In 2007, the Internal Revenue Service and 29 state workforce agencies entered into data-sharing agreements to identify workers misclassified as independent contractors, rather than common-law employees.

A significant and unanticipated liability may arise with respect to employee benefit plans if these examinations result in the reclassification of such workers from independent contractors to employees.

Often, employers hire independent contractors with the perception that they will never be required to offer benefits to those individuals. In some circumstances, the independent contractor is paid higher wages than his common-law employee counterpart because he is not entitled to any benefits.

ERISA and the tax code are the laws governing employee benefit plans. Generally, independent contractors are not covered by ERISA, as they are not common-law employees. Independent contractors are not considered employees for purposes of many sections of the tax code relating to employee benefits, including section 401(k).

Misclassified workers, however, are covered by ERISA and the tax code, usually retroactive to the date that the independent contractor was deemed to be a common-law employee. They may be entitled to retroactive participation in qualified pension plans, welfare benefit arrangements and stock-based plans.

Microsoft case

The key decision in the employee benefits area is Vizcaino v. Microsoft.

Microsoft hired independent contractors who signed agreements acknowledging that they would be responsible for providing their own insurance benefits. The individuals worked side-by-side, performed identical functions, shared the same supervisors and kept the same hours as the regular employees. The independent contractors submitted invoices for their services performed and were paid from Microsoft's accounts receivable department, rather than the payroll department.

In 1989, the IRS audited Microsoft and determined that those "independent contractors" were misclassified and were, in fact, common-law employees.

Microsoft reached an agreement with the IRS in which it paid the employees' share of the tax withholdings, issued retroactive W-2s to the workers and converted the workers' status to either Microsoft employees or employees of a temporary employment agency.

The IRS was the least of Microsoft's problems, as the former "independent contractors" realized that, if they were common law employees, they should have been eligible to participate in Microsoft's benefit plans, including the 401(k) plan and the employee stock purchase plan, which permitted eligible employees to purchase Microsoft stock at a discount.

With the benefit of hindsight and a stock that performed amazingly over the period of time at issue, the reclassified employees argued that they should have been permitted to purchase Microsoft stock at a discount during the period of time they were misclassified. Ultimately, the 9th Circuit Court determined that the misclassified workers were common-law employees and that all common-law employees of Microsoft are entitled to participate in Microsoft's benefit plans, including its 401(k) and employee stock purchase plan.

Microsoft reached a settlement with the misclassified workers for approximately $96.9 million. As a result of this case, many employers realized that, aside from the tax liability for misclassified workers, the associated benefit costs could be astronomical.

Fixing the problem

If a benefit plan excludes independent contractors who are later reclassified as employees, the employees may be entitled to retroactive benefits, and the employer may have a host of issues to sort through, including potentially jeopardizing the tax-qualified status of its plan.

There are three categories of benefit plans that an employer should be concerned about with respect to the impact of worker misclassification: tax-qualified pension plans (401(k) plans, defined contribution plans, defined benefits plans); welfare benefit plans (Section 125 plans, group health insurance plans, group term life insurance plans); and incentive stock option plans.

With respect to tax-qualified pension plans, an employer may only maintain a tax-qualified plan for the exclusive benefit of its employees, and independent contractors are not eligible to participate in a tax-qualified pension plan. When an employer hires an independent contractor and doesn't permit the independent contractor to participate in the plan, the employer is doing the right thing.

If, however, the worker is later reclassified, the employer has quite a problem because the employer will have impermissibly excluded an eligible employee from participation in a benefit plan and thus jeopardized the tax-qualified status of the plan.

To rectify the problem, the employer will need to retroactively include the worker in the plan, make a retroactive contribution as required under the terms of the plan, and make an additional contribution of annual interest and earnings.

To maintain the plan's tax-qualified status, the employer will more than likely need to correct operational failures resulting from the failure of the plan to operate in accordance with its terms under the IRS Employee Plans Compliance Resolution System program.

In addition, the employer will, in most instances, need to rerun all nondiscrimination testing conducted on the plan and possibly amend its Form 5500 filings, as the information previously provided will be inaccurate.

With respect to health and welfare arrangements, such as group health plans, Section 125 plans and group life insurance plans, an independent contractor is once again ineligible to participate in these arrangements. A misclassified worker, however, may have the right to retroactive benefit claims, not merely the cost of premiums. Thus, imagine the potential expense to an employer from a misclassified worker who incurred health expenses and can now claim that he or she should have been in the employer's health benefit plan.

As with a tax-qualified pension plan, if a worker is misclassified and is eligible to participate in certain welfare benefit arrangements, the employer will need to rerun all nondiscrimination testing relating to the years of exclusion.

If the reclassification of employees results in a testing failure, the most common remedy is to deny the tax advantages of the benefit to the highly paid employees. This could prove to be a sticky situation for employers that may be required to issue a new W-2 to a key employee in a subsequent year and force the key employee to amend his or her tax return. Finally, the employer may be required to amend or file a Form 5500 for the welfare benefit plan.

Incentive stock options under Section 422 may only be granted to common law employees. Only common-law employees may participate in a Section 423 employee stock purchase plan. The exposure may be less on an ISO because participation typically requires a specific award grant. However, an employee stock purchase plan may be automatic for all employees.

The Microsoft case illustrates the impact of worker misclassification on these benefits in that the typical remedy resulting from worker misclassification is retroactive inclusion in the employee stock purchase plan.

The Microsoft court decision was issued in 1997. At that time, it was typical to have benefit programs that were drafted with particular provisions unique to the plan sponsor. As more plan sponsors have moved to standard or prototype documents, there is a greater risk that these plans will not contain appropriate language that anticipates and addresses the possibility of a worker reclassification.

In light of the new environment, employers should re-examine the terms of their plans and, if necessary, amend the programs to properly reflect the desired treatment of these workers.

When hiring independent contractors, employers should be mindful that these workers generally are not eligible to participate in benefit plans. However, if reclassified, these workers could prove to be quite costly to the employer.

John Nixon is vice chair of WolfBlock's Employment Services Practice Group and a partner in the firm's Employee Benefits Practice Group.

Kathryn Larkin is an associate in the Employee Benefits Practice Group at WolfBlock.