Our ERISA consultants on the Columbia Management Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. Through our relationship with the Columbia Management Learning Center, we routinely guide Columbia Management financial advisor partners through the IRS, Department of Labor and Pension Benefit Guaranty Corporation rules and regulations that govern employer-sponsored retirement plans.
A recent call with an advisor in North Carolina is representative of common inquiries related to leased employees and plan eligibility. The advisor asked: “A client of mine that sponsors a 401(k) plan has some leased employees and some common-law employees. How are leased employees treated for plan purposes?”
Highlights of Discussion
That’s a straightforward question with a complex answer. Let’s begin with the IRS’ definition of leased employee under Internal Revenue Code Section 414(n)(2). The term “leased employee” means any person who is not a common-law employee of the recipient, and who provides services to the recipient:
- under an agreement between the recipient and the leasing organization;
- on a substantially full-time basis for a period of at least one year, and
- under the primary direction or control of the recipient.
If the individual meets the definition of a leased employee, then we must consider the terms of the leasing organization’s plan (if applicable) and the employer’s plan.
If the leasing organization covers the leased employee with a special “safe harbor” plan, and the leased employees do not represent more than 20% of the recipient employer’s non-highly compensated workforce, then an employer may totally disregard any leased employees for plan purposes (Section 414(n)(5)). In this case, a safe harbor plan is a money purchase plan that provides for:
- immediate participation;
- a pro-rata, 10% of compensation contribution; and
- immediate vesting.
If the above is not applicable, then we turn to the terms of the recipient employer’s plan. Does the plan include or exclude leased employees from participation? If it excludes leased employees, then the employer must still consider the leased employees when testing the plan to determine if it covers the minimum amount of employees that the IRS requires under Section 410(b). In order to satisfy the minimum coverage rules, the plan would have to benefit a percentage of nonhighly compensated employees (nonHCEs) that is more than 70% of the percentage of highly compensated employees (HCEs) that are benefiting under the plan.
Let’s take a look at an example:
CBA Inc., has 105 employees and uses the services of 20 leased employees. The company has a 401(k) plan that excludes leased employees, and covers five HCEs and 100 nonHCEs. All of the HCEs are benefiting under the plan.
In order to satisfy the IRS’ minimum coverage rules, the plan would have to benefit a percentage of nonHCEs that is more than 70% of the percentage of HCEs that are benefiting under the plan. One hundred of the 120 nonHCEs (including the leased employees), or 83.33% of the nonHCEs, are benefiting under the plan. Therefore, the plan satisfies coverage testing while excluding the leased employees from the plan.
Conclusion
Caution is warranted when an employer uses the services of leased employees and sponsors a 401(k) plan. To cover or not to cover the leased employees become the question that requires a thoroughly vetted answer. Financial advisors can remind their plan sponsor clients of plan coverage issues that may arise when they utilize leased employees’ services.
The Columbia Management Retirement Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC, a third-party industry consultant that is not affiliated with Columbia Management. For informational purposes only. Please consult a tax advisor or attorney for specific tax or legal needs. © 2014 Columbia Management Investment Advisers, LLC. Used with permission.
