4 Strategies for Avoiding Healthcare Reform Penalties for Contingent EmployeesWayne Jacobsen Corporate Counsel
02-12-2013
This is the latest in a series of columns by O’Melveny & Myers attorneys, focusing on key legal issues specific to a variety of U.S. industries.
With the obligations and penalties of the Patient Protection and Affordable Care Act (aka, Obamacare) set to take effect in 2014, many employers have begun evaluating the use of “contingent” workers as a strategy for containing healthcare costs. Contingent workers—such as independent contractors, leased employees, and part-time employees—typically are not entitled to healthcare coverage, and their expanded use could offer businesses a way around some of the new law’s costlier requirements.
But beware: The benefits of a contingent workforce also come with risks, including the potential for monetary penalties that may strike some employers as inordinate.
Under the PPACA, individuals will be required to have healthcare coverage as of January 1, 2014 (the so-called “individual mandate”). Individuals without employer-provided coverage will be able to satisfy the individual mandate by purchasing coverage through new health insurance exchanges. Individuals with incomes between 100 percent and 400 percent of the poverty level will be entitled to a “premium assistance” subsidy if they purchase coverage on an exchange. Millions of individuals are expected to do so.
Employers are not directly obligated to provide coverage to their employees. But if a “large” employer—one with 50 or more full-time equivalent employees—does not offer healthcare coverage to at least 95 percent of its full-time employees, the employer faces a penalty under Internal Revenue Code Section 4980H(a). An employer that doesn’t cover at least 95 percent of employees would be hit with a penalty if any of its full-time employees without employer-provided coverage purchases coverage from an exchange and receives premium assistance.
The annual penalty under Section 4980H(a) can be severe: $2,000, multiplied by every full-time employee, minus the first 30 full-time employees. Note that all full-time employees count toward calculating the penalty, even the employees with employer-provided coverage.
Strategy No. 1: Part-Time Employees
The 4980H(a) penalty applies only with respect to full-time employees. An employer seeking to reduce its exposure could limit the hours of certain workers or create more part-time positions. A part-time employee generally means an employee averaging fewer than 30 hours per week.
Although the failure to provide coverage to part-time employees will not subject an employer to PPACA penalties, part-time employees still count toward determining whether the employer meets the 50-employee threshold for a “large” employer.
How the Part-Time Strategy Could Go Awry
The Internal Revenue Service has issued detailed rules (Notices 2012-59 and 2012-17) for determining who is a part-time employee. An employer seeking to implement a part-time strategy will have to carefully consider these rules and closely monitor employees’ hours. A successful part-time strategy may require the employer to impose rigid restrictions on work schedules—which may, in turn, limit the employer’s ability to respond to changing business conditions and customer demands.
If an employer isn’t careful about monitoring employees’ hours, it might become subject to the Section 4980H(a) penalty. To use an extreme example, let’s say that an employer believes that it has:
- 100 full-time employees, all with employer-provided coverage, and
- 20 part-time employees, none with employer-provided coverage.
Because its entire full-time workforce appears to have employer-provided coverage, the employer believes that it has satisfied the 95 percent requirement and thus is not subject to the 4980H(a) penalty. But assume that six of the supposed part-time employees have amassed enough hours to be deemed full-time employees. The employer could then be subject to the penalty, because it actually has 106 full-time employees, and only 100 of them—94 percent—have employer-provided coverage.
The annual penalty under Section 4980H(a) would be $152,000 (106 full-time employees, minus the first 30, multiplied by $2,000).
Strategy No. 2: Independent Contractors
Under the PPACA, an “employee” means a common-law employee. Employers may be tempted to substitute independent contractors for common-law employees for a couple of reasons:
- To stay under the 50-employee threshold.
- To avoid offering healthcare coverage to a portion of its full-time workforce.
Indeed, an employer might view a successful independent contractor strategy as a double win: the business avoids both the cost of healthcare coverage for the independent contractors and the penalty that would apply for failing to offer coverage to full-time employees.
How the Independent Contractor Strategy Could Go Awry
An employer that adopts the independent contractor strategy faces an inherent pitfall: worker misclassification. Determining whether a worker should be treated as an independent contractor, rather than an employee, can be complicated, if not impossible.
A highly publicized case of worker misclassification in the late 1990s resulted in a flurry of corrective activity by employers. In Vizcaino vs. Microsoft Corporation, a group of workers were initially denied benefits on the grounds that they were independent contractors, but the workers convinced the Ninth Circuit that they were actually employees and thus entitled to benefits. Businesses were generally able to head off similar claims by amending their benefit plans with a “Microsoft fix”—that is, to expressly state that misclassified workers are not entitled to benefits. Even with a Microsoft fix, however, a business faces PPACA penalties if workers excluded from healthcare coverage turn out to be common-law employees.
As was true for the part-time strategy gone awry, the penalty under Section 4980H(a) could be disproportionately steep. For example, assume an employer believes it has 100 full-time employees, all of whom have employer-provided coverage, and 10 workers without coverage who are classified as independent contractors. If six or more of the supposed independent contractors turn out to be employees, the annual penalty of $2,000 multiplied by all full-time workers could apply.
Our recent experience suggests that state and federal authorities are becoming more focused on worker misclassification issues for a variety of reasons other than healthcare reform. The PPACA penalties are yet another reason to expect continued scrutiny.
Strategy No. 3: Leased Employees
The leased employee strategy is similar to the independent contractor strategy. A leased employee is someone employed by a third-party leasing company, but who actually performs services on behalf of the leasing company’s client. Under the PPACA, if a leased employee is actually a common-law employee of the leasing company, and not a common-law employee of the client, then the leased employee does not count toward determining whether the client is a “large” employer—and would not be considered a full-time employee of the client for purposes of the PPACA penalty.
Of course, even when employee leasing is successful—when the worker is actually an employee of the leasing company rather than the client—the PPACA obligations and penalties would apply to the leasing company. The leasing company is likely to pass the cost of healthcare coverage for the workers to its clients.
How the Leased Employee Strategy Could Go Awry
The leased employee strategy has the same inherent weakness as the independent contractor strategy—misclassification. It is difficult to be certain that the workers should be classified as employees of the leasing company, rather than its client; the leasing company and the client might also be joint employers.
A client that depends on the leasing company to provide healthcare coverage to the leased employees should verify that the coverage is actually being provided. If the leasing company fails to deliver on its promise to provide coverage, the client may be liable for the PPACA penalties.
Strategy No. 4: Separate Entities
A business is permitted to exclude up to 5 percent of its full-time employees from healthcare coverage without being subject to the 4980H(a) penalty. But what if an employer wants to exclude a group that accounts for more than 5 percent? One strategy is to have a separate entity act as the employer for the uncovered group.
The separate entity strategy could reduce, but not eliminate, the penalty. For example, assume that a business has 100 full-time employees. Eighty are employed by a subsidiary that has employer-provided coverage; the other 20 are employed by a subsidiary that does not have coverage. Both subsidiaries are at least 80 percent owned by a common parent. As a result of the common ownership, both subsidiaries are treated as a large employer. Since the first subsidiary has employer-provided coverage for its employees, it is not subject to the 4980H(a) penalty. The second subsidiary, however, is subject to a penalty of $28,000. (The 30-employee exemption from the penalty is pro-rated between the two subsidiaries. Since the second subsidiary has 20 percent of the employees of the business, it has six exemptions. Thus, the penalty is $2,000 multiplied by 14 employees.)
By contrast, if all 100 employees were employed by the same entity, the penalty for failing to cover at least 95 percent of them would be $140,000.
How the Separate Entity Strategy Could Go Awry
It is unclear how much freedom employers will have to allocate employees to separate entities. The IRS could conceivably require the separate entity to have a business purpose beyond just the avoidance of penalties. The IRS might also seek to treat separate entities as joint employers.
In sum, a carefully constructed and executed contingent worker strategy could help an employer avoid or reduce healthcare costs and PPACA penalties. Businesses must bear in mind, however, that common-law principles will determine whether such strategies are successful. Application of these principles depends on the specific facts involved, rather than the intent of the parties. As legal responses and pitfalls to these contingent worker plans continue to evolve, it’s prudent for all employers to check with legal counsel before enacting a strategy.
Wayne Jacobsen is a partner in O'Melveny & Myers LLP’s Newport Beach office and a member of the executive compensation and employee benefits practice. His practice is exclusively in the employee benefits and executive compensation field, including pension and profit sharing plans, employee stock ownership plans, deferred compensation plans, stock option plans, welfare plans, employment agreements, severance arrangements, and change of control arrangements. The opinions expressed in this article do not necessarily reflect the views of O'Melveny or its clients, and should not be relied upon as legal advice.
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