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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:
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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.
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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.
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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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