The implementation of the Affordable Care Act’s (ACA) tax credit for employers with fewer than 25 employees and the looming requirement that large employers (those with 50 or more full-time-equivalent (FTE) employees) provide affordable health insurance to their full-time employees or pay a penalty have resulted in some employers trying to limit the number of employees in their organization. One method that is gaining popularity (and that we do not recommend) is broadly classifying workers as independent contractors instead of employees. Employers must be extremely careful when trying to manipulate the system to obtain the ACA’s tax credits or avoid its requirements. Misclassifying an employee as an independent contractor can result in substantial penalties and quickly erase any benefit.
Motivating factors under the ACA
There are several provisions in the ACA that arguably incentivize an employer to reduce its number of employees. The Act provides tax credits to small employers. Tax-exempt organizations and small employers that pay at least 50% of the premium cost of employees’ health insurance qualify for a special tax credit. Employers with fewer than 25 FTEs who average less than $50,000 in wages per year are eligible. In 2014, the maximum credit will increase from 35% to 50% of premiums paid by eligible small employers and from 25% to 35% of premiums paid by eligible tax-exempt employers. The maximum credit is provided to employers with 10 or fewer FTEs who individually earn an average of $25,000 or less each year.
Soon, the ACA will require large employers to provide healthcare coverage to their employees or pay a penalty (the “play or pay” provision). Whether an employer is subject to possible penalties depends on its number of full-time employees (defined as those working 30 or more hours per week), including FTEs. If an employer has 50 full-time employees, including FTEs, it qualifies as a large employer and is subject to the “play or pay” provision. Independent contractors do not qualify as employees. Beginning January 1, 2014, if a large employer doesn’t offer coverage or its coverage doesn’t provide minimal value, it may find itself subject to monetary penalties.
If an employer is close to being considered a small or large employer based on its number of full-time employees and FTEs, it is very unwise to manipulate those numbers by converting employees to independent contractors or replacing some portion of its existing workforce with independent contractors. Each worker must be carefully and individually analyzed to determine whether he should be classified as an employee or independent contractor.
Independent contractor test
Establishing that someone truly is an independent contractor isn’t easy. Although not specifically set forth in the ACA, it appears that the appropriate test to determine independent contractor status is set forth in IRS Publication 15A. The IRS previously applied what was commonly referred to as the 20-factor test. In response to pressure for simplification, the agency recently created an 11-factor test. The 11 factors are organized into three categories: (1) behavioral control, (2) financial control, and (3) relationship of the parties.
When it comes to behavioral control, you should examine the following areas:
- Instructions that you give the worker; and
- Training that you give the worker.
In terms of financial control, you should consider the following:
- The extent to which the worker has unreimbursed business expenses;
- The extent of the worker’s investment;
- The extent to which the worker makes services available to the relevant market;
- How the worker is paid; and
- The extent to which the worker can realize a profit or loss.
The third category is the type of relationship between the parties. When contemplating that factor, you should consider:
- Written contracts describing the relationship the parties intended to create;
- Whether the company provides the worker with employee-type benefits (e.g., insurance, a pension plan, vacation pay, or sick pay);
- The permanency of the relationship; and
- The extent to which services performed by the worker are a key aspect of the company’s regular business.
You should consider all 11 factors. Unless an employer is confident it can satisfy all the factors, it should assume that the government agency administering the law will take the position that workers are employees and not independent contractors. For that reason, it generally is advisable to take a conservative approach when classifying workers as independent contractors.
Any employer that is on the line in terms of whether it is classified a large or small employer and is contemplating potential penalties under the ACA should (1) exercise extreme caution if it attempts to manipulate its number of employees by reclassifying them as independent contractors and (2) consult with legal counsel. The penalties for improperly classifying workers could substantially outweigh the benefits of a tax credit or the penalties under the ACA.
Gesina M. Seiler is a partner with Axley Brynelson, LLP. She is key member of the firm’s ACA team. She may be contacted at email@example.com.