Employee Categories & Benefit Plan Design

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Bass, Berry & Sims PLC

Benefit Plan Design Decisions

Who will be eligible to participate in the plan?When will each category of employees become eligible to participate in the plan? What plan benefits will be available to each category of employees?

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Topics

401(k) Plans► Age and service requirements► Other eligibility requirements► Nondiscrimination testing

Health and Welfare Plans► Eligibility► ACA’s “play or pay penalties”► Nondiscrimination testing

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401(k) Plans

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Age & Service RequirementsA plan may not, as a condition of eligibility to participate, require an employee to:► reach an age older than 21*► complete more than 1 year of service** measured using

either:- elapsed time method- hours count method (i.e., 1 year of service = 12-month eligibility

computation period in which at least 1,000 hours are credited)A plan may not impose an eligibility condition that is an age or service requirement “in disguise” and violates these standards

* An exception may be available for tax-exempt educational institutions** An exception may be available with respect to employer contributions that vest immediately

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Age & Service Requirements

A plan may have different age and service requirements for different categories of employees► Subject to IRC Section 410(b) coverage test

A plan may have different age and service requirements for different plan features

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Service Requirement “In Disguise”

Exclusion of part-time and seasonal employees (as defined based on customary work schedule) by classification is an impermissible service requirement ► A part-time or seasonal employee may work enough

hours to be credited with 1 year of servicePart-time and seasonal employees may be excluded on other bases IRS agents are instructed to closely scrutinize exclusions to look for service requirements “in disguise”

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Example: Service Requirement “In Disguise”

Plan X and Plan Y both have a 1 year of service eligibility requirementPlan X excludes part-time and seasonal employees, defined as an employee who is scheduled to work less than 1,000 hours in a year - impermissible service requirementPlan Y excludes part-time and seasonal employees, defined as an employee who works less than 1,000 hours of service in the 12-month eligibility computation period -permissible service requirement

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Other Eligibility RequirementsA plan may impose eligibility conditions unrelated to age and service► For example, based on job title, location,

exempt/non-exempt, department, division, union/non-union, internship/regular

► Subject to:- IRC Section 410(b) coverage test

- May require a “reasonable classification”- Employment discrimination laws

► Plan terms must be definite as to which employees are eligible

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Exclusion of Leased Employees

Certain rules apply with respect to “leased employees” as defined by IRC Section 414(n)An individual is a “leased employee” under IRC Section 414(n) if:► the individual has provided services for the

recipient on a substantially full-time basis for at least 1 year,

► the recipient has primary direction and control over the individual’s services, and

► the leasing organization, not the recipient, is the common law employer of the individual

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Exclusion of Leased Employees

Common error – employer intends to exclude all leased employees, but plan language only excludes IRC Section 414(n) leased employeesOther common errors related to leased employees:► Coverage test ► Form 5500 reporting

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401(k) Plan Nondiscrimination Testing

The 401(k) plan nondiscrimination tests are generally intended to prevent discrimination against non-highly compensated individualsWhen determining (or making changes to) a 401(k) plan design, thought should be given as to how the plan design will affect nondiscrimination testing

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401(k) Plan Nondiscrimination Testing

IRC Section 410(b) Coverage TestIRC Section 401(a)(4) General Nondiscrimination TestActual Deferral Percentage (ADP) TestActual Contribution Percentage (ACP) TestTop Heavy Test

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Notes on 401(k) Plan Nondiscrimination Testing

Special rules may apply to particular types of plans► For example, governmental plans are not subject

to the above-described nondiscrimination testingBrief description of rules only► For example, does not cover aggregation rules,

permitted disparity, current year versus prior year testing, cross testing, or safe harbor plan requirements

Focus on 401(k) plans

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IRC Section 414(q) HCE Definition

The coverage test, general nondiscrimination test, ADP test, and ACP test use the IRC Section 414(q) definition of HCEAn employee is an HCE for the plan year if the employee:► was a 5% owner at any time during the plan year or the

preceding year or► had compensation for the preceding year from the

employer in excess of $115,000 (indexed for inflation) and, if elected by the employer, was also in the group consisting of the top 20% of the employees when ranked on the basis of compensation paid during the preceding year

Attribution rules may apply when determining whether an employee is a 5% owner

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Coverage Test –Meet One of Three Tests

A plan must meet one of the following three tests:► Percentage Test – The plan benefits at least 70

percent of NHCEs► Ratio Percentage Test – The plan benefits a

percentage of NHCEs which is at least 70 percent of the percentage of HCEs benefitting under the plan

► Average Benefit Test –- Nondiscriminatory Classification – The plan benefits a

classification of employees that is a reasonable classification and does not discriminate in favor of HCEs and

- Average Benefit Percentage – The average benefit percentage of the NHCEs must be at least 70 of the average benefit percentage of the HCEs

- Only employer-provided contributions and benefits are taken into account in determining average benefit percentages

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Coverage Test – ExclusionsAll employees of the employer are taken into account, except that the following employees may be excluded:► Employees who do not meet the applicable age and/or

service eligibility conditions of the plan► Nonresident aliens who receive no U.S. source earned

income from the employer► Collectively bargained employees► Employees of qualified separate lines of business

(QSLOB)► Certain terminating employees ► Employees of certain governmental or tax-exempt entities► Certain former employees

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General ND Test –Three Subtests

All three of the following subtests must be satisfied:► Contributions or Benefits Test► Benefits, Rights and Features (BRFs) Test► Nondiscriminatory Plan Amendment

Requirement

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General ND Test –Contributions or Benefits TestContributions or benefits provided under a plan must be nondiscriminatory in amountPre-tax, Roth, after-tax and matching contributions are not subject to contributions or benefits test ► Instead, these contributions are subject to ADP and ACP testing, as

described belowNonelective contributions are subject to contributions or benefits test► Nonelective contributions generally include profit-sharing contributions

and other employer contributions that are not matching contributionsCertain formulas are considered “safe harbor” formulas► For example, a single uniform formula that allocates to each covered

employee: - the same percentage of plan year compensation, - the same dollar amount, or - the same dollar amount for each uniform unit of service

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General ND Test – Benefits, Rights and Features (BRFs) Test

The plan’s BRFs must be made currently and effectively available on a nondiscriminatory basis► A BRF is currently available if it is available to a

group of employees that satisfies either:- the IRC Section 410(b) 70% ratio percentage test or - the nondiscriminatory classification requirement of the

IRC Section 410(b) average benefit test► A BRF is effectively available if the group of

employees to whom it is available does not substantially favor HCEs, based on facts and circumstances

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General ND Test –Examples of BRFs

The right to make pre-tax, Roth or after-tax contributions is considered a BRFThe right to receive matching contributions is considered a BRFOther examples of BRFs:► retirement annuities► single sum payments► disability benefits► plan loans► the right to direct investments► investment options

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General ND Test –Nondiscriminatory Amendments

Requires that the effect of plan amendments be nondiscriminatoryFocuses on whether the timing of an amendment or series of amendments discriminates significantly in favor of HCEs or former HCEs“Amendment” includes the establishment or termination of a plan

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General ND Test –Nondiscriminatory Amendments

Example:► Plan A is a defined benefit plan that covered both

HCEs and NHCEs for most of its existence. The employer decides to wind up the business. In the processing of ceasing operations of the business, but at a time when Plan A covers only HCEs, the plan is amended to increase benefits and is thereafter terminated.

► The timing of this plan amendment has the effect of discriminating significantly in favor of HCEs.

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ADP and ACP Tests

ADP test requires that the deferral of income into the 401(k) plan by eligible HCEs be proportional to that for eligible NHCEsACP test requires that the employee and matching contributions provided for eligible HCEs be proportional to those for eligible NHCEsContributions generally counted:

ADP Test ACP Test

Pre-tax contributions and Roth contributions

Matching contributions and after-tax contributions

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ADP Test – Meet One of Two Requirements

ADP test is met if the plan meets one of the following requirements:► The ADP for eligible HCEs does not exceed

125% of the ADP for eligible NHCEs or► The ADP for eligible HCEs:

- does not exceed 200% of the ADP for eligible NHCEs and

- does not exceed the ADP for eligible NHCEs plus 2%

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ADP Test – Example

ADP for HCEs = 5%; ADP for NHCEs = 3%► Plan does not meet 125% test, since 5% is

more than 3.75% (3% x 1.25)► Plan does meet 200%/2% test, since 5% is

less than 6% (3% x 2.00) and 5% is not more than 5% (3% + 2%)

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ACP Test – Meet One of Two Requirements

ACP test is met if the plan meets one of the following requirements:► The ACP for eligible HCEs does not exceed

125% of the ACP for eligible NHCEs or► The ACP for eligible HCEs:

- does not exceed 200% of the ACP for eligible NHCEs and

- does not exceed the ACP for eligible NHCEs plus 2%

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Top-Heavy TestDesigned to ensure that lower paid employees receive at least a minimum benefit when a disproportionate amount of the plan’s assets are held for the benefit of highly compensated individuals known as “key employees”In general, a plan is top heavy if, as of the last day of the preceding plan year, 60% of the aggregate accrued benefits or account balances under the plan are for the benefit of key employees

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Top-Heavy Test –Key Employee Definition

Generally, a key employee is an employee who, at any time during the plan year, is► an officer of the employer having an annual

compensation greater than $170,000,► a 5% owner of the employer, or► a 1% owner of the employer having an annual

compensation from the employer of more than $150,000

For purposes of the above definition of key employee, no more than 50 employees (or, if less, the greater of 3 or 10% of employees) will be treated as officers

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Health & Welfare Plans

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Health & Welfare Plan Eligibility

A plan may impose any eligibility conditions► For example, based on job title, location, exempt/non-

exempt, department, division, union/non-union, internship/regular

► Subject to: - IRC Sections 125, 105(h), 129, and 79 testing with respect to

discrimination in favor of highly compensated employees- Employment discrimination laws- For “large employers,” Affordable Care Act’s employer shared

responsibility provisions (“play or pay penalties”)► Plan terms must be definite as to which employees

are eligible

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Employers Subject to ACA’s Play or Pay Provisions

“Applicable large employers” are subject to play or payAn applicable large employer for a calendar year is an employer that had an average of at least 50 full-time employees (taking into account full-time equivalents) on business days during the preceding calendar year► Special rule for new employers► Seasonal worker exception► Transition relief for 2015 applicable large employer determination

Applies to all common law employers including government entities, tax-exempt entities and churchesEntities treated as a single employer under the qualified retirement plan rules are treated as a single employer for determining whether related entities constitute an applicable large employer

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Basic Structure of ACA’s Play or Pay Penalties

Beginning 1/1/2015, a play or pay penalty may apply if at least one full-time employee receives subsidized exchange coverage:

No Minimum Essential Coverage Offered (“No MEC”)

Insufficient Minimum Essential Coverage Offered (“Insufficient MEC”)

Employer fails to offer to substantially all of its full‐time employees (and their dependents) the opportunity to enroll in minimum essential coverage

Employer’s offer of minimum essential coverage to full‐time employees (and their dependents) is unaffordable or does not provide minimum value

Penalty (for a month) equals the number of full‐time employees (reduced by 30) multiplied by 1/12th of $2,000 (indexed)

Penalty (for a month) equals the number of full‐time employees who receive subsidized exchange coverage multiplied by 1/12th of $3,000 (indexed); or, if less, the penalty that would have been imposed for No MEC

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Substantially All Full-Time Employees

Offer must be to substantially all full-time employees:► Must offer to cover all but 5%* of full-time

employees to avoid No MEC penalty► If any of the 5%* employees receives subsidized

exchange coverage, the Insufficient MEC penalty applies

* 2015 transition rule – 30% instead of 5%

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What Employees to Consider: Common Law Employees

“Employee” for purposes of the play or pay mandate means common law employee

► An individual performing services for you is your common law employee if you have the right to control and direct not only the result to be accomplished, but also the details and means by which the result is accomplished

► Individuals that you may not consider to be “employees,” such as temporary workers, contractors, and consultants, may be considered your common law employees

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How is Full-Time Status Determined?

An employee is considered a full-time employee if he/she worked an average of at least 30 hours of service per week (or 130 hours of service per month)

Hours of services that must be included:► Each hour for which an employee is paid, or entitled to

payment, for the performance of duties for any member of the controlled group or affiliated service group

► Each hour for which an employee is paid, or entitled to payment on account of a period of time which no duties are performed due to vacation, holiday, illness, incapacity (including disability), layoff, jury duty, military duty, or leave of absence

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Counting Hours

For hourly employees, actual hours must be countedFor non-hourly (i.e., salaried) employees, employers may count actual hours or use the following equivalency methods:► Days-worked equivalency – employee is credited

with 8 hours of service for each day with an hour of service

► Weeks-worked equivalency – employee is credited with 40 hours of service for each week with an hour of service

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When Should Full-Time Status be Determined?

ACA requires an employer to determine whether each employee is a full-time employee on a month-by-month basis in real time – this creates administrative challenges, especially with respect to variable hour employeesThe IRS provided a “look-back safe harbor method” under which an employee’s full-time or part-time status can be locked-in for a period of time

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Look-Back Safe Harbor: Ongoing Employees

Standard Measurement Period - employer determines each ongoing employee’s full-time status by tracking the employee’s hours during a standard measurement period of between 3 and 12 monthsAdministrative Period - optional period of no more than 90 days between measurement and stability periods to count hours and hold open enrollmentStability Period - ongoing employees retain their status as full-time or part-time employees based on hours in standard measurement period

- Employees determined to be full-time – the stability period must be the greater of at least 6 consecutive months or the length of the standard measurement period*

- Employees determined to be part-time – the stability period must be no longer than the standard measurement period

* Special 2015 transition rule – 6 month measurement period may be used with longer stability period

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Look-Back Safe Harbor: New Full-Time Employees

“New full-time employees” means new hires who are reasonably expected on their start date to be employed on average 30 hours or more per week (and who are not seasonal employees)An employer that offers coverage to a new full-time employee at or before the conclusion of the employee’s initial 3 full calendar months of employment will not be subject to a penalty

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Look-Back Safe Harbor:New Variable Hour and Seasonal Employees

“Variable hour employee” means an employee who the employer cannot determine, at the start date, is reasonably expected to work at least 30 hours per week during the initial measurement period because the employee’s hours are expected to vary or are otherwise uncertain

► The employer cannot take into account the fact that the employee is likely to terminate before the end of the initial measurement period in connection with the analysis (except for seasonal employees)

“Seasonal employee” means an employee in a position for which the customary annual employment is 6 months or less► “Customary” means that by the nature of the position the employee typically

works for a period of 6 months or less, and that period begins each calendar year in approximately the same part of the year

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Look-Back Safe Harbor:New Variable Hour and Seasonal Employees

Initial Measurement Period - employer determines each variable hour and seasonal employee’s full-time status by tracking the employee’s hours during an initial measurement period of between 3 and 12 months► Begins on the employee’s start date or any date up to and including

the first day of the first calendar month following the employee’s start date

Administrative Period - optional period of no more than 90 days between measurement and stability periods to count hours and hold open enrollment► Initial measurement period and administrative period together cannot

extend beyond the last day of the first calendar month beginning on or after the first anniversary of the employee’s start date

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Stability Period – new variable hour and seasonal employees retain their status as full-time or part-time employees based on hours in initial measurement period

► Must be the same length as the stability period for ongoing employees

► If a new variable hour employee or seasonal employee is determined to be full-time during the employee’s initial measurement period, then the stability period must be a period of at least 6 months and no shorter than the initial measurement period

► If the new variable hour employee or seasonal employee is determined to be part-time during the initial measurement period, then the stability period must not exceed more than one month longer than the initial measurement period and may not exceed the remainder of the standard measurement period (plus associated administrative period) in which the initial measurement period ends

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Look-Back Safe Harbor:New Variable Hour and Seasonal Employees

Look-Back Safe Harbor PeriodsMeasurement periods, administrative periods, and stability periods may differ in length or in their starting and ending dates for the following categories of employees:

► Collectively-bargained employees and noncollectively-bargained employees

► Each group of collectively-bargained employees covered by a separate collective bargaining agreement

► Salaried employees and hourly employees

► Employees whose primary places of employment are in different states

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H&W Nondiscrimination Testing

Like the 401(k) plan nondiscrimination tests, H&W nondiscrimination tests are intended to prevent discrimination against non-highly compensated individualsWhen determining (or making changes to) H&W plan design, thought should be given as to how the plan design will affect nondiscrimination testingUnlike the 401(k) plan nondiscrimination tests, no special exclusions for governmental or church plansThe standards for determining who is “highly compensated” vary based on which test is being applied

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Rules Governing H&W Nondiscrimination TestingIRC Section 125► Applies to cafeteria plans

IRC Section 105(h)► Applies to “self-insured medical

reimbursement plans,” including:- Self-insured medical, dental and vision plans- Health reimbursement arrangements - Health care flexible spending accounts

► Traditionally, has not applied to fully-insured plans

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Rules Governing H&W Nondiscrimination TestingIRC Section 129► Applies to dependent care benefits, including

dependent care flexible spending accountsIRC Section 79► Applies to group term life insurance

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ACA Rules Regarding Fully-Insured Plans

Traditionally, fully-insured plans were not subject to nondiscrimination testing, other than indirectly when such benefits were provided pursuant to a cafeteria plan The ACA provides that fully-insured “group health plans” must satisfy rules similar to those described in IRC Section 105(h) Enforcement postponed until after regulations or other administrative guidance has been issued

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Current State of H&W Nondiscrimination TestingH&W nondiscrimination testing is generally considered difficult to administer:► Regulations under IRC Section 125 proposed in

2007, but never finalized► Cross referencing of tests designed for other

purposes► General ambiguity as to how tests should be

appliedPractitioners expect that the ACA regulations for fully-insured plans will clarify the existing H&W nondiscrimination rules

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General Focus of H&W Nondiscrimination TestingTests generally focus on:► Which employees are eligible to participate in the

plan► What conditions employees must meet in order to

participate in the plan► What type of benefits are made available to

employees under the plan► Which employees actually receive benefits under

the plan ► What amount of benefits employees receive

under the plan

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Plan Designs Warranting Additional Caution

Separate cafeteria plans for different groups of employeesDisparate eligibility requirements for different groups of employeesDisparate waiting periods or entry dates for different groups of employeesDisparate contributions or rates for different groups of employeesExclusion of part-time, seasonal or temporary employeesExclusion of employees based on division or company within the controlled groupBenefits based on years of service or compensation

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