by Sharon Cross, technical director, and Angelica Jasso, senior consultant
Longnecker & Associates
For many companies, independent contractors have long been a popular and tax-wise alternative to traditional, full-time employees. Utilizing this classification of worker enables employers to avoid Social Security (FICA) and federal unemployment compensation (FUTA) taxes, as well as reduce employee benefit and administration expenses.
It is important to understand and observe legal and practical distinctions between employees and independent contractors. Misclassifying an employee could not only subject your business to penalties and employment taxes, but can also render your qualified retirement plan discriminatory.
Misclassifying an employee as an independent contractor means lost tax revenue for the federal government. To reduce this loss, the Internal Revenue Service (IRS) has devised a specific plan to identify misclassified workers.
Two sets of criteria exist for determining worker employment status: statutory definitions and common-law rules. Because statutory definitions are few in number and limited in scope, common-law rules are used to test most workers.
Under these rules, a worker is an employee if the employer has the right to control and direct the performance of services. This includes control over the means by which the result is accomplished. The employer doesn’t have to exercise this control, merely having the right is sufficient.
IRS has developed 20 factors to help employers determine their degree of right of control over workers. Applying these factors, however, requires more than just a simple numerical comparison. Each worker classification is based on the specific facts and circumstances in each individual case. The subjective nature of this process is one of the primary causes of misclassifications.
Should IRS determine your independent contractor does not meet the common law requirements, and in turn reclassify that worker as an employee, your business would be liable for some or all of the income and FICA tax that should have been withheld in addition to your share of matching FICA and FUTA taxes and any related penalties and interest.
You can avoid these liabilities by proving the worker reported the income, paid the income tax therein, and the self employment taxes. However, it is often difficult to locate former workers. If this reclassification also results in your qualified retirement plan becoming discriminatory, back employment taxes and penalties could be just the start of your problems.
Consequences of Discrimination on Qualified Plans
As you’re probably aware, qualified pension, profit-sharing, and stock bonus plans must meet strict nondiscrimination rules. These rules were enacted to ensure highly compensated employees (HCEs) do not receive a proportionally greater share of benefits than non-HCEs do.
The problem reclassified employees present lies in the specific nondiscrimination tests your plan must pass. These tests fall into three general categories: minimum participation in the plan, minimum coverage under the plan, and minimum contributions and benefits provided under the plan.
If your plan is judged to be discriminatory toward HCEs in any of these categories, it may lose tax-qualified status. Since the nondiscrimination rules focus on the relative plan benefits of one group of employees over another, reclassification of workers could cause your plan inadvertently to become discriminatory. The tax consequences of this could be severe.
First, your company could lose the current deduction claimed for contributions to the plan. Second, your employees may have to include any contributions made on their behalf (and HCE’s would have to include the entire amount of their accrued vested benefit) in their taxable income. Third, both your company and HCEs could be subject to excise or other penalty taxes.
Reclassification of workers could also result in certain welfare benefit plans falling into a discriminatory status. Cafeteria plans, dependent care assistance programs and group-term life insurance plans, for instance, are all subject to their own nondiscriminatory rules. Discrimination generally results in additional payroll taxes for your business and additional taxable income for HCEs and key employees.
Note that Section 530 of the Revenue Act of 1978 provides some relief to eligible taxpayers from the assessment of taxes, interest, and penalties that would otherwise arise as a result of misclassification of employees as independent contractors. However, this relief is limited to employment-tax issues only (i.e., income-tax withholding, FICA, and FUTA). It has no effect on failure of a qualified plan to meet nondiscrimination requirements due to worker reclassification.
High Costs, High Stakes
The stakes in worker classification are obviously high—errors can be extremely costly. If you currently employ independent contractors, we recommend you carefully examine each worker to make sure they meet the IRS’s criteria for this classification. If you’re considering this in the future, you can eliminate uncertainty by requesting a determination letter from the IRS district director’s office. The request must be for one worker who is representative of the class of workers subject to question.
Longnecker & Associates is a Houston-based consulting firm specializing in corporate governance, executive compensation and board of director compensation. L&A consults on complex situations ranging from high-growth, bankruptcy, shareholder and employee litigation, IRS audits, spin-offs, mergers and acquisitions, and divestitures. L&A’s consultants work with CEOs, boards of directors, investment bankers, attorneys, and CPAs for all major industries. For more information, visit www.longnecker.com.