker does a job.
> This can include telling an employee what time to work, what to wear, and how to conduct themselves as they carry out their business.
> In most cases, employees are also provided the tools and equipment needed for the job by the owner.
> Employees of a business have their income taxes taken out of their paychecks, and they get a W-2 form at the end of the year showing how much they made in wages and how much in taxes was taken out.
> Owners must pay a special tax called the Federal Insurance Contributions Act (FICA) tax for each employee. The FICA tax is a mandatory payroll tax that owners pay on behalf of each of their employees in order to fund Social Security and Medicare. The owner pays 7.65% of the employee’s income toward this fund, and the employee pays 7.65% of his or her income toward this too. (The employee’s contribution is automatically deducted from each paycheck.) The owner and employee essentially split the FICA tax.
> Employees are also protected by federal and state labor laws, which regulate minimum wage, overtime, meal periods, rest breaks, etc.
> Booth renters are essentially running their own independent business, so they fall under guidelines similar to that of the salon owner.
> Booth renters must declare all income on an appropriate tax form such as the U.S. Individual Income Tax Return Form 1040, Schedule C.
> The booth renter pays rent to the salon owner, but otherwise conducts her business in any way she sees fit, provided it does not interfere with the business of the salon owner or other booth renters.
> An owner is not liable for a booth renter’s services on clients, and she is not allowed to control the day-to-day operations of a booth renter. This means that booth renters can schedule their own hours and make as many or as few appointments as they wish.
> Booth renters also pay for all of their own supplies and tools, which they record and file as business expenses at the end of the year. The rent is included as a business expense.
> At the end of the year the booth renter provides a 1099 tax form to the salon owner for any rent paid (if the yearly total comes out to more than $600).
> Booth renters must pay their own FICA tax for Social Security and Medicare. Since they are self-employed, they pay the full amount (15.3%), as compared to employees who only pay half.
> There is no set definition for an independent contractor, but the IRS provides the following general rule in regards to their classification: An individual is classified as an independent contractor if the owner only controls the result of the work, and not the method of accomplishing it.
> Independent contractors have freedoms similar to booth renters, in that they can conduct their business without interference from the owner.
> In a true independent contractor relationship, the owner merely contracts out a task to be completed and does not have the authority to instruct the contractor on how she should perform her job.
> Independent contractors do not have income taxes taken out of their checks since they are not employees of the business.
> At the end of the tax year, independent contractors are issued a form 1099 from the salon owner. The 1099 declares the contractor’s total wages earned throughout the time of the temporary working agreement, and the contractor is responsible for paying her own appropriate income tax at the end of the year.
> Independent contractors pay their own FICA tax as well. (The full 15.3%.)
> Independent contractors are not protected by state and federal labor laws, as they are self-employed.
The problem arises when salons hire workers as independent contractors when they actually function like employees. If an audit were to take place and the IRS found these workers to be misclassified, the owner could potentially be forced to pay a lot of money in back taxes, penalties, and interest.
These misclassified independent contractors typically function just as an employee would. They adhere to a schedule designated by the owner. They use tools provided by the owner and receive clients that come in the door or are booked by a receptionist. And they operate under the rules of the establishment, just like an employee.
One reason why salons hire employees as independent contractors may be because it relieves the owner of having to pay the FICA tax on each employee. Some techs prefer it as well because their paychecks do not have income taxes taken out, meaning they get more money in the short-term.
Also, “employees” classified as independent contractors are not subject to state and federal labor laws, so they can work in excess of 40+ hours a week without overtime, earning commission and bringing in revenue at no additional cost to the salon owner. Again, this is a relationship that can benefit both the owner and tech as well, because profits can be increased for both parties.
The general feeling in the industry is that the current competitiveness within the industry has made it difficult for salon owners to play everything by the book.
Roula Nassar, owner of Roula’s Nail Spa in Houston says, “I’ve had techs quit because I would not change their status to independent contractors. And I know there are a lot of salons that will because it’s more profitable for them and for the tech.”
Another former salon owner says she was advised by her tax attorney at the time to classify her workers as independent contractors, even though she knew it was incorrect. “I was told that the benefit outweighed the risk of getting caught. And we drew up a contract that tried to classify them as independent contractors, but it was so blatantly obvious they were employees.”
Though there are financial incentives to operate in such a way, the PBA’s government affairs co-chairman, Frank Zona, says the risk of an audit far outweighs the reward. “At any given time, I’m dealing with a couple dozen or so salons that are undergoing an audit. And some of these penalties are as high as $150,000. That’s enough to sink a business,” says Zona.
Cassidy reminds us that in the event of an audit, everyone involved in a mislabeling will be held accountable. “The owner is going to be hit with back taxes, penalties, and interest, and she may also be responsible for any overtime the workers might have accrued during their time of operation,” Cassidy says. “But also, the independent contractors will be subpoenaed by the owner to produce all of their records and prove that they in fact paid their appropriate income tax. It’s a stressful ordeal for everyone involved.”
The problem of mislabeling workers is not specific to the salon industry. It exists in some facet of almost every industry, big and small businesses alike. And the problem is not going to be fixed overnight. Some will continue to operate without receiving any ill consequences, while others will one day bear the brunt of IRS penalties.
But it is important to be knowledgeable about where you stand, as a business owner and as a business worker, in the eyes of the government. And it is important to know how the government sees your industry. The nail salon industry is still in its early years, and though the IRS has not yet made a sizeable presence, it could in the future.
GET THE FACTS ON CONTRACTS
A contract that states that a worker is an independent contractor is not determinative. The state and federal labor departments will look behind the contract in order to examine the facts of the actual business relationship. They will then make their own determination based on how the relationship compares to existing IRS classification guidelines. Bottom line: The rules set up by the IRS trump anything you may have set up with a potential employee or contractor.
The IRS has information to help educate the industry about this tricky subject, and many resources are just a mouse click away.
IRS Form SS-8
The SS-8, also called the Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, is a form to help determine whether a worker is an employee or an independent contractor. It is three pages long, and asks specific questions regarding how much control the owner has over the worker, how the worker is paid, and just how “independent” the independent contractor really is.
IRS Publication 3518
A brochure made by the IRS to help make the issue of worker classification easier to understand. It is specific to the beauty, barber, and cosmetology industries.
IRS Publication 1779
A brochure to help differentiate between independent contractors and employees. It is not specific to the salon industry, but it does offer some insight in an easy-to-read format.
IRS Publication 15-A
An employer’s guide to tax responsibilities. Not specific to the salon industry, but provides lots of information on the various tax responsibilities employers have to know about. It runs about 60 pages long and has sections devoted to the distinction of independent contractors and employees.
IRS Publication 4161
A brochure that outlines federal tax guidelines for the cosmetology and barbering industry.
CORRECTING A MISCLASSIFICATION
If an employer would like to rectify a misclassification, she will still be responsible for the misclassified worker’s FICA tax back to the beginning of employment. But Internal Revenue Code Section 3509 (IRC § 3509) provides an opportunity for a reduced rate or an exemption if the employer meets a set of criteria.
A good way to research this is to use the search icon on the IRS’s homepage, www.irs.gov, search for “independent contractor,” and browse the documents that come up.
Also be sure to contact a local tax attorney or accountant if you have any questions regarding employee classification.
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