A major business trend
in the American workplace is the hiring of part-time, seasonal or
temporary employees (collectively referred to in this newsletter as
"part-time employees"). Employers believe the advantages to using
this alternative workforce include lower wages and significant
savings in terms of not providing employee benefits to these
individuals.
Unfortunately, many plan sponsors are under the misconception
that all part-time employees can be excluded from participation in
their qualified retirement plans when, in fact, the Internal Revenue
Code does not permit part-time employees to be excluded as a class.
A qualified plan may be drafted to require that an employee work
a minimum number of hours to enter the plan, but the maximum number
of hours that can be required in a twelve-month period is 1,000.
This maximum translates into approximately 20 hours a week, making
many part-time employees eligible for plan participation.
A bulletin issued by the IRS on February 14, 2006 indicates that
it will be scrutinizing plans that attempt to exclude employees who
have satisfied the 1,000-hour requirement by designating them as a
certain class of employees who are excluded from coverage. Improper
exclusion of employees can trigger expensive make-up payments or
possible plan disqualification.
This newsletter will describe the minimum coverage requirements,
the new IRS guidance and outline the correction methods for making
improperly excluded employees whole.
Minimum Coverage Requirements
Qualified plans are permitted to require an employee to satisfy
minimum age and service requirements in order to become a
participant in the plan. The maximum permissible service requirement
for salary deferrals is one year of service, generally defined as
the twelve-month period, beginning on the employee’s date of hire,
during which the employee has worked at least 1,000 hours.
If the 1,000-hour requirement has not been met at the end of the
initial twelve-month period, many plan documents will switch to the
plan year for measuring future service computation periods. Up to
two years of service may be required for employer contributions to
the plan, but employees must then become 100% vested immediately
upon plan entry.
Example: The Acme Company requires one year of service
with 1,000 hours to become eligible to participate in its 401(k)
plan. Employees become participants the first day of the month
following completion of the service requirement. Ken is hired
part-time on June 13, 2004. As of June 12, 2005 he has had 930
hours. He has not met the plan’s service requirement.
Future service computation periods are measured based on the plan
year. The next computation period begins on January 1, 2005 and
extends through December 31, 2005. During this period Ken has 1,050
hours of service. He has now satisfied the service requirement and
will enter the plan effective January 1, 2006.
Excluding Classes of Employees
Plan documents usually exclude union and nonresident alien
employees. Other classifications may be excluded on a discretionary
basis if based on objective business criteria, such as hourly
employees or a specific division of the company. However, it is not
permissible to exclude part-time employees as a job classification.
As long as a part-time employee meets the 1,000-hour requirement, it
is irrelevant for qualified plan purposes that the employee is
employed on a less than full-time basis.
If the plan excludes classifications of employees, it will be
required to pass nondiscrimination testing to ensure that the plan
is not discriminating in favor of highly compensated employees. In
general, employees in the highly compensated group include more than
5% owners and employees who earn over an indexed limit ($100,000 for
2006).
Effect of Short Service Requirement
In order to attract qualified employees in today’s competitive
job marketplace, an increasing number of 401(k) plan sponsors are
utilizing less than the traditional one year of service requirement.
Some are offering immediate entry, at least for the salary deferral
portion of the plan. A shorter service requirement or immediate
participation could potentially cause all part-time employees to
become plan participants. Generally most employers want to avoid
including part-time employees in their plans because:
- These employees generally have little interest in
participating in the plan but are still required to receive
enrollment materials and a summary plan description on a timely
basis once they have met the plan’s eligibility requirements.
- If the plan is top heavy (a plan where the key employees’
account balances make up 60% or more of the total plan assets),
minimum contributions of up to 3% of compensation may be required
for active participants, whether or not they have elected to make
salary deferrals and regardless of the number of hours worked
during the plan year.
- Increased administrative expenses.
Plan Participation Does Not Guarantee
Employer Contributions
Just because an employee has satisfied the plan’s eligibility
requirements and has become a participant in the plan does not
automatically mean that he is entitled to receive an employer
contribution unless the plan is top heavy. The plan may require a
minimum number of hours of service during the plan year (1,000 is
the maximum) and/or employment on the last day of the plan year to
receive an allocation of the employer contribution.
Example: The Crane Company requires one year of service
with 1,000 hours to become eligible to participate in its profit
sharing plan. Employees become participants the first day of the
month following completion of the service requirement. In order to
share in the profit sharing contribution, the participant is
required to work 1,000 hours during the plan year. Barbie was hired
part-time on April 16, 2004. As of April 15, 2005 she had 1,020
hours and became a participant on May 1, 2005. For the plan year
January 1, 2005 through December 31, 2005 she worked 975 hours.
Since she had less than 1,000 hours during the plan year, she is not
eligible to share in the profit sharing contribution. However, if
this plan were top heavy, she would be entitled to a top heavy
minimum contribution.
A plan that requires active participants to have a minimum number
of hours of service during the plan year or terminated participants
to have more than 500 hours of service in order to be eligible to
share in the employer’s contribution will be subject to
nondiscrimination testing.
New IRS Guidance
The IRS has long taken the position that employers cannot omit
groups of part-time employees from plan participation simply because
they work less than full time. In a bulletin issued in February 2006
the IRS indicated that document specialists will be requesting that
plan administrators remove or clarify plan language if the plan
provision could result in exclusion by reason of a minimum service
requirement of an employee who has completed a year of service.
The IRS guidance included an example of how an employer might
design the plan to exclude part-time employees but still satisfy the
participation rules. The plan could provide immediate eligibility
for full-time employees but require one year of service for
employees who are scheduled to work less than 1,000 hours during the
year as long as the plan includes fail-safe language that says such
employees will become participants if they actually work more than
1,000 hours during the computation period.
The bulletin warns that plans with improperly drafted clauses
excluding part-time employees may be subject to disqualification
regardless of whether the plan has a determination letter. If the
plan received the determination letter after June 30, 2001, the plan
sponsor cannot rely on the letter to protect the plan regarding this
issue. If the determination letter is dated before July 1, 2001,
then the letter should protect the plan from retroactive
disqualification.
Making Participants Whole
Qualified plans that have improperly excluded part-time employees
from participation are required to make these individuals whole.
Failure to make the necessary corrections can result in severe
monetary penalties and possible plan disqualification if discovered
on plan audit.
The IRS has recently updated its Voluntary Correction Program
(VCP) which includes new guidance for correcting the failure to
include an eligible employee in a 401(k) plan. With regard to the
401(k) deferral, the employer is required to make a Qualified
Nonelective Contribution (QNEC) in the amount of 50% of the "missed
deferral."
The "missed deferral" is calculated by taking the average
deferral percentage of the excluded employee’s group (either highly
compensated or non-highly compensated) times the employee’s
compensation during the period of the exclusion.
If the plan provides for matching contributions, the employee is
required to receive a QNEC equal to the matching contribution the
employee would have received on the missed deferral. The plan’s
matching percentage is multiplied by the missed deferral amount.
QNECS must be 100% immediately vested and are subject to
withdrawal restrictions. The corrective contributions must be
adjusted for earnings.
Example: Alex is a part-time, non-highly compensated
employee who was improperly excluded from his employer’s 401(k) plan
and should have become a participant effective January 1, 2005. The
average deferral percentage of the non-highly compensated group was
4.20% for the plan year ending December 31, 2005. Alex earned
$15,000 during 2005.
His missed deferral is calculated by multiplying his compensation
($15,000) times the non-highly compensated group’s average deferral
percentage (4.20%) which equals $630. To make Alex whole, his
employer makes a QNEC in the amount of 50% of the missed deferral
amount, or $315. Since the plan provides for a 25% matching
contribution, Alex will also receive a QNEC in the amount of $157.50
(25% times the $630 missed deferral). These corrective contributions
will also be adjusted for earnings.
Conclusion
Plan sponsors should carefully examine their plan document
language to determine if an amendment is necessary to ensure that
employees working 1,000 or more hours during the computation period
are eligible for plan participation. Administrative practices should
be reviewed carefully to determine if part-time employees have been
improperly excluded. If so, the plan sponsor should consider using
the IRS VCP to correct the failure and make the participants whole
to avoid stiff penalties or possible plan disqualification.
Complete census data, including part-time employees, should
always be provided to the plan’s third party administrator to ensure
that the plan is being administered properly.
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