Employers Should Use Caution When Excluding Certain Employees from a Plan
By Anne Freelove, QKA
We have a client whose business employs a number of part-time, seasonal, and temporary employees. Can the client exclude these employees from its 401(k) plan?
Employers may exclude certain classes of employees from participating, as long as the classification is reasonable and does not violate the minimum age and service requirements under Internal Revenue Code Section (IRC Sec.) 410(a). Because of these minimum requirements, the IRS generally does not consider a class exclusion of part-time, seasonal, or temporary employees to be reasonable if those classifications are based on hours or length of service (e.g., employees working fewer than 20 hours per week).
The statutory definition of a year of service is generally a 12-consecutive-month period in which an employee is credited with at least 1,000 hours of service. It is possible under this definition that a part-time, seasonal, or temporary employee could be credited with enough hours to earn a year of service. For example, a part-time employee, who typically works less than 20 hours per week, may work on a special project that requires significantly more hours than expected and may end up working more than 1,000 hours. If the plan excludes part-time employees as a classification, continuing to exclude this employee would violate the minimum service requirements.
Therefore, caution should be taken if trying to exclude part-time, seasonal, or temporary employees as a class. Some plan documents can be drafted to exclude part-time, seasonal, or temporary employees as a classification unless the employee meets the statutory one-year-of-service rule. Then they would become eligible to defer into the plan.
What should employers consider if looking to exclude a group of employees from their plans?
Any excluded class of employees should be a “reasonable business classification” that can be considered nondiscriminatory. Reasonable business classifications may include location (employees working in a certain geographical area); type of compensation (e.g., employees paid entirely on commission, salaried employees, highly compensated employees); or job role/title (e.g., salespeople, managers, etc.). Additionally, the plan must meet the IRC 410(b) coverage requirements. These groups of employees should only be excluded as a class if the plan can pass coverage testing with the excluded employees shown as “not benefiting.”
A qualified retirement plan can exclude collectively bargained employees for whom retirement benefits were the subject of good-faith bargaining, nonresident aliens with no U.S. taxable income, and employees acquired as the result of a merger or acquisition during the transition period that follows the transaction. Employees in these three statutory exclusion categories generally are not included in coverage testing, so excluding them does not have a negative effect on the test. Note that these classes of employees are only excluded from the plan if the plan document is drafted to exclude them.
What happens if excluding a class of employees causes a plan to fail coverage testing?
The corrective action for a failing coverage test due to a class exclusion is to amend the plan to remove the exclusion, bringing the excluded group(s) back into the plan until the coverage test can pass. Note that retroactively amending the plan to remove an exclusion may result in the need for corrective employer contributions to the formerly-excluded employees.
How can a plan failure be corrected if the employer improperly excluded a group of employees?
If the plan was drafted to exclude a class of employees and thereby caused a coverage testing failure, or excluded a group of employees that was later determined to be impermissible, this failure may be corrected through a retroactive amendment. A correction for excluded participants can be expected to involve a corrective employer contribution; an adjustment for earnings; and if corrected under EPCRS, either self-documentation retained with the employer or an IRS submission with fee under the IRS Voluntary Correction Program.
A plan sponsor should discuss with legal counsel whether any necessary retroactive amendment can be accomplished under the parameters of Treasury Regulation 1.401(a)(4)-11(g); could be permitted in the context of self-correction per IRS Revenue Procedure 2019-19; or whether an IRS Voluntary Correction Program filing may be required.
