Tax-Exempt Employers: IRS Issues Relief from Confusing 403(b) Eligibility Requirement Applicable to Part-Time Employees

On December 4, 2018, the Internal Revenue Service issued Notice 2018-95 (the “Notice”), which clarifies the application of the Internal Revenue Code (the “Code”) Section 403(b) plan “universal availability” rule to part-time employees normally working fewer than 20 hours a week. The IRS established relief for 403(b) plans that have not properly applied the universal availability rule to such part-time workers any time after 2008 and before 2019. The need for this rule highlights an important distinction between 403(b) plans and 401(k) plans, relieves 403(b) plans from liability (to the IRS) for prior failures to have properly covered part-time workers, and allows for a “fresh-start” following the end of the relief period.

 

In offering employees an individual account-type tax-preferred retirement plan, tax-exempt employers have the option to establish either a 401(k) plan or a 403(b) plan.¹ One important distinction between 401(k) plans and 403(b) plans is how the two types of plans are tested for nondiscrimination with respect to employee salary deferral contributions. 401(k) plans are subject to the “average deferral percentage” (or “ADP”) test, while 403(b) plans are not. A consequence of an ADP test failure can be having to return employee salary deferrals to certain highly compensated employees, or the employer-sponsor having to make additional contributions to the accounts of certain non-highly compensated employees..²

 

Rather than being subject to the ADP test and the possible consequences of a testing failure, Code Section 403(b) provides an alternative for tax-exempt employers.  Instead of having to satisfy the ADP test, Code Section 403(b) applies the “universal availability” requirement to employee salary deferral contributions. Generally speaking, this requirement is self-explanatory—if the plan permits any employee to make salary deferral contributions, every employee must be permitted to make such contributions.³ However, the Code provides for limited exceptions to this requirement. One such exception is for employees who normally work fewer than 20 hours per week. Treasury regulations explain that an employee is considered to normally work fewer than 20 hours a week if: (1) the employee is reasonably expected to work fewer than 1,000 hours in the 12-month period following the commencement of employment (this is referred to as the “first year exclusion condition”); and (2) for each plan year ending after that initial 12-month period the employee worked fewer than 1,000 hours in the immediately preceding 12-month period (generally referred to as the “preceding year exclusion condition”).

 

 

Under the Notice, 403(b) plans that had improperly excluded part-time employees under the mistaken interpretation of the exception to the universal availability rule will not be considered as having failed to satisfy the universal availability requirement, provided that such plans were consistently administered under the first year and preceding year exclusion conditions.  In other words, an employer may have interpreted the exclusion incorrectly but the employer applied that incorrect interpretation consistently from year-to-year and part-time employee to part-time employee.

 

This relief is extended for the period starting with the first tax year beginning after December 31, 2008, (the general effective date of the Code Section 403(b) final regulations), and through the last exclusion year that ends before December 31, 2019.  Thus, for plans that use the calendar year as the exclusion year, the relief period ends December 31, 2018. Accordingly, such plans must act immediately to rectify any improper part-time employee exclusion and extend the opportunity for previously improperly excluded part-timers to make salary deferral contributions starting January 1, 2019.⁴

 

 

 

Tax-exempt employers who exclude part-time employees from making salary deferral contributions to their 403(b) plans should immediately review their plan administrative practices and determine whether the exclusion was properly applied in the past years. Regardless, starting next month, these plans will need to ensure that part-time employees who worked 1,000 hours or more in 2018 are extended the opportunity to contribute starting in 2019.

 

 

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1. Taxable entities are prohibited from establishing a 403(b) plan.

2. These corrective contributions are referred to as “qualified non-elective contributions” or “QNECs”, and must be fully vested upon contribution.

3. The universal availability requirement does not apply to employer contributions (i.e., match or non-elective contributions).

4. Plans that use the calendar year as the “exclusion year” will necessarily have an overlap of the first calendar exclusion year and the first 12 months of employment. So long as the plan has treated these overlaps consistently, the relief granted under the Notice applies.