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
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
- 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
- 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
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
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.
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
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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