Internal Controls Part 2: Operational Compliance for Eligibility Classification - Reviewing the Plan

As noted in our prior article on the subject [see Protect Your Retirement Plan with Internal Controlsin Benefits News,January 2017], strong internal controls and “self-audits” are an effective way to protect your qualified retirement plan from disqualification failures and the imposition of sanctions in the event of an Internal Revenue Service examination. Internal controls can be implemented by the establishment of policies and procedures that will facilitate the detection of errors in the administration of a plan before the costs of correction become exorbitant. In order for a plan to maintain its qualified status and provide all of the favorable tax consequences that follow from plan qualification, (a) the form of the plan document must include all of the provisions required for qualification, and (b) the plan must be operated consistent with the terms of the plan document. Our prior article, which appeared in the January newsletter, focused on internal controls that help to ensure that the form of the plan document is qualified. This article focuses on operational compliance – that is, the requirement that the plan be operated in accordance with the terms of the plan document, and in particular, the terms of the plan relating to eligibility classification.


Among the suggestions for determining an employee’s eligibility classification accurately are:


▪ First and foremost, know what the plan document says.


▪ If necessary, determine which related employers are members of the same controlled group.


▪ If you have leased employees, follow the special rules that apply to them.


▪ If you use independent contractors, temporary employees or you contract for workers through a staffing firm, make sure that they are classified correctly.


▪ Use Microsoft language (but watch for coverage failures as well).


Review the Plan Document


Determining an employee’s eligibility classification in a qualified plan appears to be a simple process, when in reality there are number of pitfalls that can trip up an employer. The first step in the process should be a detailed review of the plan document’s eligibility provisions. To understand fully a plan’s provisions, an employer will usually need to reference the definitions section of the document. If the employer uses a pre-approved plan document, often there will be two different documents to review – the adoption agreement, which includes the employer’s plan design choices, and the base or basic plan document, which includes the operative provisions and often has upwards of 100 or more pages.


In reviewing the plan document, an employer should answer the following questions:


1. Which employees are eligible under the plan? Some plans cover all employees, others exclude certain groups of employees. Check the definition of “employee”. Typically, it will be defined as any common law employee of the employer. If the plan excludes certain employees, check the definition of an “eligible employee”. Many plans exclude employees who are union employees covered by a collective bargaining agreement where benefits have been the subject of good faith bargaining or nonresident aliens with no U.S. source income. These are called statutory exclusions because these groups can be excluded from the plan without violating the Code Section 410(b) coverage rules that require a plan to cover a nondiscriminatory group of employees. Other plans exclude employees based on their job classification, geographic location or the department or division in which they work. If the plan document excludes employees, make sure that the exclusions are being applied accurately and that the plan satisfies the coverage rules. Offering participation to employees who are not actually eligible for the plan is a qualification failure that can disqualify a plan [see401(k) Retirement Plan Disqualification] or result in significant penalties.


2. Which employers’ employees are covered by the plan? Check the definition of “employer”. Does it include only the employer who has signed the plan document, or does it allow for other employers’ employees to be covered by the plan? Generally, a prototype plan, which is a type of IRS pre-approved document, automatically provides that the employees of all employers included in the adopting employer’s controlled group are covered under the plan. This can be a problem when an employer acquires a wholly-owned subsidiary and does not realize that the employees of the subsidiary are then eligible for the plan. Failing to offer participation to an employee who is eligible to participate in a 401(k) plan can be an expensive qualification failure to correct. For this reason, an employer should know which employers are members of its controlled group. See Addressing the Risks of Related Employer Status for Benefit Plan Purposes in Benefits News,April 2017.


If a plan document requires that all participating employers execute the plan document (or a separate participation agreement) in order for their employees to be covered, and plan participation is offered to the employees of an employer that fails to execute the document or a participation agreement, a plan qualification failure results. Even though the failure is advantageous for the employee, it nonetheless results in a qualification failure because the terms of the plan document have not been followed.


If the employers with employees covered under a plan are not all part of the same controlled group, that plan is a multiple employer plan. However, not all plan documents have provisions that satisfy the requirements for a multiple employer plan. Thus, a plan qualification failure can result when a qualified plan is adopted by an unrelated employer and the plan document is not intended to be a multiple employer plan. Some plans, but not all, have fail-safe language that is automatically triggered when an unrelated employer adopts the plan. Even if your plan has this fail-safe language, it is still important for an employer to know whether any related employers are part of its controlled group, since the testing for a multiple employer plan is carried out on an employer by employer basis rather than with respect to the plan as a whole.


3. What is a “leased employee” and is it an excluded category? Leased employees are important for a qualified plan because they are treated as employees in determining whether the plan satisfies the coverage rules. If too many leased employees are excluded from a plan, it may fail to satisfy coverage. When reading a plan document, employers should understand that the term “leased employee” has a very specific statutory definition. It may come as a surprise to many employers that a leased employee is not actually a common law employee of the employer receiving the services of the leased employee (the “recipient employer”). A leased employee is a worker who provides services to a recipient employer under the following circumstances: (a) the worker is not a common law employee of the recipient employer; (b) there is an agreement between the recipient employer and the leasing organization, which is the business that provides the leased employees to the recipient employer; (c) the worker provides services to the recipient employer on a substantially full-time basis for at least one year; (d) the worker is under the primary direction and control of the recipient employer. Whenever an employer receives the services of workers that are not on its payroll, the employer should consider whether those workers are leased employees, and if so, whether the plan provides that leased employees are in an eligible classification. Just because a worker is on the payroll of another employer does not mean that a plan sponsor can ignore that worker for qualified plan purposes.


Many plan documents provide that leased employees are automatically covered by the plan; others explicitly exclude leased employees. If leased employees are eligible, once a worker becomes a leased employee after having satisfied the substantially full-time basis for one year requirement, he or she will become eligible for the plan and must be offered participation. If the plan has an eligibility service requirement (for example, a one-year service requirement), a leased employee’s service with the leasing organization will count toward the satisfaction of that service requirement in the recipient employer’s plan.


4. Does the plan document have Microsoft language? The use of Microsoft language in plan documents has arisen in response to the case of Vizcaino v. Microsoft,120 F3d 1006 (1997, CA9). Microsoft was sued by a number of freelance workers who claimed that they were eligible for benefits under Microsoft’s various employee benefit plans including its 401(k) plan. Microsoft believed they were not eligible because the freelancers had entered into contracts with Microsoft stating that they were not eligible and also because the freelancers were paid through the company’s accounts payable department, not payroll. Microsoft’s 401(k) plan provided that individuals who were not paid through its U.S. payroll would not be eligible. Microsoft argued that this provision in the plan document allowed the company to exclude the freelancers even if they were determined to be Microsoft’s common law employees. The court held that the eligibility issue with respect to the 401(k) plan should be determined by the plan administrator, and the case was ultimately settled.


In response to this case, many plan documents were amended to include language that excludes employees who are not treated on the employer’s payroll records as subject to federal income tax withholding even in the case where the employees are later determined to be common law employees subject to such withholding requirement. This language is commonly referred to as Microsoft language. If a plan does not include Microsoft language, the plan sponsor should consider adding it to protect the employer against the claims of misclassified employees.


If a plan sponsor uses independent contractors, temporary employees, or workers contracted from a staffing agency, know that the IRS may challenge their classification. These kinds of workers may be reclassified by the IRS as employees of the plan sponsor and that reclassification may result in a qualification failure when the employees are not permitted to participate in the plan. Including Microsoft language in your plan may be helpful, but if there are too many misclassified employees who are excluded, the employer runs the risk of failing to satisfy the coverage rules.


If you need assistance in reviewing your plan document, you can contact any Boutwell Fay attorney. Watch for our next article in this series that will describe the policies and procedures employers should establish in order to ensure that the plan document eligibility classification provisions match the group of employees who are actually being offered participation in the plan.


© Boutwell Fay LLP 2017, All Rights Reserved. This handout is for information purposes only, and may constitute attorney advertising. It should not be construed as legal advice and does not create an attorney-client relationship. If you have questions or would like our advice with respect to any of this information, please contact us. The information contained in this article is effective as of June 30, 2017.



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