The down side of downsizing. Short takes,

Companies must watch out for the employee—independent contractor
determination and employee benefit plans.

From The Tax Adviser:

The Down Side of Downsizing

M any corporations have adopted the practice of hiring temporary employees, leasing employees or using independent contractors to increase profits. Such a practice has well-documented tax and nontax advantages. On the tax side, employers are not responsible for federal insurance, unemployment and income tax withholding on payments to these workers. On the nontax side, the employer need not be encumbered by a large permanent payroll, can greatly simplify its accounting burdens, can limit its tort liability and may avoid the laws dealing with unions, collective bargaining and certain state and federal laws. In addition, the employer need not provide medical insurance, pension benefits, workers compensation, unemployment coverage, disability insurance, medical leave, vacation or holiday pay or any other benefit it normally might provide to its employees.

The problems involved in hiring nonemployees have been the subject of extensive discussion, litigation and legislation. Much of the focus has been on the tax ramifications, with the Internal Revenue Services interest in ensuring appropriate taxes are collected and paid. Another issue (which could prove to be very costly to employers) centers on retirement plans and who may need to be included in them.


Many provisions of benefit plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA), which protects the interests of employees in different types of benefit plans via rules and regulations governing reporting, participation and vesting.

Plan participants. Determining who is an employee is important for ERISA purposes; independent contractors, for example, are not allowed to participate in employee benefit plans or bring suit to enforce their rights under such plans.

Another issue is workers wishing to receive plan benefits who might be considered employees based on their employment relationships but who are excluded from plan participation based on the plan language. Central to the analysis are two basic determinations: (1) whether a worker is a common-law employee of the employer maintaining the plan (using the usual factors such as control, supervision, skill level and intent of the parties involved) and (2) whether, according to the plan language, the worker is eligible to receive a benefit under the plan.

The courts, however, have not acted uniformly in making these determinations. In some situations, both factors must be resolved in the workers favor to make him or her eligible to receive benefits; the worker must be an employee under common-law considerations and must be eligible under the terms of the plan or the legislative rules governing such plans. In other settings, the status of workers as common-law employees has been enough to require that they be included under an employers plan, effectively rewriting the plan language.

Ramifications. Obviously, the ramifications of these determinations can be significant. Having to provide benefits to an increased number of workers can have severe economic effects on a plan (depending on the level of benefits and the number of workers involved) and on an employers ability to provide benefits to its workers. In addition, depending on the type of benefit plan involved, including a large number of workers could affect its status as qualified and could disqualify the plan.

Plan language is key. The wording of the benefit plan seems to be the overriding factor in determining whether individuals are eligible to participate. If a plan (implicitly or explicitly) includes common-law employees in the definition of employee and leased employees or independent contractors are reclassified as common-law employees, an employer may be responsible for providing benefits for such workers. Therefore, employers should review their employee benefit plans to ensure the plan language explicitly excludes the classes of workers the employer intends to exclude (to the extent consistent with the plans tax-qualified status). At the same time, employers should examine carefully any independent contractor and employee lease arrangements with workers currently in place and any documents those workers have signed or executed.

For a detailed discussion of this and other developments, see the Tax Clinic, edited by Lawrence Portnoy, in the July 1997 issue of The Tax Adviser.

— Nicholas Fiore, editor
The Tax Adviser


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