While the most intuitive starting point in establishing a retirement plan is deciding the specific type of plan to adopt, it’s not the only fundamental decision facing employers. Overlooking other factors impacting plan establishment could lead to costly missteps, such as plan disqualification. These factors often have ongoing ramifications and should be revisited on a regular basis.
To avoid common errors, employers should assess considerations including controlled or affiliated service group status of the employer, employee groups eligible for the plan, and service providers who are responsible for administering the plan and ensuring compliance with the Internal Revenue Code and Employee Retirement Income Security Act (ERISA).
Controlled and Affiliated Service Groups
Failing to apply the tax code’s controlled group and affiliated service group rules is a common oversight. Under these complex rules, related employers—both foreign and domestic—are treated as a single employer for certain plan purposes, even if such related employers don’t participate in the plan.
In general, an employee’s service with a controlled group member is counted for plan eligibility and vesting purposes, and the mandatory nondiscrimination tests designed to prevent the plan from disproportionately favoring highly compensated employees must be applied across the employer’s controlled group. These rules pull together entities with certain levels of common ownership or with service relationships. To further complicate the determination, ownership attribution rules apply to spouses, certain family members, estates and trusts, and other relationships.
Crediting service is one issue for these groups. Take, for example, ABC Inc., sponsor of a 401(k) plan. Jane is hired by ABC after working with DEF Co. for three years. ABC is unaware its parent company also owns 80% of DEF. As a result, an operational error occurs when ABC fails to credit Jane with her three years of service at DEF for vesting purposes under the plan.
Employers can prevent common pitfalls by checking the plan’s eligibility provisions to avoid inadvertently sweeping in unintended controlled or affiliated service group members and confirming that only intended employee groups are covered. Where participation by a controlled or affiliated service group member is intended, that member must separately adopt the plan.
Notably, service providers contracted to perform nondiscrimination testing often require the employer to certify its controlled or affiliated service group status and provide a list of other group members. An employer can avoid errors by engaging an accountant or lawyer to perform the analysis underlying the certification.
An employer is largely free to choose the employee groups covered by the plan, subject to nondiscrimination testing. However, errors often occur regarding the inclusion or exclusion of certain employees under additional rules.
Excludable employees. Union employees, certain noncitizens, employees under age 21, and employees scheduled to work less than 1,000 hours per year may be excluded from plan eligibility and nondiscrimination testing.
This last rule prohibits the blanket exclusion of part-time, temporary, and seasonal employees unless the plan language limits the exclusion to those with less than 1,000 hours of service. Further, under a new rule effective in 2024, long-term, part-time employees with at least 500 hours of service per year for three consecutive years of employment must be included in a 401(k) plan for purposes of making elective 401(k) contributions.
“Leased” employees. Employers often miss that an employee’s service as a so-called leased employee may count for eligibility and vesting purposes under the leasing employer’s retirement plan. For example, a temporary employee’s service with a business while employed by a temp agency must be counted under the employer’s plan if the temp is later hired by that business as a common-law employee.
Additionally, unless leased employees are expressly excluded from plan eligibility, those who perform substantially full-time services for the business while employed by the leasing organization may be eligible for the plan in the same way as common-law employees.
Self-employed persons. A self-employed person—such as a sole proprietor, partner, or LLC member who performs services for the sponsoring employer—may participate in the employer’s qualified retirement plan as long as the plan defines the person’s eligible compensation as net income from self-employment, including the partnership distributive share and any guaranteed payments.
For a partnership, the pitfall lies in not understanding the partners are considered “employees” for retirement plan purposes; therefore, each partner cannot establish their own plan. Rather, the partnership is the sponsoring employer.
Employers typically engage third-party service providers to administer the plan in compliance with applicable rules. But the employer retains ERISA responsibility for selecting them and is responsible for the costs of noncompliance with the tax code. A common pitfall is failing to educate employees involved with the plan on applicable administrative and fiduciary compliance requirements, or to provide an understanding of the services for which they are responsible, versus those contracted out to third-party providers. Fiduciary liability insurance should be considered.
Multiple third parties may provide plan services, such as a CPA firm, third-party administrator, recordkeeper, trustee or custodian, attorney, investment adviser, or payroll provider. The employer should review each service agreement for the specific services provided, minimum performance standards, reasonableness of fees, liability limits, data security, and other provisions.
Plan operational errors inevitably occur due to the complexity and volume of the rules and regulations pertaining to qualified retirement plans. Failing to apply the plan’s definition of eligible compensation is a common error. Employers should check that payroll provider pay codes accurately reflect the compensation elements required by the plan definition to allocate plan contributions, apply statutory limits, and perform nondiscrimination testing.
Another common plan error is the failure to timely remit to the plan amounts deducted from employee payroll for salary deferrals and plan loan repayments. Applicable rules require deposit on the earliest date such amounts may reasonably be segregated from employer assets—often a matter of a day or two—given the employer’s reasonable administrative processes, but in no event later than the 15th business day of the next month. Many employers mistake the “15th business day” rule as a safe harbor deadline, which isn’t the case. The only permissible safe harbor is seven business days for small plans, defined as those with fewer than 100 participants.
When errors do occur, the employer should consult with its service providers for guidance and assistance in taking appropriate corrective actions to avoid putting the plan in jeopardy of losing its tax qualified status.
Employers looking to adopt a qualified retirement plan have many decisions to make. Taking time to avoid pitfalls relating to their structure and workforce and to gain an understanding of where compliance responsibilities lie will be rewarded with smoother plan operation and avoidance of unnecessary costs.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Joni L. Andrioff is a senior director in RSM’s Washington National Tax Compensation and Benefits group. She specializes in the tax aspects of executive compensation, deferred compensation under section IRC Section 409A, qualified and non-qualified retirement plans, corporate transactions, and fringe benefits with respect to for-profit businesses, tax exempt organizations, and governmental entities.
Christy Fillingame is a senior director in RSM’s Washington National Tax Compensation and Benefits group. Shespecializes in tax and compliance issues for qualified retirement plans and consults on all aspects of a plan’s life-cycle, including design, implementation, contributions, distributions, corrections, reporting, and plan closure.
Lauren Sanchez is a supervisor in RSM’s Washington National Tax Compensation and Benefits group. She specializes in a variety of tax technical compensation issues arising in connection with qualified, nonqualified, and health and welfare benefit plans, and consults with for-profit, governmental, and not-for-profit entities on plan design, implementation, optimization, compliance, and reporting.
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