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IRS Attacks 401k Employee Exclusions

By: lawrence_groves
This QAB revolutionizes the way IRS document examiners will look at 401k plan eligibility clauses and warns that inadequately drafted provisions dealing with part-time employees may be disqualifying, regardless of any plan determination letter.

Why the Attack ?

As 401(k) plans have matured, newly recruited employees are no longer willing to wait the traditional 1000 hour, one-year eligibility period to begin participating. Many employers are liberating their traditional 401k plans of a 1000 hr year wait by allowing immediate eligibility, at least for the deferral portion of the plan.

Other employers, while permitting immediate eligibility, wish to also avoid covering part-time employees because of :
(1) the negative effect on the ADP test as part-timers seldom contribute and will be counted as a zero.
(2) the administrative costs of adding and deleting new employees and
(3) the part-timers' zero balance will prescribe a top heavy contribution.

Employers are now looking to provide immediate deferral entry and simultaneously exclude part-timers as a classification.

The Problem:

Treas. Reg. ?1.410(a)-3 notes that a service condition requiring more than a one thousand hour year of service is invalid. In other words what matters is that the plan as written, could have a service requirement in excess of the Code ?410(a) limits, which is enough to disqualify the plan. Therefore, as a class- part-timers can not be excluded.

IRS additionally addressed this issue in the following:
?A 1994 Field Directive instructed IRS examiners to challenge plans which had these service requirements.
?The IRS modified Publication 794, which accompanies determination letters, added the following :

"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."

?A 2002 Recurring Issue Focus ("RIF") told IRS examiners that this would be an audit issue, not a determination letter matter.

IRS 401k Attack

Effective with the February 14, 2006 QAB the IRS examiners will again challenge 401k plans with the "part-time" exclusions. Examiners will not be challenging 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."

Employer's 401k Triumph

Plan sponsors should carefully examine their 401k plans if they 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 amending the plan.

The employer could regain the provision by including special language for the condition when a part-time employee works more than 1,000 hours of service during a plan year.

The plan can exclude part-time employees as a classification until they meet the 1,000 hour year of service requirement, even though full-time employees enter and start contributing immediately.

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About The Author, lawrence_groves

Want to retire with $1,127,085.04? Visit http://www.solo-k.com or http://www.womensolok.com or contact Lawrence Groves at Lawrence@solo-k.com

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