TAM Blesses Plan "Inoculation" Language

In 1989 and 1990, the IRS examined Microsoft's em-ployment records and found that under Rev. Rul. 87-41, certain workers Microsoft considered to be independent contractors were actually employees. After learning of the IRS's finding, some of these employees sued Microsoft for benefits, even though Microsoft told them on hire that they were not eligible.

Based on the terms of Microsoft's plans, the Ninth Circuit found that the employees were entitled to benefits (Vizcaino v. Microsoft, 97 F3d 1187 (1996)). As a result, several employers have attempted to amend plan language to exclude a class of people they viewed as independent contractors. This intended to "inoculate" the plan against what be-came known as the "Microsoft issue."

Employees in the IRS's Cincinnati field office believed that the inoculation plan provisions violated Sec. 410(a)'s minimum eligibility requirements and Regs. Sec. 1.401-1(a)(2)'s requirement that a plan be a "definite written program." The IRS National Office disagreed with the Cincinnati field office and issued a technical advice memorandum (TAM) on July 28, 1999.

The IRS has made extraordinary efforts to disseminate the TAM, and National Office officials have expressed strong support for it in meetings with benefits associations. Despite this, the IRS will not issue official guidance this year, due to other important business.

How to Meet the Requirements

Under Section 5.01(2)(b) of Rev. Proc. 2001-17, a plan not operated according to its terms is not qualified. Microsoft's plan covered "employees" and thus required the company to cover reclassified employees. Because the plan did not cover them, technically it was not qualified.

Plan qualifications. An employer who runs afoul of the Microsoft issue risks not only losing an ERISA suit to its employees, but also having the IRS disqualify its plan. As a general rule, the correction for failing to cover employees who were supposed to be eligible is to cover them retroactively. In a defined-benefit plan, this may not be a problem, although the correction may change the plan's funding status. In a defined-contribution plan, however, an employer generally contributes to the plan for the "unexpected" employees. It also contributes an amount equal to the earnings the so-called employees would otherwise have received in the plan. If part of the plan is a Sec. 401(k) plan, the employer would contribute an amount that approximates the amounts that the employees would have contributed to the Sec. 401(k) plan. The IRS generally requires a contribution equal to the average deferral percentage (i.e., the nonhighly compensated employee deferral percentage or the highly compensated employee deferral percentage). This can be very expensive, especially given the high interest that many plans earned over the last few years.

Employee classification. The plan that was the subject of the TAM contained a provision excluding workers classified as independent contractors, as well as workers in certain payroll classification codes. The independent contractors were excluded regardless of whether they were found by a court or administrative agency to be common-law employees.

The TAM concluded that the employer had not violated the definite-written-program requirement by excluding workers originally engaged as independent contractors, but later determined to be employees; the terms have independent legal significance.

Definite written program. As a test, the TAM suggests that employers ask whether the employees and plan administrators can determine who is and is not covered when they read the plan and examine all the surrounding facts. In the TAM, the IRS took the position that a plan must define both who is and is not covered. The employer must communicate this fact to employees. Plan terms cannot leave the determination of covered workers to the employer's discretion, without violating the definite-written-program rule (Regs. Sec. 1.401-1(a)(2)). Thus, an employee should be able to enforce his rights based on the plan document. However, a plan would not automatically fail this requirement if the IRS has to examine extrinsic facts to determine which employees the plan covers.

Minimum participation. Sec. 410(a) precludes a plan from limiting participation on the basis of age or service in excess of the minimum. The employer can design a plan to cover any other nondiscriminatory classification of employees that it chooses. Sec. 410(a) does not preclude an employer from retroactively excluding reclassified employees from a plan.

An exclusion by payroll code could be an indirect age or service exclusion prohibited by Regs. Sec. 1.410(a)-3(d), suggesting that employees must examine all the surrounding facts and circumstances to satisfy the test.

Conclusion

Employers are now free to inoculate their plans against the Microsoft issue.

From Robert H. Masnik, J.D., Washington, DC