Dealing with Leased Employee and Workers Misclassification Issues

From Employee Benefits Alert

December 1997

The use by employers of leased employees and contract workers has increased dramatically in recent years as employers have sought greater flexibility in their work forces and reduced costs. Employee leasing and outsourcing lead to complex relationships that can make it difficult to determine which company is really the employer and can lead to a host of problems with respect to treatment of the workers under employee benefit plans.

Recent decisions in Vizcaino v. Microsoft and other cases have shed light on problems of misclassifying workers as independent contractors and not including the workers in employee benefit plans. In Microsoft, the employer retained a large number of workers on a contract basis and had them waive their rights to coverage under the employer's stock purchase plan and 401(k) plan. The IRS audited Microsoft and determined that the workers were employees, who should have had FICA and income tax withheld from their wages. Microsoft agreed to this determination and placed many of the workers on the payroll. Other workers were terminated and hired by a temporary employment agency which supplied the workers to Microsoft as needed. Some of the workers then demanded benefits under the company's plans for the period during which they had not been treated as employees. The plan administrator denied coverage on the basis that the workers had agreed they were independent contractors and waived the right to participate in the plans. The workers sued and the federal court of appeals decided that as common law employees of Microsoft the workers were entitled to coverage under the plan.

In Bronk v. Mountain States Telephone, a U.S. district court held that leased employees who were common law employees of the employer rather than the leasing company would be entitled to benefits under the employer's qualified plans, even though the terms of the plan excluded leased employees. The court held that coverage was required because of the minimum participation requirements of ERISA.

Microsoft and Bronk can be contrasted with Clark v. E.I. Dupont de Nemours & Co., in which another federal court of appeals held that a leased employee was not entitled to coverage under the plan, even if he was a common law employee of Dupont, because the plan specifically excluded leased employees. In this case, the fact that the plan excluded leased employees and gave the plan administrator the right to interpret the eligibility provisions of the plan led the court to rule for the employer.

IRC & ERISA Eligibility Requirements

Neither the IRC nor ERISA require that an employer cover all employees under its qualified plans. Although leased employees (as defined in IRC § 414(n)) generally must be included as part of the employer's work force for purposes of testing plans for nondiscrimination, they do not have to receive a benefit under the plan. In general, employers may exclude from participation any reasonable class of employees so long as the exclusion is not based directly on age or service of the employee (or any other protected status, such as race or religion). For example, an employer cannot exclude employees on the basis that they are part-time employees, because to do so could violate the minimum service participation rule (i.e, it would exclude a person who had a year of service with at least 1,000 hours of service).

The flip side to this is that employers cannot provide coverage under a qualified plan to a person who is not an employee or the plan will be disqualified because it will not be administered for the exclusive benefit of the employees. Thus, it is always better to exclude workers who may not be employees of the employer than to provide coverage, because improper exclusion generally can be remedied through the IRS Voluntary Compliance Resolution program, without disqualification of the plan.

Plan Eligibility Provisions

Many qualified plans simply state that "employees" of the employer are eligible to participate without further defining the term employee. Other plans may state that employees on the payroll of the employer are eligible. Although most plans will exclude employees who are "leased employees" for purposes of IRC section 414(n), this may not be sufficient to exclude all leased employees or other workers who are hired through individual contracts.

It is important to have provisions in the plan that clearly define who is and who is not eligible, keeping in mind that workers who the employer may not initially consider to be "employees" may later turn out to be employees. Often, definitions that were acceptable when the employer's workforce consisted only of one class of worker may fail to provide adequate guidance once the employer has retained a variety of leased, contract, or other temporary and freelance workers.

Leased Employees and Outsourcing

Leased employees who work under the direction and control of an employer may be deemed to be common law employees of the employer. Using leased employees differs from outsourcing in that outsourcing firms provide turn-key services in which all of the employees are subject to the direction and control of the outsourcing firm. The employees therefore are not common law employees of the employer that retained the outsourcing firm. Nevertheless employers that outsource a department by transferring employees to an outsourcing firm may face law suits by the terminated employees who would lose benefits under the employer's plans. In Inter-Modal Rail Employees Association, the U.S. Supreme Court recently held that section 510 of ERISA prohibited an employer from engaging in an outsourcing plan for the purpose of depriving the transferred employees of their benefits.

Administrative Determinations

When deciding whether a worker is eligible for coverage, the plan administrator should review the terms of the plan and make a determination based on those terms and the surrounding facts and circumstances. The plan should provide the plan administrator with discretionary authority to interpret the plan, and such interpretive decisions will be upheld by a court if they are reasonable, supported by evidence, and consistent with the law. If the plan does not provide for such standard of review, decisions may be reviewed under a de novo standard which permits the courts to substitute their own judgment. The plan administrator should fashion its determination regarding eligibility as an interpretation of the plan's provisions. When contract workers have been excluded from participating in a plan on this basis, the employer has generally been successful when the workers challenged the decision in court.

For further information regarding the effect of leased employees and outsourcing on benefit plans or for information on other employee benefits matters, please contact Paul J. Powers, Jr. or Kirk H. O'Ferrall at our New York office.