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."
The Longest Year
“We thought they were independent contractors, we really did. I mean, there were days nobody was there until 5 o’clock,” Skrocki remembers. “We couldn’t make them come earlier because they were independents. They didn’t have workers’ comp, they didn’t have health insurance - they didn’t have any benefits whatsoever. Everyone paid their own taxes. We understood that this was industry practice.”
When the IRS issued its judgment, Skrocki says her accountant recommended challenging it. Bowman and Skrocki’s lawyers spent the next eight months appealing the determination. Her attorneys and accountant met numerous times with the IRS auditor.
The rest of Skrocki’s time (not spent working in the salon) was spent on her phone at home, calling other salons, other lawyers, NAILS Magazine, trade associations, “and anyone else I could think of;” says Skrocki. She was trying to provide evidence that her setup was indeed representative of standard industry practice, not a way of escaping personnel taxes.
That year was the low point of her career, she says, and the strain was incredible. “Any spare time I had was spent at law libraries, working with accountants and attorneys, digging up old files and papers, and working the numbers. I went to different salons and talked to the owners. People were sympathetic, but no one could help:” Her monthly phone bills that year regularly exceeded $400.
Ultimately, the Skrockis could not provide adequate evidence to convince the IRS. They signed an admission of guilt in June 1995 and Renee took out a personal loan for $20,000 to cover the IRS bill, including back taxes, interest, and penalties, for 1992. “Our attorney said that to fight them in court - the only avenue we had left - meant as much as $25,000 in legal fees, plus the $85,000 for the three years if we lost”.
The Skrockis had already converted their workers to employees two months earlier to avoid an audit for the current tax year. "‘Now we have to take out taxes, provide worker’s compensation and liability insurances, pay 7.8% of their earnings in Social Security taxes, and supply them completely," she says. After all was said and done, the Skrockis lost just two nail technicians during the changeover.
Still, when they paid the IRS on July 16 both breathed a sigh of relief - after 11 months it was finally over, and, they thought, time to move on.
“Here We Go Again”
Just three days later they got a call from the Michigan Employment Security Commission’s Criminal Investigation Unit. “We both thought, “Here we go again,” says Skrocki.
The woman they spoke to was B. Taylor, then head of the MESC Criminal Investigation Unit, who said she wanted to come in and do an interview “to make sure all our documents were in order,” Skrocki says. The MESC, which governs state payroll taxes, had been notified of the IRS’ findings through a standard exchange of information.
“The meeting lasted two hours, and it was not pleasant. She was very tough and told us she could lock our doors at any time because her records showed we had employees in our corporation that we had not paid taxes on in 1992 - that was criminal.
“I was stunned. I told her I had a letter from MESC that said our nail technicians were self-employed. She said that was 1987, and this audit was for 1989 through 1994. I was almost hysterical at that point - after everything we had already been through with the IRS. She said, ‘Crying won’t get you anywhere”.
“Later, though, she was kinder and she tried to help us understand what the government was doing, which no one had ever done before. She explained to us what the rules meant, why they exist, and how things work. I started to understand the logic for the first time. No one had ever told me why before, they just said, “You’re guilty; pay up:”
The bill from MESC: $7,000 for back taxes, interest, and penalties for 1989-1992. “Our attorney told us not to pay; he wanted to take the state of Michigan to court. We couldn’t afford to go to court because my attorney fees would have been a minimum of $8,000 to $10,000.”
The final tally: about $43,000, including $20,000 to the IRS, $7,000 to MESC, and another $8,000 in accountant and attorney fees. The emotional toll on both Renee and Julie: incalculable.
And still it wasn’t over. “A few months ago we got a letter from the IRS that said our 1992 numbers were incorrect and that we owed $399, plus penalties and interest of $212. This, after they were the ones who came up with the numbers! We wrote them a check. We just wanted it over, finally,” she says.
Older and Wiser
In 1997, things are looking good again to the Skrockis, who say the nail business is stronger than it’s ever been at V.I.P. ‘We’ve increased our business, which has increased our income. We also recently upgraded our tanning salon with all new stand-up beds. Just like when we first opened, it’s the tanning beds that are pulling the salon through in the slow times,’ she acknowledges.
“We’ve had to eliminate some things, like entertainment expenses. We’ve also started buying our product in bulk,’ she explains. After the switch to employees, Skrocki raised service prices by about 5% to help cover the now higher costs of doing business. To her surprise, it didn’t hurt business at all. ‘It was our first price increase in nine years anyway, so it was time. Our clients didn’t say anything,” she says.
Older and wiser, Skrocki advises anyone thinking of opening a salon to make sure they know all the rules, rather than depending on someone else to know them. “At the least, make sure you consult more than one person. I paid a supposed expert $2,000 to set the salon up right and I paid a heavy price for his mistake."
“You need to understand business if you’re going to run a salon. Knowing how to do nails isn’t enough to run a salon in today’s world,” Skrocki concludes.
In telling their story, the Skrockis threw open their salon, their files, and a lot of personal financial information to NAILS’ editors. Why share such a painful, costly experience with peers and competitors?
“We don’t ever, ever want to see salon owners put in the position where they could lose everything they’ve worked for when they went through what they thought were the proper channels, consulted experts, and lived by the rules,” she says. ‘I just hope that by learning what happened to me, people will open their eyes and correct their mistakes, because by the time they get you, it’s too late. We were lucky to survive it:”
And the chance of your salon getting an audit notification may not be as small as you think: According to a March 13, 1997, story in USA Today, the IRS audited 11,380 businesses and reclassified 483,000 people as employees, not independent contractors. USA Today cites the IRS as saying there are still 2.5 million employees wrongly classified as independent contractors. The question is could a few of them be found in your salon?
Would Your Salon Survive an Audit?
No salon owner wants to be audited by the IRS or their state tax authority. Audits can be simply random as “decided” by the IRS computer, or they can be triggered by certain characteristics of your business operation, for example how you’ve classified independent contractors or employees (especially if they apply for unemployment insurance, worker’s compensation benefits, or even welfare). Individual audits are not likely (statistics show that an individual is more likely to be attacked by a shark then chosen for an audit), but if you are audited you have a better chance of handling it successfully and without penalties if your business is set up correctly and your records are in order. So before you enter the waters of salon ownership (or even if you’re already in), make sure you’re prepared.
There are three key items the IRS and state tax authorities look for if you are an independent contractor or if you use them in your salon:
1. Is there a lease between the independent contractor and the owner? There must be a lease signed by the salon owner/landlord and each booth renter for every year of the audit. The IRS and your state can audit your records for the past three years (or as far back as they want if they determine your returns were fraudulent). The lease must clearly define the day-to-day operations of the booth rental operation and clearly define the separation between the salon owner/landlord and the booth renter. It should be clear how and when rent is paid: how service receipts are collected: hours of operation (hint: the independent contractor sets her own); receptionist services; who provides the equipment; who pays for supplies. Every aspect of the relationship must be spelled out. A true independent contractor can incur financial loss (which means she invests in the business as well as earns a living from it).The salon owner must not have any control over when, where, or how the independent contractor works.
2. How is rent paid? This was an area that got Renee Skrocki in trouble. Independent contractors must pay a flat rate - not a percentage of their service income - based on the space used. Tax agencies take a dim view on charging rent as a percentage of services because it makes it difficult for the independent contractor to incur a loss (0% of 0 income is not a loss). Paying a commission also ties the economic well-being of the salon owner to the independent contractor, making it harder to argue that the independent contractor’s services are not integral to the success of the salon.
3. Who collects payment for services rendered? Again, this area got Skrocki in trouble. The booth renter is responsible for collecting payment for all services rendered. That doesn’t just mean taking the money from them at the front desk; it means the independent contractor must have her own cash box and have checks in her name. They should be able to make change for cash paying customers and handle bad checks. A good rule of thumb is that a salon owner should never give an independent contractor money, and she should never issue an independent contractor a 1099 form.
These are not the only factors the IRS considers in determining whether the relationship is truly that of salon owner/landlord and independent contractor, but they are major issues and any one of them can cause a worker to be deemed an employee, regardless of how the relationship is handled. Be sure to use experts to ensure your business is set up appropriately, keep all your records organized, and follow your written agreements with independent contractors. The ramifications of not following the rules are back taxes, penalties, and interest. And be forewarned, when one agency wins, another is right behind looking for their piece of the pie.