How Leased Employees Affect Your Retirement Plan

Many employers are quite surprised when told how leased employees can affect their retirement plan. Knowing and understanding how leased employees can potentially affect your retirement plan can help you create a strategy on how and when to utilize leased employees and not have the leased employees adversely affect your retirement plan. 

Internal Revenue Code section 414(n) defines a "leased employee" as any person who is not an employee of a company (known as the “recipient”) and who provides services to the recipient if  (A) such services are provided pursuant to an agreement between the recipient and a leasing organization, (B) such person has performed such services for the recipient on a substantially full-time basis for a period of at least one year, (C) such services are performed under primary direction or control by the recipient, and (D) the leasing organization, not the recipient, must be the common law employer of the individual.

In order for a leased employee to be eligible for your retirement plan, such leased employee must perform services for the company for at least a one year period on a substantially full-time basis.  A substantially full-time basis is considered 1,500 hours during a 12-month period or 75 percent of the hours normally worked in such a position, if less. Once the one year qualifying period is satisfied, all service provided by such leased employee, including service earned during the one year qualifying period, is counted for plan eligibility purposes. 

For example, suppose that Employer ABC maintains the ABC 401(k) Profit Sharing Plan which has  eligibility requirements of attainment of age 21 and 1,000 hours of service during a 12-month period. Once the eligibility requirements are met employees enter the plan on the calendar quarters, January 1, April 1, July 1 and October 1.

Suppose that ABC is owned by employee owners M and S and that M and S are the only employees of the company.  M and S lease three individuals from DEF Leasing Co. These three employees work 2,080 hours per year for ABC and are hired on 02/01/07.

After one year of service on 02/01/08, all three employees are eligible for the ABC 401(k) Profit Sharing Plan and would enter the plan on the next entry date of 04/01/08.  These employees are included in the plan for all testing purposes.

Thus this employer would fail coverage testing since 70% of the non-highly compensated employees (NHCE) are not benefitting. This employer would not be able to allocate profit sharing contributions unless the three leased employees were provided benefits under their plan. Failure to include the leased employees in the plan would be deemed a operational defect and could potentially disqualify the plan.

Once a leased employee meets the plan eligibility, such leased employee should be provided an enrollment and beneficiary form and summary plan description. The employer should obtain all pertinent data on the leased employee such as name, address and date of birth. The employer should already have the leased employees date of hire and hours worked since employment began.  

A company can exclude leased employees if: (i) the leasing organization provides its employees with  a money purchase pension plan with a nonintegrated employer contribution rate for each participant of at least 10 percent of compensation, (ii) such plan provides for full and immediate vesting, (iii) each employee of the leasing organization (other than employees who perform substantially all of their services for the leasing organization) immediately participates in such plan, and (iv) leased employees do not constitute more than 20% of the recipient’s non-highly compensated workforce.

Most leasing organization do not provide a pension plan meeting these requirements. 

Over the years we have heard many examples of leased employees that don’t appear to be typical employer - leasing organization relationships, but in our opinion would be deemed as such by the IRS.  Below are a couple of these examples. 

Example 1: Employer A leases office space from Company B. In addition to office space, Company B also provides Employer A with four employees who work full-time and are paid by Company B. Believing that it has no employees, Employer A sets up a plan and does not provide benefits to the leased employees.  Employer A should include these leased employees in the plan and annual testing.  If the plan fails annual testing, the plan may not be qualified.

Example 2: Three professionals share office space and each set up separate corporations, corporation R, S and T. In addition they set up a corporation Z with each owning 33%, that leases office space and has four employees as administrative staff. Corporations R, S and T each set up separate plans believing they have no employees. Corporation R, S and T each should include these leased employees in their plans and annual testing.  If the plan fails annual testing, the plan may not be qualified.

Employers that do not want to have problems with leased employees can:

1. Only lease employees from a leasing organization that has a 10% Money Purchase plan.

2. Utilize the services of each leased employee for less than a 12 month period.

3. Have a firm policy to hire leased employees that work longer than 12 months.

We bring all of this to your attention because careful plan drafting can be used to exclude your leased employees from participation in your retirement plan.

If you have leased contract employees and it's your intent to exclude them from participation in your retirement plan, you may want to take a look at the plan documents and see if the plan documents exclude leased employees at all and, if they do, whether the exclusion should perhaps be stated in a way that is not directly dependent on the distinction between leased employees and. common law employee. If the plan documents does not give you the comfort or support you need to exclude your leased employees, you may want to consider amending your plan. Note, however, that any excluded leased employees will have to be counted when you prepare your coverage and nondiscrimination testing.

Employers that must use leased employees for various business reasons should now have a clear understanding of the impact leased employees will have on their retirement plan and can plan and budget accordingly.

Contact Administrative Retirement Services, Inc. if you have questions about leased employees.

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