Some employers have discovered the convenience of contracting with a Professional Employer Organization (PEO) or staffing agency for “leased employees.” These are the employees who remain on the PEO or agency payroll but go to work at an employer’s workplace (called the recipient employer). Most recipient employers understand something of joint-employer liability with respect to certain employment practices. However, many fall into the widespread misunderstanding that leased employees have no impact on the recipient employer’s retirement plan. Even when the plan excludes leased employees as a class, recipient employers are required by IRS regulations to count the leased employees in the required nondiscrimination coverage tests of IRS Code §410(b). Yes, they must be part of the tests–even when the leased employees are excluded from the plan. This IRS requirement applies to most qualified retirement plans, including 401(k), pensions, profit sharing, savings, and money purchase plans.
Leased employees are categorized as recipient-employer employees when it comes to retirement plan compliance, even though they are not on the payroll of the recipient. Employees who are hired through a PEO or staffing agency must be included in the recipient’s annual coverage testing for retirement plans. Many retirement plan administrators and providers fail to point this out to the recipient employer plan sponsor, or to even ask whether the employer has any leased employees. Consequently, while the plan provider may reassure the employer that all plan tests have been passed, when it comes to leased employees, those providers may, in fact, be incorrect. Regrettably, some providers are unaware of the impact of IRS Code §414(n) on plan coverage tests. As such, they fail to request leased employee information in the data collection request sent to the plan sponsor. From there, the test is missing required data and the result is then inaccurate reporting of §410(b) test passing. Note that this is an audit item for IRS auditors’ review.
What steps should recipient employers take to ensure plan compliance? This Bulletin article is intended to provide some very basic guidance to members who use leased employees and who also sponsor a retirement plan.
What is the Definition of a Leased Employee?
IRS Code §414(n) defines who is a leased employee. Most employees from a PEO or staffing agency (hereafter “leasing organization”) will fall under the IRS definition of a leased employee for the recipient employer if the three criteria of §414(n) are met.
1. The individual must be hired pursuant to an agreement between the recipient employer (who sponsors the retirement plan) and the PEO, staffing agency, or leasing organization.
2. The individual must work on a substantially full-time basis for at least one year. (Note that there are differing definitions of full time; it may be as few as 1,000 hours per year.)
3. The individual must perform services under the primary direction and control of the recipient employer.
If all three of the above tests are satisfied, the workers in question are classified as leased employees of the recipient employer by the IRS. Your leased employees would be presumptively covered by your retirement plan on the same basis as employees on your payroll. The IRS counts leased employees as eligible for retirement plans unless the plan document specifically excludes them.
Inadvertently excluding leased employees from the recipient’s retirement plan solely because they are not on the recipient’s payroll is an error that can result in IRS fines and penalties, and in serious cases, plan disqualification. However, your retirement plan documents may have elected to exclude the leased employees as a group.
How to Exclude Leased Employees
As the plan sponsor, the recipient employer generally has the option to exclude any nondiscriminatory category of employees. It is not uncommon for leased employees to be excluded in the plan’s documents. If you have leased employees, now may be a good time to review your retirement plan documents to confirm that under the eligible employees section of the documents, you have excluded the classification of leased employees. If your document does not exclude leased employees, and you have leased employees working for you, your plan may be in non-compliance. If so, you should contact your plan provider or ERISA counsel to address the non-compliant situation immediately–before your plan is audited. A recipient employer who has failed to exclude leased employees from its plan may have to make sometimes expensive and time-consuming corrective contributions on behalf of those leased employees. Using one of the correction programs offered by the IRS’ Employee Plans Compliance Resolution Systems is highly recommended if you find yourself in this situation.
In addition to following an IRS correction process, you may want to give serious consideration to amending your plan to exclude the category of leased employees in the future, while you work to correct past noncompliance. For recipient employers who have properly excluded leased employees in their plan documents, but still use a number of them in the workforce, read on, as your situation could present a different sort of noncompliance concern.
My Plan Documents Already Exclude Leased Employees. Are There Any Related Compliance Concerns?
Even when your leased employees are excluded in the plan documents, that does not mean they are excludable from annual plan coverage testing. Under most circumstances, the recipient employer must still include leased employees for purposes of performing the minimum coverage test, even if the plan has already been drafted to exclude leased employees from actual participation. [IRS Code §414(n)(3)(B).]
How does this work? The head counts are added to the test in their respective categories–i.e., as highly compensated employees or non-highly compensated employees–showing zero participation. Often, there will not be enough leased employees to swing the test results to a failure, but it has happened. It is most likely to happen where the recipient has a large number of leased employees who are not highly compensated and very few to no highly compensated leased employees.
Note that if the leasing organization provides any retirement benefits to the recipient’s leased employees, the recipient employer should obtain this information. In this case, the recipient may count any qualified plan benefits that the leasing organization provides to the leased employees in the recipient’s coverage tests.
Any Safe Harbor Whereby Recipient Employers Can Ignore Leased Employees in Retirement Tests?
The IRS provides one safe-harbor exception to the leased employee rules in situations where the leasing organization offers a specific type of plan for the leased employees who works at the recipient employer, and where the recipient’s percentage of employees who are leased does not exceed the maximum IRS guideline. For the recipient employer to use the safe-harbor exemption of IRS Code §414(n)(5), the leasing organization must meet the two factors below:
- The leased employee must be covered by a money purchase pension plan maintained by the PEO or leasing organization, which provides a non-integrated employer contribution of at least 10 percent of annual compensation, as well as immediate participation and full, immediate vesting; and
- Leased employees may not constitute more than 20 percent of the recipient’s non-highly compensated workforce.
If both of these tests are met, the recipient employer is eligible for a safe-harbor exemption and is not required to count leased employees in performing the minimum coverage test. Where the recipient’s plan has been drafted to exclude leased employees, the employer will have no further concerns with respect to leased-employee impact on the retirement plans testing … at least for that plan year.
The reality is that very few leasing organizations sponsor such a generous money purchase plan and so very few can meet this safe-harbor exception. Nevertheless, as the recipient employer prepares for the annual nondiscrimination testing, it is worthwhile to ask the leasing organization whether it provides such a plan.
If the answer to either one of the above two factors is “no,” the recipient employer must count the leased employees in performing its minimum coverage test–regardless of what the plan says. If the retirement plan passes the test, the employer is in the clear. However, if the plan flunks the test (because the employer has a relatively large leased-employee population, which is not covered by a leasing organization’s safe-harbor plan), then the employer must count leased employees in order for the plan to pass coverage. In this case, contact your plan provider or ERISA counsel for assistance.
What Should Employers Do?
After following the analysis briefly outlined in this article, if the recipient employer discovers a potential non-compliant situation resulting from the presence of leased employees, the employer should take immediate action to correct the past non-compliant situation, and, if necessary, consider amending the plan for future compliance. In either event, contact your plan provider or ERISA counsel for assistance in determining the current state of compliance for your retirement plan and whether filing a correction with the IRS is prudent in your particular situation to protect the recipient employer plan.