Money Matters

Misclassification: The Ultimate Nightmare

It is a true, life-changing story that can easily happen to anyone who is not classifying salon personnel correctly in the eyes of the government. You probably think you know the rules about employment classifications, but you’re probably wrong.

 The Hammer Comes Down

While being proactive researching similar cases in the law libraries, the final dreaded letter came on October 26, 1994, indicating that the government did indeed feel that my technicians were employees. They said they based this on 20 common law factors that they use in determinations. Five of their top reasons were as follows:

1. Realization of profit or loss: They said there was no element of risk for the manicurists. While it was true that the manicurists did not earn money if they did not work, they said that none of the manicurists were responsible for any of the financial burdens such as rent, utilities, and insurance, and could not then sustain a loss from the business operation. Even though they did supply their own equipment, this was not enough expense to incur a substantial loss.

2. Significant investment: None of the manicurists had a significant financial investment in the shop. The premises were leased by VIP. The majority of the equipment used was owned by VIP.

3. Integration: The services of the manicurists were fully integrated into the business operations. Without the services of the manicurists, VIP could not have continued business as a successful nail salon.

4. Payment by the hour, week, month…: Upon completion of each customer serviced, the manicurists received payment and turned it over to the front desk or the customer paid at the front desk or central location. An independent contractor would retain all compensation as they earn it and not turn it over to another party. They would take responsibility to deposit into their own bank accounts and be responsible for it.

5. Set hours of work: The business did not require the manicurists to work set hours (so there was not a factor of control), but the services were made available during the times allocated for business by the shop owners.

They concluded that 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. VIP argued that the manicurists did not have a dictated set schedule and that they could come and go as the clients were booked. They did not get paid for not working so there was not an hourly rate paid. The manicurists had expenses that they incurred for their jobs and they could incur a loss. However, the IRS disagreed.

In Layman’s Terms

Since that time I have contacted several people in our industry and asked them to put this in terms that we, as owners and technicians can understand. This is my understanding of the terms of
the categories:

Booth renter: A set fee is determined with a contract based on a daily, weekly, or monthly rate (or the amount of time you decide). The booth renter shall have her own liability insurance, bank accounts, credit card processing, phones, hours, schedule, and access to the facility at any time along with anything else to run her business. The booth renter is basically a tenant (like a renter in an apartment) who pays a rental fee to the owner of the “complex” (salon). You, the booth renter, are your own business with a structure. You pay your own self-employment taxes. You issue a 1099 to the owner at the end of the year for the fee you pay her company, LLC, corporation, DBA, S-corp, etc, to rent space if it is over $600. You can retail your own products, collect and set your service prices, etc. There is no control at all of you or your situation other than rental agreement conditions.

Independent contractor: This category was created because situations arose in the industry that did not fall into the booth renter or employee category. I was told that only a handful of technicians truly are independent contractors. I wish I had known this. The way to describe this category (I understand why it is so confusing to technicians) is: Let’s say that you are a hotel owner and you want to call someone into your hotel to do a service that you do not offer on the premises (meaning that you do not have a nail salon on the premises). So you call and outsource the services of a nail technician who travels to other locations besides yours to work for other hotels besides yours. The “independent contractor” is her own boss without a definite daily position for a business that relies on her income. In other words, it is not the source of the hotel’s income. It is an outside business that can be called upon at any time and the hotel uses several sources within the area when needed on an on-call basis. Therefore the hotel can pay the technician as a 1099 without taking out taxes since the independent contractor is not an employee of the hotel. The independent contractor incurs all expenses of the job including workers compensation insurance, self-employment taxes, products used, and anything else to do the job.

Employee: This is where they say most technicians fall unless they are booth renters. You go to the same job every day (even if you have another job in the same industry across town; you would be an employee at both locations), you service your clients, and the client pays the company — even if they pay you directly and you make the change and give the portion to the salon owner after taking your percentage or if the salon owner collects the money and gives your portion of the percentage back to you either in cash or check. Service fees are not given to you by the customer for you to deposit in full into your own bank account and
pay ­self-employment taxes on. Your appointments are booked through a front desk receptionist (which means that you do not have your own phone and/or phone number). The credit card machine is centralized for everyone to use, the retail area is not your own, and you are receiving retail commission (if the salon pays retail commission).

I have been told that even if you have three technicians in the same salon and you want to classify them differently you can; however, they must be compensated completely differently and their working practices must be different. One could have a rental space that she would lease with everything of her own and pay a daily, weekly, or monthly rental to the owner with signed agreements. One could travel and work on an inconsistent basis for the salon as a backup, vacation or emergency help, on call, as well as work for other salons in the area and supply everything upon arrival and set her own prices. And then one could be an employee, in which case the salon owner has control of the hours of the business, sees the individual on a regular basis, has the control to set rules that she cannot work for competition or anywhere else, collects the money and issues the technician a check with taxes taken out, has a central credit card machine for customer sales, has a retail area located inside of the salon and pays commission to the technicians for sales of retail products, pays workers compensation and liability insurance, supplies products to do the job, and provides a W-2 that shows taxes taken out at the end of the year.

 

V.I.P. opened in 1986 with three techs. You can see how the staff has grown.
<p>V.I.P. opened in 1986 with three techs. You can see how the staff has grown.</p>

The Saga Continues

So as the nightmare goes, I couldn’t prove my case. After 11 months and several attorneys later, the government told me that if I signed on the dotted line they couldn’t guarantee it, but most likely I would only be responsible for two years instead of going back the seven years that they could require since it was considered tax evasion in their eyes. If I didn’t pay, they had the right to freeze my bank accounts and any other assets tied to my name since it was back taxes involving payroll. The total owed could end up being more than $85,000. The final bill from them was $20,000 plus interest. So on July 16, 1995, I signed and it was finally over — so I thought. I couldn’t fight any longer and I did not have finances to cover the costs. I would have to apply for a loan or make payments to them with outrageous interest and penalties. Besides all of that to deal with I still hadn’t decided how I would explain to the technicians how they would have to take a decrease from 65% to I wasn’t sure what. I would have to explain to them that becoming an employee would cost my company more than 10% per nail technician — the 7.65 FICA/FUDA, liability insurance, workers’ compensation, and other expenses associated with an employee-based business. Even if I dropped the technicians pay from 65% to 60%, it would cost VIP much more than we had paid them before this happened.

How do you tell technicians that they are actually gaining income when you are dropping their percentage? I had a hard enough time understanding all of this, let alone explaining it to them. If they reclassified themselves as booth renters, they would have to pay all expenses of owning their own company and face their own risk of audit and back taxes. They would ­­have to purchase their own liability insurance ­policies, set up bank accounts, purchase a workers’ compensation policy, set up a business structure, etc., and we would have to restructure our front desk, retail — everything. I would now be a salon that would house booth renters (which I am not saying is a bad thing at all; I just was not prepared to try and explain to everyone why and how to do all of this). I was exhausted trying to take care of it myself, let alone try and instruct an entire salon. The technicians could never have been able to make these investments. So instead, I took the technicians down to 60% and took care of the rest. It was too ­complicated and I had a short amount of time to change everything before the new year would be here. So in reality I was paying almost 75% to each technician and I had still not paid the rent, phone, electric, and other expenses incurred to run a company. Service prices had to be increased as well as retail inventory to try and recoup some of these additional expenses.

As I was working on changing the way my company was structured and signing to put this entire dilemma behind me, we received a letter from the state of Michigan Criminal Investigation Unit. The letter indicated that they wanted to do a review to “make sure all of our documents were in order.” I thought I would be severely ill. We again allowed the interview at VIP, which lasted two hours — the longest two hours of my life. We were told that the state of Michigan could lock our doors because we had not paid our taxes and they called this tax evasion because we had admitted guilt by settling with the IRS. It was horrific. I felt like the biggest criminal in the world and yet did not know I was doing anything wrong. The amount due was over $25,000. I explained and showed the letter received in 1987 stating that I had received complete acceptance from the state but they indicated that since I signed with the federal government I had admitted guilt and now I owed them.

So, after all was said and done and more of my life was spent trying to research and understand this mess, I realized that it wasn’t worth my life anymore. I wasn’t going to win. I didn’t have the money to fight — nor the energy — and I wanted my life and my company back. The state of Michigan ended up settling with my company for $7,000 plus interest. Both the IRS and the state of Michigan told me that even though I paid a professional for my set up, in the end it was my responsibility. Ignorance of the law is not an acceptable excuse. Wow. That was a really tough way to learn. People can argue that I should have sued the CPA but again, where was my proof and where was the money for the suit going to come from? I had too many other issues with the government at the time.

The cost for the misclassification ended up being $43,000 plus the interest on the loan that took years to pay off. With everything said and done, the total for being set up incorrectly was over $70,000. I was still paying the tax burden when both of my parents passed to cancer one week apart in 1999. (My mother was also my salon partner.) My salon was lost to a five-alarm fire in June 2002. I had to give up my nail clientele to be there to help oversee the rebuilding of the salon. It took exactly five months and four days but we reopened right before the Thanksgiving holiday. We now employ 65 and business is very steady and growing.

To say it took its toll is an understatement. I highly encourage each and every salon owner and technician to really look at how you are set up. It is not worth any type of risk, let alone losing everything you have worked so hard for. Thank you for giving me the opportunity to share with you an experience that could have been avoided.

> I sought advice for this article from CPA Larry Kopsa, who helped by providing explanations of the three categories of classification. Larry is a partner of the 25-member CPA firm of Kopsa Otte, which specializes in the salon and spa industry. His firm is located in York, Neb., and can be reached at (800) 975-4829.

> I would also like to dedicate this article to Ken Cassidy who recently passed away. Ken was a major asset in trying to help me though this ordeal. He was president of Kassidy’s Management Consulting Company in Long Beach, Calif., and was a huge advocate in our industry trying to teach and educate on how not to be on the “wrong” side of the law.

 

For further information and a continuation of this story related to FICA/FUTA tip match income please go to www.salonguidance.com.


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Keywords:   booth rental     employee issues     independent contractors     IRS     Ken Cassidy     taxes  



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