USA Today recently ran
an article describing how many companies are using alternative work
arrangements to meet staffing needs during the economic recovery. Such
arrangements may include use of leased employees, independent contractors or
part-time/seasonal workers, all of which are commonly referred to as
One of several reasons often cited is the savings in benefit-related
costs; however, it takes careful planning to ensure benefit plans properly
reflect those intentions. The analysis generally requires employers to
answer three key questions:
- Which workers are legally considered to be my employees?
- What does my plan document say about employees?
- Will my plan be considered discriminatory if I exclude certain
Who Are Your Employees?
You may be thinking, “Of course I know who my employees are!” However,
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
To avoid the complexities, some employers simply include all workers in
their benefit plans, but this option also has its drawbacks. The federal
laws governing retirement plans mandate 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
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.
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 a.m. to 5:00 p.m. 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 W-2. The
IRS has provided guidelines for employers to use in its so-called “Twenty
Factor Test” which focuses on whether a company, Shady Oaks in this case,
has the right to control the worker. Several of the factors include whether
the company has the right to:
- Set the work schedule;
- Establish the work location;
- Pay by the time worked rather than by the job or on commission;
- Furnish equipment for the worker’s use; and
- Require work-related training.
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.
Employees Not Working Full-Time
Aaron hires Spencer as a W-2 employee but specifies that he will not
receive benefits, because he is not working on a full-time basis.
This situation is much more straightforward 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 such that he can be excluded from
In 2006, the IRS issued a Quality Assurance Bulletin 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
- 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 in winter; and
- 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 less than a
certain number of hours, e.g. someone who is normally scheduled to work less
than 20 hours per week.
Based on the Quality Assurance Bulletin, Spencer is a regular employee
whose eligibility for Shady Oaks’ retirement plan must be determined by the
plan document regardless of the side agreement he made with Aaron.
What Does the Plan Document Say About Exclusions?
Plan documents are generally written to include all employees unless a
certain classification is specifically excluded. Common exclusions are
independent contractors, union members and non-resident aliens. However,
documents can be tailored to a company’s needs by excluding others such as
students, interns, groundskeepers, etc.
Proper worker classification is key to knowing if the plan excludes
certain individuals. In the 1990s, a group of workers classified as
independent contractors sued Microsoft, claiming they were entitled to
benefits. Microsoft defended itself by pointing out that the plan document
specifically excluded independent contractors. While the court agreed that
the exclusion was in place, it ruled that the workers in question were not
actually contractors but common law employees; therefore, they did not fall
under the documented exclusion. Microsoft was ordered to pay nearly $100
million in back benefits.
While this is a high profile case involving a large company, the IRS is
aware of the issue of misclassification and looks for it when auditing plans
of all sizes.
Precise Document Language
Classification issues can sometimes be addressed by precise wording in
the plan document. The Microsoft case prompted many document amendments to
exclude workers classified as independent contractors on the payroll records
of the company. This more precise exclusion takes the determination out of
the realm of the common law definition of employee and ties it to how the
particular plan sponsor classifies workers.
Another example of a classification that may require precision is that of
student. If a plan excludes students, is the intention to exclude all
students or just college students? What about a senior executive who decides
to go back and earn an MBA? That person is a college student. Should he or
she now be excluded from the plan? Careful planning and precise wording at
the beginning can eliminate much of the frustration and liability that can
arise later due to ambiguity.
Election to Waive Benefits
Employers will sometimes indicate that a particular individual waived
benefits. In the above examples, Spencer agreed in writing to forego
benefits. Again, the plan document must be consulted. Many retirement plans
simply do not allow a participant to waive benefits. In that situation,
Spencer’s waiver cannot be applied to the retirement plan whether he wants
the benefits or not. For plans that do allow waivers, regulations prescribe
the process. Specifically, the waiver must be in writing, must indicate that
it is irrevocable and must be signed before the employee becomes eligible.
For a plan that provides immediate eligibility, that means the waiver must
be signed before the employee's first day on the job.
What Does the Plan Document Say About Eligibility?
Once it is determined which classifications are covered by the plan, it
is necessary to understand the age and service requirements an employee must
satisfy to join. The law generally limits the maximum age requirement to 21
and the maximum service requirement to one year (defined as completion of
1,000 hours in a 12-month period) but plans are free to implement more
This is where the part-time/seasonal/temporary classifications come into
play. As noted above, these individuals must be treated as any other
employees. That means if a plan permits employees to join after completion
of 30 days of service, seasonal employees who remain employed for more than
30 days become eligible. Similarly, an employee who works 20 hours a week
for a year becomes eligible for a plan that imposes the maximum wait of
1,000 hours in a 12-month period (20 hours per week x 52 weeks = 1,040
Furthermore, regulations require that service be combined for employees
who are terminated and rehired within certain timeframes. If Spencer works
for Shady Oaks during winter break, spring break and summer vacation all in
the same year, his service during all three of those stints is combined to
determine if he has worked the requisite 1,000 hours.
The easy solution may seem to be to simply exclude these groups. However,
the Quality Assurance Bulletin indicates that doing so will, in most cases,
violate the maximum statutory eligibility requirements, in that it
indirectly keeps someone out of the plan based on the amount of time they
work even though that time may be greater than the one year maximum. It may
be possible, however, to exclude these individuals by some other means. For
example, if all of Shady Oaks’ seasonal employees are groundskeepers like
Spencer, they could write their plan document to exclude groundskeepers
(type of work) rather than seasonal employees (length of service).
What About Nondiscrimination Issues?
There is one final step to determine if the plan can exclude contingent
workers and that is ensuring that the exclusions do not violate the
nondiscrimination requirements. The primary test involved is the ratio
percentage test. While a full description of the test is beyond the scope of
this article, it generally dictates that a plan cannot exclude any more than
30% of its Non-Highly Compensated Employees, i.e. non-owners and those who
earn less than $110,000 per year. In other words, if the sum of all the
excluded employees is less than 30% of the total number of NHCEs, the plan
satisfies the ratio percentage test and the exclusions are permitted.
The use of contingent workers carries many benefit-related issues. It is
possible, in many cases, to exclude them from retirement benefits, but all
three components discussed above (proper classification, precise document
language and a passing nondiscrimination test) are required. 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.
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