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Who's the Employer?

Answers are provided by S. Derrin Watson, JD, APM

Excluding "Leased" Employees

(Posted February 22, 2003)

Question 251: A company recently started utilizing a PEO. It had a 401(k) plan in place when the relationship with the PEO began. The plan excludes leased employees. Should it be amended to "not" exclude leased employees, due to the relationship with the PEO?

Answer: Let's go back to the fundamental question, "Who's the Employer?" With that answer, we can provide a framework that will let you answer your question. I will be referring throughout to my book, Who's the Employer?. (Subscribers can click to view online the text of those questions.)

The workers in your question fall into one of 3 possible categories:

They are common law employees, even though they are on the payroll of the PEO. (Q 4:12 et. seq.)
They truly are leased employees. In other words, they are not the company's common law employees and they meet all of the requirements of IRC 414(n) to be treated as leased employees. (Q 4:8)
They are Worksite Employees (Q 4:7) who are not the company's common law employees but have not completed the requirements to be treated as leased employees (perhaps because they have not satisfied the "substantially full-time" standard). (See Q 4:25.)

One of the key messages underpinning Rev. Proc. 2002-21 is that the first of these answers is likely correct. That means these workers are likely the company's common law employees, even though they are on the payroll of a PEO.

Why is the status of the worker important here? It matters for several reasons.

If the workers are the company's common law employees, a clause excluding "leased employees as defined in 414(n)" will not exclude them. Pacific Gas and Electric learned that lesson the hard way. (See Q 4:17.)
If the workers are either the company's common law employees or leased employees, then the company must count them in the denominator of its coverage testing fractions. Either way, they are treated as though they are the company's employees. You can exclude them, but you must take them into consideration in determining if your plan passes coverage. (Q 4:31.)
If the workers are Worksite Employees who are not leased employees, they are not entitled to be covered in the company's plan. In other words, clause or no clause, they are out. (Of course, if the plan were to cover them on the grounds that they are the company's common law employees, odds are good that the IRS would agree with that determination without a lot of fighting.)
If the workers are the company's common law employees and are not considered leased employees, the company is not entitled to offset their benefits by those provided in the PEO's plan, which the company does not cosponsor. (Q 4:75.)

Let's take it as a given for the moment that most, if not all, of these workers are either the company's common law employees or are leased employees. Can the company exclude them from its plan? Yes, if the plan is drafted carefully and it passes the tests of IRC sections 410(b) and 401(a)(26) after considering the exclusion. (Q 4:37.) The key is to exclude workers not on the company's payroll, not just workers on who are "leased employees" within the meaning of 414(n).

So, now we get to your question. Should you exclude these workers or not. As I've already suggested, you may not be able to exclude them, or at least not all of them, under 410(b). If the Code allows you to exclude them, should you? Obviously, you save money if you do exclude them. Just as obviously, the productivity and loyalty benefits that a qualified plan provide are unavailable to you if you do exclude them. At that point, the matter is a business decision.

Important notice:

Answers are provided as general guidance on the subjects covered in the question and are not provided as legal advice to the questioner or to readers. Any legal issues should be reviewed by your legal counsel to apply the law to the particular facts of this and similar situations.

The law in this area changes frequently. Answers are believed to be correct as of the posting dates shown. The completeness or accuracy of a particular answer may be affected by changes in the law (statutes, regulations, rulings, court decisions, etc.) that occur after the date on which a particular Q&A is posted.