Issues with Independent Contractors and Pension Plans

By David J. Kupstas, FSA, EA, MSPA

David J. Kupstas, FSA, EA, MSPA

David J. Kupstas, FSA, EA, MSPA Chief Actuary

A number of our retirement plan clients have independent contractors performing services for them.  There are often questions about whether these independent contractors can or should be covered in the company retirement plan.  The answer can be boiled down to two important points:

  1. Independent contractors are not employees, so there is no requirement to cover them in the company retirement plan. In fact, you can’t cover independent contractors in your qualified plan even if you wanted to.
  2. However, many workers that companies think are independent contractors or would like to be independent contractors, aren’t. They are common-law employees instead.

Employees vs. Independent Contractors

What is an employee?  What is an independent contractor?  Let’s start with employee.  A qualified plan’s document will define employee to mean something like “any person who is employed by the employer.”  This is not terribly helpful.

Fortunately, the IRS has some good information on its website about the distinction between employees and independent contractors.  Properly classifying workers is important to the IRS because it determines if an employer must withhold income taxes and pay Social Security, Medicare taxes, and unemployment tax on wages paid to an employee.  Businesses normally do not have to withhold or pay any taxes on payments to independent contractors.  Rather, the earnings of a person working as an independent contractor are subject to self-employment tax for which the independent contractor is responsible, not the employer.

The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done.  The IRS gives three categories to help an employer better determine how to properly classify a worker:  behavioral control, financial control, and relationship of the parties.

Behavioral control:

  • Does the employer tell the worker when and where to work, what tools to use, or where to purchase supplies and services? If so, the worker is likely an employee.
  • If the employer gives detailed instructions, the worker is likely an employee.
  • If the evaluation system measures the details of how the work is done, as opposed to just the end result, the worker is likely an employee.
  • Training a worker on how to do the job or about procedures and methods is strong evidence that the worker is an employee.

Financial control:

  • If the employer invests significantly in the worker’s equipment, the worker is likely an employee.
  • If the worker has the opportunity for profit or loss, the worker is likely an independent contractor.
  • If the worker can seek out other business opportunities, the worker is likely an independent contractor.
  • If the worker gets a regular wage, rather than a flat fee per job, the worker is likely an employee.

Relationship:

  • Is there a contract that describes the intent regarding employee vs. independent contractor status? While this is helpful, it is not sufficient for determining the worker’s status.
  • If the worker is getting benefits like vacation and insurance, the worker is likely an employee.
  • If there is an expectation that the relationship will continue indefinitely, rather than for a specific project or period, the worker is likely an employee.
  • If the services provided are a key activity of the business, the worker is likely an employee.

Two examples come to mind:

Independent contractor:  Assume a company has no one on staff with computer expertise.  Bill is hired to set up the computer network and come in and provide support when there are problems.  Bill does these same services for other companies.  Bill is probably an independent contractor.

Employee:  ABC Company makes fancy, sophisticated pieces of equipment.  Catherine comes in two days a week, sits by herself in a separate room, and makes one part for ABC’s equipment that few people know how to make.  She works for no one else.  It’s expected she will continue this arrangement for a long time.  She goes to company meetings, eats cake in the lounge whenever there’s a birthday, and is expected to follow company rules.  Catherine is probably an employee.

You may have heard of a “20-factor test” for determining independent contractor status.  This is old.  IRS compressed the 20-factor test into the three categories described above.

Vizcaino v. Microsoft Corporation is a famous case related to worker classification.  Microsoft hired thousands of “freelancers” to perform various tasks.  The intent was to treat the freelancers as independent contractors; indeed, the freelancers signed agreements acknowledging they were independent contractors not entitled to fringe benefits.  Trouble is, they generally worked alongside regular employees and under the same supervision.  Long story short, the court ruled the freelancers were employees and not independent contractors.  Microsoft had to pay a very expensive settlement.

The Microsoft case serves as a cautionary tale for employers looking to classify workers as independent contractors.  Among other things, the case showed that what is agreed to in a contract is less important than the actual relationship.

What It All Means for Pension Plans

Let’s look more closely at the impact on a qualified retirement plan of misclassifying an employee as an independent contractor.  We won’t spend any time talking about workers classified as employees who are really independent contractors since that’s not the direction the error usually goes.

Suppose for many years ABC Company has been treating Catherine from our example above as an independent contractor.  The incorrect classification could have happened for any number of reasons.  Maybe ABC thought she was different because she has a unique skill.  They may have gotten bad advice.

In any event, Catherine has been excluded from the ABC 401(k) plan because she was thought not to be an employee.  But she really is an employee.  Is ABC Company in trouble?  Perhaps not, but the situation does need addressing.

Most retirement plan documents nowadays will have language to the effect of, “If an employee is thought to be an independent contractor but is later determined by a court, the IRS, or another governmental agency to be an employee, that employee shall not be eligible for the plan.”  This language started to be included in plans after the Microsoft case.

Based on this language, Catherine will still not be eligible for the 401(k) plan even after being reclassified as an employee.  However, that’s only half the battle.  An employer is generally free to exclude an employee from its retirement plans by job title, location, or some other reasonable classification.  What ABC Company needs to be concerned about is passing coverage and nondiscrimination testing.

Here’s a simple example involving coverage testing, the rules of which may be found in Internal Revenue Code Section 410(b) and its regulations.  Assume the ABC Company has 110 employees – 10 Highly Compensated Employees (HCEs) and 100 Non-Highly Compensated Employees (NHCEs).  To satisfy the ratio percentage test of Section 410(b), the percentage of NHCEs benefitting under the plan has to be at least 70% of the percentage of HCEs benefitting under the plan.

If all employees benefit under the ABC 401(k) plan, then 10 out of 10 HCEs (100%) and 100 out of 100 NHCEs (100%) are benefitting.  Dividing 100% by 100% gives us 100%.  Since 100% is greater than 70%, the ratio percentage test is passed, and Section 410(b) is satisfied.  The test would also pass if half the HCEs and half the NHCEs benefit, since 50% divided by 50% equals 100%.

Now assume the following with respect to Catherine:

  • She is one of the 100 NHCEs at ABC Company.
  • When she was treated as an independent contractor, it was believed there were 99 NHCEs.
  • Catherine remains excluded from the ABC 401(k) because of language calling for the exclusion of any independent contractors later determined to be employees.

Now that Catherine is known to be a common-law employee, but still excluded from the 401(k) plan, the ratio percentage is 99%.  That is, 99 out of 100 NHCEs are covered under the plan (99%), and 10 out of 10 HCEs (100%), and 99% divided by 100% is 99%.  This is still way over 70%.  Absolutely no harm has been done to ABC’s coverage testing by continuing to exclude this one employee, Catherine, from the 401(k) after her reclassification.

What if ABC Company thought 50 of those 100 workers were independent contractors, but it turns out they’re all employees and are still excluded from the 401(k)?  Ah, now that could be a problem.  The NHCE benefitting ratio would be down to 50%.  The ratio percentage would also be 50%, which is not a passing result under Section 410(b).  ABC Company either has to hope coverage testing can be passed in some other way, or it has to open up the 401(k) plan to some or all of those independent contractors-turned-employees.  Covering an extra 20 to 50 employees could be quite expensive for ABC Company.

It would be bad enough for ABC Company to have to cover more employees than expected going forward.  If this problem has been around a while, there could be years of coverage testing failures to correct.  Going through that arduous process and retroactively paying years of benefits would be far worse than properly classifying the employees in the first place.

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— Topics: Retirement, Financial Planning, options