The IRS has issued a new internal bulletin dealing with plan exclusions of part-time, temporary, and seasonal (collectively “part-time”) employees. The February 14, 2006 Quality Assurance Bulletin (“QAB”) changes the way document examiners will look at certain plan clauses. The QAB also warns that improperly drafted clauses dealing with part-time employees may be disqualifying, whether or not the plan has a determination letter but also suggests some drafting options many practitioners did not know they had.

Why the Issue? As 401(k) plans have become increasingly more popular, many employees no longer are willing to wait the traditional one-year eligibility period before participating. Many employers have responded by allowing immediate eligibility, at least for the deferral portion of the plan. However, other employers have been reticent to eliminate the one-year eligibility condition because part-time employees will become plan participants. Employers generally wish to avoid covering part-time employees because of the: (1) negative impact on the ADP test, (2) administrative costs, (3) lack of interest in the benefit, and (4) cost of providing a top-heavy minimum contribution. Accordingly, employers often inquire about the possibility of providing immediate entry into the plan (or at least for the deferral portion of the plan) for most employees, but excluding part-time employees as a classification.

Background. Treas. Reg. §1.410(a)-3 notes that the maximum service requirement a plan can impose is one year of service (in some cases two years). While a plan can impose other eligibility requirements, a service condition which could require more than one year of service is invalid. The regulation explains that a clause excluding part-time employees whose “customary employment is for not more than 20 hours per week” is an impermissible service requirement. Why? Because such an employee may, in fact, work more than 1,000 hours in an eligibility computation period (regardless of how many hours the employee “customarily” works) and therefore the “part-time” exclusion would be a service requirement exceeding the Code §410(a) limits.

This issue is a plan document issue. In other words, it doesn’t matter whether any part-time employee in fact works more than 1,000 hours. If the plan, as written, could have a service requirement in excess of the Code §410(a) limits, that is enough to disqualify the plan. Additional IRS guidance on the issue includes the following:

• A Field Directive issued 2/22/1994 instructed document examiners to challenge plans which had these impermissible service requirements.
• In a Technical Advice Memo issued 11/28/2000, the IRS shifted focus and said that the issue was best decided at audit, rather than as a part of the determination letter process. Examiners were told to caveat letters of plans which had the issue.
• On 7/1/2001, the IRS modified Publication 794, which accompanies determination letters, to add the following caveat: “A determination letter may not be relied on with respect to whether a plan’s exclusion classifications, if any, violate the minimum age or service requirements of section 410 by indirectly imposing an impermissible age or service requirement.”
• On 9/6/2002, a Recurring Issue Focus (“RIF”) told document examiners to stop challenging plans with the part-time issue present. This would be an audit issue, not a determination letter matter.

Document Examination. The new QAB rescinds the RIF. Effective February 1, 2006, IRS document specialists should again challenge plans with potentially improper exclusions. Such exclusion provisions include those relating to part-time, seasonal or temporary employees and the QAB instructs IRS specialists to scrutinize carefully any such exclusion to determine if it violates Code §410(a). However, specialists are not to challenge an exclusion classification that is defined without reference to hours of service (e.g., hourly paid employees). The QAB states:

Specialists should take note that the issue of whether a plan is providing a direct or indirect service requirement is not limited to part-time or seasonal employees. Any exclusion classification, whether it be part-time, seasonal, temporary, or any other classification of employees, should be closely scrutinized. Specialists should require that any such classification be clearly defined.

Existing Plans; Reliance. According to both the QAB and Publication 794, if a plan received a 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 unless it has a caveat.

Plan sponsors should carefully examine plans which currently exclude part-time employees from participation. If the plan does not have a fail-safe to assure that the plan will comply with Code §410(a), the sponsor should consider using the Voluntary Correction Program to correct the document failure.

Interestingly, there is no such caveat in IRS pronouncements which allow plan sponsors who adopt prototype or volume submitter documents to rely on the favorable opinion or notification letter of the document’s sponsors.

Plan Design. The QAB indicates that a plan may exclude part-time employees as long as the employer designs the provision in such a way that there is no possibility of indirectly imposing an hour of service requirement in excess of the Code §410(a)(1) statutory maximum. The QAB gives examples of which plan provisions are permissible and impermissible clauses.

The first example suggests a plan with a one year eligibility provision could exclude part-time employees as long as the plan defined part-time employees as anyone who actually works less than 1,000 hours of service. This exclusion serves no purpose because the usual statutory one year eligibility provisions would prevent any part-time employee who actually works less than 1,000 hours (determined at the end of the computation period) from entering the plan.

However, another example does provide useful guidance on how an employer might design a part-time employee exclusion. Generally, a plan provision that excludes an employee who “is scheduled” to work less than 1,000 hours of service is impermissible because the employee could work more than 1,000 hours but still be excluded. However, the IRS indicates that the employer could salvage the provision by including fail-safe language for the situation where the employer works more than 1,000 hours of service during a computation period. Such a provision could operate as a prospective exclusion (subject to the fail-safe). In effect, in a plan with immediate eligibility, this creates 2 sets of eligibility conditions, one for full-time employees (immediate entry) and one for part-time employees (one year of service). Consider the following example:

Example. Corporation X maintains a calendar year 401(k) plan. The plan is top-heavy, provides for immediate eligibility for deferrals and provides for matching contributions (either after completion of one year of service or immediately). The plan also excludes part-time employees. The plan defines a part-time employee as any employee who is scheduled to work less than 1,000 hours of service. If a part-time employee actually works more than 1,000 hours of service during a computation period (despite not being “scheduled” to do so), the employee will become a participant on the first semi-annual plan entry date following the computation period. X hires two part-time employees on November 1, 2006 (A and B). Their job description indicates they normally will work 15 hours/week or less, thus they are “part-time” and excluded under the plan’s definition. However, the plan admits all remaining employees who are not part-time immediately. During their initial computation period, A works 550 hours and does not become a participant. B, on the other hand, ends up working 1,100 hours during the computation period and will become a participant on January 1, 2008. Neither A nor B will be able to defer or receive a top-heavy minimum during the 2006 and 2007 plan years or otherwise be considered a plan participant. B will be eligible to defer in 2008, and therefore is eligible to receive a top-heavy minimum contribution for that year.

The employer can eat its cake and have it, too. So long as the appropriate fail-safe language is in the plan, to assure that the plan will always satisfy 410(a), the plan can exclude part-time employees as a classification until they meet the year of service requirement, even though full-time employees enter immediately.

Coverage. The QAB only addresses the eligibility rules of Code §410(a) and not the coverage rules of Code §410(b). A sponsor must make certain the plan still covers a sufficient percentage of nonhighly compensated employees to satisfy the coverage requirements. Employees who do not satisfy the plan’s minimum age and service condition are statutorily excludible and do not adversely affect coverage. However, as noted above, a plan with a part-time exclusion and fail safe language effectively is imposing two eligibility conditions (immediate entry for the full-time employees and one year of service for the part-time employees). In such a situation, the coverage regulations indicate that the plan only may exclude employees who fail to satisfy both eligibility conditions. In other words, the plan must use the lowest service condition in determining which employees are excludible. In the example above, neither A nor B would be excludible for coverage because the lowest service condition is immediate. As nonhighly compensated employees who are not benefiting, this may cause the plan to fail coverage. However, often a plan can satisfy the coverage test by using the otherwise excludible employee rule of Code §410(b)(4)(B).

Conclusion. Practitioners with plans that exclude “part-time,” “seasonal” or “temporary” employee should review their provisions to make certain they comply with the guidance. Practitioners that have avoided such provisions because of the risk of violation of Code §410(a)(1) may wish to review their plans to determine whether a properly drafted exclusion provision which includes a fail-safe might be beneficial to the employer. Employee Plans Determinations Quality Assurance Bulletin, February 14, 2006.

Join us on Thursday, April 6, for a 75-minute Web Seminar, "New Options for Part-timers." During this program, we will be exploring the IRS bulletin and what it means, including the pitfalls, perils and possibilities.

In addition, during April and May, we are presenting a one-day 401(k) Plan Workshop. In this Workshop we will explain how you can design plans to take advantage of this new part-time employee guidance. In addition, we will explain the new Roth distribution and taxation requirements, deferrals on post-severance compensation, final 401(k) plan regulations, and more. As an added bonus, we are presenting the one-day Form 5500 Workshop on the day preceding the 401(k) Plan Workshop. For a complete listing of the cities and dates, visit our Web site.