An employer asks if he only pays people via 1099 does he have to let them participate in a business retirement plan. Does anyone have an answer to this?

An employer that asks the question that way should re-examine whether or not it is proper to pay only "via 1099" because if the employer proceeds to exclude all the payees from the retirement plan, the stakes get much higher. The combined use of "employer" and "1099" should give pause.

Or, to be simplistic, paying a W-2 employee as though the employee were an independent contractor (via 1099), will cause nothing but trouble when it comes to compliance with retirement plan rules.

Guess I should have stated it this way. Business owner only pays people work provides services to him a 1099. Does the owner have to include them in his business retirement plan?

You've posted your question to the 401(k) Plans forum, so I'll assume that you're asking about a qualified plan when you say "business retirement plan".

Independent contractors aren't eligible for qualified plan participation. Under the exclusive benefit rule of I.R.C. Sec. 401(a)(2), a qualified plan must benefit employees and their beneficiaries exclusively. So, the issue isn't whether this employer must cover the Form 1099 workers; the issue is that these individuals can't be covered.

But, you can provide a great service to your client by considering QDROphile's comments. The employee-independent contractor classification isn't arbitrary, and it's among the most sensitive topics before the IRS and DOL. If your client is misclassifying some or all of the workers (and this is very likely, given that 100% of the staff gets Form 1099), your client could be sitting on top of a huge mountain of pain. All you have to do is read some of the court cases to see the consequences of worker misclassification.

To pile on with the other commenters. If the 1099 recipients are actually common law employees, unless the plan terms specifically exclude reclassified employees they will be entitled to retroactive contributions under case law. In addition, even if the plan excludes them from participation, they would count as eligible but non-participating employees in the coverage and non-discrimination tests.

If the only participant is the (HCE) business owner, the plan would likely fail if there is even one misclassified (NHCE) individual.

On the other side, as QDROPhile noted, a plan cannot cover independent contractors so, if the classification is correct, extending plan participation is not permitted.

Given the stakes, a prudent advisor would recommend taking a long and hard look at the classification question. If I recall there is even a process to raise the question before the service (I don't have time to look it up now though).

Good luck

For a really scary lesson about the qualified plan consequences of employee misclassification, read Donald J. Kenney v. Commissioner, TC Memo 1995-431. The IRS reclassified independent contractors as employees, so the qualified plan failed to meet the coverage and participation requirements. The plan was retroactively disqualified. The owner's entire vested benefit of $696,000 had to be included in his current year's taxable income.

Thanks for all of your help