Misclassification: The Ultimate Nightmare

Most of the time technicians and salon owners in our industry do not realize that they are working and reporting income incorrectly. Many people I’ve spoken with have relied on the advice of a CPA, like I did, thinking they are paid a higher fee than a regular accountant to know the law. Wow…what was I thinking?

I want to share my story to help others understand what is considered legal. I would not want anyone to experience what I, my family, and my friends did for two full years of our lives. It was the most devastating and life-changing experience I have ever had.

My Story Begins

The year was 1986 and I was working full time for a great company and living at home; I was 24 years old. I wasn’t sure where my life was going but I had quite a bit of energy and was pretty creative. My mom had always loved the beauty industry even though she wasn’t in it herself. However, she encouraged my sisters and me to attend nail school and become licensed. My sisters took her advice and had completed school and now I wanted to do the same. I went part-time after work and took the course and received my license. I realized I had a deep passion for doing nails and wanted to continue in the beauty industry.

While in beauty school I met really great girls and wanted to stay in contact with them. However, we soon became frustrated trying to find employment. The only positions that seemed to be available back then were in hair salons that didn’t see nail technicians as a higher source of income. There was little space in the salons for manicurists; usually an old table with a mismatched chair in the corner. I was so discouraged. I really saw nails differently; I saw it bigger and as its own standalone business. So, after much consideration, I gave up a great full-time job with full benefits, weekends off, and little worry to open a nail salon and employ the nail techs I went to school with. People who knew me weren’t shocked, but some really couldn’t believe that I would give up stability for “polishing fingernails,” as they saw it. I didn’t know everything about salon ownership but I would dedicate my time, educate myself, and hire the necessary people to fill in the blanks for areas in which I was not informed — such as tax law and legalities.

VIP Nails & Tans opened after one year of planning and dealing with tons of bumps in the road. Not to mention the fact that after being open a few short weeks I got sick and had to be off for six weeks. My mother stepped up and held things together while I struggled to get better and back to work. If it had not been for the simple fact that I still lived at home and kept expenses at a minimum I could not have survived financially. I was very blessed that I was conservative enough with my spending and planning. But even so, you never can completely budget for the unexpected.

Business in the late ’80s was really starting to catch on. Nails were booming. Opening with three nail technicians in 1986, we ended the ’80s with a total of 10. VIP was surely growing. By 1992 we went from leasing a 1,400-sq.-ft. building to 2,200 square feet. We increased our boutique area with more unique purses and jewelry. With more than six years having passed since our opening it was an exciting time.

A Letter From the IRS

So, the real story begins when a letter from the IRS arrived in the late summer of 1994 stating that the IRS was reviewing our company for a random payroll audit. The only correspondence I had ever received was from the State of Michigan in 1987, the year after we opened, requesting information regarding my technicians. I filled out the form and they sent back that everything was correct and that my technicians were deemed independent contractors. I thought, OK, was there an issue? I had no idea. I called my accountant and told him about the letter. He too did not seem concerned and said he had all the company records in order and he would work with them. I called the agent and set up our meeting at the salon. Since I was doing everything the way the business was set up, was never late filing anything, and always paid my bills on time, I felt confident the audit would be just fine. The agent met with me and my mother at VIP. The agent was, of course, very businesslike but asked us many questions that didn’t feel relevant to a random payroll audit. A few of the questions that were asked were: “Who set up the business ­organization?” “Do you write off your car?” “What type of benefits do you give your technicians?” She requested mileage logs, copies of bank deposits, and any type of agreements that we had with technicians. I told the agent to schedule a meeting with our accountant for that information. She spent the next few weeks at his office going through all of our company’s financial information.The dreaded phone call came on October 11, 1994, from my accountant. He told me the IRS felt the workers were misclassified. He said they were currently classified as independent contractors and the government felt they should be classified as employees. I will never forget the words said to me after that. He told me, “If this is true you would owe the government more than $85,000.” I was absolutely speechless and in total in shock.

The truth of the matter was that I had no idea what the differences were between an independent contractor or employee when I opened my company. I did not know that one matched FICA/FUTA payment for Social Security to the federal government and one didn’t. I had gone to a CPA firm to set up my company and find out if I should be a corporation, DBA, etc., and also how to handle everything from the payroll to any legal requirements. If I had been told the differences, I would have set my company up completely differently.

I also had an attorney who oversaw the incorporation for me but was not involved in the day-to-day set up and filings. There are many things that you do not realize need to be prepared to create a business such as your sales tax licenses, federal identification numbers, state requirements, etc. I paid the CPA to take care of those business details for me. I was busy setting up the business strategy, lease, signage, inventory, equipment purchases, and all the many things it takes just to open the doors. My passion was nails, not really business.

After receiving the dreaded call I immediately started researching everything. I called the CPA who had set me up (he is out of business now) and he indicated to me that it was industry practice, but he would not have set me up that way unless I had agreed. Agreed? If that was so, why was I not privy to the implications of doing it wrong? I was devastated. I felt that, at the least, responsibility for doing the job incorrectly would be a burden that he should incur. He obviously was paid to do the job that I didn’t know how to do. I was livid to say the least.

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 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.

 

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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