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Clarify Your Business Classification

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In a tough economy with tight profit margins, shop owners get excited when they find ways to cut costs from their operating budget. A few owners have gone the route of classifying workers as independent contractors rather than employees in an effort to reduce taxes. But the path is not an easy one to take, and you’re likely to bump into the Internal Revenue Service (IRS) along the way.

Yet the allure of tax savings is great. Erica Eversman, chief counsel at Vehicle Information Services, says businesses can save quite a bit of money by avoiding Social Security, Medicare and unemployment insurance, not to mention the savings from not needing employee benefit packages. In the same breath, Eversman cautions that many shop owners have tried this, but strict IRS rules make it impractical for most body shops to legally comply.

Businesses that classify workers as independent contractors cannot have any behavioral or financial control over those people, says Eric Smith, spokesman for the IRS. And so in trying to sneak through what feels like a tax loophole, shop owners risk misclassifying their workers. Eversman estimates as many as 25 percent of body shops out there today are improperly classifying their workers.

“If a business owner has the right to direct or control their workers, chances are they should be classified as an employee.”
— Eric Smith, spokesman, Internal Revenue Service

And that’s a no-no under the watchful eye of the IRS. Misclassifying employees is civil tax fraud, Eversman says, and can carry steep penalties. So if your shop is staffed with folks you’ve labeled independent contractors, it’s worth a gut check and a review of the letter of the law to be sure you’re on the up and up. Because if you get caught making this misclassification mistake, you’ll soon realize that the potential fines far outweigh your tax savings.

The Difference in the Details

Worker classification is confusing for many employers, says the IRS’s Smith. “Some business owners think if they just call somebody a certain thing, then that’s what they are.” But that’s not how it works.

The IRS, not surprisingly, has extensive guidelines as to what constitutes an independent contractor relationship and what constitutes an employee relationship, Smith says. “Business owners need to look at the guidelines carefully to determine the proper classification.”

The IRS provides a list of criteria at irs.gov/newsroom, and an article from the Tennessee Society of Certified Public Accountants offers both a cautionary tale and a checklist for knowing the difference between contractors and employees. (You can check it out at bit.ly/FenderBenderTaxes) The key factor is a business owner’s right to control a particular worker.

In the body shop context, a shop owner cannot direct an independent contractor in the following:

• When and where work is performed,

• What tools, equipment and materials to use for a job,

• Where to purchase parts and supplies,

• Which repair procedures to use,

• Employee benefits.

“If a business owner has the right to direct or control their workers, chances are they should be classified as an employee,” Smith says, noting that many people don’t fully know the rules in this area.

Business owners can determine their worker classification by submitting to the IRS an SS-8 form, which can be downloaded from the IRS website.

An Exceptional Example

Carrie Griggs, co-owner of Shanklin’s Auto Body in Hayward, Calif., says her shop has successfully classified workers as independent contractors for more than six decades now. Shanklin’s story is an exceptional example, one that shows a shop that’s getting this right, and one that shows just how deliberate an owner has to be to properly classify contractors.

Griggs doesn’t tell her contractor when to come into work, how long to stay, or even what clothes to wear, she says. Griggs doesn’t offer any benefits, and her contractor pays his own taxes. Her contractor brings in all of his own tools, supplies and materials needed to complete each repair job. Griggs doesn’t say where to purchase those supplies, or what brands of materials to use. Her contractor even set up his own company, Curt’s Auto Body, to ensure that he is his own entity—one that merely operates under Shanklin’s roof. Even shanklinsbodyshop.com explains that cars are repaired by a staff of independent contractors.

The timeline for the completion of each repair job completely depends on when the contractor chooses to be there. If he chooses not to come in to work one day, the repair jobs he has to complete just won’t get done.

“This is why we hire competent, skilled craftsmen who have self-discipline and take pride in their business,” says Griggs, adding that repairs are almost always completed on time and with the skill level required. “It’s like having a business within our business.”

Griggs admits it’s likely Shanklin’s has been able to operate like this because it’s a really tiny shop, with only one worker and $250,000 of annual revenue.

So, it is possible for shop owners to classify their workers as independent contractors, but Shanklin’s highlights the great lengths you have to go to in order to ensure legal compliance.

In today’s repair environment, most shop operators strive to give customers a guaranteed time of repair completion, and many implement lean operational strategies to improve cycle time, touch time and repair accuracy. All that goes out the window when classifying workers as independent contractors because shop owners can no longer tell workers when, where and how to complete their work.

For nearly all shop environments, this is a really impractical way to run daily operations, says Andrew Rodenhouse, a partner with Rodenhouse Kuipers and former vice president of Rodenhouse Body Shop in Grand Rapids, Mich. Giving up that kind of control is out of the question for most shop owners.

A Costly Lesson

More often than not, shop owners aren’t intentionally trying to break the law, Eversman says. They see financial savings as a competitive advantage, but don’t understand all the repercussions that go along with classifying people as independent contractors.

“Fines for improperly categorizing workers can be significant.
The penalties vary from state to state, but it’s significant.”
— Andrew Rodenhouse, attorney and former vice president,
Rodenhouse Body Shop

In the legal world, ignorance is never an excuse, Eversman says. “If you’re in business, you’re expected to know these things.” Regardless of a shop owner’s motive, worker misclassification can pose a liability for penalties far greater than any potential tax breaks—which is why this isn’t a recommended road for repairers to travel.

“Fines for improperly categorizing workers can be significant,” Rodenhouse says. “The penalties vary from state to state, but it’s significant.”
Smith says employers who don’t classify somebody as an employee—when they should be—will be on the hook for all past taxes they should have paid on behalf of each worker. That includes all past due unemployment tax and the 7.5 percent employer portion of FICA taxes.

Eversman says she’s heard of shop owners being penalized as much as $5,000 per offense—every time the owner improperly paid a worker. Clearly, that could add up for shops with multiple employees.

The statute of limitations for the IRS is generally seven years. But that’s only if you’ve been filing appropriate tax returns, Smith says. The statute of limitations doesn’t apply for businesses that haven’t filed appropriate returns. You could conceivably be held liable for tax obligations dating even further back, and for each worker.

It’s hard to put a quantifiable number on the penalties a business could face for worker misclassification, Smith says, because it varies greatly depending on the unique situation of each business: how long ago an offense occurred, what kinds of taxes were avoided, whether it was intentional, and many other factors. At the extreme end, business owners could face criminal prosecution if they’re found to be breaking employment laws knowingly, he says.

The potential for financial penalties should direct shop owners away from classifying people as independent contractors, Rodenhouse says. “The upside potential of gaining some additional monies through tax savings is completely outweighed by all the possible downsides.”

It isn’t just the IRS that takes issue with this. Shop owners could find themselves in trouble with state treasury departments, the Department of Labor, and maybe even OSHA, given that owners can’t force workers to take proper safety measures while working, says Rodenhouse, emphasizing that shop owners should consult with an attorney who specializes in employment law in their state.

Smith says business owners that realize they are misclassifying their workers may be able to avoid additional penalties by showing good faith, and bringing the mistake to the attention of the IRS.

Fighting An Unfair Advantage

Despite the risks, some shop owners are still willing to gamble on misclassifying their workers. And while the IRS may not be actively policing your worker classifications, Eversman says, your peers might be.

“I hear complaints from shops all over the country that their competitors are improperly classifying their workers,” Eversman says. It might not sound like a big deal, but it causes a bigger problem outside of that shop’s walls.

Shop owners who improperly classify their workers are acquiring an unethical competitive edge in the market, Eversman says. “It allows shops that are doing this to unfairly compete with counterparts that are engaged in proper employment payment arrangements,” Eversman says.

Rodenhouse agrees: Shops skirting employment taxes may be able to charge less for repairs as a result of their decreased overhead costs. Or, they may have the ability to claim higher profit margins. Either way, the advantages they get from their cash cushion could drive legally compliant organizations out of business. And that makes for some cranky competition.

The IRS actually banks on business owners’ desire for a level playing field. Owner and employee complaints to the IRS from competing businesses, Smith says, are one way the agency catches wind that certain businesses are engaged in unlawful activity.

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