Solutions in a Flash – Retirement Plan Correction Solution: Who’s that Girl? It’s an Employee! Solo 401(k)s That Aren’t So Solo
Retirement Plan Correction Solution
Who’s that Girl? It’s an Employee!
Solo 401(k)s That Aren’t So Solo
By: Leah E. Dean, Esq.
Jess Day, the owner of Glitter and Glue, Inc. (“Glitter and Glue”) and trustee for the Glitter and Glue 401(k) Profit Sharing Plan (the “Plan”), saw a huge increase in business during the holiday season and has decided she needs an extra set of hands to help her run Glitter and Glue. One day, she called her friend and former roommate Schmidt to chat and mentioned how excited she is to expand her business. As a third-party administrator (“TPA”) at Schmidt & Sons, the alarm bells immediately went off in Schmidt’s head, and he began asking Jess about Glitter and Glue’s retirement plan.
Jess explained that she established the Plan in 2019, when she started Glitter and Glue, on the advice of Set For Life, a large service provider that she also uses for her financial planning. She said, “The nice person I spoke with at Set For Life set me up with a Solo 401(k) and told me it only has to cover me and my husband, so I’m not worried about it! Wait…should I be worried about it?!?”
Schmidt asked Jess to look at the Plan’s eligibility requirements and tell him what they are. Jess told him that because it’s just her and her husband, Nick, they opted to not select any age or service eligibility requirements, and they also didn’t select a vesting schedule. Schmidt responded, “Wow! Jessica! I’m glad you called me to catch up! Let’s discuss what to do before you start hiring employees.”
Solo 401(k)s Generally
Solo 401(k)s are also referred to as called “Solo-ks,” “one participant plans,” and “owner-only plans.” All of these labels give the illusion that this is a type of plan that only has to cover an owner and, possibly, their spouse. That’s wrong on two fronts. First, a Solo-k is simply a 401(k) plan with simplified provisions that are selected because of the assumption that there will be no rank-and-file employees. This one-size-fits-all concept works great as long as that assumption is correct. However, as soon a non-owner employee is hired, they can become eligible to be in the plan – often as soon as they start work. For example, most Solo-ks are set up with no eligibility conditions, as is the case for Glitter and Glue’s Plan. This means any new hires immediately become eligible and must be offered an opportunity to participate in the plan. Solo-ks also usually provide for immediate vesting, which means that any contribution the company makes for the employees will be theirs if they leave. Once there is an employee, the plan must pass nondiscrimination testing or provide for certain minimum contributions for the employees – so this means that the cost to Jess of having the Plan is more than just letting the employee make their own deferral contributions to the Plan.
Reporting and disclosure requirements are also different for plans covering only owners vs. plans that cover rank-and-file employees. Therefore, the administrative requirements increase when a plan covers other employees.
What Proactive Measures Should Jess Take Before Hiring an Employee?
There are several items Jess should address in the Glitter and Glue Plan before hiring an employee. First, she should consider amending the Plan to change the eligibility requirements. With the eligibility requirements the Plan currently has (which are no requirements at all!), as soon as Jess hires an employee, that individual will be eligible for the Plan. Jess should talk with her TPA to figure out what eligibility requirements make sense to her. Commonly, employers will select the longest eligibility requirements allowed, which are one year of service and age 21. Additionally, Jess will want to look into amending the vesting schedule and allocation requirements set forth in the Plan. While they are reviewing the Plan, it would be a good time to look over the other provisions and discuss any plan design changes that Jess may want to consider as her business expands.
What Would Happen if Jess Already Hired an Employee?
Let’s say that, when Jess was catching up with Schmidt on the phone, she told him she was so excited because she hired a new employee a few weeks ago to help with her crafts. Because there are no eligibility requirements, Cece, the new employee, would immediately be eligible for the Plan and should have been offered the opportunity to make her own salary deferrals into the Plan. Fortunately, the IRS provides corrective procedures when an error like this is made.
Fixing the Failure to Let Cece Enter the Plan
Schmidt recommends that, before Jess does anything else, she should offer the Plan to Cece. This corrects the problem for the future and helps stop the metaphorical bleeding caused by Cece’s improper exclusion from the Plan. Now we just have to correct the problem for the period during which Cece wasn’t let into the Plan.
Jess needs to correct the failure and compensate Cece for the period of time during which she was not offered the Plan. Because Jess failed to offer her the opportunity to participate in the Plan, Cece might be owed a qualified nonelective contribution (“QNEC”) for her missed deferral opportunity (“MDO”). To determine how much the QNEC would be, Schmidt would refer to the IRS’s plan correction program, the Employee Plan Compliance Resolution System (“EPCRS”). EPCRS prescribes that the amount of the QNEC is equal to 50% of the employee’s missed deferral. The missed deferral is determined by multiplying the actual deferral percentage (“ADP”) for the year of exclusion for the employee’s group (this means whether the employee is a highly compensated employee (“HCE”) or nonhighly compensated employee (“NHCE”)) in the plan by the employee’s compensation for that year. Here, Jess and Nick are HCEs (because they are both more than 5% owners) and Cece is an NHCE.
But there are no NHCEs participating in the Plan yet…so the ADP for NHCEs would be 0%. Does that mean Cece should get nothing? No! Unfortunately, there is a gap in EPCRS that the IRS has not yet addressed about what employers should do when faced with this situation. Realistically, there are three options here:
- The most conservative option is to use the HCE ADP to determine the correction.
- Another option is to use an NHCE ADP equal to what would have been required in the applicable plan year to pass nondiscrimination testing.
- The least conservative option is to use the rule set forth in EPCRS that is applicable for safe harbor plans, which assumes that the NHCE ADP was 3%.
If you are faced with this situation, we recommend you consult with an attorney to discuss your options and determine which is most appropriate in your case.
EPCRS contains some exceptions to the 50% QNEC that might apply, requiring only a 25% QNEC or even possibly no QNEC at all. Again, it is important that Jess have a qualified TPA or lawyer help her know what correction is required. For a more in depth discussion on correcting deferrals failures, see our previous Solution.
In addition to any required QNEC, if the Plan provided a matching contribution during the period Cece was improperly excluded, Jess must also provide her with a matching contribution equal to what the Plan provides on the full amount of the missed deferral, plus earnings on both the QNEC and the matching contribution from the date they would have been deposited had the plan operated correctly to the date of correction.
But There’s More … Reporting and Disclosure Requirements
Something else that changes now that Jess has an employee are the reporting requirements for the Plan. Previously, Glitter and Glue would need to file their annual return on Form 5500-EZ as the Plan only included owners, Jess and her husband – and that was required only if Plan assets exceeded $250,000. Now, Glitter and Glue needs to file either on Form 5500-SF or the full Form 5500 (which is generally needed only if the Plan covers more than 100 people). Additionally, if there are any notice requirements related to the Plan that she has been lax about, she needs to correct that by issuing those notices to employees.
Anything Else Jess Should Be Concerned About?
Not uncommonly, Solo-ks are recommended by plan service providers other than TPAs – often by a person who concentrates on personal investments, rather than retirement plan design and administration. While these plans may make perfect sense in the moment, the individual recommending the plan may not consider and caution the client about what may happen in future years.
Sometimes, other items get missed by these individuals. This includes missing (or incorrect) Forms 5500, usually due to relying on the assumption that the plan has no participants. Late or missing forms are subject to penalties. Penalties on missing Forms 5500-EZ can be fixed through the IRS’s correction program that is prescribed in Revenue Procedure 2015-32. If a Form 5500-SF or 5500 should have been filed, the problem can be corrected through the Department of Labor’s Delinquent Filer Voluntary Compliance Program (DFVCP). For more information about how to correct late Forms 5500, read our past Solution.
Another item Jess needs to watch out for is keeping the Glitter and Glue plan documents up to date with relevant legislation. Retirement plans must be restated onto a new document approximately every six years. Set For Life should help to keep Jess on track, but often we see this fall through the cracks, either because the restatement does not get prepared by the service provider, or the client does not understand that they need to sign and date the new documents. If a restatement does get missed, not to worry – there’s a Solution for that!
Solo-ks cease to be so solo once employees are hired. If you (or your client) have an owner-only plan and believe that there are – or will be – employees, try to be proactive and consider the need for plan modifications beforehand. If you are already past that point, no need to worry! Make sure the employee is offered the Plan when the document says they are eligible and given any required QNEC for a missed deferral. Looking forward, you can always change the plan design to better fit the employee population and the employer’s goals. For additional information on Solo issues, check out Ilene Ferenczy’s The Solo 401(k) Death Trap article in the Journal of Pension Benefits.
If you have a Solo-k that you don’t think is so solo after all, or have a Solo-k and are considering hiring employees, contact us. After all, we are your ERISA solution!
- Posted by Ferenczy Benefits Law Center
- On August 7, 2023