If the IRS asked to examine your salon's Federal Tax returns, would you survive the audit? Read on for an account of a salon owner who thought she was doing everything "by the book."
Renee Skrocki (left) and her mother Julie.
Although the nightmare began nearly three years ago, Renee Skrocki can remember it as though it was last night. The letter from the Internal Revenue Service was innocuous enough - mixed in with the salon’s mail, it looked just like any other piece of business correspondence.
When Skrocki, who co-owns V.I.P. Nails & Tans Inc., with her mother, Julie, realized that it was indeed from the IRS, she felt a twinge of concern, but not panic. “As a business, we got notifications and letters from the IRS regularly;” she says. But upon reading the words, “Your Federal tax returns for the above year(s) have been assigned to me for examination,” the vague sense of unease she originally felt was panic in full bloom. “I freaked out:” she says now.
Skrocki remembers: “I called immediately and asked for the agent who sent the letter. She said, “There’s no problem. This is just a random audit; it’s no big deal. All I need are a couple of things and I’ll be on my way:” Skrocki allowed herself to be relieved. “I knew we did everything by the book, so I didn’t think we had anything to worry about.”
Skrocki was confident that her setup was legal and legitimate because before she even opened V.I.P.’s doors, she had consulted and paid a CPA $2,000 to help her write the business plan and set up the business, including how to classify her workers.
“He set them up as independent contractors. He represented a lot of beauty salons, and he said that’s how salons did it. Everything seemed to be fine.” And the state of Michigan agreed: In 1987, Skrocki received a form letter from the Michigan Employer Securities Commission (MESC) that asked how her workers were classified. She completed the attached questionnaire and soon received a letter from the (MESC) confirming that her workers were independent contractors.
In fact, when the auditor asked to come to the salon, Skrocki allowed her. “I felt she should meet the owners of the business and I wanted to know what kind of questions they had”. (Although Renee and her mother are very close and faced this challenge together as co-owners of the salon, this story is told through Renee’s perspective.)
“The auditor was businesslike, but very pleasant - she seemed like someone you could talk to. She very much wanted us to think it wasn’t a big deal so we would open up to her. The meeting lasted two and a half hours and she asked a lot of questions: When did we open? How are we set up? Who set up the business organization? Do we write off our car? What kinds of benefits do we give workers? Where do we buy our boutique items? She wanted to know everything. At that point I knew something wasn’t right because I knew an auditor wouldn’t ask those kinds of questions on a random payroll audit.
“Then she asked for mileage logs, bank deposits, agreements between us and officers of the corporation,” she finishes.
After leaving V.I.P. that day, the IRS agent went to Accounting Plus, where she spent six hours with Skrocki’s accountant, Jerry Bowman, reviewing V.I.P’s corporate records, check registers, bank deposit slips, car mileage logs, and other papers. The agent returned on August 31 and again on September 1 and 2.
“You’re joking ... Right?”
On October 11, the agent met again with Bowman, who had been Skrocki’s accountant since 1990. This time, Skrocki was not present. “After they met, Jerry; called me and said, “We have a real issue here. The IRS feels your workers are misclassified as independent contractors and should actually be employees.”
Skrocki continues, “I’ll never forget this part. Jerry said, 'If this is true, you will owe the government $85,000:” She says she simply couldn’t believe it. But a letter from the IRS to Skrocki dated October 26, 1994, made it perfectly clear. The letter explained that based on “the most significant factors” from the IRS’s 20 common law factors, V.I.P’s workers should have been classified as employees.
In a nutshell, the IRS based its determination mainly on five of the factors. From the actual letter, here is the IRS’s explanation to Skrocki for its findings:
1. Realization of Profit or Loss…There was no element of risk for the manicurists. While it was true that the manicurists did not earn money if they did no work ... None of the manicurists were responsible for any of the financial burdens, such as rent, utilities, and insurance and could not sustain a loss from the business operation.
The manicurists provided their own supplies.... However, it has not been proved that the manicurists incurred substantial expenses for their supplies…
2. Significant Investment ... None of the manicurists had any significant financial investment in the shop. The premises were being leased by V.I.P.... The majority of the equipment used was owned by V.I.P.
3. Integration ... The services of the manicurists were fully integrated into the business operations.... Without the services of the manicurists, V.I.P. could not have continued business operations as a successful nail salon.
4. Payment by Hour, Week, and Month ... Upon completion of each customer serviced, the manicurists received payment directly from the customer. The manicurists then turned over the total received to the shop owner or another employee ... An independent contractor would retain all compensation as they earn it, not turn it over to another party.
5. Set Hours of Work ... The business did not require the manicurists to work set hours, but the services were made available during the times allocated for business by the shop owners...
In conclusion ... Due to the amount of expertise of the manicurist, there was relatively little actual control exercised by the shop owner, but the right to control was present, as indicated by the major factors addressed above.... It is the government’s position that the manicurists are employees of V.I.P. Nails & Tans Inc.
Before the IRS turned her world upside down, Skrocki already had beaten the odds as a small-business owner: V.I.P. had been operating more than eight years, a considerable accomplishment considering that most small businesses fail in less than three years. She opened V.I.P. fresh out of nail school at age 25.
“I met a couple of girls in nail school and we talked about finding a salon where we could work together. But all we found were side tables in beauty salons. My mom and I did some research and decided I would open my own salon. I lived at home and had saved enough money to open my own business.
“My salon opened in September 1986. It was a rocky year: We learned on the job, like so many new business owners. We built a small clientele, but it took a long time to build the client loyalty because we simply didn’t have the technical experience.”
Not only did a full book come more slowly than she expected, but expenses mounted more rapidly than she had calculated. “The landlord didn’t tell me I had to get liability insurance to cover the outside of the building as well as the inside. That was $1,500 more than I’d budgeted. I couldn’t afford surprises like that”.
In 1987, just as the salon began to break even, Skrocki fell ill. Just three weeks after telling her mother she planned to let her health insurance lapse because she could no longer afford the premiums, Skrocki was rushed to the hospital with a ruptured ovarian cyst.
“Thank God my mother paid the bill for me in secret. If she hadn’t done that, it would have wiped me out.” The situation was grim enough: V.I.P. was breaking even by then, but Skrocki had yet to collect a paycheck for herself since opening. The hospital bills exceeded $10,000, and Skrocki was off work recuperating for six weeks.
While she was out, her mom (who had just taken early retirement after 25 years with one company as a billing clerk) helped run the salon. When Skrocki returned to work, her mom stayed on.
Then in 1988 the salon was burglarized. The insurance covered most of the loss, she says, but she had a $1,000 deductible, and the insurance company didn’t reimburse the stolen cash. “We all continued to try to build a nail and tanning clientele as well as build retail sales;” Skrocki says.
Still, things weren’t all bad: 1988 was also the year Skrocki could take a paycheck for herself - albeit a small one. “I was just barely making my car payment then;” she says with a laugh.
By 1991, she and her mother were enjoying a good living from the salon, so when a space almost twice the size of their current location opened just two doors down, they decided to expand. (Skrocki proudly notes the salon paid for the $20,000 move, including six new tanning beds, out of its own savings.) At the same time, she and her mother formalized their partnership agreement, with her mother buying 50% of the corporation’s shares.
“Everything was going great;” Skrocki says. “I bought a house and moved in August 1. Then two weeks later I got the letter from the IRS.”