Some employers want to exclude certain groups of employees from participation in a retirement plan. These might be groups of employees located in a certain plant or state. Sometimes a plan covers only salaried employees, excluding hourly employees. Employees covered by collective bargaining agreements are often excluded (unless coverage under the plan has been negotiated). Employers also tend to exclude part-time employees working less than 20 hours per week or five months in any plan year.
The IRS issued a field directive to provide guidance about part-time employees' exclusion under Section 410 of the Internal Revenue Code, taking the following position:
"It is our view...that regardless of whether the exclusion of part-time employees satisfies Section 410(b), such exclusion violates Section 410(a). Section 410(a) and Section 410(b) impose independent requirements on plans, both of which must be satisfied in order for a plan to remain qualified."
Maximum Service Exclusion
Section 410(a) of the Code provides that a plan cannot impose a condition of participation which extends beyond the later of the date on which the employee attains age 21 or the date on which the employee completes one year of service. (The year of service can be extended to two years of service if participants become 100 percent vested after two years.)
Typically, a year of service is 12 consecutive months during which the employee completes not less than 1,000 hours of service. Usually, a part-time employee working less than 20 hours a week on average will not complete 1,000 hours within a year; however, it can occur when workloads change.
This means that part-time employees can no longer be excluded from the plan if they would earn 1,000 hours or more during the plan year.
Minimum Coverage Rule
The second prong of Section 410 of the Code, subsection (b), sets forth standards to ensure that a plan does not discriminate in favor of highly compensated employees. Either a plan can satisfy the ratio percentage test or the average benefit percentage test.
In either case, a plan must be able to show that it covers at least 70 percent of the non-highly compensated employees who meet the eligibility standard, typically 1,000 hours in a 12 month period. It has been thought that an employer could exclude part-time employees, even though they might meet the 1,000 hour per year service requirement, as long as the 70 percent test under 410(b) was met. That is, if part-timers were counted for testing purposes, but the plan still met the 70 percent test, there was no violation of Code Section 410.
The field directive makes it clear, however, that part-time employees can no longer be excluded from the plan if they would earn 1,000 hours or more during the plan year.
This is an issue particularly for employers contributing to multi-employer plans. Frequently, collective bargaining agreements will exclude contributions for employees who are classified as "part-time," "temporary," or "seasonal." Excluding such categories by contract could result in exclusion of employees performing 1,000 or more hours of work during a 12 month period.
If the work they perform is essentially the same as other employees covered by the contract, the plan could be violating Section 410(a). Upon a payroll audit the pension fund could assess delinquent contributions against the employer with respect to all part-time employees working 1,000 hours or more. This is, in fact, the current position of one of the largest multi-employer pension funds in the country.
The IRS did note that a plan which has received a favorable determination letter, even though it excluded part-time employees from participation, may be entitled to retroactive relief. However, new plans will not find such relief available.
Still May Be Able to Exclude Part-Time Employees
It may still be possible to exclude part-time employees through a change in plan design. If different methods deemed to be equivalent under the Internal Revenue Code are used for crediting service for part-time and full-time employees, or if different sets of minimum age and service conditions are imposed on full-time and part-time employees, the result may be that part-time employees can still be excluded.
However, the group of eligible employees in either case must still satisfy the discrimination rules of Section 410(b). An example of using different methods for crediting service would be to cover part-time employees who completed 1,000 hours of service, but to use the elapsed time method for full-time employees.
Similarly, full-time employees could become immediately eligible, while part-time employees could be required to complete 1,000 hours of service.
To ensure that part-time employees will not become eligible for plan participation, the safest means an employer can use is to monitor their hours of work and limit part-time employees to less than 1,000 hours of work per year.
An IRS field directive is issued to all IRS district offices and is used as local IRS staff review determination letter requests for plan qualification and perform audits of retirement plans. To eliminate this problem, employers who exclude part-time employees should consider appropriate amendments to the plan.