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Employee or Independent Contractor?

When California labor inspectors conducted a sweep of 108 spas and salons in 2008, they decided many massage therapists who were working as independent contractors were actually employees. The reclassifications led to fines for many spa owners. At one spa, fines totaled $40,000.

The California enforcements are part of a trend that has been observed at the federal level and in many state governments. To increase tax collections, government agencies are categorizing fewer workers as independent contractors.

Stan Youngs, a Seattle accountant who has worked for three massage therapists, describes the California franchise tax board as "the Gestapo of taxing in the U.S." He also says that people in bodywork are often helpful and trusting, making them easy targets for enforcement.

Being Blindsided

Some owners of spas who were caught up in the California sweep said they didn't understand what was at stake. Tanya Wigger, for example, says she mistook the inspector who came to her practice, Napa Valley Day Spa, for a saleswoman. "She said, ‘We're just visiting spas,'" Wigger says, "acting kind of nicey-nice." Wigger, unassuming and unaware of the potential for trouble, continued making polite conversation. "She gave me a business card," she adds. "I didn't look at it. I didn't have my glasses. We just visited. We talked about hot flashes."

Wigger says the inspector, Marcia Shaw, complimented the decor of the spa and asked what services were offered and how many employees worked there. "I said we don't have employees, we have independent contractors," Wigger explains. But when she turned away to make a phone call, Wigger noticed the inspector "taking the check register off my desk." All told, she received a fine for every check that had been written to someone whose name appeared on the spa's phone list that Shaw had also gotten hold of. "She never asked for any records," Wigger recalls. "She didn't say, ‘We need to go somewhere private.'" Instead, the inspector changed her tone and began berating her in front of clients. "She's just hollering at me, ‘You've been in business long enough, you've got to know these people can't be independent contractors,'" Wigger says.

Wigger was fined $24,500 for 12 people Shaw classified as employees instead of independent contractors. "One of them is only here one day a month!" she says, almost in disbelief. The fines were for violating California labor laws that require employee paycheck stubs show withholding. Wigger was also fined for not having workers' compensation for the employees she believed were independent contractors.

"The fines are so [high], they're just bullying you into paying it," Wigger says. "You know you're going to have to go out and hire a lawyer because nobody's got $24,000 lying around. We're just crossing our fingers and hoping it doesn't put us out of business."

Wigger's attorney, Kathleen Herdell, who has an office in St. Helena, California, says using independent contractors is deceptively attractive to business owners. "I call it trouble in paradise," she explains. "The employers are very happy because they're not paying payroll taxes and workers' compensation. The workers are happy because there's more money in their pockets."

The trouble happens when a worker, upset at being terminated, makes a claim for unemployment or overtime. If it is determined that the contractor really was an employee, the employer may be fined. "It just compounds into these numbers that, for a small business owner, are astronomical," Herdell explains.

Real-life Learning Experience

Susan George's Emerald Day Spa in Napa, California, was also inspected by Shaw during the sweep. George describes the inspector's behavior as businesslike. "She was very kind and polite and asked if she could talk to me," George remembers. "She wanted to know how many independent contractors I had."

When George told Shaw she didn't have any independent contractors, the inspector asked to look at her payroll records, and then interviewed the employees, asking how much they were paid and whether they got breaks as state labor law requires.

Shaw also asked to see the list of state labor laws that employers must post in the workplace, as well as proof that George carried workers' compensation insurance. "I got fined $6,000 for not having workers' compensation," George says.

George's comparatively light $6,000 in fines may have been due to her decision six years ago to stop using independent contractors in her spa. She is happy to have made the switch to employing those who provide services in her spa, and says they are well compensated. One employee, she says, made $76,000 plus cash tips last year.

Being Inspected

Shaw said she could not comment on the inspections, but she did say spas have problems with labor law compliance. "We get a lot of complaints about them, actually," she says. "Hair salons are pretty good. They understand that [independent contractors] have to make their own appointments and collect the money. But some of the spa owners … they want more control."

There is no single definition of who qualifies as an independent contractor. Instead, the determination is made on a case-by-case basis. For federal taxes, the Internal Revenue Service applies a 20-part test, looking at factors that help establish whether the independent contractor or the business owner has control over the work. The California labor standards enforcement division looks at those 20 factors, as do labor officials in many states. Some states define who is an independent contractor in statute.

Dean Fryer, a spokesman for the California Division of Labor Standards Enforcement, says that for a massage therapist in a spa to qualify as an independent contractor, the spa owner would have to have very little input into how they did the work. "The individual coming in is providing their own tools, setting their own schedule and bringing their own clientele," he explains. Independent contractors must also pay their own business taxes.

Fryer's agency conducts workshops for employers, but because the law is complicated, he believes that most business owners should be in touch with either an employment attorney or an industry association. If a massage therapist is deemed to be an employee and the employer has no workers' compensation insurance, the agency issues a $1,000 fine. "The requirement is for the protection of workers," Fryer explains. "If they get injured on the job, they can have medical coverage. It's a no-fault system."

Other California fines include $250 for each paycheck for which there is not a pay stub itemizing deductions. The statute of limitations for the fines goes back three years, he says, and the employer bears the burden of keeping accurate time records.

Workers who were misclassified may also be able to make a separate minimum wage claim. Although Shaw could not answer questions about the sweep, Fryer describes the way inspections should be conducted. "When we come in, first we identify ourselves," he says. "Normally we have two to three people. We introduce everyone and we provide business cards. We'll say, ‘We want to see your payroll records, your workers' compensation records, and this other person is going to talk to your employees.'"

Fryer believes inspectors should try to inspire cooperation from business owners. "We don't carry handcuffs," he explains. "We don't even carry guns. There have been times when we've been confronted with very hostile business owners. If that happens, we back away and come back with law enforcement."

Once admitted to the business, inspectors set up separate interviews with workers. "We ask what they're being paid, how often they get paid and when they get their meal breaks," Fryer says. With a cooperative owner, an inspection could be over in 45 minutes, he says. If records are missing, the process could take two hours.

The incentive to cooperate is that inspectors can sometimes work with business owners, even when they're in violation. "When there's a violation, there's a violation," Fryer says. "But we don't have to take it to the full three years of the statute of limitations."

Get Protection

Cooperating with authorities is always recommended, but Herdell advises that business owners protect themselves before they find themselves being inspected. "Be very mindful, no matter what their demeanor, that they are from the labor commission," Herdell explains. "When an inspector comes, call an attorney. [Inspectors] have a right to see any personnel data, but they do not have a right to go into any place that is not open to the general public."

California is not the only state where the independent contractor status of massage therapists has been scrutinized. Beth Milito, senior executive counsel at the National Federation of Independent Business, says her organization has received reports of stepped-up enforcement in many states across a broad range of industries.

"More and more, both the federal and state governments are trying to classify workers as employees because they want the taxes," Milito explains. "You read about the tax gap, between what is owed and what is paid. One way the IRS can close the tax gap is by clamping down on employees who they believe are misclassified. You have state initiatives to redefine who can be an independent contractor, and they're defining it more narrowly." She warns that even business owners who had accurate legal advice when their business was formed could now be out of compliance.

Ray Schmidgall, a business professor at Michigan State University who has worked for the International Spa Association, echoed Milito's concern. "What's pushing this is that governments need money," Schmidgall says. "When governments are running deficits, they're going to push harder."

Rebecca Ary, a Seattle attorney who recently handled a thorny case on whether a worker was an independent contractor, says that those who must hire an attorney to represent them in a dispute can lower the cost by quickly getting all the facts out. "Be honest from the beginning," she advises.

When deciding whether a worker is an employee or an independent contractor, this 20-part test is one way—but not the only way—the IRS and many state agencies try to determine who controls the work. It's reprinted here as it appears in the newly revised Independent Contractors Guide from the National Federation of Independent Business.

1 Instructions
Employee: Provided with instructions from the business regarding when, where and how to perform the work.
Independent Contractor: Decides when, where and how to accomplish the services he or she is providing.

2 Training
Employee: Receives training directly from the employer, demonstrating that the business wants the services performed in a particular manner.
Independent Contractor:Receives little or no training from the business, but rather hiring is based on pre-existing proficiency or expertise in a particular line of work.

3 Services rendered by the worker personally
Employee: Personally performs any assigned duties.
Independent Contractor: Free to hire employees or subcontract tasks.

4 Set hours of work
Employee: Works hours established by the employer.
Independent Contractor: Retains the ability to set own hours.

5 Realization of profit or loss
Employee: Receives pay for time and labor only without realizing any additional gain or sharing in the risk of loss realized by the company based on the worker's services.
Independent Contractor: Personally stands to gain or to lose economically based on performance of his or her services.

6 Time required
Employee: Usually devotes their employment to the business; full-time employment could prevent the worker from engaging in other gainful employment.
Independent Contractor: Does not necessarily work solely for one business and remains free to pursue other projects.

7 Doing work on employer's premises
Employee: Performs services on the premises of the employer to the extent to which the nature of the services requires the work to be done on the employer's premises. If the business has the right to compel the worker to perform services at an alternative specified location, then the level of control remains the same.
Independent Contractor: Chooses where to perform the services.

8 Order or sequence of the work
Employee: Required to perform services in the order set by the employer.
Independent Contractor: Retains the option of deciding the sequence in which the work is performed.

9 Continuing relationship
Employee: There exists a continuing, non-sporadic relationship between the business and the worker.
Independent Contractor: Free to perform a service and then move on to other projects.

10 Hiring, supervising and paying assistants
Employee: May hire assistants only under the direction of the employer.
Independent Contractor: Free to hire, supervise and pay additional assistants or subcontractors as necessary.

11 Integration of the Worker's Services
Employee: Services are integrated into the daily success and operation of the business.
Independent Contractor: Services provided do not substantially affect the overall success of the business.

12 Oral or written reports
Employee: Submits regular reports to the employer for whom the services are being performed.
Independent Contractor: Accountable for end results only and not necessarily required to provide regular reports.

13 Payment method
Employee: Paid by the hour, week or month.
Independent Contractor: Paid by the project or on a straight commission.

14 Payment of business expenses
Employee: The business usually pays expenses for the worker.
Independent Contractor: Pays for own business and traveling expenses.

15 Furnishing of tools and materials
Employee: Receives tools and equipment from the employer.
Independent Contractor: Provides tools, equipment and materials.

16 Significant investment
Employee: Depends on the continued success of the business without taking on any investment in the working facilities or equipment.
Independent Contractor: Invests in facilities or equipment used to perform any services, showing that the worker is in business for himself/herself.

17 Working for more than one business
Employee: Restricted, either explicitly or effectively, from providing services to several businesses at once.
Independent Contractor: Free to provide services to multiple, unrelated businesses at the same time.

18 Availability of service to the general publIc
Employee: Provides services to only one business.
Independent Contractor: Offers services openly to the general public.

19 Right to fire the worker
Employee: Employer maintains the discretion to discharge a worker.
Independent Contractor: May not be terminated as long as the performance proceeds according to the agreed upon terms.

20 Worker's right to quit
Employee: Generally has the right to terminate the relationship with the business at any time.
Independent Contractor: Must fulfill any contractual obligations or else risk liability for breach.

Fines and back taxes owed when a worker is misclassified can be significant. Since classification standards can change, it may be a sensible precaution to seek advice from an accountant or business attorney.

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