IRS Guidance for Part-time Employee Exclusions Under 401(k) Plans
By Sheldon M. GellerJULY 2007 - The IRS issued guidance regarding the exclusion of part-time, temporary, seasonal, and project employees under qualified plans, including 401(k)s. Plan provisions that are improperly drafted to exclude part-time and other non–full-time employees, as well as plans excluding part-time employees in actual operation without any provisions excluding these employees, may cause disqualification. A qualified plan that is disqualified would lose its tax-favorable treatment and the tax-exempt status of the trust established as a part thereof, regardless of whether the qualified plan is the subject of a favorable determination letter.
IRC section 401(k) plans have become increasingly popular with plan sponsors and participants. Eligibility requirements have been lowered from the traditional one-year waiting period to less than 1,000 hours of service during 12 consecutive months. Indeed, many employers have permitted entry into their 401(k) plans after six months of work, or as of the employee’s date of hire, with respect to the 401(k) deferral feature.
Any waiting period less than 12 consecutive months may not include as a condition the performance of 1,000 hours of service. That is, a six-month waiting period would mean that an employee must perform six months of service without any minimum number of hours. Accordingly, such a plan provision would allow part-time, seasonal, and project employees to enter the plan.
Plan sponsors would rather not cover part-time employees because of the adverse impact on the special nondiscrimination test, which may result in the refund of excess 401(k) deferrals to highly compensated employees. Furthermore, many employers do not intend to provide retirement plan benefits for their part-time and other non–full-time employees. Federal pension law under the Employee Retirement Income Security Act (ERISA) does not require that a qualified plan cover all employees when determining compliance with coverage requirements.
The maximum service requirement a qualified plan may impose upon common-law employees is one year of service (or two years of service for non–401(k) plans). A qualified plan may not exclude part-time employees whose customary schedule is not more than 20 hours per week, because such an employee may perform more than 1,000 hours of service. That is, a qualified plan may not have a waiting period of more than 1,000 hours in more than 12 consecutive months.
IRS determination letters include a caveat advising that a determination letter may not be relied upon with respect to whether the plan’s exclusion classifications, if any, violate the IRC’s minimum age and service requirements. Furthermore, an exclusion from coverage of part-time and other non–full-time employees is not a matter of a determination letter, but rather an audit issue that directly affects the qualification of the plan and the tax-exempt status of the trust.
The IRS will not challenge an exclusion classification that is defined without reference to hours of service. In other words, an exclusion classification may be defined by reference to job title or job functionality, even if such exclusion may effectively exclude part-time and other non–full-time employees. Any exclusion classification must be clearly defined and will be examined by an IRS specialist when a plan is submitted for a favorable determination, or when it is audited.
Plan sponsors should carefully examine plan documents to properly exclude any otherwise eligible employee, part-time or otherwise. If a plan does not have a properly drafted exclusion, the plan sponsor should consider using the IRS’s Voluntary Correction Program to cure the document defect.
Accordingly, a qualified plan may exclude part-time employees by having a one-year eligibility provision and, thus, exclude any employee who does not perform at least 1,000 hours of service in 12 consecutive months. If a plan has a waiting period of less than one year, the plan might design a part-time employee exclusion through a provision that excludes an employee scheduled to work less than 1,000 hours of service annually. Such a provision may be valid only if it also includes language that employees who perform more than the scheduled 1,000 hours of service during their relevant period are eligible for plan participation.
Following this example, a plan would have two eligibility conditions: immediate entry for full-time employees and one year of service for part-time employees. Excludable part-time employees who work more than the scheduled 1,000 hours must be eligible in order for the plan to qualify for favorable tax treatment under the IRC. That is, even though a part-time job description may include less than 20 hours of services performed weekly, if the plan admits all employees who work more than 1,000 hours to be eligible for the plan, they will qualify under the IRC. This fail-safe language protects the integrity of the plan and excludes part-time employees who do not complete the 1,000 hours of service requirements during the plan year.
A qualified plan must cover at least 70% of its otherwise eligible non–highly compensated employees if it covers 100% of its eligible highly compensated employees. Thus, a qualified plan may not exclude more than 30% of its eligible non–highly compensated employees who are part-time and other non–full-time employees. Employees who do not satisfy the plan’s minimum age and service requirement are statutorily excludable and not taken into account when determining the 70% coverage test.
Advisors may draft plans that exclude part-time, seasonal, temporary, and project employees without reference to hours of service and within the required coverage tests. Plan sponsors who have failed to cover part-time and other non–full-time employees in the absence of a properly drafted exclusion provision may wish to review their plan documents and actual plan operation to either cover these employees or properly draft an exclusion provision that includes fail-safe language beneficial to the employer.
Plan sponsors may design their plans to take advantage of this part-time employee guidance to reach their objectives regarding the classification of employees covered by their 401(k) plans.
Sheldon M. Geller, Esq., is managing director of the Geller Group LLC, a member of Focus Financial Partners, New York, N.Y. He is a member of The CPA Journal Editorial Board.