What employee classification means for your 401(k) testing

An individual’s employee classification defines their working relationship with your business and determines their eligibility to participate in your 401(k) plan. These classifications also affect your top-heavy, coverage, and other nondiscrimination tests. Knowing which employee types apply to your business is essential for managing your plan and helping avoid costly compliance issues.

Factors that help determine employee type

Before we delve into the specific classifications, let’s look at some of the factors that can put an employee in one category or another.

  • Employment arrangement: Was the employee hired directly by your business or through a staffing or leasing agency?
  • Control: Do you control how and where the employee performs their job? Can they accept work from other companies?
  • Tax reporting: Do you report the employee’s earnings on IRS Form W2 or a 1099?
  • Business ownership/structure: Is your company related to other businesses or service groups?   

Your answers to these questions and others will help you identify who’s considered an employee for plan purposes.

Common law employees

Most likely, common law employees make up the majority, if not all, of your workforce. These are individuals who were hired directly by your business. You control their job responsibilities and report their annual compensation on IRS Form W2.

Impact on 401(k) administration: In general, common law employees are eligible to participate in your plan and must be included in top-heavy, coverage, actual deferral percentage (ADP), and actual contribution percentage (ACP) tests, subject to IRS rules and the eligibility requirements stated in your plan document. 

Independent contractors

Depending on your business needs, you might hire contract workers, rather than full-time employees. On the surface, it seems obvious that these individuals aren’t your employees, but it’s really not that cut and dry. The IRS has a 20-factor test to help business owners make this determination. In general, an independent contractor:

  • Receives 1099 income
  • Uses their own supplies or equipment to perform the requested services
  • Provides similar services for more than one company at a time
  • Makes their services available to the general public
  • Can set their own hours and location
  • Realizes a profit or a loss 

A worker doesn’t have to meet all 20 criteria to qualify as an employee or independent contractor, and no single factor is decisive in determining a worker’s status.

Impact on 401(k) administration: Contract workers who don’t satisfy the 20-factor test may be considered common law employees of your business. As such, they may be able to participate in your plan and must be included in compliance testing. Plan sponsors who use contract workers should work closely with their ERISA legal counsel and consultant to make sure these individuals are classified correctly.

Leased employees

Leased employees are often confused with temporary workers and independent contractors because an agency is involved with the employment relationship. But there’s a distinct difference. A person is considered a leased employee if they meet the following requirements:

  • Your business pays an agency a fee for the individual’s services.
  • The individual has performed services for your company for at least one year on a substantially full-time basis (1,500 hours in a 12-month period).
  • You have primary control over the services rendered by the individual.

Impact on 401(k) administration: For plan purposes, leased employees are generally treated like common law employees. They’re eligible to participate in your plan and included in the various nondiscrimination tests, subject to IRS rules (e.g., safe harbor exclusion for leased employees) and the eligibility requirements stated in your plan document. As such, you should put procedures in place to track their hours to ensure they receive enrollment materials once they’ve satisfied the service requirement. While you can exclude leased employees from participating in your 401(k), doing so could affect your coverage test results, as they can’t be excluded from this test.   

Controlled groups

The controlled group designation is tied directly to your company’s relationship with other businesses, specifically situations where there’s common ownership. There are two types of controlled groups, although it’s possible to have a combination of both:

  • Parent/subsidiary: A controlled group exists when the parent company owns at least 80% of the subsidiary.
  • Brother/sister: This type of controlled group is more complex. In this case, five or fewer people own at least 80% of the stock value or voting power of one company, and these same individuals have at least 50% effective control in another company when looking at each person’s identical interest.

Impact on 401(k) administration: All businesses in a controlled group are treated as a single employer for plan purposes, even if each entity maintains its own 401(k). This means you have to take the employees of all the companies into account when performing the top-heavy, coverage, ADP, and ACP tests for your plan. They must also be included when determining eligibility and highly compensated employees (HCEs, defined below). Given the complexity of this employee classification, plan sponsors should work closely with their ERISA legal counsel and consultant to make sure plan administration is handled properly.     

Affiliated service groups

Similar to controlled groups, affiliated service groups involve several entities that are considered under common control because of the services they provide. A law firm is a good example of this classification. While the attorneys may each be individually incorporated, they collectively practice as one firm.

Impact on 401(k) administration: All businesses in an affiliated service group are treated as a single employer for plan purposes, which has the same implications as those described for controlled groups.

Key employees and HCEs

Once you identify who’s an employee for plan purposes, you next need to determine which of these individuals are key employees and which ones are HCEs.

  • Key employee: An individual who owns more than 5% of the company, owns more than 1% and earns more than $150,000 per year, or is an officer of the company and earns at least $185,000 (2021 limit, indexed for inflation).      
  • HCE: An individual who owns more than 5% of the company at any point during the current or previous plan year or earned more than $130,000 in the preceding year (2021 limit, indexed for inflation).

Impact on 401(k) administration: The top-heavy, coverage, ADP, and ACP nondiscrimination tests are designed to ensure that your 401(k) plan doesn’t favor key employees and HCEs over non-key and non-highly compensated employees (NHCEs). If employees aren’t properly identified, you won’t get accurate test results, which can create compliance issues for your plan.

Review and confirm your employee classifications

The employee-employer relationship has many nuances that can affect how you design and manage your 401(k) plan. And many plan sponsors don’t have the expertise to successfully navigate these nuances on their own. Now may be a good time to connect with your financial professional, ERISA consultant, and legal counsel to confirm your processes and procedures for determining who’s an employee.      

The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.

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