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Rev. Proc. 2002-21 Transition Rule Revisited; Other Compliance Problems
(Posted April 27, 2002)
Question 165: Now that you've had 48 hours to think about it, would you care to revise your comments on the transition rule in Rev. Proc. 2002-21?
Answer: Absolutely, yes. So much so that I've removed my former Q&A on the subject. Let's try again.
Rev. Proc. 2002-21 offers specific procedures which, if followed, will enable a PEO to go forward without the stigma of having violated the exclusive benefit rule by covering people who were not its employees. Those procedures must be completed by "the Compliance Date," the last day of the plan year beginning in 2003. However, the relief offered by the Rev. Proc. is limited to exclusive benefit rule issues, except with regard to terminating plans who follow the procedures the IRS has outlined.
That caveat also applies to the transition rule in the Rev. Proc., which states:
A careful reader pointed out that I had misread this provision. (In my defense, I note that I'm on the road attending my son's graduation from college and only getting about 3 hours of sleep a night. Not much of an excuse, but it will have to do. My apologies for misreading it earlier.)
For purposes of determining whether a retirement plan maintained by a PEO for the benefit of Worksite Employees of COs satisfies the requirements of § 401(a)(2) prior to the Compliance Date, a PEO may treat Worksite Employees as its employees.
Instead of referring to all of 401(a), the transition rule is limited to 401(a)(2), the exclusive benefit rule. To best understand what that means, consider the following extended example:
Remember, Rev. Proc. 2002-21 reaffirms what courts have said, that the traditional rules used to differentiate employees from independent contractors also are used to determine "which of two entities is the employer for purposes of retirement plans." I discuss those rules in Chapter 2 of Who's the Employer.
Fred owns 100% of Astaire Permatemps, a PEO. Fred has long believed that his company is the "co-employer" of the 1,000 workers (Worksite Employees) on its payroll which Fred "leases" to other companies. In addition, there are 50 "back office" employees at Astaire who run the shop, cut the paychecks, interface with the clients, etc. The only highly compensated employee is Fred.
For several years, Fred has maintained a single employer safe harbor 401(k) plan (providing a 3% nonelective contribution). The plan covers Fred and the Worksite Employees. Other back office employees are not eligible. The most recent 5500 Schedule T shows 1 out of 1 HCE benefiting under the plan, and 1,000 out of 1,049 NHCEs benefiting, and easily passes the ratio percentage test.
Fred is concerned about Rev. Proc. 2002-21 and seeks legal advice on what it means for him. Fred's lawyer advises him to comply with its procedures and establish a multiple employer plan, reasoning that if Astaire Permatemps is not the employer of its Worksite Employees, then by following the procedures Astaire Permatemps can go forward in a safe manner without the problems of disqualification for failure to satisfy the exclusive benefit rule. Moreover, if Astaire Permatemps does not comply, perhaps under the belief that it really is the common law employer of the workers, then Astaire will not be able to rely on any determination letters for its single employer plan after 2004.
But Fred's counsel isn't solely concerned about the future. He asks the question: what if Astaire Permatemps has never been the common law employer of its stable of Worksite Employees? Because it will comply with the Rev. Proc., it will not need to worry about the exclusive benefit rule, but what about other rules?
Consider, for example, the coverage requirements of IRC 410(b). If the Worksite Employees are not common law employees of Astaire Permatemps, then they cannot be counted in determining whether the plan covers enough NHCEs. In fact, in that case, the plan will have covered 0 out of 49 NHCEs and 1 out of 1 HCE. This is as clear a coverage failure as you could ask for. And Rev. Proc. 2002-21 provides absolutely no relief for that failure.
Fred's lawyer carefully reviews the situation and determines that the Worksite Employees are not Astaire Permatemps employees under general common law principles. Accordingly, in addition to telling Fred to comply with Rev. Proc. 2002-21, the attorney urges Fred to use EPCRS to correct the prior coverage failure.
The IRS never has been enamored of the co-employer concept as applied to PEOs. No case has found that such a dual employer relationship exists with a PEO. I discuss this at great length in Chapter 4 of my book, citing all the cases, rulings, and history of this issue. And there is very little in that history to give a staffing firm comfort that it would be able to convince the IRS or a judge that it is the common law employer of workers with whom it has no relationship other than writing out a paycheck and filling out forms.
The great rule of employee/independent contractor relationships is that calling someone an independent contractor doesn't make them one. A corollary to that rule is that calling yourself a co-employer doesn't make you one. Rev. Proc. 2002-21, for all its generosity in allowing PEOs an opportunity to resolve the exclusive benefit rule issue and providing a road map for future compliance, does nothing-- absolutely nothing-- for continuing plans dealing with other qualification issues, as described here.
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