Retirement Plans and the Misclassification of Workers

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Hi, I'm Mikio and I work for the IRS. Misclassifying workers as independent contractors or employees can have serious federal tax consequences for workers, employers and tax-qualified retirement plans.

Improperly classifying a worker may affect retirement plan eligibility, nondiscrimination testing, employer deductions and taxation of the worker's income.  

Only "employees" are eligible to participate in a qualified plan. These include common law employees, self-employed individuals who own all or part of the business maintaining the plan, and certain leased employees. Former employees and employees on a temporary leave of absence may continue to be covered by the plan.

If you misclassify an employee as an "independent contractor," you might exclude the worker from plan participation, which could result in the disqualification of the plan.

Misclassifying a worker may cause your census data to change. This data is used to prove the plan doesn't favor the highly compensated employees.

In addition, misclassification of workers will result in improper withholding from their wages.

How do you distinguish employees from independent contractors? The Internal Revenue Code identifies categories of employees for employment tax purposes. By far, the largest category is the "common law employee."

The most important factor used to identify common law employees is "the right to control" the individual who performs the services. This includes both the right to control the result of the services and how the result is accomplished. The degree of control appropriate given the nature of the work must be present, but doesn't have to be exercised.

The IRS has published 20 factors to be used for determining whether the degree of control is present for an individual to be a common law employee.

These factors may be grouped into three broad categories: behavioral control, financial control and the relationship of the parties.

"Behavioral control" refers to the right to direct how the worker does a task. Providing instruction or training could indicate behavioral control.

"Financial control" means there is a right to direct how the worker conducts his business activities. For example, significant worker investment, unreimbursed expenses, services available to the public, method of payment and opportunity for profit or loss are factors in analyzing whether there is financial control.

The "relationship of the parties" refers to how the parties see their relationship. For example, employee benefits, a written contract, the permanency of the relationship, and the right to fire the worker, or terminate the relationship, without liability are factors for evaluating the relationship of the parties.

If you prefer, you can ask the IRS to make a determination of the status of your workers. You can make this request by filing Form SS-8, available on the IRS website.

If you discover that you've incorrectly included an independent contractor in your qualified plan, or erroneously excluded an employee, you may be able to fix the problem voluntarily without adversely affecting the qualified status of the plan. The IRS's Employee Plans Compliance Resolution System, or EPCRS, has "standard" corrections for these types of errors that can usually be used to maintain the qualified status of your plan. To learn more about EPCRS, you can visit our website at www.irs.gov and search for "Correcting Plan Errors."