Beware of plan sponsors when classifying independent contractors for benefit plan purposes

Employers generally understand that “employee benefit plans” should only be offered to “employees” and that “independent contractors” should be excluded from benefit plan participation. Although this concept is simple in principle, it is not so simple in application, since the determination of whether an individual is an independent contractor or an employee is not based on a clear line test; rather, it is based on an analysis of the facts and circumstances. With the increase in the “on-demand” economy, the continued use of temporary or leased employees, and the periodic need for an employee to provide transition services on a limited basis following a termination of job, minds can easily differ on the appropriate classification of an individual.

To further complicate the matter, there are two different sets of rules that govern the determination of whether a person is an independent contractor or an employee. As we noted in the alert from our Labor and Employment Group (a copy of which can be found here), the DOL recently announced the release of a proposed rule for employers to use when classifying service providers as employees or independent contractors. Although this new rule, if finalized, would impact the classification of employees for the purposes of the Fair Labor Standards Act (“LSF”), it does not apply for the purposes of the Code.

For the purposes of the Code (and therefore certain requirements of employee benefit plans), plan sponsors are required to apply a common law test that examines behavioural, financial and relationship factors to determine whether the degree of control and level of independence of the service provider would merit its classification as an employee or independent contractor. Information regarding these requirements can be found on the IRS website here

Whenever different tests are used for the purpose of analyzing a problem, there is always a risk that the two tests will give different results. Therefore, plan sponsors must separately test whether a person is an employee or an independent contractor for the purposes of their benefit plans, and not rely solely on the determination made for FLSA purposes. In addition, even after an individual has been classified as an independent contractor, the plan sponsor may need to consider additional matters under Section 409A of the Code to determine whether the individual’s compensation is subject to the Section 409A of the Code (which applies to certain independent contractor relationships) and whether a person changing status from employee to independent contractor has effectively ceased employment and is therefore entitled to distributions under certain plans severance pay and non-qualified deferred compensation.

To avoid potential missteps, employers should exercise caution when determining whether a person is an independent contractor and retain documentation to support the determination of the person’s status. Plan sponsors should also review their plan documents and summary plan descriptions to ensure that if an individual is incorrectly classified as an independent contractor, any coverage will only be available on a prospective (and not retroactive) basis. Carefully navigating these questions at the time of determination can help reduce potential challenges to an individual’s status in the future.

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