PEO and Multiple Employer Plans

PEO and Multiple Employer Plans by: Alan Moore, CFO Slavic Investment Group Retirement Plans A retirement plan is a written document defining benefits provided by the employer on a nondiscriminating basis for the exclusive benefit of the employees (Treas.1.401-1 (a)(2)). It must specify how employees become eligible for benefits, how contributions are made to the trust and under what conditions participants may receive their money. The operation of the plan must conform to a host of regulations from the Treasury Department, Internal Revenue Service (IRS) and ERISA. The Department of Labor is also involved in reviewing the Form 5500 information returns and policing the operation of the plan, along with the IRS. A determination letter may be applied for at the IRS certifying that the plan is drafted in a compliant way, although it is not a requirement to have D letter. The IRS opinion that is ultimately received will not address how the plans are actually operated. That responsibility falls on the Sponsor, Trustees and the third-party administrator. The interactions of the regulations are especially complex when applied to the multiple-employer plan because each client company must be tested as if it were standing alone. Super-imposed on the normal employer/employee relationship is the PEO which takes the position of co-employer, although for plan purposes the PEO client company is the common law employer under Revenue Procedures 2001-21 and 2003-86. If a PEO client company has several plans, they must be aggregated for testing as required in IRC Section 414(b), c, m, n, or o. A control group is defined as common ownership of a group of companies whereby the same owners own 80% of each company in the group. In this case, all employees working for the group of companies must be tested as one plan whether or not several of the companies are PEO clients and adopt the multiple employer plan. If the client does not have a plan or has never had one, setting up the plan becomes a matter of going through the steps of information gathering, adoption and enrollment. The company survey and last year s census can be used to identify possible control groups, HCEs(those making over 105k and Key Employees, 5% owners). The adoption agreement includes several options whereby the eligibility can be modified or waived entirely as of a specified date. If eligibility is waived, be sure to waive both the

service and age requirement and make sure the client understands that part-time employees employed on the waiver date will be in the plan. NOTE: The waiver could ruin the ability of the HCEs to defer in a meaningful way due to the ADP test. Also, the adoption document allows a limit as to who receives a profit sharing contribution, if one is declared. By selecting the last-day rule, employees not employed on the last day of the year don t receive the contribution. If the last-day rule is not selected, those employees eligible for the plan before their termination must receive the profit sharing. Lastly, do not overlook the importance of the effective date. Try and use an effective date that corresponds to the date deferrals will actually begin. This will enable the deferrals to be matched accurately with the covered compensation and the tests that we perform will be more accurate. The enrollment should include (not counting a waiver) all employees age 21 who have worked for one year (at least 1, 000 hours). They may defer up to 85% of their W-2 pay, or $16,000 (in 2008), if they are not a HCE or Key limited by the ADP test. The $16,000 (IRC 402(g)) maximum amount is limited by the Average Deferral Percentage (ADP) test. The Average Contribution Percentage (ACP) test is also performed and is the same as the ADP test, but performed on the matching contribution. The PEO actually calculates the match with their system per pay period; Slavic simply tests the match per ACP. The ADP/ACP tests require: 1) the Key and Highly-Compensated employees (HCEs) must be identified; 2) the deferral rates of the Non-Highly-Compensated employees (NHCEs) are averaged together with the eligible non-deferring employees being averaged in as zeros. The HCEs and Keys are only allowed to defer, on average, 2% more than the NHCE average rate. The exception to the rule is if the NHCE rate is less than 2%, then the rate must be multiplied by two (Sec. 401(a)). About 60% of clients choose to match contributions when the advantages are explained. A good match will entice the NHCEs to defer more, thereby increasing the allowed rate for the owners and HCEs. The tax savings on the increased HCE contributions and the fact that the match is subject to a vesting schedule reduces the real out-of-pocket cost of a match. Because the ER funds are not fully vested for six years, a portion of the match will be forfeited back to the client when employees, who are not fully vested, terminate. These forfeited funds are then placed into a forfeiture account and used in the first quarter of the following year as a credit against the match at that time. The procedure is for the trustee to send a letter with one of the PEO transmittals reading, take a credit in the amount of $xxx for client s forfeiture account, thereby reducing the amount of the check that normally adds up to the contribution amount in the electronic file. Slavic does not automatically forfeit the accounts of terminated participants. The trustee or participant may initiate that action.

This brings up several questions to being in a multiple employer plan. First, to be considered terminated, the employee must leave the PEO and the client company and must not work for another client company of the PEO. Otherwise, the employee may not receive a distribution or IRA rollover and no forfeiture of ER money may occur. If the participant begins to work for another client company, his EE and ER balances go with him and he continues to accrue service years and vesting and he is immediately eligible for the new employer s plan. The original employer may not receive any forfeiture until the employee has terminated from the PEO client company. By this time, the employee may be 100% vested. If the client company leaves the PEO, participants may not receive a distribution or an IRA rollover option while they are still employed at the worksite and they would become automatically 100% vested (Sec. 401(k)(2)(b), 408k), unless a successor plan is setup within 90 days. To receive the assets out of the plan, the employer must establish another qualified 401(k) plan with the client as the trustee. That plan may be terminated and distributions made if the client does not set-up or adopt a successor pension plan for one year (Treas. Reg. 1.401(k)-(1)(d)(3)). The client should consult their attorney if any plan is to be terminated. Profit sharing is also included as another way of contributing to the plan and is also subject to vesting. A profit sharing contribution is discretionary and employer funded using a formula such as 6% of W-2 pay. As with the match, this ER source is not subject to FICA tax as the EE deferral is. It is different from the match in that it must be contributed to all eligible employees whether or not they defer to the plan. A 3% profit sharing contribution to non-key employees is required if the plan is top-heavy. The Board of Directors should declare the profit sharing at year-end and employer has until the filing date of the 1120 tax return to fund it. In this instance, the client would send a check directly to the plan trust account at Depository Services (DSI) with an accounting. The accounting is necessary because profit sharing is not typically funded through the PEO payroll. As mentioned before, the adoption agreement includes the option of the last-day rule for eligibility to receive profit sharing. This means only the employees employed as of 12/31 will receive the contribution. Most employers desire this selection once it has been explained to them; however this option is not available for Safe Harbor Plans. As you can see, the multiple employer plan allows wide latitude for contributions to be made to the trust. The trust is the legal entity that holds the funds on behalf of the participants. Only the trustees may authorize distributions from the trust. The trustees have hired Slavic Integrated Administration (SIA) to act as the third-party administrator (TPA) in charge of processing and accounting for

contributions, distributions and tax filings. Slavic Mutual Fund Management Corporation (SMF), an affiliate of SIA, has been appointed as the Advisor to the plan, providing investment advice to the participants and monitoring the fund platform. Slavic Investment Corporation (SIC) is the broker/dealer making the actual transactions at the fund company level. Thus, the plan has a one-source provider for the full range of services needed to run a successful 401(k) plan. It is the TPA s job to perform the ADP and ACP tests along with a number of other testes important to the plan. One of those tests is the top-heavy test. After the first year, a plan is deemed to be top-heavy in the year following the current year s 12/31 valuation if the Key employees (Treas. Reg. 1.416) own 60% or more of the assets in the trust at the client level. A Key employee is an employee who owns more than 5% of the business, their spouses and lineal relatives, a shareholder owning 1% of company stock and earning over $150,000 per year and corporate officers who earn over $140,000 per year. Even if a Key employee sells their stock, they will be considered a Key in the year of the sale and the following year. This is especially important when mergers and acquisitions occur. Key employees and HCEs in the acquired company remain so as employees of the acquirer for a period of time. If the merged or acquired company also had a plan, the Key employee s balances would be added to the acquiring company s plan balances for the top-heavy test (Rev. Proc. 93-42, Sec. 414). In addition, in service distributions made within five years are added back for the top-heavy determination. Accounting for this activity is very difficult because clients rarely have the necessary information. If a plan is found to be top-heavy in the first year (Treas. Reg. 1.416) a top-heavy penalty will be required based on the payroll from the plan effective date of the eligible non-key employees, regardless of when they became eligible. After the first year, the plan is considered top-heavy in the year after it fails the test. The normal 3% profit sharing contribution required for non-key employees may not need to be that much if, individually, all of the Key employees received contributions equal to less than 3% of their pay. For example, if no Key employees had any money placed in the plan in the top-heavy year, no profit sharing penalty would be required. If the highest Key employee received 2% from EE and ER resources, then 2% would be the amount of profit sharing required to be made to all non-key employees. Therefore, the client can avoid any top-heavy penalties as long as Key employees do not participate. Interim testing will not guarantee that top-heavy plans will be discovered and so it is not done. New employees become eligible in the last quarter, year-end bonuses are paid, and deferral rates change all the time. It is difficult to keep up with these changes considering that the payroll data is transferred a

month after it occurs. The best way to insure against a plan becoming top-heavy is to look at the first deferral and gage whether more than 60% of the contributions belong to the Key employees. But because a Key employee related rollover may be rolled in or changes in deferrals may occur in the last quarter, there is no guarantee. Slavic will run the test as of 12/31 and the client may make changes in the following year to mitigate the penalty. However, new plans do not have that luxury. Because new plans that are top-heavy in the first year are also considered top-heavy in the second year, automatically, the initial deferral set-up is important. This is another reason administration is required to include a census in the start-up package. If a plan is deemed top-heavy, the PEO must convey that information to the client immediately. The penalty must be paid before the tax return is filed in order to receive a deduction in the top-heavy year. The penalty may be funded as late as September 15th if the client extends the 1120 tax return. Payment is mandatory in order for the plan to remain in compliance. Below is a summary of the more important tests that are routinely performed: Slavic does not aggregate other plans outside of the PEO plan. 1. ADP for the deferrals, max pay used is $225,000 2. ACP for the match, max pay used is $225,000 3. Top-heavy, Key employees have 60% of assets 4. $16,000 deferral 5. 415 limit of 46,000 plus 5000 catchup 6. 25% deduction limit per employer 7. 410B 70% discrimination test 8. Eligibility of participants The quality of the date is the determining factor as to how accurate the tests will be. SIA is dependent on the file downloads from the PEO and client updates on changes in ownership for the necessary information. Because the match and profit sharing formulas are discretionary, SIA does not verify or test these. The ACP test is applied to the total match in the plan and does not determine whether the formula was correctly applied. That is the responsibility of the PEO payroll system and the client company. It is important that the client does not start a match that is anything other than a pro rata

percentage of pay for all employees. Varying the match for different groups of employees complicates the 410B test and SIA would not have the necessary information to determine that. Participants may receive their benefits or money from the plan in several ways. The typical way to request a taxable distribution without a penalty is to retire or reach age 59½. Disability, death or termination of employment are other permissible means of receiving a taxable distribution, however, terminated employees under the age of 59½ are subject to a 10% penalty. Anyone who has a balance greater than $5,000 may leave their funds in the plan until age 70½; then, if not working, they must take minimum distributions or receive a 50% penalty. (Sub S owners still working must take a distribution at age 70½.) While a participant is under the age of 59½ and working, the only way to receive money out of the plan is to take a hardship (except in the case of disability or death). In this context, working means employed by either the PEO or the worksite employer. Participants may borrow up to 50% of their vested balance (Sec. 72p). Once the loan provision has been maxed out, a hardship (tax and 10% penalty due) may be taken for the EE balance only (no earnings). Loans should be considered a last resort because of the way the IRS taxes a default. If a quarter s payment is missed, a 1099 will be generated in the amount of the unpaid balance and income tax and penalty will be due. In addition, the participant must still pay back the loan if under age 59½. After taking a hardship distribution, the participant is barred from deferring to the plan for a period of six months. Upon resuming deferrals, the current year deferral limit of $16,000 is reduced by the deferrals made in the year the hardship was taken. If a termination occurs, balances may also be rolled to an IRA or another qualified 401(k) plan, tax free. Simple IRA plans cannot be rolled into a 401(k) plan. Taking money out of a retirement plan is a cumbersome process. Because of this, make sure the client is a valid 401(k) candidate before advising them to adopt. As a rule of thumb, if there are five or fewer employees who wish to defer $4,000 each, do not set-up a 401(k) plan unless the employer is making a significant match. One alternative you might offer to a qualified pension plan is the IRA (Sec. 408). A 401(k) plan is expensive to maintain and more difficult to take money out of when compared to individual IRAs.

There are two types of IRAs to select from: the Roth and the Regular. Roth IRAs have limits that employees must be made aware of. In order for a married couple to contribute to a Roth IRA, they must have an adjusted gross income between $150,000 and $160,000 and jointly under $100,000 to convert a Regular IRA to a Roth. Roth IRA contributors may also participate in a 401(k) plan (subject to income limits). However, those who contribute to a Regular IRA may not contribute to a 401(k) if, as a couple, they earn $75,000 or more or, as an individual, earn $55,000 or more. However, if married, the spouse who is not contributing to a 401(k) may contribute $4,000 to a Regular IRA without regard to those limits. The question then becomes which IRA an employee should choose. The Roth IRA is better in the longrun (over 10 years) because distributions are tax-free. Because retirement is usually a long-term objective, the Regular IRA is less important and has several drawbacks. First, you must begin taking distributions at age 70½. Secondly, at death it becomes subject to estate and income taxes. The only time that a Regular IRA would be advisable is if the client is in a high tax bracket and is close to retirement (age 60 or older). Then, the tax deduction for the contribution becomes a significant advantage over the nondeductible Roth contribution, an advantage that may not be made up by growth of the fund before distributions would start. Therefore, the Roth IRA will be a strategic tool for HCE/Key participants in a 401(k) plan when they are limited by the ADP test. The Payroll-Deducted IRA is offered on an after-tax basis with four major fund companies. Any of the B-share funds (back-end loaded) at the fund company selected are available. The tax deduction for the Regular IRA contribution may be taken when the individual s 1040 tax return is filed. The Safe Harbor provisions may be available to clients if the PEO amends the master plan to allow for them. The Summary Plan Description (SPD) of that client should also be amended and distributed by the employer. Once the PEO formally adopts the Safe Harbor option, a client may adopt and agree to it by choosing to a use the 100% vested 3% profit sharing or a 4% match (max of 6%), thereby allowing the HCEs to defer up to 16,000 without limitation by the ADP test. This higher deferral allowance may cause the plan to become top-heavy, but a safe harbor plan is exempt from top heavy penalties. The client should carefully consider the impact of adopting Safe Harbor. Whatever option is adopted, it must be communicated to the employees 60 days prior to the effective date and it must be completed before the beginning of the plan year. The notice should clearly state which employer contribution has been adopted.

Taking over client plans or changing investment platforms: There is a fee associated with merging a clients plan into the PEO plan. Whenever this subject comes up, the client should be referred to the Merger Department of Slavic for guidance. Under no circumstances should anyone other than out Merger Department tell a client to liquidate balances in another plan and send it to Slavic or Depository Services. The process includes a due diligence check on the source of the money and it will be rejected without that approval. When a liquidation occurs, the funds are usually held out of the market for one to three weeks as the transfer is made and an accounting is reconciled. This means Slavic must depend on outside vendors for information and they all work on different schedules. Therefore, Slavic processes these transfers on a best efforts basis. The 30 day notice explains the transfer process to work-site employees. Summary Plan Descriptions: Usually the attorney who drafted the plan provides the SPD on disk. The PEO is responsible for distributing the SPD to each participant within 30 days. Whenever a new client adopts, the SPD should be changed to reflect what was adopted: i.e., the safe harbor election, eligibility, vesting, etc. When the Department of Labor investigates any participant complaint, their first request is for a copy of the SPD and it must be right. Each PEO should review their operations and make sure the SPD is being distributed as required. Slavic Fees: The annual administration fee of approximately $39 per participant, taken out of the accounts, is not pro-rated for the length of time the participant is in the plan, although we process billing on a quarterly basis. At the end of the year, we will conduct extra billing to catch up participants who became eligible during the year and charge the full $39. There is also a minimum plan fee of approximately $350. This is a bill sent to the PEO at the end of the year for plans with less than 9 participants. We do not bill the client companies. The asset fee is a quarterly fee based on assets charged by Slavic Mutual Fund Management Corporation. Usually it starts at 85 basis points for assets in a client company's plan less than $600,000

and it falls to 50 basis points when assets reach $2,000,000. These break points are at the client company level and not based on the total assets in the PEO's trust. There is also an optional portfolio management fee of 25 basis points for those participants selecting that option. Other fees charged by the mutual fund companies will be taken from accounts as set out in the prospectus. The prospectuses can be downloaded from our website, www.slavic.net, or from the fund company's websites. Fund information is included in every enrollment kit given to participants and they may call a Slavic representative for investment advice.