Indenpendent Contractor or Employee?

A reader left a comment asking if the salon owner should be withholding taxes from her commission-based paycheck. That's a great question and deserves a blog entry all to itself.

Many employers/salon-owners believe it is their decision whether or not to withhold taxes from a worker's pay. They believe if they call you a "contractor" instead of an "employee" they are OK to not pay the taxes. The IRS, however, looks at things a little differently. The IRS's website has a whole section on Independent Contractor versus Employee. Go to www.irs.gov and search on "independent contractor or employee" for more information. The general rule is that if a business exercises a certain amount of control over the worker, they are a legal employee (subject to payroll taxes) no matter what the employer says. The IRS looks at three areas to make the determination:

1) Behavioral

2) Financial

3) Type of relationship

Behavioral refers to how you perform your job. How much control does the salon owner have over the performance of your work? Do you set your own hours, or do you have a schedule you are required to maintain? Are you required to use certain products or tools, or are you free to choose? Are there certain procedures you are to follow when performing the work or are you determining how the service is performed?

Financial - Contractors are free to offer their services to the community at large. They often advertise and promote their own business. They also have an opportunity for profit or loss. Do you go out and find your own clients, or does the salon owner advertise on behalf of the salon? Do you control your own client data or does the salon?

Type of relationship - An independent contractor relationship is generally for a specific period of time or for a specific project. If a worker is hired with the expectation that the relationship will continue indenfinately, this is a sign of an employee/employer relationship.

OK, so now you may have a good idea whether you are, in the eyes of the IRS, an employee or an independent contractor. Why should you care and why should the salon owner care?

Employee Perspective - An independent contractor is responsible for their own taxes. You receive your gross pay and must be disciplined enough to put some of that money away so it will available at tax time. You may also need to make estimated payments during the year to avoid penalties. You are considered self-employed so you can deduct from that gross income any business expenses (business cards, advertising, license, etc.). In addition to paying income taxes on the net profits of the business, you also must pay Self-Employment Tax. This is a tax of 15.3% on top of the income tax. (It's actually 7.65% of employee social security tax + 7.65% for the employer's share of social security tax - since you are self-employed you pay both halves of the social security tax).

Salon-Owner Perspective - The salon owner is calling you an independent contractor for two reasons - 1) she doesn't want the bother of withholding and paying in taxes and 2) she doesn't want the financial burden of paying the employer share of social security (not to mention unemployment tax, worker's compensation insurance, etc). If the IRS catches up with a business that is paying people as independent contractors instead of as employees, it can be a fatal blow to the business, not to mention the owner's personal finances. The IRS can go after the owner PERSONALLY for the unpaid taxes. As a salon owner, this is not a risk I would take. All it takes is one disgruntled former worker to open an IRS investigation.

Now, in defense of the salon owner - the writer did not mention what her commission % is. It may be that the owner is paying a really high commission so the worker can pay in all the taxes and come out about the same. Meanwhile the owner saves a lot of time and trouble. That will not save her from the IRS if they come calling. But if an owner is paying a crazy-high commission already, the salon will not be able to afford payroll taxes on top of that. If she converts you to employee status and starts withholding taxes, you need to expect a cut in the commission rate so the salon can remain financially healthy. It's bad for everyone if the salon isn't financially viable.

If you think you are an employee in the eyes of the IRS and should have taxes taken out, you may want to print out this post and show it to your salon owner. Misclassifying employees as contractors is a HUGE financial risk on the owner's part. If she is concerned about the hassles of payroll (and who isn't) she can hire a payroll service to handle everything. I use Advanced Payroll Service (www.advancedpayroll.com) and love them. Other services are Paychex and ADP. Many bookkeepers and accountants also offer payroll services for a reasonable rate. APS is responsible for all the tax filings related to my payroll, they generate the W-2's annually, and they handle the new hire reporting required by my state. I pay about $75 per pay period (every 2 weeks)for about 18 employees. That rate includes some extras like direct deposit and delivery so it could be whittled down if necessary.

By the way, the salon owner is also required to withhold taxes on your tips, and again, the owner can be held liable if this is not done.

My advice for salon owners - don't play with fire. If you don't know if you are paying your workers appropriately, talk to your accountant or bookkeeper. If you should classify your workers as employees, just do it - yes, it's a hassle, but not half the hassle of having the IRS breathing down your neck.