Independent Contractors and the IRS

Editor’s note: this article is not intended as legal advice. If you have any questions about booth rental or independent contractors, or are currently audited, seek the counsel of a qualified CPA and an attorney who specializes in labor law and employment issues.

There’s an old saying: If you go to war with the IRS, you’ve already lost. NAILS spoke to several salon owners who are currently facing the unforgiving eye of the IRS over the classification of their workers. We found that regardless of region, business owners – not just beauty business owners – are having a hard time understanding where they went wrong when it came to classifying workers as independent contractors (ICS), not as employees.

If you are a salon owner and you want nail technicians working on site but you don’t want to take taxes out of their paychecks, or if you want to simply rent space, the best thing you can do to ensure that you are complying with the law is to talk to a lawyer who specializes in employment issues to ensure that you set up your system legally and appropriately. Don’t rely on the advice of other salon owner: don’t get involved in schemes that are cute, complex or too-good-to-be-true; and don’t expect ignorance to be a defense.

Gary Pierson, a partner with the law firm of Lytle Soule Curlee in Oklahoma City, Oklahoma, specializes in the representation of management in Labor and employment Law Section of the Oklahoma Bar Association.

Says Pierson, “The biggest problem with the [independent contractor] issue is that people are taking an ‘ostrich’ approach. They are hoping they can get away with classifying someone as an independent contractor rather than doing any type of investigation with someone who knows how to classify employees and checking to see whether they are on good grounds or not.”

WHAT’S GOING ON

Misclassification of workers (calling IRS those workers who should be employees) is a violation of the Fair Labor Standards Act (FLSA). The whole topic is among the most hotly debated and high misunderstood human resource topics today. One obvious reason for the turmoil is that when workers are incorrectly classified, the IRS doesn’t get its fair share of taxes (independent workers are notorious for under reporting their income). The estimated tax loss from uncollected taxes is $ 2 billion nationwide. For ICs, business owners don’t withhold what are called “employee trust monies,” which include social security and unemployment taxes. Neither do employers pay workers compensation tax on them. Independent contractors are supposed to pay their own taxes.

Many of those involved with ICs say that IRS does not really care how you pay someone, as long as it can be assured that everyone is paying their maximum amount of taxes and that the system doesn’t become a way to avoid taxes, but the IRS isn’t satisfied that it is getting its fair share of individual income and so it has begun gong after business owners. Granted, there are some employers using ICs as a way of avoiding paying fair wages or offering benefits but most owners have set up the way they have because that’s the way so many people in the beauty business do it. The real or imagined abuse of the system has led to a situation where everyone is now under the microscope. Unfortunately small business owners are the ones most like to be caught in this spider’s web.

WHO’S IN HOT WATER

Numerous industries besides the nail business have been affected by the IRS clamp-down, and all operate under slightly different enough that it’s unlikely that business owners in different fields can help each other navigate the rules, regulations, gray areas, and black holes of IC law. For example, real estate agents, who have always had powerful lobby representation, got nationwide IC classification years ago. Limousine drivers, bicycle messengers, construction workers, summer interns, electricians, exotic dancers wanted the right to be classified as employees for workers compensation purposes, sued for it in court, and have won the first round.)

Rather reclassify yo9ur workers after years of doing business one way – which could draw unwanted attention – many business owners have attempted to use “safe harbor,” which means that owners could avoid penalties and taxes for having done so, as long as they could prove that they could prove that they did adhere to the law’s qualifications. Passed in 1978, Section 530 notes three major qualifications that “employers” must meet if they are to be permitted to continue to treat “workers” as ICs – with impunity from employment tax liability.

First, the “employer” must have consistently treated similarly-situated workers as ICs. (In other words, no mixing of employees and contractors; you must have used all ICs as nail technicians.)

Second, you must have filed “information returns” (1099) indicating the worker was an IC. Since renter pay you a rent and no 1099s are issued, you cannot get safe harbor if you are operating under a rental situation. This means you must have issued a 1099 for each person.

Third, you must have had a reasonable basis upon which to make the determination that the “employees” were ICs. Reasonable basis includes 1) a prior IRS audit; 2) a judicial decision, review ruling, technical advice, or private letter; to 3) long-standing, recognized practice of a significant segment of the industry in which you are engaged.

Section 530 also makes a clear legal separation between booth renters and ICs, which is something the nail industry has never done.

If you rent, forget safe harbor. If you’ve mixed employees and ICs or if you issued 1099 but had no “reasonable basis” for doing so, it won’t apply. And if you have always had an arrangement that involved payments, such as commissions, and you called everyone independent, don’t expect an easy out.

Says Pierson, “We have never taken a safe harbor defense; we’ve always taken the defense that the people are truly independent contractors. When you take safe harbor, you are admitting you can’t prove your workers are ICs, which is an admission my clients are not willing to make.”

Desperate salon owners are clinging to the “recognized practice” defense hoping that a plea of “We’ve always done it that way” will suffice. But saying there’s a long-standing precedent and proving it are two very different things.

You can’t simply produce an industry survey or say that everyone knows that nail salons don’t use employees. You must produce a list of specific names of competitive nail business, the individuals who own them, and their addresses. These businesses must operate the same way that yo9u do and be located in your metropolitan area.

Can anyone think of a reason that your competitors might not happily go on a list that is essentially a red flag the IRS – all to help you out?

Kevin Gallagher, who was recently featured in Inc. Magazine for his problems with worker classification and his fight to get bicycle messenger declared ICs in the state of Illinois, says that when Section 530 was initially passed, the IRS stood back for a while. But when the agency began to receive “surveys,” supposedly proving long-standing practice, they began to pick those surveys apart.

“We had a survey done by our national organization that showed 83% of messengers as independent contractors,” he says. “But the survey was done without company names.

“UP to 1980, the IRS interpreted Section 530 liberally, but once it saw it was losing revenue because independent contractors were not paying taxes, its interpretation narrowed,” he says.

“For now, the mood of the auditor and the IRS district representative can decide what a ‘significant portion’ of the industry is. If you get a list of names and after five years of appeals your case comes up, the IRS could say the companies are different now and reject a large portion of your list. It would be the death of 1000 cuts for you.”

BETTER NEWS FOR SOME

Wayne Smith, owner of the Wayne Smith Co., a limousine operation in Washington D.C. claims he has had great success with Section 530.

“Congress created it when it decided the taxpayer needed some protection from arbitrary rules,” he says. “If you’re audited and can show you always issued 1099s and that a significant number of competitors in your metropolitan area operate the same way to do, you do not have to reclassify independent contractors as employees. I’ve done surveys in specific areas for limousine companies and showed list to the IRS establishing that 60%-70% of the businesses operated with independent contractors. Once the IRS saw these lists, they did approve safe harbor for submitting company.”

Cautions Smith, “of course you must have faithfully issued 1099s and be able to show that you always used independent contractors.” Smith says that for an investment of about $1000, a salon owner could get a phone book and nail mail surveys to all competitors in the metropolitan area.

If you’re facing an IRS audit, there are some things you can do. “Start with an informal telephone survey,” Smith says. “If the owner says, “This is how I do business,’ send out a survey. The questionnaire of the survey should ask for the company name, the identification of the person filling it out the number of independent contractors, the number of years in business, and so forth. Getting the person’s signature is the trick. A lot of people are afraid to fill it out. That’s why it’s best to have an outside person come in and invite all your competitors to a meeting on the issue.”

Smith, who acts as a mediator for a fee, tells, meeting attendees that if just one business in the industry in questions loses, the others will soon. He stresses the “one for all” approach.

But before you run to do a survey, consider how nail technicians differ from limo drivers, who are mostly ICs, not renters for the purposes of safe harbor, how will renters be treated?

Since safe harbor does not affect rental salons because, theoretically, they do not issue 1099s, it’s unlikely that they will get involved with a survey that will be given to the IRS. In fact, since rental is a different situation (when done right), the IRS could look at a survey and decide it is invalid because 50% of the salons in your area are rental, not users of ICs; therefore, a significant portion of your competitors are not doing business they way you do (Your competitors would be primarily sole proprietors.)

Another drawback of safe harbor is that it does nothing for the “employee,” If you get safe harbor, your workers are considered ICs only where your taxes are concerned. The IRS can still classify them as employees where their own taxes are concerned. This own taxes are concerned. This might invalidate an individual’s Keogh deductions, because Keoghs are only for the self-employed. The person would not be able to participate in an employer’s retirement plan, and some cases, would not be able to set up one of his own. If the “employer” offered no retirement plan, the worker could, in some cases, open an IRA, but allowable IRA deductions are far less than those of a Keogh. Numerous other deductions could be disallowed as well if the person in question is not considered self-employed for his or her own tax filing purpose.

By gaining safe harbor, you might save yourself, but mess up your “non-employees.” Even after winning safe harbor, making workers employees or renters might make more sense from their point of view.

The risk of ignoring these issues is great. The government wants its money. Says one salon owner, “The IRS can demand not just your portion, but the employee’s portion, plus penalties and possibly charge criminal penalties.”

If you are found to have misclassified employees, you can try to avoid penalties by proving you had no intent to defraud, but you cannot avoid paying the back employee trust monies.

Says Pierson, “No law exists that says back taxes are forgiven. You can attempt to avoid IRS penalties and criminal prosecution by showing that you operated in good faith by obtaining information to ascertain whether a person is truly independent or an employee. If you called a CPA, gave him all the details and he told you – preferably in writing – that the person can be classified as an independent contractor, you may have operated in good faith. But to tell a technician, you’ll be an independent contractor and we’ll both say that’s how we work,’ is not good faith; nor is casually asking a CPA neighbor. You don’t avoid the taxes under any scenario, only the penalty. There is no tax waiver even if you acted in good faith.”

Of course, if you are armed to the teeth with documentation and expert advice for which you paid good money – and if you have followed every letter of the law – you may be found to be in compliance.

AFTER THE FACT

If you are found to have misclassified employees, often the easiest way out is to surrender, however begrudgingly, and set up a payment schedule to pay taxes and penalties and penalties that hopefully won’t bankrupt you. You can appeal an IRS ruling, but remember that the IRS has all the time, authority, and manpower in the world to get the money it wants. And it doesn’t have to waive payment while you appeal. One owner was told to pay within 30 days and then appeal is she wanted. If you have any doubt whether you’ve correctly classified, you should consult an attorney who specialize in these issues. The longer you will spend building up tax liability and potential penalties. Notes Pierson, “Legal fees to fight the IRS can be astronomical. Sometimes it’s better to take your lumps.”

Every situation is different; therefore, don’t stake your business on advice from anyone other than an advice from anyone other than an attorney who specializes in employment. If you are audited or if you choose to fight the IRS, gather all the documentation you can and get specialized representation.

If you are a rental salon, be prepared to product leases, workers compensation waivers, and evidence that you complied with the IRS’s 20 points, which ironically refer to ICs, not renters.

If you’ve been paying employees ICs, also be prepared to present evidence that you meet the IRS’ 20 points. Try to get a survey of your competitors as Smith suggest. If you can get a significant number to participate and sign the proper form, your likelihood of meeting safe harbor increases standards significantly. But don’t do a survey and assume nothing else can trip you up. Follow legal advice to the letter.

If all this sounds ugly, it is. You can try to make absolutely certain you have true ICs or renters, but some guidelines are vague. If you don’t know how to put yourself in compliance or don’t know what being in compliance even means, take responsibility for educating yourself.

DETERMINING WORKER CLASSIFICATION

While salons have muddied the waters, there have always been renters and ICs. Says Ada Menzies, who co-authored a manual on managing booth rental that is available through the NCA, “I had an electrologist who was an independent contractor, not a renter. She came in my shop one day a week. She had her own phone and worked at several other locations. She carried her own insurance. She got a 1099 from me.”

One important point here is that the IC was not dependent on Menzies for her income, this is part of the “economic reality” test, which courts have used.

Still confused? Look at this example: a freelance envelope stuffer who works at home stuffs envelopes for dozens of companies that issues her 1099s, which she files with her taxes. She buys all her own materials, pays for her own health insurance, gets up as late as she wants in the morning, drinks beer while she works if she wants, and occasionally accepts a job where she goes into a facility to work, but is responsible only for the end product – her stuffed envelopes. She is a true freelancer.

On the other hand, her only relationship with her landlord is that she pays him rent. It is in no way similar to her relationship with insurance companies of anyone else who hires her stuff envelopes. Also, her primary business is different than that of most of the companies that purchase her services.

If you want ICs, not booth renters, no matter what has been done in the past, or what your current opinion is, start gathering data today to make a good faith effort to determine whether you have misclassified your nail technicians as ICs when they should be employees.

Says Pierson, My best advice is to get a listing of the factors that judicial and administrative bodies look at from the courts, to the unemployment commission, to the IRS. Look at the factors they use and try to make a good faith determination. Don’t be cute and don’t think you can get away with something. Any idea you come up with, someone else has tried before. Look at the factions objectively and if you think you have a close call, ask your CPA or attorney and spend a couple hundred bucks to avoid what could be a financial disaster a few years down the road.

Gathering all the pertinent factors is time-consuming but well worth the effort. Call 1-800-TAX FORM and request publication 937, which includes the IRS’s 20 factors for determining IC or employee status. Then, check state laws. Sometimes the IRS regulations are different than state land on IC issues. You want to meet the requirements of both bodies. The unemployment compensation commission usually has different methods for determining IC status and this is no small thing.

Says Pierson, “If an independent contractor worked for you, the relationship breaks apart, she goes to unemployment, files and, is awarded $9,000 guess who will pay? Sometimes, the most strict regulations are with the unemployment.”

According to an article Pierson wrote for HR magazine, a 50-state survey revealed that the basic tenet of an IC relationship is that the contractor has an independent occupation and is only responsible for the finished product. Despite this, a specified definition that suits all situations that could arise is difficult to come by. Therefore, it’s vital that decision makers consider the wide variety factors that come into play.

Besides the three basic areas mentioned above, courts have looked at who controls the work. Pierson notes that control can mean the right to control rather than the actual exercises of control.

“My final advice is to simply follow good business practices,” adds Pierson. “You can’t do through the back door that which you can’t through the front door.”

RENTERS ARE SOLE PROPRIETORS

If you want to operate a rental business or are currently acting as one, learn everything you can about renting and strictly adhere to the guidelines. You might go talk to landlords, as opposed to owners if rental salons, besides acting like “just a landlord, further measures are essential because you are both working out of a business and that business relates to both occupations. This makes for every muddied waters where employee classification is concerned. Get a legal lease. Follow the IRS’s 20 points. Insist renters carry all insurance, including liability, disability, and business insurance. (ICs should, too) Don’t accept any money other than your rent and declare it as rental income, which is taxed at its own rate. If your state has a separate IC license, insist on seeing it. (Texas, California, and Colorado do.) Ask renters if they’ve incorporated their business. Any sole proprietor can. This will help you further. Every state has a worker’s compensation waiver; use it. Tell renters they are not entitled to unemployment. It is almost always workers compensation or unemployment agencies that are alerted to a situation by a worker, who ends up triggering an IRS audit. If they have absolutely no question that the person is not entitled to payments, the IRS is less likely to be brought into the matter.

A salon owner in the northeast, who requested that her name not be used, says she was following the IRS’s 20 guidelines and used a former IRS agent, as well as a tax specialist and a CPA, to set up her business. She had written contracts. She had workers compensation waivers. She says she did everything right. Still, the IRS came visiting and found her to be in non-compliance. She was told she owned $80,000 in back taxes and had to reclassify workers.

It cost her $20,000 to set up contracts and another $30,000 in legal fees to fight the ruling after filing an appeal; she got a verbal statement from the appeals agent that she was in compliance. She’s still waiting for written confirmation.

“The upside [of my experience] is that once they rule in my favor; they can’t come back against me again for the same thing,” she says. “If the IRS says you are in compliance with independent contractor issues, they can’t bring you up on them again, ever – IF you keep doing things the same way you were doing them when you got the ruling.”

Just the same, she asked her name be omitted from this article.

IF YOU ARE AN EMPLOYER

If you currently operate under an employee/employer set up, th8ink twice before you change it. There is no reason to enter a chaotic situation at a time when it is political hotbed.

If you are having a hard time getting or keeping employees in your area, fight back with facts. Have a prepared list that compares the cost and responsibilities of being independent versus working for you. Include benefits you offer on one side and the cost of doing business, such as advertising, self-employment taxes, and various types of insurance, accounting and supplies on the other. Without using scare tactics, tell a prospective employee what is the situation is regarding misclassification of employees. Stress that they cannot get unemployment or workers as ICs. Let them know the real story. In the end, they might find it easier to work for you as an employee than to be an IC a competitor.

FUTURES IN LIMBO

If you’ve already set up a particular relationship and suspect it may not be compliance, try to bring it into compliance as soon as possible. If, for whatever reason, you’d prefer to abandon ship, there is no guarantee that you can reclassify and not get in trouble for the time during which you were incorrectly classified. However, if you reclassify January 1, it is less of a “red flag” because you did not issue 1099s and W-2s in the same year. Small comfort, but it’ all there is right now.

Gallagher believes that the only way around the complexities is to lobby for a law for your specific industry. With the help of a former legislator and his lawyer, he has written and filed Illinois House Bill 179, which would exempt couriers in his state from penalties for using ICs.

If you truly want to reclassify, do it January 1; if you want to fight for safe harbor, contact your attorney. And no matter how you classify workers, keep paperwork like you’ve never kept paperwork before.

Most of all, avoid overly creative solutions and those who offer them.

“We have a saying here in the Southwest,” says Pierson in response to a description of a particular creative setup. “You can name a pig Pegasus, but it still can’t fly.