Solo 401(k) Plans — Beware of Common Law Employees

Had a call that I absolutely welcomed receiving today from a client.  The issue he raised can always be re-addressed with Trustees of 401(k) plans….and that is what issues should be considered if you are even thinking of hiring employees to your self-employed business.  Believe it or not, the issue of a business that sponsors a 401(k) plan adding ANY common law employees (individuals that meet the IRS definition of a common law employee) is an important topic and one that a Trustee can lose sight of and not take seriously.  To not consider can be disastrous.

We all know some of the inherent benefits of a Solo 401(k).  The plan, while still a qualified plan, has much flexibility and is not burdened by some of the onerous rules governing a 401(k) plan with employees and participants in the plan.  However, a self-employed business owner who is thinking of adding an employee (other than their spouse) may sometimes only consider the impact on their business by adding an employee.  For example, can they afford to bring on an employee?  Will the employee provide valued services?  How much do I pay the employee?  What about payroll taxes?  Do I have to offer them health insurance?  All very important questions, but…..

Does Your Employee have to be Included into the 401(k)?

An important consideration if you hire a “common law” employee.  While we will examine at what time you will need to include your employee(s) as participants of the 401(k) plan, generally speaking at some point in time, you WILL need to include them in the plan.    Part of “including” them in a safe harbor 401(k) plan will require the employer to do a certain level of employer contributions for the employee’s benefit.    Further, your plan, now needing to meet ERISA requirements will most likely dictate that you retain the services of a TPA (Third Party Administrator) to oversee the plan for compliance purposes and file the annual, required 5500 form.  Does this mean you should not add the employee…of course not.  You will make that decision based on what is in the best interests of your business moving forward.  But…these are considerations to take into account as the business owner.

When making the decision to add a common law employee, don’t be folly and believe you can still operate your 401(k) as a Solo.  The minute you add that employee and they are eligible to enter the plan (per the plan documents), you no longer have a Solo plan.   Some might say, “well it is my business….they are just helping me out.”  Folks, I think you know this, but that won’t cut it.  Do not even begin to think that if you have hired a common law employee that you are self-employed.  You aren’t!  But, just because you have hired an employee, there are various rules that can potentially exclude the employee from participation or delay the effective date of when the employee must be included in the plan.  IRS and DOL rules address these, but you should always review your particular situation with professional tax counsel:

1)  Generally speaking, any class of employees who do not work more than 1,000 hours per year may be potentially excluded from participation (again provided the plan documents stipulate this).

2)  Is the person a seasonal position?  This individual, if seasonal, should also be falling into #1 as well.

3)  Are they under the age of 21?  If so, and provided such a class is excluded in the plan documents, no employee under the age of 21 need be included in the plan.  Of course, you could not have a plan that would discriminate in class (e.g, allowing some individuals under the age of 21 to participate while restricting others).

4)  If  the person is a legitimate 1099 individual they are not a common law employee.  That only stands to reason.  However, you want to make sure that the individual is truly a 1099 as defined by the IRS.  If there is even a hint that they truly are or should be considered (e.g., you direct their work activities, you have the opportunity to fire them) a W-2 based on their activities, well, you don’t want to go there.

In the next blog we will address some other considerations and options you have when hiring a common law employee.  As always, the information provided is intended to be educational in nature.  It is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice.  You must always consult with your respective professional in all such matters.