[Case Study] Audit: A $60K Mistake That Rattled This Pet Sitting Businesses Structure.

michelleA note from Michelle Cohn
“I wanted to share with you a story, related to the employee versus contractor debate and related to an audit I underwent, but grew into so much more over the last few years. I do think it is important for the group to hear and truly understand what I am communicating. It is, however, long, so I thought I would send you the e-mail and let you link it whatever way you would like.”
When I first started my business five years ago, I did an accurate and concise amount of research, specifically around having employees versus contractors. I researched the topic with both nationally-recognized pet sitting associations, researched 50 local companies, spoke with two accountants, and read the Department of Labor standards for an employee. The advice of all and from what I read and researched, the topic, although already starting to become controversial, was that I should be fine with contractors, but to make certain I did whatever I could to cement the relationship.
In 2011, I was sent a letter, from the State of Maryland Department of Labor. It stated that they believed my independent contractors are improperly classified and should, in fact, be employees. As with most people that would be concerned when they received a letter like this, I went immediately to seek the advice of attorneys and accountants. All told me the same thing “You cannot win this fight. It will cost you a lot of money. In the end, you will end up converting to employees anyway”.
I read the information the state auditor had provided me as to why my workers should be classified as employees. The information he provided me, although I had never seen it written quite that way, showed the criterion of classification of either employees or contractors. To be honest, I couldn’t argue it when I read it myself. After reading it, I really feel there is almost no scenario where a contractor is properly classified. The only scenario where it made sense was if they were truly running their own business, had many other clients, and were not performing a duty that is a primary duty of your business. For example, if you contract an HR professional to write your policies, that makes sense as a contractor. If they provide your primary service, i.e. pet sitting, not so.
In the end, I switched to employees, almost immediately. I would like to mention that my accountant and lawyer, that I consulted, basically just told me to comply and they did NOT stand by what they said to me that I was covered or that their advice protected me, in any way. Ultimately, it is just advice and they are not the decision-makers. If you think just because your accountant or attorney told you you were fine, that you are, you are lying to yourself.

“Ultimately, it is just advice and they [attorney and accountant] are not the decision-makers. If you think just because your accountant or attorney told you you were fine…you are lying to yourself.”

 

* Even though I switched to employees right away, the state came after me for back taxes. I then went to see another accountant that assured me he could negotiate, on my behalf, and hopefully get them to drop the request for back taxes, interest, and fines. At the time, I only grossed $100,000 a year for the business. I only had five Independent Contractors at the time. That isn’t that much money. I say this to point out that many of the people who “decide” they “don’t want” employees and think they are small enough that it won’t matter.
NOTE FROM BELLA: If you find yourself in a similar situation, with ICs and wanting to switch, but are NOT under and audit, there is a program through the IRS that will grant you the privilege of switching without the risk of being audited. 
This isn’t even where the story ends, unfortunately. At this point, the state then classified me as a new business owner and my unemployment rate, since I now owed taxes to them and was a new employer, started at 13.5% and I now had to get Workers’ Compensation insurance, also as a new employer, was 7%. Can you imagine now adding 20% cost to your bottom line?
All the while, my new accountant, who promised me the world, did absolutely nothing about negotiating with the state. In the end, he said he didn’t get anywhere and that was that. I never got any copies of letters that he attempted to get them to consider or anything. Now I had nine more months of interest and penalties and the total amount due was now $19,000.
I was not making much of a profit, as it was, because I suddenly had this huge increase in my monthly costs to have employees. But it doesn’t end there because now that I have employees, I needed to make sure I knew what I was doing with payroll, an employee handbook, and enforcing policies, procedures, and managing unemployment claims. I couldn’t afford to keep the unemployment rate that high. The cost to put all of these in place is expensive, particularly when you are trying to do it fast, so that you can be in compliance. If I had been able to prepare for this structure ahead of time, as I had done for the other aspects of the business, it would not have been as expensive to prepare. Proactive planning is always less costly than “Monday-morning quarterbacking” or having to react to a change/request immediately.
Ultimately, how this played out is that I could not afford to take a single paycheck out of my business for over twelve months. This was only two years into the business so I had already depleted my savings account and had a second job, all planned based on my carefully planned and executed business plan. I had not, however, planned on this structural catastrophe. Consequently, I went into personal debt $60,000 just trying to stay afloat.
Fast forward two more years, I am employing 22 people, finally able to pay myself somewhat of a regular salary, still paying back unemployment, personal debt, and trying not to get into more debt. The sad part about that is I have a very successful business but the cost to repair this one, initially small, issue was significant.
Carefully, I worked to get my unemployment rate down, markedly. I just unfortunately, though, had a huge set back with my Workers’ Compensation insurance, skyrocketing my rate again. It was a very expensive lesson. I will not be out of this financial hole for at least another two years. That is tough pill to swallow, considering I work long days and have, for the most part, always done the right things with my business.
I am telling this story because I really want everyone to understand that I am now grossing a considerable amount more than when I was first contacted by the state. However, just having this one issue with the state, has significantly affected me personally, professionally, and financially. Even though I am a “successful” business, which is honestly pretty hard to do for small businesses, I am struggling significantly.

Michelle’s Reflection:

You may feel the decision to have employees or contractors is up to you and that your attorney or accountant advised you, so you are fine, but that simply isn’t true. You may feel you don’t “want” the control over your employees. Likely, that argument won’t hold up either. You may feel you cannot afford to have employees and so you go the route of contractors. You may feel you have done everything in your power to show a contractor relationship. In the end, it is simply not up to you. 
Many of you are using the argument that you have decided that this what is best for you and you are choosing to run your business that way. It doesn’t mean anything, though, because you are not in the position of power to make that decision. It isn’t up to you, it is up to the auditors at the state and federal levels. You can do what you can to demonstrate the relationship, but honestly it is a much harder battle to prove, when it is all said an done, than to just go the route of employees. The IRS and the state do NOT want contractors. In the end, the thought is that the workers suffer because they are not protected in the many ways that these government agencies would like them to be protected. Had I really understood those facts, I would have started with employees right from the start.

“Many of you are using the argument that you have decided that this what is best for you and you are choosing to run your business that way. It doesn’t mean anything, though, because you are not in the position of power to make that decision. It isn’t up to you, it is up to the auditors…”

I would like to point out, too, that when your attorneys and accountants advised you, they likely will never give you a guarantee that if they are wrong, they will pay the back taxes, fines, and interest. Just ask them. You may change your mind about taking that advice once you realize they will not stand behind that one. They will likely do that for a return they prepare for you, but nothing else. Why? Because they know they are not the governing body. They don’t have the power to make that decision.
I wanted to share this story because I think many people feel that they are smaller and that they can wait to make these decisions or invest in this change down the road. Waiting can be extremely expensive. What I demonstrated, in this example, is only for two years of not having employees. There are many people, in our group, in business at least that long, that are probably as big as I was at that time. If they are in business longer or have grossed much more than that, they can extrapolate that potential cost.

 

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