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Thursday, April 6, 2017

Worker Reclassification and SEPs

Recently, I wrote an article on Three Things to Remember About SEPs. This is a follow-up to that article regarding the difference between simplified employee pension (SEP) plans and qualified plans [retirement plans described in Code section 401(a)], in regard to the situation where “independent contractors” are reclassified as employees upon investigation by a governmental agency. This difference may be enough to make a qualified plan a better choice for some employers.

It is convenient for employers to classify workers as independent contractors rather than employees for a variety of tax, insurance and other reasons. The distinctions various governmental agencies use to differentiate between independent contractors and employees are complex and fact specific. Suffice it to say that controversies sometimes arise and reclassification occurs.

Much has been written about the effects of reclassification on payroll taxes and workers’ compensation, but let’s narrow the focus to retirement plans.

Suppose individual A owns 100% of newly established S corporation X, which employs A and five others. Additionally, X uses the services of 100 other independent contractors. X has decided to sponsor a retirement plan for its employees and makes a contribution for the first year. Immediately thereafter, an IRS investigation of worker status is begun as a consequence of an independent contractor having filed Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding). The IRS determines that the 100 workers originally classified as independent contractors are actually employees.

If X had begun a SEP: X might be forced to make the same percentage contribution for the 100 reclassified employees as was contributed for A and the others.

If X had begun a qualified plan: The plan might be threatened with disqualification (for failure to satisfy coverage), but there would be no automatic necessity to contribute for the reclassified workers.

The reason for this difference is that SEPs cover all employees of the employer (subject to any required service and age criteria), and qualified plans cover only the employees the plan states will be covered. Now, that might mean that the plan could be disqualified for failure to satisfy coverage requirements, but there is no mandate for coverage.

In addition, most qualified plan documents contain language similar to this:

    If an individual is subsequently reclassified as, or determined to be, an Employee by a court, the Internal Revenue Service or any other governmental agency or authority, or if the Company is required to reclassify such individual as an Employee as a result of such reclassification or determination (including any reclassification by the Company in settlement of any claim or action relating to such individual's employment status), such individual shall not become an Eligible Employee by reason of such reclassification or determination.
This subtle difference may be reason enough for some employers to sponsor a regular qualified plan rather than a SEP.

To learn more about using SEPs and qualified plans, contact your local Armanino expert.


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