Don't let part-time employee exclusions jeopardize your plan

Posted on Wednesday, January 17th 2007

Abstract: Employers often design 401(k) plan and other defined contribution plan documents so that, based on a full-time hours requirement, part-time employees are excluded from entering the plan. The IRS has issued a ruling providing clear guidance on when plans can exclude such employees, when they should be included, and how plans could be disqualified if they don't handle these employees' status properly. This article examines the IRS ruling.

Employers often design 401(k) plan and other defined contribution plan documents so that, based on a full-time hours requirement, part-time employees are excluded from entering the plan. But today many new full-time employees want to enter 401(k) plans sooner. So employers are looking for ways to allow full-time employees immediate participation while continuing to exclude most part-time employees.

The IRS has issued a ruling providing clear guidance on when you can exclude such employees, when they should be included, and how your plan could be disqualified if you don't handle these employees' status properly.

Why exclude part-timers?

Employers prefer to exclude part-time employees for a number of reasons, including:

• Administrative costs,

• Part-time employees' lack of interest in making salary deferrals, and

• Having to provide a minimum contribution should the plan be determined to be top heavy.

Plans also exclude part-time employees because of their impact on other discrimination testing. With the inclusion of part-time employees, testing under the average deferral percentage (ADP) test can result in more failures because the plan must count the increased number of eligible employees, yet generally these part-time eligible employees don't make contributions into the plan.

The 1,000 hour rule

When a plan has a set hours-of-service requirement, an employee generally waits from his or her hire date through the plan's computation period and then enters the plan on the next entry date - usually monthly, quarterly or semiannually. Typically, plans define the requirement as 1,000 hours of service.

This traditional limit doesn't mean that the full-time employee must meet the 1,000 hours to participate in the plan - he or she could do this in about half a year based on a 40-hour work week. But rather, it targets what a part-time employee - an employee working 20 hours a week or less - will not meet. Plans using this language will usually exclude part-time employees from participation because they will most often not meet the requirement.

Basics of the IRS ruling

An IRS Quality Assurance Bulletin (QAB) dated Feb. 14, 2006, looks at how plan documents address part-time employees, including seasonal or temporary employees. Basically, the QAB states that you could run into disqualification issues if your plan documents don't contain clauses that effectively exclude part-time employees.

The ruling also says that simply because a plan receives a determination letter stating that the plan isn't violating plan rules doesn't mean there is favorable treatment as to part-time employees. And the QAB doesn't allow plan sponsors who adopt prototype or volume submitter documents to rely on the favorable opinion or notification letter if the plan document contains impermissible part-time employee clauses. However, if your plan doesn't properly exclude these employees, your plan sponsor can use the Voluntary Correction Program to correct the document failure.

Best of both worlds

The QAB gives several examples of permissible and impermissible plan document clauses, which provide some clues as to how you can safely include new full-timers sooner and exclude most part-timers. For instance, a clause that excludes part-time employees who are scheduled to work "less than 1,000 hours of service in one year" is an impermissible service requirement. Why? Because a part-time employee may, in fact, work more than 1,000 hours in the computation period. If the employee does work more than 1,000 hours, he or she is eligible to participate in the plan and the exclusion is invalid. So this plan design doesn't meet the QAB requirements.

But you can allow full-time employees immediate entry and minimize part-time employee eligibility by designing the plan document to allow a fail-safe provision stating that part-time employees will enter the plan if they "work over 1,000 hours." In the above example, this would be as easy as changing the definition of a part-time employee to an employee who works "less than 1,000 hours of service in an eligibility computation period."

If you implement such a strategy, don't forget about how the addition of even some part-time employees may affect discrimination testing. All plans must still comply with general nondiscrimination tests. If a plan is deemed to be discriminatory and no correction is made, the plan may be disqualified, and both the plan sponsor and participants may incur taxes.

A practical fail-safe

Employers and plan sponsors should scrutinize any exclusion classification, whether part-time, seasonal, temporary or other employee classification. Your plan document should clearly define any such classification.

As a practical fail-safe, continually examine your exclusion clauses to ensure your plan documents comply with IRS rulings and provisions, and be cautious when excluding part-time employees from the plan. If you want to be absolutely sure that your plan is in compliance, you can submit such clauses to the IRS for a determination of compliance.