Benefits Issues That Arise When Employees Are Misclassified | Newsletters | Legal Update: Overview of Employee Benefits
Worker classification is a major concern for employers of all sizes. The misclassification of workers as independent contractors has ramifications for labor and employment as well as employee benefits. Guidelines from the Internal Revenue Service (IRS) and the Department of Labor emphasize that worker classification issues are closely scrutinized.
This article focuses on the impact of misclassification risks on employer-qualified pension plans and health and welfare plans. These misclassification issues are in addition to other employment and tax issues, including, but not limited to, salary arrears (for exampleminimum wage and overtime pay), failure to withhold and underpay federal and state/local income and employment taxes, and failure to provide proper wage records, such as W-2 forms.
Common law employees
Under common law rules, anyone who provides services to an employer is generally its employee if the employer has the right to control what that service provider does and how it does it. This is so even when the employer grants 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 there is an employer-employee relationship, it doesn’t matter how it is labeled by the employer. The substance of the relationship, not the label, governs the status of the worker. It doesn’t matter if the person works full-time or part-time.
If an employer classifies a worker as an independent contractor when they have no reasonable basis for doing so, they will be liable for employment taxes.
The facts that testify to 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, Additional Tax Guide for Employers (2020) (December 23, 2019) announced relevant new or amended standards that the IRS will use to make these decisions and an IRS policy to focus on three “areas” of criteria when applying the “control test” pre-existing. The fundamental “test of control” in the so-called “factor of 20” test set forth in Tax Ruling 87-41 remains valid. IRS Publication 15-A was last updated on January 13, 2022.
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 benefits coverage and appropriate corrective action;
- failure to pay employer and employee contributions to pension and other benefit plans;
- failure to provide the individual with required benefit plan disclosure and administrative notices; and
- excise taxes under the Affordable Care Act (ACA) for failure to provide required health insurance coverage.
Impact of the Affordable Care Act
Many aspects of the ACA, including the employer’s responsibilities for coverage and the calculation of penalties for not providing compliant health coverage, depend on the correct classification of workers. Misclassifications have serious negative consequences. A single classification error can trigger the imposition of ACA excise tax penalties based on the employer’s entire full-time workforce.
Employers should review existing contracts with employment agencies or other service providers to reduce their potential legal exposure. Employers should require service providers to provide ACA-compliant coverage to their full-time employees and acknowledge full responsibility for the classification of such employees.
Service provider contracts should also address potential co-employment issues by stating that the provider’s workers are its common law employees only and that the provider exclusively manages all employee issues relating to compensation, performance issues, leave and any other HR-related issues that are the responsibility of an employer.
Finally, the contract should contain specifically targeted indemnities to compel the provider to indemnify employers for misclassification errors of their employees and any ACA penalties.
Treatment of misclassified employees under the benefits plan document
Most health plans (insured and self-funded) and tax-qualified pension plans exclude independent contractors from coverage. Unless expressly provided otherwise, an independent contractor who is reclassified as an employee may become eligible for coverage, including retroactive coverage, under a plan. Some employers address this issue by including explicit language in their plans that excludes reclassified workers from coverage in order to protect an employer against claims for retroactive coverage and to allow the employer to exclude reclassified workers from future coverage.
An example of such a language is:
“The term ‘Employee’ does not include any person who is not contractually classified by the Employer as a common law employee of the Employer, whether or not such person is included in the payroll of Employer for purposes of federal income tax withholding or if such person is subsequently classified as an employee by the Internal Revenue Service, Department of Labor, court, administrative agency, or employer.
Employers should determine if their health insurance policies contain appropriate language to exclude reclassified workers because without it, the insurance company may disavow financial responsibility for reclassified workers’ claims, leaving the employer with this liability.
Effect on health insurance premiums
Misclassification can affect the amount of an employer’s health insurance premiums since policies are written based on the number and claims experience of an employer’s “employees”. If this population changes due to reclassification, the cost of health coverage could also change.
Minimum coverage and non-discrimination tests
The data an employer uses to perform minimum coverage and non-discrimination testing for self-funded health plans, cafeteria (Section 125) plans, and tax-qualified pension plans does not include independent contractors. Depending on the size and characteristics of the misclassified group, the test results of the plan may change. An employer should evaluate and possibly redo previous plan tests to determine the potential impact of misclassification.
Notice required for employees
Employers are required to provide their employees with various types of tax-restricted health plan and pension plan notices. An employer whose independent contractors are reclassified as employees must determine not only what notice should have been provided, but also how to remedy the lack of notice. For example, an employer should 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 failing to provide such notices when required. Similar consideration should be given to the failure to provide summary plan descriptions, summaries of material amendments and summary annual returns on Form 5500 to members of qualifying pension plans.
Recommendations on preventive measures to avoid misclassifications
In addition to the recommended actions outlined above, employers should consider taking preventative measures to avoid worker misclassification issues, such as conducting a preferred workforce review to determine whether sub- contractors are properly classified and, if necessary, take corrective action. Employers should also consider putting in place strict requirements for hiring contractors and ensuring that these requirements are met. Employers may also choose to engage a third party to screen and hire its subcontractors, in which case the contract with the third party should include a strong indemnification clause to protect the employer in the event of an alleged misclassification.
|As part of Foley’s ongoing commitment to providing legal insights to our clients and colleagues, our Employee Benefits and Executive Compensation Group publishes a monthly newsletter we call “Employee Benefits Insights”, in which we provide you updates on the latest and most pressing employee issues. benefits and other related matters. Click here or click the button on the left to subscribe.|