Employee or Independent Contractor: a Rose by Any Other Name

USA Today recently ran an article describing how many companies are using alternative work arrangements to adapt to an ever-changing business environment. Some may rely on more part-time workers, while others may choose to work with independent contractors. There are also leased employees, seasonal employees, and interns. All of these types of workers are often referred to as contingent workers.

Regardless of the reason a company gravitates to contingent workers, alternative work arrangements present some unique challenges, and it takes careful planning to ensure benefit plans properly reflect the company’s intentions. That analysis generally require a company to answer three key questions:

  1. Which workers are legally considered to be my employees?
  2. What does my plan document say about the employees who are covered and when they become eligible for benefits?
  3. Will my plan be considered discriminatory if I exclude certain workers?

This article focuses on the first question, with questions 2 and 3 covered here and here, respectively.

Who Are Your Employees?

You may be thinking, “Of course I know who my employees are!” This seems like such a simple question, but the answer can be much more complex than it seems and has tripped-up many well-intentioned companies. In fact, employers as large as Microsoft, Coca-Cola and Time Warner have found themselves in litigation over this very issue.

To avoid the complexities, some employers simply include all workers in their benefit plans. Unfortunately, that option has a serious drawback known as the exclusive benefit rule, which mandates that plans be maintained and operated for the exclusive benefit and in the best interest of employees. By covering workers that are not employees, a plan sponsor violates this foundational rule.

Making an accurate determination is also critical for two other reasons:

  • Plan Eligibility: There is quite a bit of flexibility in designing plans to include/exclude certain groups of employees, but in order to take full advantage of that flexibility, it is important to first have a solid understanding of which workers are part of the mix.
  • Nondiscrimination: Properly classifying workers is an important first step to ensuring that a plan is in compliance, provides the promised benefits and does so in a manner that does not discriminate in favor of Highly Compensated Employees (HCEs) – generally those who own more than 5% of the company or who have annual compensation exceeding $120,000 (indexed for inflation).

Making the Determination

It is generally up to each employer to ensure its workers are properly classified; however, all but the simplest arrangements usually requires some expert assistance. Perhaps the easiest way to examine the situation is through a series of examples, so let’s consider the following basic fact pattern:

Spencer is a college student who is home for break and looking for work. Shady Oaks Golf Club is looking for temporary help but does not need to bring on full-time employees. Spencer speaks to Aaron, the hiring manager at Shady Oaks, and they discuss several arrangements.

Employee or Independent Contractor

Aaron tells Spencer that he can come on board as an independent contractor. He will work as a groundskeeper and is to report to work daily from 7:30 to 4:30 and will use the club’s equipment. His hourly compensation will be reported on Form 1099; no taxes will be withheld; and he will not be eligible for benefits. Both agree to these terms in writing. Is Spencer an independent contractor or an employee?

Unfortunately, it’s not as simple as pointing to Aaron and Spencer’s agreement or the fact that Spencer will receive a 1099 instead of a W2. The IRS has provided guidelines for employers to use in its so-called “Twenty Factor Test” (found in Revenue Ruling 87-41) which focuses on whether a company, Shady Oaks in this case, has the right to control the worker.

As a general rule, the following factors suggest that the company has that right, meaning that the worker is like an employee rather than an independent contractor:

The worker…

  • Is required to comply with instructions regarding when/where/how to work;
  • Performs services at the company’s place of business;
  • Must submit regular or written reports; and
  • Is in a continuing relationship with the company.

The company…

  • Has the ability to hire, supervise or terminate the worker;
  • Sets the work schedule and location;
  • Pays by the time worked rather than by the job;
  • Furnishes equipment for the worker’s use; and
  • Pays/reimburses business expenses such as for travel, etc.

Conversely, the following factors tend to support a determination that the worker is an independent contractor and not an employee:

The worker…

  • Has a significant investment in facilities, equipment, etc. that are used for performing services;
  • Realizes a profit or loss;
  • Provides similar services for more than one firm at a time; and
  • Makes his or her services available to the general public.

Based on these criteria, it is likely that Spencer is legally an employee of Shady Oaks even though he is being treated as a contractor. Apart from liability for the payroll taxes it didn’t withhold from Spencer’s compensation, Shady Oaks may also be required to provide retroactive benefits to Spencer due to the misclassification.

Leased Employees

Many people think of “leased employee” as a generic term that refers to any worker that comes from some sort of staffing agency; however, the law includes a very specific and lengthy definition. Although a true Leased Employee is, by definition, a common law employee of the leasing organization, he or she may also be treated as an employee of the company for which services are performed if all of the following conditions are met:

  • The recipient company must pay a fee for the services of the individual;
  • The worker must have performed services for at least one year on a substantially full-time basis (at least 1,500 hours in a 12-month period); and
  • The recipient company must have primary direction over the services rendered by the worker.

Since Spencer has a direct relationship with Shady Oaks and his length of service is expected to be less than a year, he is not a leased employee.

PEOs

There are companies called Professional Employee Organizations (PEOs) that specialize in acting as sort of an outsourced human resources department. They handle new hire paperwork, payroll, and benefits, among other HR-type functions, so that their clients can focus on running their businesses. PEOs often refer to themselves as “co-employers” of their clients’ employees in that the workers are still under the primary direction of the client company even though the PEO is handling the administrative aspects of the employment relationship. It is not uncommon for a PEO to “hire” a company’s entire workforce and “lease” them back.

Are these workers employees of the PEO or the PEO’s client company? IRS guidance on PEOs from 2002 says, “The critical issue in determining who is the employer of an individual is which entity has the right to direct and control the individual performing the services.” So, that pretty much takes us back to the same analysis that applies in the independent contractor situation.

Also, that guidance from 2002 provides direction to PEOs for maintaining so-called multiple employer plans, covering “client organization” workers that are not the common-law employees of the PEO. That suggests further that the workers are employees of the client company in the typical PEO arrangement. 

Employee Classifications

So, far, we have focused on determining who is or is not an employee. Once that step is done, it is important to consider how those who are employees might be classified or subdivided.

Employees Not Working Full-Time

Back to Shady Oaks. Aaron hires Spencer as a W2 employee but specifies that he will not receive benefits, because he is not working on a full-time basis. This situation is much more straight-forward in that Spencer and Aaron both consider Spencer to be an employee of Shady Oaks. The issue is whether or not he is somehow less of an employee because of his part-time status such that he can be excluded from company benefits.

In 2006, the IRS issued a Quality Assurance Bulletin (QAB) to address this issue. It indicates that employees who work other than full-time schedules are still employees and that the plan documents, not employment agreements, must be consulted to determine eligibility for benefits. Examples of classifications that are often mishandled include:

  • Part time employees – Those who work less than a standard 40-hour work week.
  • Temporary employees – Those who are employed for a limited period, delineated by specific dates or the duration of a project.
  • Seasonal employees – Those who work during a specific season such as retail workers during the holidays or snow-plow operators during the winter.
  • Per Diem employees – Those who do not have a set work schedule but are called in as needed.

The list also includes those whose normal work schedule is fewer than a certain number of hours, e.g. someone who is normally scheduled to work fewer than 20 hours per week.

Based on the QAB, Spencer is a regular employee whose eligibility for Shady Oaks’ retirement plan (and any other benefits) must be determined by the plan document regardless of the side agreement he made with Aaron. As a general rule, the IRS frowns on excluding employees based on the amount they work rather than using other factors such as the type of work they perform.

Students

We regularly see unintended consequences when companies use the “student” classification. Although we will touch on this in greater detail in the article on plan eligibility, suffice it to say it is critical to use precise wording to describe exactly which workers are covered by this classification. For example, if a company employs students and wants to treat them differently as a group, the company should define whether the “student” group applies to all students or just those enrolled full-time in an undergraduate program or whatever other variations that may be appropriate. If defined broadly, the “student” group could also include the company CFO who goes to graduate school to pursue an MBA. Maybe that’s ok, but maybe it isn’t, depending on the company’s intent. 

Miscellaneous

There are any number of other categories that companies might use to classify their employees. Some may be driven by extraneous factors – union members, non-resident aliens, etc. – while others may be the result of a particular company’s internal structure – front office staff, factory floor workers, senior managers, the owner’s children, etc. It is not unusual for different locations to operate as different profit centers, so employees may be classified by the office in which they primarily work. Whatever categories are used, it is important to describe them with some precision and apply them consistently.

Conclusion

As you can see, there is quite a bit that goes into properly classifying workers, and proactive planning in the beginning can prevent unintended consequences down the road. Given the complexities involved, it is very important for employers facing this challenge to work with knowledgeable experts who can provide guidance every step of the way.

Contact DWC

The views expressed in this blog are those of the authors and do not necessarily represent the views of any other person or organization. All content is provided for informational purposes only and is not intended to be tax or legal advice.