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Practical Considerations In Converting Personnel From Independent Contractor Status To Employee Status

John T. Mulligan, Esq., McDonald, Hopkins, LLC, Cleveland, OH
Jill E. Thompson, CPA, Vice President of Financial/Consulting Services, ABC

Some physician groups, including anesthesia groups, treat certain of their personnel (physicians, CRNAs, office staff) as independent contractors rather than as employees. From an operational standpoint, the primary differences between independent contractors and employees are that independent contractors are paid a gross amount of wages, with no withholdings or payroll taxes being taken or paid on those amounts, and receive no fringe benefits.

Many medical practices which have treated certain personnel as independent contractors are reassessing this treatment. This reassessment has been prompted by recent announcements by federal and state taxing authorities that they view independent contractor treatment as a device that costs them tax revenues, and that they will be aggressively challenging it on the grounds that many “independent contractors” are actually “employees.” It is the purpose of this article to describe some of the issues involved in converting individuals previously treated as independent contractors to employee status.

1. The Starting Point. The starting point for any practice that treats personnel as independent contractors is to determine whether, in fact, the practice has been improperly treating individuals who were actually “employees” as “independent contractors”. There is nothing necessarily illegal or otherwise improper in treating a particular individual as an independent contractor if, in fact, the nature of the relationship between the practice and the independent contractor can justify that treatment.

To the extent that you have determined that certain personnel should not be treated as independent contractors given the nature of their relationship with your practice, the next step is to determine if there is something you can do to change the nature of the relationship going forward so that you can justify independent contractor treatment. In many cases it may be difficult if not impossible to sufficiently change the nature of the relationship (particularly with respect to the key ingredient which is the control by the practice of the services of the individual) to such a degree that independent contractor status can be justified on a going-forward basis.

Assuming that you have reached the determination that some, if not all, of your independent contractor personnel should be treated as employees, then you face a number of practical issues and questions.

2. When To Make The Conversion. From an administrative perspective, the ideal effective date for the conversion would be January 1. If your practice has a fiscal year which ends on a date other than December 31, you could consider using the first day of your fiscal year as the conversion date. However, making the conversion on a date other than the start of the calendar year will result in the individual receiving both a 1099 and a W-2 for the same year, a fact that may increase the likelihood of scrutiny by taxing authorities.

That being said, the sooner you correct the situation the sooner you will end the period for which you could experience tax-related or other problems, and any date during the year could be used.

3. Be Committed To Seeing The Conversion Process Through. The two primary stumbling blocks that you will likely face in converting independent contractors to employee status are:

  1. as discussed further below, it may increase your personnel costs;
  2. some of your personnel may be resistant to the change.

You need to be prepared for resistance on the part of at least some of your independent contractors. Be prepared to hear something such as: “My accountant [wife/husband/next door neighbor] told me I qualify as an independent contractor, and I don’t have to do this. She [he] also said it would cost me money.” Some of your independent contractor personnel will have grown accustomed to that status. Some of them may have created their own fringe benefit or retirement plan structure. Some of them may even have formed their own corporations or limited liability companies. They may see a host of tax planning or other advantages in their independent contractor status, most or all of which will be affected, if not eliminated, by becoming employees. They may well have an exaggerated view of the significance of these “advantages.” Some of these “advantages” may exist only because they or their advisors have taken some questionable actions with regard to the recognition of income or expenses.

Because you may well encounter resistance and difficulties in the conversion process you need to be committed up front to seeing the process through with regard to every individual who should be treated as an employee—no exceptions.

4. Assessing The Financial Impact On Your Independent Contractor Personnel And On Your Practice. The most immediate impact on your independent contractors is that no longer will they receive a flat dollar amount as wages. Instead, they will receive some form of time-based rate or salary, with federal, state and local taxes taken out, and with payroll taxes being paid.

Trying to maintain the same out-of-pocket dollar cost for an individual as an employee that you had for that individual as an independent contractor, while at the same time keeping the individual in the same relative economic position, will be difficult.

Simply as an example, assume that you were paying an independent contractor $15,000 a month. Your total out-of-pocket expenditures over the course of a year would be $180,000. Assume for this example that the practice is also providing professional liability insurance. If you view the $180,000 as a maximum “economic package,” once you convert the individual to employee status, those wages will no longer be paid in equal monthly installments of $15,000 but, instead, will be allocated among a variety of items such as:

Your independent contractors will want to know in advance how this allocation of their wages will impact them, particularly in terms of net “dollars in my pocket.” What makes an assessment difficult is that every individual’s situation will be different. Much of the challenge that you will face will be in educating affected personnel on the true implications of the conversion. That will take time and effort.

You will need to appreciate how the change will affect them. There will need to be advance discussion with your independent contractors with regard to the economic impact of the change. From an employee morale perception, you obviously do not want to be in a situation where at the end of their first month as “employees” they are shocked to receive a pay stub that shows their accustomed $15,000 reduced to a net paycheck of $8,000 or perhaps even less.

Make certain that you have consulted with your professional advisers before you have discussions with your personnel and before you make promises with respect to financially related adjustments. For example, an individual who wishes to maximize his or her take home pay may request that you exclude them from participation in your qualified retirement plan. This may not be possible under the tax laws that regulate qualified retirement plans. You obviously cannot promise something that is not possible.

Depending on the circumstances, you may find that the only way to make the conversion economically palatable to your personnel is to increase the amount you pay them. If so, you need to decide how much additional cost your practice can handle.

5. Adopting New Service Agreements With The Affected Individuals. If you have had written agreements with independent contractors such as physicians or CRNAs, those agreements should be formally terminated and replaced with written employment contracts that contain language consistent with an employer-employee relationship. If you have not previously had written service agreements with the independent contractors it is recommended that you enter into written employment contracts with each of them (or at least with physicians and CRNAs), clearly identifying them as “employees” subject to your control. If nothing else, these new contracts would support an argument that the nature of the relationship between the practice and the individual has changed.

6. Issues Involving The Practice’s Qualified Retirement Plan. Except, perhaps, under the “leased employee” concept discussed below, the independent contractors have probably not been eligible to participate in any qualified retirement plan that the practice maintains. You should review the practice’s current plan document. How does it address (if at all) participation by independent contractors? Does it deal with the participation rights of individuals who under federal pension laws are considered to be “leased employees?” The practice may find that it has been administering its retirement plan in a manner not consistent with what its own plan document or the Internal Revenue Code provides or requires. Remedying any such problem can be expensive, but it is preferable to risking the tax qualification of the plan.

Of all the issues that surround converting independent contractors to employees, few are as potentially complicated as those involving retirement plan participation. For example:

  1. When will the former independent contractors become participants in the plan?
  2. Is there any way to exclude them from participation?
  3. If the plan has a vesting schedule, must (or should) it give them vesting credit for the years in which they were independent contractors?
  4. How much will be contributed to the plan on their behalf, and what impact will this have on the overall cost of maintaining the plan?

One of the risks of treating personnel as independent contractors who are not eligible to participate in the practice’s qualified retirement plan is that if the Internal Revenue Service were successful in demonstrating that they were, in fact, “employees” or “leased employees,” the fact that they were not included in the plan will create tax qualification issues for the plan. To minimize any risk, it would generally be recommended that individuals being converted from independent contractor status to employee status be brought into the plan effective upon their conversion or, in effect, be given credit for eligibility and vesting purposes for all of their years of service as independent contractors.

This may create issues. The independent contractors may have been maintaining their own retirement plans that they would prefer to maintain. They may have been maintaining no retirement plan, and have become accustomed to a higher level of earned income. They may have been content with IRA contributions. There is no way for an “employee” to contribute to his or her own qualified retirement plan based on wages received as your practice’s employee, and qualified plan participants with income above a certain level cannot contribute to IRAs. From the practice’s perspective, including them as retirement plan participants may significantly increase overhead costs unless the plan contribution cost can be offset by a wage reduction.

One way to resolve the problem of increased operating expenses is to exclude the former independent contractor personnel from participating in the plan. There are ways in which persons who are considered highly compensated employees can be excluded from participating in the plan. However, excluding employees from participating in a qualified plan in this manner is something that should be approached with great care. Do not attempt to accomplish this by having them execute “waivers” of participation.

Another approach to control retirement plan costs may be to redesign your plan. For example, many practices have been able to reduce their employer contribution costs by utilizing age weighted plans or by incorporating 401(k) provisions under which a large component of the overall contribution is from the employee and not from the practice.

The starting point for any practice in dealing with this issue would be to meet with your accountant, your attorney, or retirement plan consultant or advisor and consider the options that may exist for cost control while at the same time bringing the former independent contractors into the practice’s qualified plan. A comprehensive retirement plan assessment will take time. The process should begin a number of months in advance of the effective date of any change so as to enable everyone to understand the issues, consider the alternatives, and adopt a course of action.

A practice will need to address the issue of whether an individual who has been improperly treated as an independent contractor could assert legitimate a claim for prior retirement plan benefits of which he or she was deprived. Some of the former independent contractors may say to themselves something like: “If I am now an ‘employee’ but nothing has really changed, wasn’t I really an ‘employee’ all along and don’t I have a claim for past retirement plan benefits?” Such a claim is possible. Dealing with this by making “catch-up” retirement plan contributions may be out of the question for a variety of reasons. Asking former independent contractors to “waive” any claim for past benefits will create issues as well. An effective waiver would need to be supported by “adequate consideration.” An independent contractor would need to be provided information with respect to how much the retirement plan benefits he or should would have received had he or she been treated as a participant in the plan. Trying to obtain a waiver may cause more problems than it would solve.

7. Other Benefit Plans. The implications with respect to other benefit plans such as health insurance, disability insurance, group term life insurance, cafeteria plans, or medical expense reimbursement plans also need to be considered. The implications of the new federal healthcare reform legislation, the provisions of which are beyond the intended scope of this article, would need to be considered.

Historically, the only such benefit programs common to group medical practices that were affected by legal participation requirements were medical expense reimbursement plans, cafeteria plans, and group term life insurance plans. The questions that will arise in the context of these plans involve whether the practice will need to provide benefits to the individuals being transferred to employee status, and at what level. In the case of some plans, such as medical expense reimbursement plans, there are specific nondiscrimination rules under the Internal Revenue Code.

8. Professional Liability Insurance Considerations. If the practice has been covering independent contractors under its professional liability insurance, converting independent contractors to employee status may not entail complications. If the independent contractors have been maintaining their own insurance, the implications of this transition on their insurance coverage will need to be considered. For example, if they will be transitioned into the practice’s coverage, will that coverage pick up their “prior acts”, or will “tail” coverage be needed on their prior coverage? To the extent that the former independent contractors become covered by the group’s insurance policy, how will “tail” coverage in the event of subsequent termination of employment be handled?

Dealing with these issues will necessitate close coordination with the practice’s insurance agent. It will also necessitate an understanding of exactly what coverage the independent contractors currently have.

Summary

The conversion of independent contractors to employee status is a complicated and time consuming process. If done incorrectly, it can create personnel related problems. As a practice embarks on this process its leadership needs to give itself sufficient time to consider and resolve all the issues which will be presented. The close, coordinated involvement of professional advisors will be critical.

John T. Mulligan is a member of the law firm McDonald Hopkins, LLC, in its Cleveland, Ohio office. McDonald Hopkins has other offices in Chicago, Detroit, Columbus, West Palm Beach, and Dennis, Mass. Mr. Mulligan’s practice focuses on the representation of physicians and physician groups, with a particular focus on the representation of hospital-based groups. He is listed in the “Best Lawyers in America” for health care law. He can be reached at (216) 348-5435 or jmulligan@mcdonaldhopkins.com.