Because of the popularity of the 401(k) plan and the mobility of employees, many employees do not want to wait until they complete the traditional "one year of service" before participating in their employer's 401(k) plan. Therefore, many employers have liberalized the eligibility requirements with respect to the elective deferral portion of their 401(k) plan. Such plans allow either for immediate participation in the elective deferral portion of the plan or require only a monthly or quarterly waiting period. However, these plans generally continue to require the employees to complete one year of service to be eligible for the matching and profit sharing portions of the plan.
The advantage to the employer in offering early eligibility in a 401(k) plan is that the employer can provide a popular low cost benefit to the employees. The disadvantage of offering early eligibility is that part-time and short-term employees become eligible to participate. Since the part-time and short-term employees almost always are nonhighly compensated employees (NHCEs) and usually defer less than other NHCEs, the plan may have difficulty in passing the ADP test. To avoid penalizing an employer for providing more liberal deferral eligibility provisions, the Code provides two alternative methods for applying the ADP test that may reduce the negative impact of the early eligibility provisions:
- (1) the otherwise excludible employee rule
(Code Section 410(b)(4)(B)), and
- (2) the early participation rule
(Code Section 401(k)(3)(F)).
Otherwise Excludible Employee Rule. The otherwise excludible employee rule permits the employer to divide operationally the plan into two plans for ADP testing purposes. One plan will include the employees who could have satisfied one year of service and age 21 eligibility conditions if the plan had imposed such conditions (“upper group”). The other plan is made up of employees who could not have satisfied such conditions if the plan had imposed them (“lower group”). The employer then applies the ADP test separately to each “plan.” In applying the separate tests, the employer may exclude the employees of the other group. The advantage of the rule is that it removes the employees who are less likely to defer from the upper group; thus improving the likelihood that the group would pass the test, or at least, reducing the amount by which it would fail. The employer still must test the lower group employees. However, generally the lower group consists solely of NHCEs. Therefore, the lower group plan would automatically pass the ADP test.
The basis for the otherwise excludible employee rule is found in the coverage requirements. However, the IRS confirmed in its audit guidelines that an employer may also use this rule for purposes of applying the ADP test. See Announcement 94-101, §445.1. The employer should note that before it may apply the separate ADP tests to the two “plans” it must apply the coverage tests separately to the two “plans.” In applying the coverage tests, the regulations treat the employees of the other group as excludible.
Treas. Reg. 1.410(b)-6(b)(3).
Early Participation Rule. The early participation rule is similar but not identical to the otherwise excludible employee rule. Under the early participation rule, the employer eliminates any lower group NHCE from the ADP test. The plan applies a single ADP test instead of two tests. However, the plan must include all highly compensated employees in the test. As with the otherwise excludible employee rule, the employer must divide the employees into the separate groups for purposes of the coverage test.
ACP Test. The employer also may use both rules in applying the ACP test if the plan provides early eligibility for the plan's matching contributions.
Continuing Viability of Otherwise Excludible Employee Rule. Recently, we have received inquiries from practitioners who have questioned whether the early participation rule replaced the otherwise excludible employee rule for 401(k) testing, commencing in 1999. IRS guidance, as well as IRS officials, have stated that both rules continue to apply. In fact, in Notice 98-52, SectionVIII.H and IX.B.1, the IRS indicated that an employer only may use the otherwise excludible employee rule (and may not use the early participation rule) in connection with a safe harbor 401(k) plan.
Some practitioners inquire as to which rule an employer should use. The proper answer is the rule that produces the better results. The rule that will produce the better result depends on the facts. However, since the rules are testing rules, the employer has the discretion to try both tests and to determine which test provides the better results.
In our 401(k) update program, we discuss the otherwise excludible employee and early participation rules in much more detail. Specifically, the program illustrates how to apply the tests and how to determine which employee is in which testing group.