IRS and DOL Requirements Complicate Employers Classification of Independent Contractors, Consultants and Service Providers

Saturday, May 1, 1999

by Jackson Lewis

In an ideal work environment, an employer would know that those individuals over whom the employer exercises management, control, and direction for an unlimited time period are "employees." They are on the employer's payroll; appropriate taxes are withheld by the employer from their wages; they may participate in pension, profit-sharing, and welfare benefits plans sponsored by the employer.

Add to this legally simplistic scenario contractors who provide services to the employer. They are either self-employed or employed by other employers. The employer uses them to provide services for limited periods of time or for special or professional skills. The relationship is defined by a contract which specifies the tasks the contractors are to accomplish. The contractors exercise management, control, and direction of their employees to meet their contractual obligations to the employer. The contractors regularly send invoices to the employer for services rendered, and the employer pays for the contractors' services. The contractors handle the payroll and benefits plans for their employees similar to the way the employer does for its employees. However, the scope of the contractors' benefits plans may differ significantly in areas such as co-payments, benefits levels, and coverage.

Microsoft case. Unfortunately, the clearly-defined legal environment described above does not reflect the realities of our time, and neither the courts nor the legislature are making compliance less difficult for businesses, whether small and privately held or large and publicly traded. By now, most employers are aware that, in addition to the U.S. government's investigation and prosecution of Microsoft for restraint of trade, the company also recently has faced a spate of litigation involving its use of independent contractors. As Microsoft's business expanded in the late 80's and early 90's it "hired/contracted for" the services of programmers at a rapid pace. Some of them became full-time, regular employees while others agreed to be "independent contractors" and were paid out of the purchasing department with payments reported to the IRS on a Form 1099 and no payroll taxes withheld. These "independent contractors", not being "employees" but often working side by side, did not participate in Microsoft's employee benefits plans - most notably Microsoft's Employee Stock Purchase Plan under which those designated as employees on Microsoft's payroll realized large cash gains.

The "contractors" sued seeking equivalent treatment. While the facts and the law in the case became far too complex to explain fully here, the U. S. Court of Appeals for the Ninth Circuit held, among other things, that Microsoft owed certain individuals what they would have received had they participated in the Stock Purchase Plan. The court ultimately decided that "some" of the "independent contractors" should have been classified as "employees." However, the court issued its final decision with separate opinions by five of the judges, two of which dissented from the majority. Since the U.S. Supreme Court declined to hear Microsoft's appeal of the case, the determination of how to classify such workers remains unclear.

Time Warner case. On the heels of the Microsoft case, the Department of Labor initiated a lawsuit in late 1995 against Time Warner for excluding persons the company identified as independent contractors and temporary employees -- less than 1,000 of Time's 40,000 employees -- from its benefits plans. From a legal standpoint, the Time Warner case is complicated by the fact that the Department of Labor brought the suit, not Time's "independent contractors and temporary employees," nor the IRS which normally enforces the requirements for tax-qualified employee benefit plans.

Time Warner has argued that the Department of Labor's actions were "unprecedented and represent a clear departure from the DOL's longstanding recognition of the limits to its jurisdiction." Many of the less than 1,000 workers covered by the DOL's lawsuit are "stringers," including college students, care-givers, senior citizens, novelists and others who report local events to Time Warner publications when and if such events occur. Many have other revenue-generating activities and value their flexible work styles. Moreover, the exclusion of 1,000 such workers from Time Warner's benefits plans covering forty times that many employees passes muster with the IRS's non-discrimination rules.

Potential issues. In light of these developments, any change in employment status from a full-time traditional relationship to consultant, independent contractor, or other contingent arrangement because of declining business, advancement of other key employees, or changing technology may trigger problems. If former employees come back to work after termination or retirement on a part-time basis or for full-time work on a specific project, questions arise as to their employment status. Do you put them on the payroll? Do vested retirement benefits continue to accrue? If retirement benefits started, should they be suspended while the "retiree" continues to work? Should they continue to participate in your 401K (and profit-sharing plans), does their presence as a plan participant count in the plan qualification anti-discrimination tests?

While some help may be on the legislative horizon, the law and regulations in this area continue to confound most employers. However, employers can limit their risks by creating a proper business structure within which to implement changes that could result in claims and litigation. Strategic and preventive planning before deciding to spin off segments of the work force or add contract workers could avoid many of these problems.

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