FIS Relius
IRS Warning on Questionable Employment Practices 5/20/2004
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The IRS recently issued an alert regarding several “schemes” employers may use to avoid properly withholding employment taxes:

  1. unreliable third party payers (e.g., PEOs),
  2. offshore leasing,
  3. misclassifying workers (independent contractors vs. employees),
  4. paying employees cash, and
  5. S corporation officers compensation treated as corporate distributions.
The warning comes on the heels of several recent convictions and court rulings involving employment tax schemes. Although the warning applies to employment taxes, employers should take note that many of these schemes affect employee status and compensation, and therefore could affect an employer’s liability for retirement plan benefits.

Employers participating in PEOs should be aware that the IRS generally considers the “employees” of the PEOs (“worksite employees”) who provide services to the participating employers (“client organizations”) as employees of the client organization. Accordingly, a single employer plan sponsored by the PEO covering the worksite employees would violate the exclusive benefit requirement because such employees are not employees of the PEO. If the PEO establishes a retirement plan for the worksite employees, the plan must be a multiple employer plan in which the client organizations are participating employers.

Employers who use extensively the services of “independent contractors” need to evaluate the status of these contractors to determine whether the contractors are in fact independent contractors or employees. The misclassification of or workers continues to be an area in which the IRS focuses attention. Employers who use the services of questionable independent contractors run the risk of reclassification as employees. Employers in such circumstances should consider including a plan provision that excludes a reclassified employee to avoid the risk of retroactive liability for retirement plan benefits.

S corporations sometimes designate a portion of a shareholder’s “compensation” as an S corporation distribution rather than W-2 compensation. The advantage of such a designation is that S corporation distributions are not subject to employment taxes. However, the distributions also are not compensation on which the employer may make a contribution or compensation from which the employee may make an elective deferral. The IRS requires compensation a corporation pays to its employees to be reasonable. If the IRS feels that a corporation’s determination of compensation for its shareholders is unreasonable because it treats a portion of the payments to an employee as S corporation distributions rather than W-2 compensation, the IRS can reclassify the payments as compensation. The reclassification can affect the employer’s contribution liability to the plan. IRS News Release 2004-47.

In our half-day specialty program, “Who’s The Employer”, we will provide a thorough discussion of PEOs, misclassified employees, leased employees, etc. along with our explanation of the controlled group, affiliated service group and attribution rules.