Employers traditionally have used temporary employees when not seeking to hire permanent full-time employees. In most situations, employers will work through a temporary employment agency to avoid placing an individual on payroll.
The use of temp employees is usually driven by a corporate culture that does not wish to increase head count, even when additional resources are necessary to satisfy internal and/or client obligations.
Properly used, temporary employees can result in flexibility to employ individuals for short-term projects. However, employers frequently do not anticipate the true length of projects. Similarly, it is common to test an employee's skills through a temp agency and to hire them if they are determined to be a good worker.
There is nothing wrong with hiring a temp into a full-time position. However, employers must carefully consider the impact upon their employee benefit programs.
Using temporary employees through temp agencies must also be evaluated in terms of the leased employee rules. Leased employees are individuals who work for an employer under a separate agreement with a temp agency. Leased employees also include individuals working as independent contractors.
Leased employees
An individual is generally deemed to be a leased employee if they perform 1,500 hours of work in a 12-month period of time. Practitioners generally follow this rule, even though the IRS has withdrawn proposed regulations outlining the leased employee rules. Leased employees must be identified on Form 5500 and taken into consideration for qualified retirement plan testing purposes.
Assume that a small business with 20 employees has 10 individuals working through temp agencies and/or as independent contractors. In this situation, one-third of the employer's workforce is leased employees, and the 70% minimum coverage threshold under Section 410 of the tax code may not be satisfied. Alternative means will exist to satisfy the coverage rule, such as the ratio percentage or average benefits test. Nevertheless, an employer must be aware of the obligation to monitor such issues.
New hires
Assume that an employer hires a temporary employee after they have worked for a period of two years and have been designated as a leased employee. Many employers treat the individual as a new hire for human resource purposes. Unfortunately, all time worked as a leased employee must be taken into consideration for purposes of eligibility and vesting under a qualified retirement plan.
So, the individual who has worked for two years will be immediately eligible to enter an employer's 401(k) plan, pension plan or other qualified retirement plan on the next entry date, without the need to work another 1,000 hours of service or to satisfy any other eligibility requirements. If an employer requires an individual to satisfy a new eligibility requirement, then an employer may be required to make retroactive contributions or benefits for the individual.
Retirement plans
Under the Voluntary Compliance Program, as outlined in Revenue Procedure 2008-50 under the Employee Plan Compliance Resolution System Program, an employer will be required to make a salary deferral contribution for the individual equal to 50% of the actual deferral percentage for all nonhighly compensated employees during the period that an individual was improperly excluded from the 401(k) plan.
The employer will also be responsible for making 100% of any matching contributions, based upon the full ADP for nonhighly compensated employees, making up any profit sharing or other employer contributions, as well as making an individual "whole" for lost earnings.
Having to make up contributions for several employees, plus earnings, could result in substantial liability for an employer with a consistent pattern of improperly excluding employees from defined contributions plans. The employer will similarly encounter increased funding obligations when employees are improperly excluded from defined benefit plans.
If an employer hires a temporary employee after only six months of service, the individual has not yet satisfied the rules to be a leased employee. Nevertheless, the individual should also be given past service credits for purposes of eligibility.
Employers who have used temporary employees in the past, or who are currently using them to supplement their workforce, should give consideration to the above issues before an IRS audit occurs for their qualified retirement plans.
The correction methods under VCP are easy to use, and the IRS is excellent to work with on correcting inadvertent administrative errors. Less flexibility exists when errors must be corrected during an audit.
Frank Palmieri can be reached at fpalmieri@p-ebenefitslaw.com. Any advice in this summary concerning a federal tax issue is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding any tax penalties that can be imposed by the Internal Revenue Service, or for promoting, marketing or recommending any tax-related matters addressed herein in accordance with IRS Circular 230.
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