Corporate downsizing - tax treatment of leased employees.

A business that downsizes may find itself without sufficient staff to complete current projects or meet the anticipated demands of future projects. To fulfill these needs, the company may lease workers from a third-party employment agency. In some cases, the employment agency engages former or retired employees of the company and leases them to the company to perform job assignments.

As the IRS sharpens its focus on employment tax issues, the question of who employs the leased workers for Federal tax purposes - the employment agency or the company - becomes increasingly important. The tax issues will become even more significant if Congress enacts health care legislation requiring businesses to insure or finance health coverage for their employees, but not for independent contractors rendering services to a company.

Under Federal income and employment tax rules, there are significant differences between the tax treatment of employees and the tax treatment of independent contractors. Compensation paid to an employee is subject to employment and income tax withholding, and must be reported by the employer on Form W-2. By contrast, businesses using independent contractor's must comply with Form 1099 reporting and backup withholding rules. In addition, favorable tax treatment of a company's benefit plans may depend in part on coverage of employees. A misclassification of workers may expose the business to tax liabilities, possible penalties and potential disqualification of the company's benefit plans.

If a company leases workers on a substantially full-time basis for work historically performed by employees, the Service may take the position that the leased workers are company employees for retirement and profit-sharing plan purposes. Under this position, the leased employees would be taken into account in determining whether minimum participation, minimum coverage and nondiscrimination rules applicable to those plans are satisfied. In addition, if a former employee is leased back to the company in the same capacity within a short time period after leaving the company, the IRS may question whether there was an actual termination of employment. Because it generally is a violation of plan qualification rules to make a distribution of pretax contributions under a Sec. 401(k) plan or of any amounts from certain other qualified retirement plans prior to an employee's termination of employment, distributions to such leased employees could jeopardize the plan's qualified status and create problems for the former employee.

In the past, the Service has examined various worker arrangements. In Rev. Rev. 75-41, the IRS considered the relationship, for employment tax purposes, between certain workers and a professional service corporation providing the workers' services to medical organizations. The ruling concluded that the workers were employees of the professional service corporation for Federal employment tax purposes. By contrast, on examination of another leased employee arrangement, the Service looked through the employment agency and designated the service recipient as the worker's employer. The IRS position was upheld in court, with the consequence that the service recipient's pension and profit-sharing plans were held not to meet the exclusive benefit rule of Sec. 401(a)(2), and thus were denied qualified plan treatment under Sec. 401 Professional & Executive Leasing, 862 F2d 751 (9th Cir. 1988)).

The Service recognizes that significant tax dollars may be left unpaid by businesses that have misclassified workers as independent contractors, and has increased its focus on employment tax issues, even while conducting income tax examinations. Further, taxpayers can expect the IRS to expand the scope of employment tax examinations if health care reform legislation providing for an employer mandate is enacted. Companies neglecting the question of worker classification may run the risk of taxes and other adverse consequences on audit, as well as a missed opportunity for tax planning resulting from careful attention to such classification.

Businesses should assess their current tax treatment of workers, review and modify internal structures and written agreements as needed, and put into place safeguards to minimize the chance of reclassification. In some situations, a company may want to obtain an IRS letter ruling on the Federal tax classification of specific types of workers. Of course, the state tax and nontax consequences of worker classification should also be part of this analysis.