It took five years and more than $100,000, but Nails Now! Owner Ira Bloom finally prevailed in his quest for the IRS to recognize his nail technicians as independent contractors.
Editor’s Note: The article “You’re Being Audited!” in our June 1997 issue told the story of how Renee Skrocki, co-owner of VIP Nails & Tans Inc. in Riverview, Mich., was audited several years ago by the IRS because she categorized workers as independent contractors. She ended up paying $45,000 in attorney fees, taxes and penalties because the agency deemed her nail technicians were employees, not independent contractors. At about the same time, Ira Bloom (above with his Addison, Texas, salon in the background), CEO of Nails NOW! Salon chain in Dallas, Texas, was undergoing similar scrutiny of his workers’ status. Bloom ultimately won his battle, roving that he did not control his independent contractors’ businesses. He ended up spending considerable time and money proving that his setup was legitimate, resources most nail salon owners cannot afford to spend. Industry experts caution salon owners to cover in a signed agreement all financial compensation/business fees they plan to charge their independent contractors and have the agreement reviewed by an attorney. They also recommend consulting with someone who specializes in contract labor issues and is familiar with the salon industry whether it’s an attorney, accountant, or consultant, and follow all other guidelines give by the IRS.
Ira Bloom in one of his NAILS Now! salons in 1997 with NAILS editor Cyndy Drummey.
When Ira Bloom opened his first two Nails Now! salons in 1991, he was new to the nail industry, but he was by no means new to the business world. A former real estate developer, restaurateur, and consultant, Bloom spent 18 months preparing for his new business venture, researching and developing every aspect of his business–from the logo to the custom workstations and ventilation systems.
He paid particular attention to the development of his independent contractor contract, spending about $25,000 and long hours working and reworking the contract with his lawyers and other advisers.
“I knew I was going to have problems with the IRS before I even opened the business,” Bloom explains, “because everyone I talked to warned me that using independent contractors is rough.”
So when an IRS agent appeared in 1992 at his Greenville location in Addison, Texas, on what he termed a “good will visit,” Bloom’s guard went up.
“He said, ‘I’m here to help you out and make sure you’re doing everything right,’” Bloom remembers. “He went through my workers’ records, my check books; he even asked me personal information. I didn’t know what he wanted.” At least, not until the agent started questioning the status of the nail technicians working at Nails Now! as independent contractors.
“I showed him my contract and indicated it was worked on by a former IRS auditor and by my tax lawyer as well as another retired IRS person,” Bloom says. The agent took a copy of the contract and continued to call and visit Bloom for almost a year. “He kept asking all these crazy questions that had nothing to do with independent contractor status. Finally, I threw him out of my office.”
A Port in the Storm
Soon after wards, Bloom received a letter from the IRS that said Nails Now! was not in conformity with the federal independent contractor guidelines and that the IRS had deemed the salon’s nail technicians employees. According to the IRS, Nails Now! owed the IRS more than $60,000 in taxes, interest, and penalties.
“At that point I hired a top tax firm,” says Bloom, who up to then had been using his regular attorney. “We contested their finding and it went to the next level, where it was reviewed by more senior agents,” Bloom recounts.
Bloom and his lawyers decided to seek “safe harbor” protection under section 530, a provision in the Revenue Act of 1978 that allows a company with incorrectly classified workers to continue treating them as independent contractors for tax purposes, provided they have a reasonable basis for having treated them that way.
Bloom claimed that the classification of nail technicians as independent contractors is a widespread practice in the nail industry, citing statistics from trade magazines and other publications. He also conducted a survey of more than 50 salons within a three-mile radius of his Greenville and Addison locations, and found that most of them, too, considered their workers to be independent contractors. He gave that information to the IRS. At this point, he says, the IRS tentatively agreed that the practice seemed to be industry norm.
Not Over Yet
Bloom thought he’d won the dispute, and expected written confirmation “any day” for months. “But then they came back and said, ‘You’re collecting payment for services, and that indicates control,” remembers Bloom, who argued that the guidelines don’t even mention who collects the payment.
The guidelines Bloom refers to are the IRS’s 20 common-law factors, which the IRS uses to determine the correct working relationship between business owner and worker. Essentially, if the business owner is found to provide significant direction and control, the worker will be deemed an employee; if the worker controls her own business, she is considered self-employed as an independent contractor.
“Our contract follows the 20 guidelines,” Bloom says. “In my contract I say that independent contractors will either be charged a flat rent or a commission (whichever is higher). A certain percentage pays for bookkeeping, another percentage is for collecting payments, and another percentage is for making appointments. It goes right down the line to the pencils they use. They’re contracting for these services when they contract with us.” A nail technician who is fully booked will pay more for receptionist services than one who is only partially booked, but she is also using the service more heavily, he argues.
Even after the salon opened Bloom continued to tinker with the contract, addressing questions as they arose. “Revisions are normal because even lawyers and accountants who have experience working with the IRS and independent contractor issues don’t know the idio¬syncrasies of a particular industry, things like charge-backs for work that wasn’t done properly,” he explains.
“One of the important issues with the IRS is that independent contractors have the ability to lose money as well as make it. In our contract we show they have the ability to lose because it spells out that if they don’t show up they still have to pay for the space, and that if they do poor work that has to be redone by someone else in the salon, they’ll have to pay that other person. They face the same risks any business owner faces,” he says.
Bloom and his attorneys and the IRS continued to wrangle over the issues, and time continued to drag on. It took a year for the initial finding that he had classified his workers incorrectly to be issued, then almost one and a half years for the IRS to consider his appeal. Every time they met, the IRS requested more information, Bloom says, adding it would then be weeks or months before he heard from them again—and it was usually once again a request for more information. By mid-1996, four years after the questions began, Bloom finally had had enough.
A Calculated Risk
“I got to the point where I said to my lawyer, ‘This is absolutely crazy. We keep opening salons and every time we do we have more liability. I’m tired of this. Let’s sue them.’”
To force the issue, Bloom’s lawyer recommended he make a minimal tax payment and then make a request for a refund, claiming the payment was made in error. “It forced them to take action,” he says. Sure enough, at the end of 1996 the IRS contacted Bloom, offering to drop everything if Bloom would reclassify his workers as employees.
“I told them absolutely not,” he remembers. “I had put a lot of time and money into my contract.” Bloom had, in fact, put a lot of time into proving he didn’t “control” his independent contractors. He even requires all his independent contractors to submit a handwritten schedule of the times they want to rent a station a month in advance to prove they set their own hours. “I knew I was right,” he asserts.
Again several months went by before Bloom heard from the IRS, who then repeated the offer: They’d drop the matter and forgive all taxes and penalties if he’d reclassify his workers as employees. Again, he refused and directed his attorney to aggressively pursue a resolution.
Finally, in June 1997, Bloom received a letter from the IRS granting him “safe harbor” protection in classifying his workers as independent contractors. This means, he says, that as long as safe harbor protection exists and as long as he continues to follow the same procedures he follows now, he is safe from further hassles with the IRS. Bloom is satisfied in having won, but his ebullience is tinged with frustration over the time and money it took for him to do so.
“It cost me more than $100,000,” he says. “That’s what they count on — that you can’t afford to go up against them. They wear you down financially, dragging it on until you give in.
“But I have four salons now with a lot of people in each salon, and we’re looking to open more, so in that sense it was worth it. If I’m right, I’d rather fight than give in, no matter what the cost. Someone has to stand up.”
[Sidebar] Rules of the Game
Editor’s Note: The following are some of the questions sent to NAILS and to Renee Skrocki after her article appeared form nail technicians and salon owners about what is and is not allowed for an independent contractor setup. Ken Cassidy, a salon management consultant and owner of Kassidy’s Salon Management Consultant Company in Long Beach, Calif., specializes in booth rental issues and responds.
Q: What is the first thing you should do to avoid and IRS audit?
A: We are frequently asked questions about the IRS and state requirements in relation to booth renting. What surprises us is the number of salon owners and booth renters who look for information from friends who own salons or to others who do not have legal background.
Begin by having an attorney draft a written contract that describes the relationship between salon owner/landlord and booth renter/mini salon owner The IRS and state taxing authorities agree that if there is no formal document signed by both parties, the business relationship is automatically one of employer and employee.
IRS audits usually occur about three years after the tax year. For example, you get notification in 1997 that you are being audited for the year 1994. If the IRS determines that you deliberately were avoiding your tax obligations, it can then go back seven years. If it is determined that you own money for any of these years, penalties and interest are added for all that time. However, if you were doing something incorrectly but you documented where and how you became aware of this and what you did to correct the situation, it shows sincere effort on you part. This may not save you entirely, but it will help.
Q: If I only have one booth renter, do I still have to have a contract?
A: Yes. The IRS and state taxing authorities look at one renter the same as 100 renters. They are concerned with the tax obligations of the business arrangement, no how many people are involved in the arrangement.
Q: If I am a renter, can I deduct retail bonuses or commissions I’m supposed to receive from the rent?
A: No. Retailing is a totally separate issue from rent.
Q: Can the salon owner/landlord control all the retailing rights in the salon?
A: Yes. The way this would b handled is that nothing in the slaon gets sold without going though the front desk. This must, f course, be incorporated into the business lease/contract between owner and renter.
Q:I am a booth renter and I’ve heard that a salon owner cannot give me a new client. Is this true?
A: Not necessarily. The salon owner can give new clients to booth renters under the following conditions.
1) The salon owner and booth renter have agreed in advance and it is recorded in the contract.
2) The salon owner takes a one-time fee from the booth renter the first time the client visits her. Thereafter, all fees remain with the booth renter; the client is now hers.
Q: Can receptionist duties be included as part o the rent?
A: Usually not. The IRS looks at truly independent contractors as having their own phone, making their own appointments, etc. However, if the renter wants the salon receptionist to make appointments for them, the salon owner must charge a fee for that service. That fee is added on to the base rent, and is stipulated in the contact/business lease.
Q: Is there an ay I can charge my renters rent on a commission or percentage basis?
A: No. This is one of the issues upon which Renee Skrocki lost her audit with the IRS. There is a way to charge additional rent above the base rent, as in a triple net rental agreement, but it’s too complex a topic for discussion here.
Ken Cassidy can be reached at email@example.com; (562) 432-4462, or write to Kassidy’s Salon Management Consulting Company, 5740 E. 2nd St., Long Beach, CA 90803.