October 24, 2021

Volume XI, Number 297

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October 22, 2021

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The Misclassified Worker and Employee Benefit Plan Considerations

If an employer is found to have misclassified an employee as an independent contractor or other contingent worker, then liability can be substantial under applicable federal and state labor, employment, tax and withholding laws including laws regarding payment of wages, overtime and unemployment compensation, workers’ compensation, discrimination and rights of workers and unions. It is equally important to understand that compliance of employee benefit plans with requirements under the Employee Retirement Income Security Act of 1974 (“ERISA”) and the Internal Revenue Code of 1986, (the “Code”) can also be at risk.  Employers must be mindful of the effects misclassification of employees can have on their employee benefit plans.

Improper exclusion of workers from participation in employee benefit plans governed by ERISA can jeopardize a plan’s tax-qualified status as determined under the Code and can also provide these workers with a cause of action under ERISA. Retirement plans can lose their tax-qualified status for a variety of reasons, including as a result of “demographic failures” (where the plan does not pass coverage and nondiscrimination tests) or “operational failures” (where an employer impermissibly excludes a common law employee from plan participation believing that the worker is an independent contractor).   Worker misclassification can also expose employers to penalties under the Patient Protection and Affordable Care Act for failure to properly account for the number of its employees to determine applicable large employer status as well as its failure to offer any health coverage or to offer adequate or affordable coverage to full-time employees (and their dependents).   Further, the employer may be subject to penalties for violating the Code’s annual informational return and statement requirements.  Workers who are improperly excluded from ERISA plan participation may be able to bring a lawsuit for benefits due, to enforce rights under a plan or to clarify rights to future benefits, or raise breach of fiduciary duty claims.

Leased employees, as defined under Section 414(n) of the Code[1], also present additional challenges for plan administration and can place the qualified status of the plan at risk. Leased employees must be counted in the nondiscrimination tests of qualified retirement plans unless a safe harbor exception[2] is met. Leased employees are also counted when conducting nondiscrimination tests for other benefit plans under various provisions of the Code (such as Section 79 (group-term life insurance), Section 106 (contributions by an employer to accident and health plans), Section 125 (cafeteria plans) and Section 132 (certain fringe benefits)).  Generally, where these plans do not pass applicable nondiscrimination tests, the benefits that are otherwise provided on a tax-free basis are includible in the income of the key and/or highly compensated employees benefiting under the plan. Furthermore, in the case where a leased employee converts his or her status to that of a regular employee, he or she must be credited with any periods of service previously performed for the employer for purposes of retirement plan eligibility and vesting.  Prior service as a leased employee is not required to be credited for determining eligibility under a self-insured medical plan.[3]

Employers must also be careful when engaging in joint-employer relationships, especially if they have not evaluated whether they are party to such relationships or whether they are the employer of the employees.  It is imperative to define in all relevant agreements and documentation which party is responsible for providing the workers with their benefits.

Plan sponsors may generally exclude from participation in employee benefit plans any leased employees or independent contractors.  However, there have been situations where such individuals have challenged their non-employee classifications and their exclusion from plans.  For example, in Vizcaino v. Microsoft (120 F.3d 1006 (9th Cir. 1997)), a class of freelancers sued Microsoft for participation in various employee benefit plans after the Internal Revenue Service determined, upon audit, that these workers were common law employees since they performed the same work as regular employees, under the same conditions and often under the same supervision.  As a result of this case, many plans include a provision which provides that if a leased employee or independent contractor is reclassified as an employee by a government agency or a court, then such worker shall not become eligible to become a participant in the plan by reason of such reclassification. These types of plan provisions may be drafted to exclude participation on a retroactive basis or on both a retroactive and prospective basis, provided applicable plan coverage and nondiscrimination tests can be met.  Such a provision is meant to evidence the clear intent of the plan sponsor.  Furthermore, many plans also include certain “Bruch” language (Firestone Tire & Rubber Co. v. Bruch489 U.S. 101 (1989)) which gives the plan administrator discretionary powers to interpret the plan itself and make determinations of fact with respect to such issues as eligibility for benefits, which can only be overturned by a court if the decision is deemed arbitrary and capricious.

It is important for employers to self-audit their worker classifications and to review benefits issues as part of any analysis, such as:

  • Benefit plan eligibility terms and distinctions between definition of employees, independent contractors, temporary employees and leased employees to ensure proper inclusion/exclusion of workers

  • Plan nondiscrimination tests and inclusion of leased employees

  • Proper crediting of service for workers who have converted to employee status

  • Plan language regarding treatment of workers following reclassification and plan administrator discretion

  • Consistency of provisions in all plan related documents, policies, procedures, communications and agreements regarding eligibility for benefits and excluded workers

  • Once an initial assessment is completed, decisions should be made as to any plan and related document revisions, or any corrective plan action, which may be required.


[1] A leased employee is a person who provides services to a service recipient if (i) such services are provided pursuant to an agreement between the recipient and a leasing organization, (ii) such person has performed such services for the recipient on a substantially full-time basis for a period of at least one year, and (iii) such services are performed under the primary direction or control by the recipient.

[2] The safe harbor exception which allows the exclusion of leased employees from nondiscrimination testing requires that the (i) leased employees comprise not more than 20% of the service recipient’s non-highly compensated workforce, (ii) leased employee is covered under the leasing organization’s qualified pension plan, and (iii) the leasing organization’s qualified pension plan is a money purchase pension plan that provides for immediate participation and vesting and employer contributions of at least 10% of compensation for each participant.

[3] Self-insured medical plans also undergo nondiscrimination tests under Section 105(h) of the Code and must cover at least 70% of a company’s employees.  If too many workers are misclassified as independent contractors, for example, a self-insured medical plan might not pass its nondiscrimination tests which could cause benefits to become taxable to highly compensated employees.

©2021 Epstein Becker & Green, P.C. All rights reserved.National Law Review, Volume V, Number 251
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Epstein Becker Green’s Employment, Labor, and Workforce Management practice is one of the largest in the United States limited to the representation of management as listed in Workforce Management magazine's most recent ranking of the top 10 U.S. employment law firms. We take a personalized approach to our clients, providing services that are tailored to, and focused on, meeting all their labor and employment law needs.

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Ian Carleton Schaefer Employment Attorney, Epstein Becker,
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IAN CARLETON SCHAEFER is a Member of the Firm in the Employment, Labor & Workforce Management practice, in the New York office of Epstein Becker Green, and a member of the firm’s National Employment, Labor & Workforce Management Steering Committee. 

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