Employee or independent contractor?

Talk about a loaded question. For years the industry has been split on whether employees or independent contractors make a better staff. But philosophical arguments aside, it all comes down to Finance 101 for many in the salon industry. For some salon owners the savings in payroll taxes alone by using independent contractors are about 8.5%, not to mention that the savings in benefits, worker’s compensation and unemployment insurances, and product costs means the difference between an “Open” and an “Out of Business” sign. For nail techni­cians, on the other hand, the allure of “being their own boss” and collecting all the money is equally strong.

“From a salon owner’s standpoint, it’s advantageous to rent because you get a guaranteed return on your investment,” says Ken Lange, editor and publisher of Salon Publications and author of Booth Rental Made Easy. “To have a profitable employee-based salon today, you’re only able to pay 42%-45%, and then you have to take product costs out of that. For the nail technician to earn a 40% commission, she might as well flip hamburgers at McDonald’s.”

The problem arises, at least with the IRS and other government agencies, when salon owners straddle the fence, claiming their workers are independent contactors when it comes to payroll, yet treating them as employees in almost every other way. Again, it all comes down to money.

“In 1996 the beauty industry as a whole reported [to the IRS] $20 billion of income, while a National Accrediting Commission of Cosmetology Arts and Science (NACCAS) study that came out in April 1999 based on 1998 figures labelled it a $50 billion industry,” says IRS senior program analyst Don Segal. “Employment status is not necessarily the problem; it’s workers not reporting their income. [But] independent contractors have a greater opportunity not to report their income than someone who gets wages and tips.”

Nor is the IRS the only one scrutinizing business’s treatment of independent contractors. The United States Department of Labor or your state’s own department of labor may investigate an independent contractor’s claim for overtime, unemployment, state disability, or workers compensation for an on-the-job injury. Or, your state’s tax agency (usually the state franchise board) may decide to conduct an employment audit to review workers’ status. While everyone fears the IRS, experts say that an independent contractor’s unemployment or worker’s compensation claim triggers worker status reviews more often than the IRS snooping around.

Don’t Bet These Odds

Would your operations withstand the scrutiny? Experts say most wouldn’t. “I would say at least half of independent contractors are classified incorrectly,” asserts James Urquhart, a tax attorney in Irvine, Calif., and the editor of “The Independent Contractor Report,” a monthly report that cites more than 700 sources on employment tax cases, rulings, and other issues concerning the independent contractor issue.

Misclassifying your workers is one mistake you don’t want to make. As an example, Urquhart points to the 1998 case, LA Nails vs. United States, in which the judge deemed the Rockville, Md., LA Nails’ nail technicians were employees. LA Nails, which had filed suit seeking a $2,265 refund and challenging the assessment of payroll taxes, came away with a whopping $96,545.65 tax bill (plus interest and costs). In his decision, the judge cited several factors that indicated to him that the nail technicians were employees: The employer retained the right to control the manner in which services were performed, and the nail technicians had minimal exposure to business loss as they did not lease their stations, purchase their supplies, or have sole responsibility for resolving customer disputes.

Not that victory is always much sweeter: As NAILS reported in 1997, Dallas nail salon chain owner Ira Bloom won a battle with the IRS over the status of his independent contractors, but it took five years and approximately $100,000 in legal fees.

Contrary to popular rumor, Segal asserts that the IRS is not “cracking down” on the salon industry, but it does want its due. If, as a salon owner you’re treating nail technicians as independent contractors for payroll purposes but is found to be treating them otherwise as employees, you will be left holding the checkbook, so to speak.

Not that anyone’s made it easy to follow the rules, as the rules themselves—the IRS’ infamous “20 Common Law Factors” list—are vague and subject to interpretation. Which is why we asked the IRS, employment law experts, and salon industry consultants to clarify the difference between booth renters and independent contractors in the industry, explain the tests and measurements government agencies use, and point out the most common mistakes of salon owners in regards to independent contractors.

Booth Renter or Independent Contractor?

In the salon industry, the terms independent contractor and booth renter are used interchangeably and, true, both are self-employed. However, a booth renter is an independent business owner who leases space in a salon much like the salon owner leases space in a larger shopping center or office building. While an independent contractor contracts her services to other business owners, and receives a Form 1099 at the end of the year I showing payment for services rendered.

Segal explains: “A booth renter is a small-business owner renting space from the salon owner, who is her landlord. The booth renter handles her own receipts and will not get a Form 1099 from the salon owner showing payments for services performed. Instead, the booth renter will issue a Form 1099 to the salon owner for rent paid.

“An independent contractor, on the other hand, is someone the salon owner has come in to do a specific task for the salon owner at an agreed price, and who in most cases receives a Form 1099 showing payments from the salon owner,” he continues. “When you get into the differences between an independent contractor and an employee there are different shades of gray, but in the purest sense an independent contractor is called in to do a specific task”

“A critical concept is the direction of the flow of money,” Urquhart adds. “In a booth rental situation, the nail technician is the tenant and the salon owner is the landlord. The flow of money is from the tenant to the landlord. In an audit, the IRS always looks to the payer, in this case the tenant, to see if they’re misclassifying the relationship. If the payer is the tenant, it’s a rare thing the IRS would call on the landlord because the landlord isn’t paying any money to the tenant.”

Ken Cassidy, president of Kassidy Salon Management (Long Beach, Calif.), consults with salons on booth renting and employee relationships and also markets booth rental contracts that show salon owners how to be more profitable above collecting base rent. As are-suit of his years working with the industry and the IRS, urges salon owners and nail technicians alike to book for & rent with a flat rental fee. “The IRS is looking for the completers opposite of the employer/employee relationship,” he asserts. “My understanding from working with them is that in some states they don’t accept a commission relationship at all.” 

By the same token, Cassidy argues that the line between booth renter and independent contractor blurs in the salon industry because, in the larger sense, independent contractors work for many people, come and go as they please, and generally don’t have long-term relationships with one business. In the salon industry, quite the opposite is true: Booth renters rarely work in more than two salons, often stay in the same location for long periods of time, and often work a set by their own choice.

As far as Urquhart’s concerned, that reality is another strong argument for a booth rental arrangement, saying it’s quite simply a less risky arrangement. Even more telling is the IRS’ Market Segment Specialization Program (MSSP), Beauty and Shops. The MSSP, a training manual for auditors, states that “the one factor which appears to hold overriding persuasive value in the case of hairstylists is the nature of the remuneration... the factors tending to show an employee relationship seemed to predominate over independent contract type factors in those situations where remuneration is based on a percentage of earnings, whereas the opposite is true in those situations such where the hairstylists rents the chair for a fixed...fee.”

Additionally, the IRS has told NAILS and other industry experts that independent contractors paid on commissions are most often determined to be employees.

All Tests Graded Pass/Fail

The biggest problem with choosing an independent  contractor relationship is that there are no hard-and-fast rules as to what makes an independent contractor relationship as opposed to one that’s employer/employee. In part, it’s because there are few laws governing the relationship. Instead, most of the guidelines are based on common law factors, which are gleaned from court decisions made over the years and are subject to varying interpretations. According to Urquhart, the IRS based its examination on a list of 20 common-law factors from the 1930s until recently. In 1997, though, Segal says the IRS attempted to simplify the question by grouping the 20 factors into three categories that encompass behavioural control, financial control, and relationship of the parties. These three categories include:

Facts of behavioural control show whether there is a right to direct or control how the worker does the work and include instructions about how, when, or where to do the work; what tools or equipment to use; what assistants to hire to help; where to purchase supplies.

Facts of financial control show whether there is a right to direct or control the business part of the work. For example, independent contractors should have a "significant investment" in their work, have unreimbursed business expenses, and -soma say most importantly- have an opportunity to realize a loss as well as a profit.

Relationshp of the parties facts illustrate how the business and the worker perceive the relationship. For example, a written contract may show how the business and the independent contractor have defined each other's rights and responsibilities. (For a full explanation of these three factors, which the IRS says it introduced in 1997 in place of the 20 Common Law factors, see IRS Publications 15-A and 1779.)

And once you think you've navigated the IRS' three-pronged test successfully, beware: Other government agencies may use different tests- such as the "economic realities" test and the ABC test- with completely different results. In brief, the economic realities test asks such questions as whether the work is an "intergal part" of the employers' business; if the employee depends on the compensation for payment of living expenses; if the individuals offer her services to the public in her own business name; if the work is customarily performed by an independent contractor; and who has the right to control.

The ABC test, on the other hand, requires that all independent contractor relationships meet the following three conditions: a) the individual is free from control or direction of ther performance of such services; b) the service is either outside the usual course of the business or is performed outised of all the places of business; and c) the individual is engaged in an independently established trade, occupation, profession, or business. Almost two-thirds of state departments of labor utilize the ABC test (with most of the rest using the common law factors; only Michigan uses the economic reality test at this time.)

Spell It Out

To try and examine each of the various factors the IRS and government agencies consider when examining the status of a salon’s workers would take an entire book As Urquhart points out in his book, The IRS, Independent Contractors, and You!, there are in reality more than 50 common law matters-of-fact that can be used to determine the status of a worker. Even so, the IRS’ new, three-category approach makes sense at least for the salon industry in light of the feet that the most common mistakes Urquhart and the other experts we consulted cite fell into those three broad categories.

First and foremost, Cassidy says, many salons neglect to use a written contract “For those who do, it’s often incomplete and inadequate,” Cassidy notes. “Salon owners and renters have to understand that they need a contract not just for the IRS and state but for day-to-day operations. The contract makes the booth renter totally responsible for the operation of her business and lets her know what she can and can’t do. It should present a complete structure for the business relationship.”

“Contracts are becoming much more important,” agrees Rebecca Naser, an attorney specializing in labor and employment law at Arter & Haddon in Washington, D.C. “A contract provides your first line of defense because it’s a document that sets out the parameters of the relationship. If anything, it supports your good-faith efforts.”

While Naser says the contract doesn’t have to be overly complicated, she and the others agree it must clearly spell out each parties’ rights and responsibilities. Naser cites eight points she thinks must be covered in every independent contractor contract:

1. Spell out that you are hiring the person as an independent contractor and make a statement that explains that in signing the contract the independent contractor understands she is self-employed and is not eligible for employee benefits or to make claims against the salon for unemployment insurance.

2. Describe the relationship in terms of what each of you will provide and how the independent contractor will be compensated.

3. State that the independent contractor is to provide her own equipment and supplies. If the salon is to provide any equipment such as the workstation, spell out what percentage of the rent paid or service pays for the use of the equipment. Likewise, spell out any other products and services - including everything from paper towels to receptionist and janitorial services to use of the telephone - that are included in the rent or commission. These items are traditionally provided to employees and should not be provided as part of the rent; however, you can contract for their provision. Also make clear that there will be no salon reimbursement of the independent contractor’s business expenses.

4. State that the independent contractor is an independent agent and, as such, can subcontract her work. (If you demand they do the work themselves, you’re exercising control, which means they’re an employee.)

5. Make the independent contractor responsible for collecting payment for her services.

6. State that yours is not an exclusive arrangement and that the technician is free to provide her services to other salons.

7. Require that they obtain and maintain the appropriate business licenses and insurances such as professional liability insurance, general liability insurance, etc. (Know what licenses your state board requires of independent contrac­tors and specify that they must have those licenses.)

8. Make the contract valid for a defined time period, and define what situations and circumstances can make the contract null and void. (For example, Naser says a salon owner is perfectly within her rights to require an independent contractor to present a valid license and comply with state board regulations or risk termination of the contract.)

Mind Your Own Business

If it looks like a duck, waddles like a duck, and quacks like a duck it’s a duck. To the IRS, that means if it looks like an employee ... you know the rest. A contract goes a long way to legitimizing the relationship, but it has to be more than a piece of paper stuck away in a file For example, Urquhart cautions salon owners against training or paying for training of independent contractors because that indicates you have control over the way they do nails. Likewise, he emphasizes that independent contractors must supply their own equipment and products, and that their business cards should be printed with their business name, not yours (unless ifs to say something like,”... located in XYZ Salon”). Urquhart also encourages independent contractors to do their own advertising in their own business name, which shows they’re offering their services to the general public.

To cover the “significant risk of loss” such as that the court looked for with LA Nails and did not find, other experts rec­ommend charging a flat rent.

Then, of course, there are all the other factors such as control over prices, schedule, dress, technique, and products, just to name a few. Everything else being equal, though, Segal says the party that has financial control is most telling to him.

“If the salon owner is handling all the money through a central register and paying the independent contractor, the contractor has no financial control,” he explains. “To me, a true independent contractor has financial control, a significant investment in her business, and liability for customer complaints and injuries. If the owner handles the money and carries the insurance, those are important, negative factors. Next is a written contract. You should have a professional get involved in establishing the relationship and creating a contract to formally define it.”

Not for the Weak of Heart

Get professional advice before determining which direction to go! Your best resources include an accountant, tax attorney, or industry consultant. Regardless of which you choose, make sure the person understands both the independent contractor issue and the salon industry because you’re the one who’s ultimately liable for the decisions they help you make and the structures they help to create. While the several hundred dollars may seem to be more than you want to spend, consider the tens of thousands of dollars it could save you a few years down the road.

At the same time, Urquhart cautions salon owners that the choice to utilize independent contractors is risky regardless of the safeguards you put in place. “Is it legal? Yes,” he asserts. “But it’s a very dangerous thing. If I was going to set up a salon, I wouldn’t do it because I consider it an unacceptable risk.”

Surprisingly, one of the nail industry’s strongest proponents of independent contractors and a triumphant victor against the IRS echoes Urquhart’s comments. “If I was opening again from day one, I would probably try to figure out a way to make my nail technicians employees and avoid the whole issue,” Bloom says. “If the IRS or the state wants to come after you, it’s easy to do and unfortunately in tax law you’re not innocent until proven guilty. I don’t know that it was worth all the expense and aggravation and disruption to my personal and business lives.”

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