Transcript The Ten Commandments of an ERISA Fiduciary

Charles C. Shulman, Esq.
www.EBEClaw.com
October 26, 2010
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Recent focus on misclassification of employees as independent
contractors.
Leasing companies – e.g. PEOs* - have similar issues
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“Professional employer organizations” or “PEOs” are leasing companies that are
responsible for HR - hiring and firing workers, managing payroll, providing benefits,
etc. PEOs consider themselves co-employers with the client companies
*
Employer/Employee - Right to control manner and means by which
work is accomplished
2002 revenue procedure – employees of PEO may really be the
employees solely of the client companies
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If co-employers, impact to gov’t on payroll tax is minimal
Even if leased employees are not common-law employees of the
recipient company, if they meet the definition of “leased employee”
under IRC § 414(n), which is similar to common-law employee
definition but not identical, they must be aggregated for testing
purposes with recipient company’s employees
Consequences of misclassification of leased employees include
payment of payroll tax, unemployment tax, workers compensation,
overtime, union participation, entitlement to benefits
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Crackdown on Employees Misclassified as Independent
Contractors
◦ IRS announced it would audit 6,000 randomly selected
companies in 2010
◦ $25 million allocated for IRS and DOL audits and
enforcement regarding misclassified workers
◦ State enforcement, e.g., New York Joint Enforcement
Task Force on Employee Misclassification
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Leasing Organization (PEO) May Be (i) Sole Employer, (ii) Joint
Employers With Client Co or (iii) Client Company Alone May
Be the Employer
◦ Most government audits focus on independent contractors because
failure to withhold for payroll taxes, to pay workers comp, or to pay
overtime, etc. For leased employees, these have already been paid by
leasing organization even if client company is co-employer
◦ Even for co-employers, workers may be losing out on benefits at client
company and may be excluded from joining union at client company
◦ Authority for Co-Employer Status:
 Rev. Rul. 66-162 (sales clerks were employees of both the concessionaire
who leased space at a department store and the department store)
 Chief Counsel Memo. 200415008 (PEO and clients were co-employers, and
where PEO goes bankrupt client company is liable for employment taxes)
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Leasing Organization (PEO) May Be (i) Sole Employer, (ii) Joint
Employers With Client Co or (iii) Client Company Alone May Be the
Employer (con’t)
◦ In certain cases leased employees are reclassified as employees solely of
recipient company. Payment of payroll tax with interest and penalties
may be due from client as real employer, with PEO required to file for
refund
◦ Authority for status of PEO workers as employees solely of client
company:
 Professional & Executive Leasing, Inc. v. Commissioner (9th Cir. 1988) leased employees were not employees of leasing company but employees of
client companies alone and therefore leasing company violated the exclusive
benefit rule of IRC § 401(a)(2) for qualified plans by including such workers
in the leasing company’s plans (see further below)
 Rev. Proc. 2002-21 - PEOs that maintain defined contribution plan must
treat plan as a multiple-employer plan, since leased employees may be
common law employees solely of client company (see further below)
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“Darden” Standard—Common-Law Definition for ERISA—Right
to Control Manner and Means by Which Work Is Accomplished
◦ Nationwide Mutual Insurance Co. v. Darden (Supreme Court 1992)
- For ERISA use common-law definition of employee, and whether
a hired party is an employee depends primarily on hiring party’s
right to control the manner and means by which the product is
accomplished, not just receipt of final product
◦ Other factors include: (1) skills required; (2) source of tools; (3) location of
work; (4) duration of relationship; (5) right of hiring party to assign
additional projects; (6) hired party’s discretion over when and how long to
work; (7) method of payment; (8) hired party’s role in hiring and paying
assistants; (9) whether the work is part of regular business of the hiring
party; (10) whether the hiring party is in business; (11) provision of
employee benefits; and (12) tax treatment of hired party. Id
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Common-Law Definition Adopted in Payroll Tax
Regulations
◦ Treasury Regulations apply Darden standard and other
factors to payroll taxes (income tax, FICA & FUTA).
Employee under common law exists when
 service recipient has right to control and direct service
provider, not only as to the result to be accomplished but also
as to the details and means by which that result is
accomplished,
 i.e., employee is subject to control of employer not only as to
what shall be done but how it shall be done.
◦ Other factors are furnishing tools and furnishing of place
to work. Treas. Reg. §§ 1.3121(d)-1(c), 31.3306(i)-1(b) & 31.3401(c)-1(b)
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20 Factors in Rev. Rul. 87-41 Which Have Been Combined
Into 3 Categories
◦ Rev. Rul. 87-41 re payroll tax, provides 20 factors identified in
rulings or cases. 20 factors have been broken down in IRS
guidance to three categories
 1. Behavioral control - whether there is a right to direct or
control how the worker does the work, i.e., receiving extensive
instructions on how work is to be done and training about
required procedures and methods
 2. Financial control - whether there is a right to direct or control
the business part of the work—having significant investment in
the work, not being reimbursed for business expenses and
ability to realize a profit or incur a loss
 3. Relationship between parties - what does the employment
agreement say; are there employee benefits
◦ Form SS-8 - Determination of Worker Status for Purposes of
Employment and Income Tax Withholding can be filed with IRS
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Section 530 of the Revenue Act of 1978 Relief —
if Reasonable Basis for Worker Classification
◦ Section 530 of the Revenue Act of 1978 - Employer relief
from employment taxes for workers who have been
retroactively reclassified as employees, if (1) employer
consistently treated similar workers as independent
contractors, (2) reasonable basis for doing so, and (3) tax
returns including 1099s are consistent with such treatment
◦ Reasonable basis — reasonable reliance on case-law, prior
audits and industry standard
◦ IRS challenges: (i) whether there was reasonable basis for
classification, (ii) whether 1099s were filed and (iii) whether
similar workers treated the same.
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Section 530 of Revenue Act of 1978 Relief—if
Reasonable Basis for Worker Classification (con’t)
◦ Audit of employee classification can lead to an expanded IRS
audit of other issues
◦ Section 530 not directly applicable to leased employees, but
shows Congressional intent to not reclassify employees who
are classified on a reasonable basis
◦ Proposed employee classification legislation that would repeal
Section 530
 Taxpayer Responsibility, Accountability and Consistency Act
(S. 2882)
 Fair Playing Field Act of 2010 (H.R. 6128)
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Vizcaino v. Microsoft — Employees Reclassified Require Retroactive
Benefits Unless “Microsoft Inoculation” Language Inserted in Plans
◦ Where there is an employee misclassification, the employee may be
retroactively entitled to employee benefits
◦ Vizcaino v. Microsoft (9th Cir. 1997) ― Freelancers at Microsoft held to really
be common-law employees, and entitled to benefits under retirement savings
plan, employee stock purchase plan and stock option plan. Microsoft case was
ultimately settled for approximately $97 million
◦ To avoid issue, plan sometimes add “Microsoft inoculation” provision that
persons originally classified as independent contractors are not eligible under
plan even if later reclassified by IRS, until date of reclassification
◦ For leased employees, client company plans should specifically exclude leased
employees from participation even if later classified as “leased employees”
under IRC § 414(n) even though aggregated under § 414(n) for
nondiscrimination testing
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Professional & Executive Leasing, Inc. v. Comm’r (9th Cir. 1988) —
Where Leasing Co. Exerts Only Illusory Control over Professionals
They Are Not Leasing Co’s Employees and Cannot Remain in its
Retirement Plan
◦ Leasing company hired professionals (doctors, lawyers and executives)
and covered them under its rich employee benefits and retirement plan
◦ Court ruled professionals were not employees of leasing co because
leasing company exercised no meaningful control over professionals
(leasing co never reassigned professionals, most professionals had
preexisting equity interest in recipient company, salary decisions were not
made by leasing co, leasing co did not screen employees).
◦ Office, equipment and malpractice insurance were supplied by client
companies
◦ Therefore participation by professionals in leasing co’s retirement plans
violated exclusive benefit rule of IRC § 401(a)(2)
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6 Factor Economic Realities Test Used in Second Circuit CoEmployer Case - Zheng v. Liberty Apparel Co. (2d Cir. 2003)
◦ Garment company hired subcontractors who hired workers to sew clothing
◦ 6 factor “economic realities test” to determine if garment co. was joint
employer together w/ subcontractors
1.
Whether company’s premises and equipment are used
2.
Whether subcontractors business can shift from one employer to another
3.
Extent to which workers perform assembly line jobs that are integral to
company’s operations
4.
Whether contract between subcontractors and company could pass from
one subcontractor to another
5.
Degree to which garment company supervises employees work
6.
Whether employee works exclusively or predominantly for the company
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Rev. Proc. 2002-21— Employees of PEO are Actually
Employees of Recipient Company and not of PEO,
and Each Employer Must Sign Onto PEO’s 401(k) Plan
◦ Rev. Proc. 2002-21 (amplified by Rev. Proc. 2003-86)
requires professional employer organization that maintains
defined contribution plan to treat plan as multiple-employer
plan
◦ Citing Darden and Professional & Executive Leasing, IRS
acknowledges complexity in determining whether leased
employee is in fact common-law employee of client company
and not of PEO
◦ Ruling notes that § 414(n) not applicable if common-law
employee of client company
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Rev. Proc. 2002-21 — Employees of PEO are Actually
Employees of Recipient Company, and Each Employer
Must Sign Onto PEO’s 401(k) Plan (con’t)
◦ Rev Proc provides safe harbor under which plans sponsored
by PEOs not treated as violating IRC § 401(a)(2) exclusive
benefit rule solely because the benefits provided to workers
who may be common-law employees only of client company
— provided PEO either terminates plan by May 2, 2003 or
converts it to multiple employer plan under IRC § 413(c)
◦ Rev Proc only deals with retirement plans sponsored by the
PEO and not retirement plans of the client company
◦ Rev Proc shows IRS bias toward finding employees of PEO to
be employees solely of client company. However, if PEO,
rather than the company, maintains primary control over
employees, and other criteria also point to PEO being
employer, presumption of Rev. Proc. 2002-21 should be
negated
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PEO Health Plans as MEWAs
◦ If employees of PEO recharacterized as common-law
employees of client companies, PEO health plan would be
multiple employer welfare arrangement (“MEWA”)
◦ MEWAs have limited ERISA preemption under ERISA §
514(b)(6) and are subject to state insurance laws regarding
required minimum reserves and contributions. This creates
problem for self-insured plan, but with insured plans
insurance company already meets reserves and contributions
requirements
◦ DOL Annual Form M-1 filing (under ERISA § 101(g) and DOL Reg. §
2520.101-2) would be required even for insured MEWAs
◦ Very common area of noncompliance, as PEOs often not aware
of the MEWA requirements
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Right to Discharge Employee as a Factor in Determining
Employee Classification (with Respect to Independent
Contractors but not with Respect to Leased Employees)
◦ Treas. Reg. § 1.3121(d)-1(c) (regarding Social Security & Medicare)
provides that right to discharge is an important factor indicating that
the person with that power is the real employer
◦ Legislative history re changes made by SBJPA 1996 to IRC §
414(n)(2)(C) (adding primary direction and control to leased employee)
states that factors that generally are not relevant in determining
whether such direction or control exists are whether the service
recipient has the right to hire or fire the individual
◦ Regs and legis. history can be reconciled — if determination is
whether employee or independent contractor (e.g., for payroll tax)
right to discharge is important factor indicating that person is
employer. However, for leased employees whether service recipient
has right to hire or fire individual not relevant because even
nonemployer client of PEO would want right to remove leased worker
if not satisfied with work
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Castiglione v. U.S. Life Insurance Co. (D. Ariz. 2003) Leased Employees Were Legitimately Classified as
Employees of Leasing Co. Since Leasing Co was Acting
as Employer With Regard to Benefit Plans
◦ Leasing company was employer for purposes of ERISA plan.
Client companies entered into employee leasing contracts
where leasing co agreed to adhere to federal, state, and local
tax laws, payroll, workers’ compensation laws and to provide
group health and life insurance.
◦ Leasing company purchased several insurance policies for
employees. Court noted that ERISA § 3(5) defined employer as
any person acting directly as an employer, or indirectly in the
interest of an employer, in relation to an employee benefit
plan.
◦ Court found that leasing agency was employee’s direct
employer in relation to employee benefits plan, even though it
did not control the employee’s day to day activities.
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Leasing Organization for Only One Company
◦ PEO that services numerous companies (e.g.,
Administaff, ADP, Paychex, Trinet, etc.) is less
likely to be attacked as illusory, than PEO set up
for solely one employer.
◦ Easier to demonstrate that large PEO exerts
sufficient control independent of the client
company when there are numerous clients and
employees are sent on varying assignments for
varying periods of time
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Generally
◦ For nondiscrimination testing for qualified plans, if employee found to be
common-law employee of client company, employee must be included in
testing of the company’s plans, and would be included in the client
company plans even if the plan excludes leased employees under §
414(n) or even if not a leased employee under § 414(n) *
*
See, Burrey v. Pacific Gas and Elec. Co. (9th Cir. 1998), where qualified plans plan excluded leased
employees as defined in § 414(n). Court held that individuals classified as leased employees who were
found to be common law employees were employees and therefore would not be excluded if the plan
excluded leased employees
◦ Even if not a common-law employee of the company if the employee is a
“leased employee” as defined in IRC § 414(n) as described below, they
would also have to be aggregated with client company and not with
leasing co. for testing and qualification rules
◦ For participation, the plans can specifically exclude leased employees
from coverage
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Leased Employees Under IRC § 414(n) Aggregated with
All Company Employees for Nondiscrimination Testing
◦ “Leased employee” as defined in IRC § 414(n) is treated as an
employee of the service recipient. Also, any contributions or benefits
provided by leasing co is treated as provided by recipient company
◦ IRC § 414(n)(3) requires that “leased employee” be treated as
an employee of the service recipient for the following:
1.
General nondiscrimination requirements of IRC § 401(a)(4) (and
presumably ADP/ACP nondiscrimination requirements), unless
leased employees specifically excluded from participation
2.
Minimum coverage requirements of IRC § 410(b) (and minimum
participation under § 401(a)(26) to extent applicable)
3.
Top-heavy requirements of IRC § 416
4.
Maximum benefit and annual addition requirements of IRC § 415
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Leased Employee Under § 414(n) Defined as Service Provider
for One Year or More Where Services Are Performed Under
Primary Direction or Control of Service Recipient
◦ “Leased employee” defined in IRC § 414(n)(2) as any
person who
 1. is not an employee of the service recipient, and
 2. provides services to the recipient company if:
 (a) such services are provided pursuant to an agreement
between service recipient and leasing organization,
 (b) services are on substantially full-time basis for at least one
year, and
 (c) services are performed under the primary direction or control
of the service recipient
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Criteria for Determining Whether Services Are Performed
Under Primary Direction or Control of Service Recipient—
Similar to Common-Law Employee Definition
◦ Legis. History to SBJPA 1996 provides:
 “Whether services are performed by an individual under primary
direction or control by the service recipient depends on the facts and
circumstances
 In general, primary direction and control means that the service
recipient exercises the majority of direction and control over the
individual
 Factors that are relevant in determining whether primary direction or
control exists include:
 whether the individual is required to comply with instructions of the
service recipient about when, where, and how he or she is to
perform the services,
 whether the services must be performed by a particular person,
(next slide)
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Criteria for Determining Whether Services Are Performed
Under Primary Direction or Control of Service Recipient—
Similar to Common-Law Employee Definition (con’t)
 whether the individual is subject to the supervision of the service
recipient, and
 whether the individual must perform services in the order or
sequence set by the service recipient.”
◦ “Primary direction or control” test of IRC § 414(n)(2) similar to
common-law employee test that service recipient has right to control
and direct individual as to details and means by which work is
accomplished
◦ (There may be situations where worker is not a common-law
employee because the recipient company does not have the right to
control the details and means by which the work is accomplished or
sufficient other factors, but still be under the primary direction and
control of the recipient company under § 414(n)(2))
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a. Affiliated Service Group as Single Employer for Qualification Rules
Under IRC § 414(m)
◦ Under IRC § 414(m)(1) all employees of members of affiliated service group treated as
employed by single employer for nondiscrimination rules of IRC §§ 401(a)(4) and 410(b)
and for qualified plan limits of IRC §§ 401(a)(17), 401(a)(26), 411, 415, 416, etc. IRC §
414(m)(1) & (m)(4)
◦ 414(m) enacted in 1980 to combat abuses, e.g., professional service corps with rich
benefits formed for each doctor of medical practice
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b. Definition of Affiliated Service Group
◦ A Org or B Org Affiliated Service Groups - Affiliated service group under IRC §
414(m)(2) is group consisting of
 i. first service organization (“FSO”) – i.e., a service organization (principal business is
performance of services), AND
 ii. either

(A) an “A” Org Under § 414(m)(2)(A) – which is service organization that is shareholder or
partner of FSO, and regularly performs services for FSO (or is regularly associated with
FSO in performing services for third parties), OR

(B) a “B” Org under § 414(m)(2)(B) – which is any other organization if significant portion
of its business is performance of services for the FSO or for an A Org, and at least 10% of
this organization is owned by highly compensated employees of the FSO
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◦ Management Org Affiliated Service Groups - Affiliated service group
also includes under IRC § 414(m)(5) an organization the principal
business of which is performing “management functions” for another
organization, and such other organization
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d. Affiliated Service Group Rules Would Generally Not Impact
Leased Employees - Leased employees from a PEO would not
fit within the affiliated service group rules because:
◦ PEO would typically not have any ownership interests in the recipient
companies, nor would PEO be for principal business of conducting
management functions for recipient company
◦ There is no affiliated service org of the recipient companies for the PEO, because the
recipient companies would not be performing services for the PEO, the recipient
companies do not have an ownership interest in the PEO, and the recipient
companies do not perform management services for the recipient companies
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◦ Consequences of misclassification of independent contractors would include
 liability for income tax withholding,
 FICA and FUTA withholding,
 state unemployment,
 workers compensation
◦ For leased employees, if company recipient is treated as sole employer, the
government may collect from employer and leasing company will seek a refund for
amounts paid
◦ However, if the IRS considers the recipient company to be co-employer with the
leasing organization and in all events taxes and payments will have been received
from one of the parties, government will generally not seek a duplicate payment
from the recipient company
◦ Adverse consequences of reclassification of workers as employees of recipient
company or as § 414(n) leased employees is that there may be retroactive benefits
claims under the company’s benefit plans, although if the plans specifically exclude
those misclassified (or determined not to be leased employees under§ 414(n)) until
reclassified, this won’t be a problem
◦ Eligibility for overtime ,union participation and benefits if reclassified
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◦ If reclassified or if determined to be leased employees under §
414(n), company would retroactively test qualified plans for
nondiscrimination taking into account that leasing company
employees have not been included in the plans—and since they are
typically non-highly compensated employees, company would likely
fail the nondiscrimination tests
◦ An additional, adverse impact could occur if the addition of
employees to the company would bring it over the threshold for
certain employment laws (For example, 15 employees are required for
application of the Americans With Disabilities Act and Title VII, 20 employees for
the Age Discrimination in Employment Act and COBRA, 50 employees for the Family
and Medical Leave Act, 100 employees for WARN Act, etc.)
◦ Where company that has leased employee arrangements exerts
control over leased employee, and company may be employer or coemployer, leasing co and/or client company should conduct selfaudit to determine if treatment of employees of the PEO is proper. (If
audit is done with or under the direction of legal counsel, the
attorney-client privilege will generally be retained.)
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Misclassifying Leased Employees. Are They Really Your Workers?
October 26, 2010 at 1:30 pm ET Duration: 60 minutes
Speaker: Charles C. Shulman, Esq.
(201) 357-0577; (212) 380-3834
[email protected] www.ebeclaw.com
www.parkavenuepresentations.com/description_misclassifying.html
Charles C. Shulman is in private practice, specializing in employee benefits & executive
compensation law. Charlie has close to 20 years experience advising in all aspects of
employee benefits and executive compensation, as well as employment law, and has
handled significant employee benefits compliance and M&A work, negotiating and
advising various issues relating to qualified and non-qualified plans, ERISA liability,
executive compensation, welfare plans and employment issues.
Before starting his own practice, Charlie practiced employee benefits and executive
compensation law at Paul Weiss, Cahill Gordon and Skadden Arps.
Charlie has authored numerous employee benefit and executive compensation-related
articles and chapters. He authors a chapter on employee benefits and executive
compensation in mergers and acquisitions that has become the primary reference and
training source for employee benefit lawyers with M&A practices.
Charlie received a J.D. as well as an LL.M. (taxation) from N.Y.U. School of Law. Charlie is
admitted to practice in New York and New Jersey.
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