Renee Skrocki (left) and her mother Julie.

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.

Renee’s Story

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.”


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.

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