The IRS is cracking down on spa owners for classifying their therapists as independent contractors when, in fact, they are employees. The penalties for this violation are severe and can equal 100% of the tax that should have been withheld, or more. This punishment can be held against both the spa owners and the massage therapist. The reality is that, in this business, it's estimated that up to 99% of spa and wellness center owners with booth rentals or independent contractors would not pass an IRS audit.

Many businesses have been gravely affected by audits due to their ignorance of tax laws and bad legal advice. The choice of whether to classify a massage therapist as an employee or an independent contractor depends on several factors, such as the specific goals of the business and the personalities of the individual therapists.

This important difference between an employee and an independent contractor is determined through strict IRS regulation and under common law. Each factor depends on the degree of control shown in the relationship between the business and the independent contractor or the employer and the employee. It's not imperative that he or she actually exercise this control, but that he or she has the right to do so. There are three degrees of control and independence: behavioral, financial, and finally, the parties' relationship.

Attempting to "simply" follow each specification of the IRS's 20-point test will produce a large gray area of misunderstanding. Nevertheless, to follow each of the 20 specifications to a T would be like driving in exact accordance with the Department of Motor Vehicles handbook it's nearly impossible.

In the behavioral category, a business determines whether it has a right to direct and manage the employee or independent contractor. Any instructions given to the worker, including when, what and in which order to do the work, which tools to use, what workers to hire, and where to purchase supplies, are all contributing factors. Since an employee usually receives formal training from the employer, the key question is whether the business has the right to control the details of workers or whether the independent contractor uses his or her own methods.

The financial control category of an employee usually is seen as an extension of the employers set business structure. Independent contractors are more likely to have non-reimbursed expenses and an investment in the facilities he or she uses. Moreover, the method of payment from the business to worker is paid as a flat fee, rather than an hourly wage.

Ken Cassidy, of Cassidy's Management Consulting, has been working with the IRS to make them more familiar with the spa/salon independent contractor system. "Typically, at the end of the calendar year, the salon/spa owner provides the independent contractor and the IRS with a 1099 tax form showing how much he or she has been paid in fees. The IRS would be unlikely to consider a massage therapist who worked at the same spa every day an independent contractor," Cassidy said. "According to the IRS, 99.5% of spa workers don't qualify as contract laborer people, or independent contractors. Independent contractors don't work on a regular schedule, with regular hours, and they usually work for multiple businesses." So, when you find you're in a 9-to-5 monogamous relationship with your employer, you are an employee.

The category that defines the parties' relationship is determined by written contracts. If the business provides benefits such as insurance, a pension plan, vacation or sick pay, it would indicate an employee-type relationship. The permanency of the worker at the location and the extent that the individual has freedom to conduct his or her own separate entity also is a contributing factor. The spa owner must save all those fringe benefits for the employee, because an independent contractor trades in benefits, as well as financial security, for their freedom.

Ultimately, to share a common interest in the same business would imply an employer or employee arrangement. An example of this setup could be paralleled with a dance teacher who works at a dance studio. She brings all her own music and decides exactly what and when she will teach. Since the owner of the dance studio and the dance instructor are in the same type of business, the IRS considers them integrated. However, if the dance studio hires a plumber to fix the toilets every week, the plumber is still independent because he is in the business of plumbing, not the business of dance.

Another system of dealing with these issues, the Licensee System, was developed by Ahmos Netanel, president of Lucrative Spas. The Licensee System utilizes an outside company as a middleman between therapists and their clients. "This method has survived four different tax audits," Netanel said. "The system appeals to spa owners to work with self-starting therapists who don't require a lot of management."

In the end, the booth-rental system may save the business owners overhead costs by saving the money otherwise spent on taxes. Many start-up salons recruit these booth renters due to their tendency to be more productive than employees. Becoming a booth renter gives the therapist a greater sense of flexibility to conduct business when and how they choose. Some salon and spa owners recoil at the thought of receiving only rental income, while others feel uncomfortable with the loss of control. This usually can be avoided by putting together a contract for all parties involved, which states all requirements and establishes a standard of professionalism, such as discussions of termination issues and any other specific recoup costs.

Your choice of whether to have employees or independent contractors should depend on factors that would make one outcome favorable to another. To ensure the success of the individual employee and small-business owner, their personalities, long-term goals and their finances must be carefully and clearly contracted. In the age of the paper trail, it's wise to document everything, in full, with adequate legal advice. Remember, if you misclassify, you are eligible to be pulled aside, and unlike the DMV, the IRS will stick you with more than a speeding ticket.