“I have a client who is converting his 401(k) plan from one TPA to another and switching plan documents. In the switch, we discovered the original plan references ‘reclassified employees.’ Can you shed some light as to the relevance of this reference?”
ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.
A recent call with a financial advisor from Massachusetts is representative of a common inquiry related to employee classifications for plan purposes.
Highlights of the Discussion
Worker classification is a high priority for the IRS because it affects whether an employer must withhold income taxes and pay Social Security, Medicare and unemployment taxes on wages paid to an employee. Worker classification also affects whether a participant will be considered eligible to participate in a qualified retirement plan sponsored by an employer.
For example, businesses normally do not have to withhold or pay any taxes on payments to workers classified as independent contractors. The earnings of a person working as an independent contractor are subject to self-employment tax and are, generally, reported on a Form 1099-MISC, Miscellaneous Income. Because they do not meet the definition of eligible employee for retirement plan purposes, independent contracts are excluded from participation in any retirement plan sponsored by their employer. An independent contractor would have the ability to establish his or her own retirement plan based on his or her self-employment earnings.
In the past decade, the IRS has undertaken a series of employment tax audit initiatives focused on worker classification issues—especially on employers who have treated workers as independent contractors when they should have been treated as common law employees. (See IRS Topic No. 762 Independent Contractor vs. Employee.) Since 2011, the IRS has sponsored a Voluntary Classification Settlement Program (VCSP) that provides an opportunity for taxpayers to reclassify their workers as employees for employment tax purposes for future tax periods with partial relief from federal employment taxes. To participate in this voluntary program, the taxpayer must meet certain eligibility requirements and apply to participate in the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS.
For retirement plan purposes, whether an employer will have to retroactively cover workers who have been reclassified as common-law employees will depend on the plan document language. Some plans only require employers to cover reclassified employees prospectively as of the date the IRS makes a formal determination as to the individual’s employee status. Other plans allow the employer to elect or may mandate retroactive coverage of reclassified employees. Consequently, plan sponsors should review their plan documents for language that addresses reclassified employees to determine their proper treatment. Should an employer discover that it has prevented otherwise eligible employees from participating in the plan, a prudent course of action would be to consider the correction provisions of the IRS’s Employee Plans Compliance Resolution System for exclusion of an otherwise eligible employee.
Not only do reclassified employees affect payroll departments, they also can impact retirement plan operations. Therefore, plan sponsors have an obligation to properly categorize workers, and treat such workers for plan purposes according to the terms of their plan documents.