SOLUTIONS IN A FLASH – RETIREMENT PLAN CORRECTION SOLUTION:
YOU KNOW NOTHING, JON SNOW: EMPLOYEES VS INDEPENDENT CONTRACTORS

By: Hayden Speed Herock, Esq.

In a kingdom far, far away (yet still subject to Internal Revenue Service (“IRS”) and Department of Labor (“DOL”) regulation), lived Jon Snow, who owned a security company called “The Night Watch.” Hearing rumors of other companies offering retirement plans, Jon consulted his accountant, Theon Greyjoy, for advice. Theon suggested Jon establish a 401(k) for himself but expressed concern about the cost of covering his entire workforce. To save money, Theon advised Jon to fire some of his workers and rehire them as independent contractors paid by Form 1099-MISC. This would exclude them from the 401(k) plan, allowing Jon to maintain the company’s financial stability, and eventually retire to someplace warm for a change. Despite his reservations, Jon agreed to Theon’s advice and hired Sansa Stark as a third-party administrator (“TPA”) to set up the plan. The next day, Jon fired half of his employees, and immediately re-hired them as independent contractors, even though their job responsibilities, schedule, and pay remained the same. Sansa quickly discovered these “independent contractors.” Upon further discussions with Jon, Sansa learned of Theon’s advice and expressed concern that this scheme was not going to work as planned.

Has Jon dug himself a deeper financial grave?

Classifying Workers: Employee vs Independent Contractor

The IRS, DOL, and courts have all promulgated guidance about what makes someone an employee versus an independent contractor. In the broadest sense, the IRS defines an employee as any individual who performs services for the employer if the employer controls what, when, and how a service is performed. The IRS originally published a 20-factor test in Revenue Ruling 87-41 to determine who is an independent contractor. This test has been simplified to three main criteria: behavioral control, financial control, and the type of relationship between the employer and the worker.

Behavioral Control: 

For the worker to be considered an employee under the behavioral criteria, the employer must control how the worker does their job, including work schedule, scope of work, and work methods. Employees often have assigned and consistent work hours, while independent contractors generally set their own schedules.

Financial Control:

Financial control involves how the worker is paid and who furnishes the necessary work materials. An independent contractor brings their own tools, but an employee often receives work tools from the employer.  Further, employees generally get paid based on doing the work, whether the work is successful or not.  Independent contractors likely get paid only if the work they do is satisfactory and can suffer a loss if performing the task costs more than the bargained-for price charged to the hiring party.

Relationship:

Finally, a view of the relationship between the person commissioning the work and the one performing it may be indicative of whether the worker’s status is that of an employee or an independent contractor.  What is the contract or agreement between the parties?  If the potential employer provides training, benefits, insurance, or other employee benefits, that is indicative of an employment relationship.  Finally, the importance of the work being performed vis-à-vis the normal business of the company can also indicate employee status.

Theon, as an accountant, should have been aware of these factors and asked more questions before considering independent contracting to be a panacea for the company’s employment costs.  In this case, pretty much all the criteria discussed above militates in favor of the workers being employees.

If he had asked, Jon would have told Theon that he oversees all the workers’ schedules and approves any shift change or vacation time. This indicates behavioral control, suggesting employee status. Jon also pays his workers a salary on a bi-weekly basis. It is more common for independent contractors to be paid per project, hourly, or on an irregular basis. Further, Jon provides all necessary work materials to his workers including training, uniforms, and lunches. This satisfies the financial control criteria. Finally, Jon provides employee benefits such as vacation pay, sick leave, and healthcare. The consistency of the workers are vital to his business model, which further supports an employee classification under the relationship criteria. Therefore, the proper classification would likely be that Jon’s “independent contractors” are employees, regardless of the tax form he gave them.

Retirement Plan Consequences of Jon’s Misclassification

Unfortunately, winter might be coming sooner than Jon thinks. Jon intentionally fired and re-hired his workers on the advice of Theon because he thought this would save him money. As a result, he improperly excluded eligible participants from the plan. The IRS may appreciate a good faith attempt at classifying your employees. However, because Theon gave bad advice to Jon, the misclassification would likely not be considered a reasonable mistake and could result in serious financial repercussions and potential plan disqualification by the IRS and DOL. Jon may owe the excluded “independent contractors” a contribution to make up for what they lost by not being able to participate in the plan.

Like The Night Watch, Microsoft also excluded independent contractors from its retirement plan, only to have a court later determine that they were regular employees. This resulted in a $90 million settlement for retroactive contributions to the affected employees. Consequently, retirement plan document providers developed so-called “anti-Microsoft” language to protect plan adopters from a similar fate. This language will basically say that individuals classified as independent contractors by the company are excluded from the plan, even if a court or administrative agency later determines that such individuals were common law employees and not independent contractors.  This exclusionary language protects the plan from being found to exclude otherwise eligible individuals – one problem taken care of.  It does not, however, protect the plan from failing coverage testing as a result of the exclusion – the second and perhaps more complex issue.

As an aside, Jon’s problems aren’t limited to the 401(k) plan.  The IRS can also go after back employment taxes and withholding that should have been paid on the affected individuals.  Jon will have to talk to his accountant – either Theon or, perhaps, his replacement – to determine how best to handle that aspect of the issue.

Reversing the Damage

In the event that Jon does not have anti-Microsoft language in his plan, the Employee Plans Compliance Resolution System, currently embodied in Rev. Proc. 2021-30, explains how Jon can fix the failure to cover those improperly classified as independent contractors. He can correct improperly excluded otherwise eligible employees from the plan by making a contribution to put the affected employees in the position they would have been in had they been allowed to participate in the first place.

For a detailed explanation on how to calculate the missed deferral opportunity for a 401(k) plan check out our previous Solution here as well as our Solution on calculating earnings here!

Conclusion

Despite Jon being led astray, he cannot reasonably claim his employees are independent contractors and now it may cost him more than if he just kept the workers as W-2 employees and offered them the plan.  It is important to know from whom you are getting your advice from, and if it doesn’t seem right, check with someone else.

If you have any questions about whether you have improperly excluded your employees, give us a call. As always, we are your ERISA solution!

Happy Holidays and best wishes for a prosperous new year!