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Employee vs. Independent Contractor and Retirement Plan Impact

This article originally ran on September 1, 2015.

By Michael Webb

Normally, 403(b) and other retirement plan sponsors would not be directly concerned with employment law, since such issues often have little effect on employee benefits in general and retirement plans in particular. However, plan sponsors, ERISA and non-ERISA alike, should always keep a close eye on the area of worker classification — namely, employee vs. independent contractor. This is because developments in such an area have a unique — and potentially far-reaching — effect on retirement plans in general, and 403(b) plans in particular. This article will outline differences under current law between and employees and independent contractors and explain the impact on 403(b) and other types of retirement plans. 

The Definition

Though the regulations addressing the differences between employers and independent contractors have been extremely complicated (at one point, the definitive guidance was a 20 — yes 20! — factor common law test), in recent years the IRS has made attempts to streamline such guidance. 

Today, the IRS essentially utilizes three factors to determine if an individual is an employee or an independent contractor. 

  • Behavioral control considers the level of control the recipient of services has over how the individual does the job. Factors to be considered include the nature of any training and depth of the instructions given to the individual performing the task.
  • Financial control looks to the commercial aspects of the individual's performance of the job. Factors to be considered include whether the individual has made any investment in order to perform the task and whether the individual or the recipient of services pays the expenses incurred.
  • Type of relationship considerations look to such factors as whether the relationship is bound by written contracts or specific periods of service.
Basically, the stronger the control and more definitive the relationship, the more likely the individual would be classified as an employee by the IRS. Ellie Lowder, in her recent NTSA MarketBeat article on Severance of Employment, provided an excellent example of the employee vs. independent contractor issue as it relates to teachers, as follows:

A participant retires from the school district in June; however, in November he receives a contract to work on some specific projects for the district. The contract describes the projects that are to be completed, and the timing for completion; however, it does not provide specifics on how the projects are to be undertaken. The participant is not assigned an office, and must provide his own tools and equipment to undertake the specific projects. Has this individual severed employment? It is probable that he will be regarded as an independent contractor because he is under contract for activities that differ from the job he filled during employment. The independent contractor status is also strengthened because the school district is not providing a work site for him, and is not setting specific activities he must perform to achieve completion of the projects.

Practice Pointer: School districts and other plan sponsors are increasing their utilization of recently retired employees as independent contractors. Thus, you may want to examine this issue among your particular client base to determine if there are specific opportunities related to such individuals such as use of the special post-retirement employer contribution in 403(b) plans, or 457(b) plan contributions for independent contractors. 

The Implications

Obviously, from an employment tax perspective, misclassification of employees as independent contractors is a serious issue, as payroll taxes would be owed. However, the correction of employment misclassification issues by the IRS/DOL historically has led to the newly classified employees making claims for retroactive benefits under employee benefit plans.

For many types of retirement plans, such as 401(k) plans, the inclusion of proper plan language that would exclude independent contractors, even if they are later determined to be employees of the company, has often served as a valid defense to such claims. However, 403(b) plans are unique as to who can be excluded from the plan from an elective deferral standpoint. And 457(b) plans, though they can include independent contractors, have some unique issues of their own. 

403(b) Plans

Unlike 401(k) plans, where virtually any classification of employee can be excluded for all purposes, unless the classification is discriminatory or has the effect of imposing a noncompliant age/service requirement, 403(b) plans contain a universal availability requirement for elective deferrals. The universal availability requirement means that, with limited exceptions, all employees (but not independent contractors) must be provided with the opportunity to make elective deferrals to the plan. 

Fortunately (and logically) the universal availability requirement does not apply to employer contributions. However, if employees are improperly excluded from the right to make elective deferrals to a 403(b) plan, the corrective procedure generally is for the employer to make an employer contribution, which can be a significant cost to the employer (though recent EPCRS guidance has lessened this cost somewhat). 

Thus, if employees who were independent contractors are subsequently reclassified as employees in a 403(b) plan, it is conceivable that such employees could be entitled to an employer contribution to the 403(b) plan for the period that they were erroneously prohibited from the right to make elective deferrals to the 403(b). However, there should be no issue with excluding such employees from the right to receive employer contributions, provided that the fail-safe employee definition described above is included.

457(b) Plans

Though, at first glance, the employee vs. independent contractor issues is not as impactful on 457(b) plans due to the fact that independent contractors are permitted to participate in a 457(b) plan. However, there are some nuances in the 457(b) plan rules that do complicate coverage of independent contractors. 

The first issue involves governmental 457(b) plans. Though 457 permits independent contractors to participate, the rules that define a governmental plan under ERISA stipulate the governmental plans may cover only employees Thus, if independent contractors are included in a governmental 457(b) plan, the plan’s governmental status could be jeopardized.

The solution? Plans that cover only independent contractors are automatically exempt from ERISA, since such plans do not cover employees. Thus, governmental 457(b) plan sponsors that wish to cover independent contractors should maintain two 457(b) plans; one for employees, and one for independent contractors. 

The second issue relates to the lack of an employment relationship. In 457(b) plans severance of employment is a primary triggering event for distribution purposes. But how can there be a severance of employment for non-employees? 

The IRS has addressed this issue in the 457(b) regulations by defining severance of employment for independent contractors as complete termination of the contractual relationship, via expiration of the contract or otherwise. However, if the employer anticipates a renewal of the contract or intends to hire the individual as an employee, there is no severance of employment. 

Conclusion

Due to the employer tax implications, all employers should work with appropriate counsel to make certain that no employee is ever misclassified as an independent contractor. However, 403(b) plan sponsors should recognize the additional exposure related to the universal availability requirement of such plans, and 457(b) plan sponsors should recognize the special rules regarding such plans. 

Michael Webb is the NTSA Education Committee Co-Chair and a Vice President at Cammack Retirement. 

Cammack Retirement is an independent retirement plan consulting firm specializing in non-profit industries. Offering tailored, actionable solutions, to help clients achieve the greatest return on their employee investment, Cammack Retirement delivers end-to-end solutions for complex retirement plan challenges.

Please note that this article is for general informational purposes only, is not intended to be taken as legal advice or a recommended course of action in any given situation. Readers should consult their own legal advisor before taking any actions suggested in this article.

Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA, or its members.

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