The Internal Revenue Code provides significant tax benefits to employers that sponsor tax-favored retirement and health/welfare plans. For employers, the cost of providing benefits coverage may be deducted from taxable income, while plan participants are not taxed on the value of benefits received at that time (although for retirement plan contributions, they may be taxed on funds withdrawn at a later date).
These tax benefits are available only if the employer sponsoring the plan does not discriminate against its rank-and-file employees. Determining who are in the group of covered employees for discrimination testing is critical to the analysis.
Tax Laws vs. Business Objectives
The tax code's nondiscrimination norm might run counter to the employer's business objectives to increase staffing flexibility and to provide greater benefits to those individuals who are judged most valuable. As a result of this tension, sponsors have outsourced some functions to independent contractors and outside employment agencies. Because the discrimination rules apply only to employees of the plan's sponsor, this technique might work. However, there are significant problems if a court or the IRS should decide to recharacterize the workers as employees. Careful planning is required to minimize this risk.
Employers and their advisors have used several techniques to limit the group of workers that are covered by benefit plans. Before the enactment of the Employee Retirement Income Security Act (ERISA), some employers divided their operations into multiple business entities with one business employing high-paid employees who earned generous benefits and another business employing rank-and-file employees who earned no or minimal benefits. This technique was limited by ERISA's controlled group rules, which resulted in the aggregation of employee groups for discrimination testing purposes. Other techniques were developed by benefit advisors, leading Congress and the IRS to eliminate strategies intended to restrict benefits to the higher-paid group.
Some businesses—often startup enterprises—have tried to enhance their workforce flexibility by designating workers as independent contractors. Frequently, the relationship between the parties is memorialized in a written agreement in which the worker acknowledges that he is an independent contractor and that he is ineligible to participate in the recipient's benefit plans. However, the courts and the IRS are not bound by the parties' characterization of their relationship.
The courts and the IRS are not bound by the
parties' characterization of their relationship.
In determining the appropriate classification of the workers, the IRS uses 20 factors that are described in regulations. The IRS has divided these factors into three broad categories: behavioral control, financial control and the type of relationship.
• Behavioral controlexamines whether the recipient of the services has the authority to direct and control the work of the service provider and considers whether the worker receives instruction and training.
• Financial controlexamines whether the worker can realize a profit or loss and whether he or she has unreimbursed expenses.
• The relationship element focuses on the text of any agreement between the parties and whether the worker receives benefits.
Note that none of the various factors is dispositive on its own and that the relationship between the parties might change over time—which could alter the appropriate characterization of the parties' relationship. (For more guidance, see the IRS brochure Independent Contractor or Employee.)
An employer that fails to characterize individuals as employees when they fit that designation will owe back taxes and penalties. In addition, the cost of extending benefit coverage several years after the fact might be a significant burden. An employer might have to pay for accrued health claims that the worker paid out of pocket. A health carrier or stop-loss provider might refuse to pay these claims, and the employer would have to pay the entire cost of the benefit received.
If in Doubt, Seek Advice
Employers should confer with legal counsel to determine the appropriate classification of workers. If the issue is in doubt, particular attention should be paid to the language in the benefit plan documents describing the eligible class of covered individuals. Careful drafting might eliminate many unintended consequences of an employer's misclassification of workers.
Thomas M. White is an employment law partner at Rimon PC. He has extensive experience in the development, documentation and administration of executive compensation programs and employee benefit plans, including pension, profit sharing, 401(k) and ESOP plans, and health and welfare benefit programs.
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