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Home ACA Compliance IRS Memo Signals Importance of Proper Employee Classification in ACA Compliance

IRS Memo Signals Importance of Proper Employee Classification in ACA Compliance

4 minute read
by Joanna Kim-Brunetti

The Department of Labor (DOL) and IRS recently issued an updated memorandum of understanding (MOU) regarding the way the two agencies identify and enforce employee misclassifications. 

The agencies make clear in the notice that they will continue to combat employee misclassification through a series of efforts. The first is that the agencies are introducing a more “streamlined” process for identifying instances of wrongful employee classifications. 

As part of the initiative, the IRS will be held accountable for three main duties:

  • Evaluate employment tax referrals sent by the DOL-Wage and Hour Division (WHD) that meet standardized criteria, in addition to conducting exams to ensure compliance with various employment law
  • Provide reports that summarize results achieved through the tax referrals to the WHD annually
  • When requested, communicate to the DOL new or revised employment tax updates, training, and other relevant information

Also included in the MOU is a standardized form and decision tree which outline the required information for submitting employment misclassification referrals to the IRS. These additional resources are intended to help streamline the process of submitting and identifying instances of misclassification. 

Following the release of the updated MOU, Principal Deputy Wage and Hour Administrator Jessica Looman said, “Renewing our memorandum of understanding with the IRS strengthens our existing partnership by improving referral processes and information sharing to help us better serve the nation’s workers.”

The updated MOU clarifies the two agencies’ goals to identify and penalize organizations that misclassify employees more effectively. The IRS specifically will begin targeting organizations that do not in good conscience classify their workforce accordingly.

Implications for ACA compliance

Classifying employees correctly is a critical step in the ACA compliance process. Employers that wrongfully classify their workers can receive steep penalties from the IRS under IRC Section 4980H of the ACA’s Employer Mandate as well as other penalties. 

Of course, misclassifications can happen for several reasons, from a human error to a lack of process and everything in between. Below we identify the top reasons that organizations misclassify their employees.

1. Inadequate training

Many organizations sometimes lack the training programs and resources to educate their staff on the importance of employee classification. For example, a new HR department may not understand the significance of employee classifications for new hires with regard to ACA compliance. As a result, new staff may be classified inconsistently and important offers of ACA coverage are missed.

In other words, when inconsistent classifications are applied across a workforce, certain employees may become eligible for healthcare and others might not, and for no legitimate reason.

2. Poor documentation

It’s true that sufficient training and process are key to ensuring consistent, accurate employee classification. The same is true for how this information is documented.

Without documentation to back up on what basis employees get classified, employers put themselves at risk during the event of an IRS audit or examination. Supporting evidence detailing the classification process can help employers defend themselves in the event of an IRS inquiry.

3. Bad input 

Having a documented process is key, but ensuring that the procedure is being carried out effectively in your various HCM systems is critical too. Many times, worker details are entered into databases manually, which can put employers at risk due to human error or “bad input.” 

Coding the information incorrectly into your systems may result in an employee losing important benefits like healthcare. And when an employee doesn’t receive the offer of coverage they need, it may result in them obtaining a Premium Tax Credit (PTC) from a state or federal health exchange, which could ultimately lead to a Letter 226J penalty assessment from the IRS.

4. Lack of understanding

The last reason for employee misclassification relates to specific knowledge about the ACA. HR staff and compliance officers may confuse classification meanings and subsequently assign incorrect benefits eligibility. For example, full-time is oftentimes determined to be 40 hours a week, but under the ACA the employee only needs to work 30 hours to be considered full-time

Additionally, employee classifications may vary across organizations, but from an ACA perspective, employees are either full-time or not, and depending on your workforce determining full-time status can be challenging. The IRS provides two measurement methods for calculating full-time status.

Furthermore, inaccurate employee classifications can affect full-time counts, which directly impact an organization’s Applicable Large Employer (ALE) status.  This is of particular importance since determining ALE status is critical for understanding whether the requirements of ACA’s Employer Mandate apply.

Getting employee classifications right

Employers watching from the sidelines should take note of the IRS and DOL’s renewed focus on employee misclassification enforcement. The new MOU demonstrates the agency’s increasing efforts to identify and penalize employers who apply inaccurate classifications across their organization. 

Savvy employers should assess their workforce to make sure they are accurately classifying their employees in accordance with the ACA’s Employer Mandate. This may require a review of your entire workforce’s hours of service. 

For example, organizations that employ predominantly high-variable workforces, such as those within home healthcare, construction, restaurants, hospitality, and staffing should implement the Look-Back Measurement Method to determine employee classifications over time.

Employers that need assistance verifying the accuracy of their employee classifications should contact Trusaic for help. Our full-service suite of ACA solutions ensures data accuracy, tracks employee eligibility for benefits on a monthly basis, and provides IRS audit defense. We’ve helped our clients prevent over $1 billion in ACA penalties.

For more information on the importance of employee classifications from an ACA perspective, download the ACA Essential Guide for Employers below.

Download: ACA Essential Guide

For information on ACA penalty amounts, affordability percentages, important filing deadlines, steps for responding to penalty notices, and best practices for minimizing IRS penalty risk, download the ACA 101 Toolkit.

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