By Stephen J. Gilles
Worker classification is an area of major concern for employers of all sizes. Misclassification of workers as independent contractors has labor and employment ramifications as well as employee benefits ramifications. Guidance from the Internal Revenue Service (IRS) and the Department of Labor highlight that worker classification issues are being closely scrutinized.
This article focuses on the impact of misclassification risks on employer qualified retirement plans and health and welfare plans. These misclassification issues are in addition to other employment and tax issues that arise, including, but not limited to, back pay (e.g., minimum wage and overtime pay), failure to withhold and underpayment of Federal and state/local income and employment taxes, and failure to provide proper wage statements, such as Forms W-2.
Common Law Employees
Under common law rules, anyone who performs services for an employer is generally its employee if the employer has the right to control what that service provider does and how they do it. This is so even when the employer gives the worker freedom of action. What matters is that the employer has the right to control the details of how the services are performed.
If an employer-employee relationship exists, it makes no difference how it is labeled by the employer. The substance of the relationship, not the label, governs the worker’s status. It does not matter whether the individual is employed full time or part time.
If an employer classifies a worker as an independent contractor where it has no reasonable basis for doing so, it will be liable for employment taxes.
Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties. IRS Publication 15-A, Employer’s Supplemental Tax Guide (2020) (Dec. 23, 2019) announced relevant new or changed standards the IRS will use in making these determinations and an IRS policy to focus on three “areas” of criteria in applying the preexisting “control test.” The fundamental “control test” in the so-called “20 Factor” test set forth in Revenue Ruling 87-41 remains valid. IRS Publication 15-A was most recently updated on January 13, 2022.
Employee Benefits Issues Related to Worker Misclassification
The effects of worker misclassification on employee benefit plans may include, but are not limited to:
- failure to provide employee benefit coverage and appropriate remedial action;
- failure to make employer and employee contributions to retirement and other employee benefit plans;
- failure to provide the individual with required benefit plan disclosure and administrative notices; and
- excise taxes under the Affordable Care Act (the ACA) for failure to provide required health plan coverage.
Impact of the Affordable Care Act
Many aspects of the ACA, including employer coverage responsibilities and the calculation of penalties for failure to provide compliant health coverage, depend upon classifying workers correctly. There are serious adverse consequences of misclassification. A single misclassification may trigger the assessment of ACA excise tax penalties based on the employer’s entire full-time workforce.
Employers should review existing contracts with staffing agencies or other service providers to reduce their potential legal exposure. Employers should require that service providers provide ACA-compliant coverage to their full-time employees and acknowledge sole responsibility for the classification of those employees.
Service provider contracts also should address potential co-employment issues by stating that the provider’s workers are solely its common law employees and that the provider exclusively manages all employee issues regarding compensation, performance issues, time off, and any other HR-related issues that typically are the responsibility of an employer.
Finally, the contract should contain indemnities specifically targeted to require the provider to indemnify employers for misclassification errors of their employees and any ACA penalties.
Treatment of Misclassified Employees Under the Benefit Plan Document
Most health plans (both insured and self-funded) and tax-qualified retirement plans exclude independent contractors from coverage. Without an express provision to the contrary, an independent contractor that is reclassified as an employee may become eligible for coverage—including retroactive coverage—under a plan. Some employers address this issue by including express language in their plans that excludes reclassified workers from coverage in order to protect an employer from claims for retroactive coverage and enable the employer to exclude reclassified workers from future coverage.
An example of such language is:
“The term “Employee” shall not include any individual who by contract is not classified by the Employer as a common law employee of the Employer, regardless of whether such individual is included on the Employer’s payroll for Federal income tax withholding purposes or whether such person is later classified as an employee by the Internal Revenue Service, the Department of Labor, a court, an administrative agency, or an Employer.”
Employers should determine whether their health insurance policies contain appropriate language to exclude reclassified workers because, without it, the insurance company could disavow financial responsibility for claims of reclassified workers, leaving the employer with that liability.
Effect on Health Insurance Premiums
Misclassification may impact the amount of an employer’s health insurance premiums since policies are underwritten based on the number and claims experience of an employer’s “employees.” If that population changes due to reclassification, the cost of health coverage also could change.
Minimum Coverage and Nondiscrimination Testing
The data that an employer uses to perform minimum coverage and nondiscrimination testing for self-funded health plans, cafeteria (Section 125) plans and tax-qualified retirement plans does not include independent contractors. Depending on the size and characteristics of the misclassified group, it is possible that the plan’s testing results could change. An employer should assess and possibly re-run prior plan testing to determine potential impact of a misclassification.
Required Notices for Employees
Employers are responsible for providing various types of health plan and tax-qualified retirement plan notices to their employees. An employer whose independent contractors are reclassified as employees must determine not only which notices should have been provided, but also how to address the prior lack of notice. For example, an employer must consider the extent to which COBRA notices or a Summary of Benefits Coverage required under the ACA should have been provided, and the impact of failure to provide those notices at the required time. Similar consideration should be given to the failure to provide summary plan descriptions, summaries of material modifications and Form 5500 Summary Annual Reports to participants in qualified retirement plans.
Recommendations on Preemptive Steps to Avoid Misclassification
In addition to the recommended actions discussed above, employers should consider taking preemptive steps to avoid worker misclassification issues, such as conducting a privileged examination of the work force to determine whether contractors are properly classified and, if necessary, taking remedial action. Employers should also consider setting up strict requirements for hiring contractors and be vigilant in meeting those requirements. Employers may also choose to engage a third party to screen and hire its contractors, in which case the contract with the third party should include a strong indemnification clause to provide protection for the employer in the case of alleged misclassification.