To deal with the economic downturn without laying off workers, some employers have instituted voluntary and involuntary unpaid leave programs. However, reduced hours or unpaid leave can have an unexpected negative effect on employee benefits, including worker eligibility for pension plans, employer matching contributions to 401(k) plans, and health care coverage.

According to a report by Watson Wyatt, Effect of the Economic Crisis on HR Programs, Update: April 2009, cost-cutting methods used by surveyed employers included decreasing hours through reduced workweeks (22 percent), mandatory furloughs (17 percent), and voluntary furloughs (11 percent).

In addition, over the next 12 months, 4 percent of surveyed employers expect to continue reduced weeks, 4 percent expect to continue mandatory furloughs, and 5 percent expect to continue voluntary furloughs. The report was based on a survey of 141 U.S. companies.

Steven Friedman, shareholder and chair of the Employee Benefits and Executive Compensation Practice Group for Littler Mendelson in New York City, told us that furloughs could cause employees to lose benefits if they participate in plans with eligibility requirements stated in hours.

Pamela Perdue, of counsel at the St. Louis office of Summers Compton Wells, said that the way in which a furlough impacts benefits, "if at all, really depends upon how it's structured, and the company's own policies and benefit plan provisions."

An Internal Revenue Service spokesman, meanwhile, said "the subject of unpaid leave and employee benefits is an unsettled area."

New interest in furloughs. Perdue said it used to be that furloughs were something more often seen by state governments or the automobile industry. Now, more and more private employers are looking at it as a way to avoid employee layoffs or terminations. For example, some employers that may have traditionally closed down during the period between Christmas and New Year's Day, with employees continuing to receive pay, are now looking at the same practice but without pay.

Friedman said at his practice, employer clients have been expressing interest in furloughing employees, which is something that he said many benefits attorneys have never been asked about before.

According to Friedman, "employers are coming to grips first with the idea of saving money by furloughing employees, and then asking their management how to treat people on furloughs." He said companies are trying to avoid implementing leave programs that affect employees' benefits. For example, some employers are considering that for the purpose of furloughs, the employees would remain active for plan eligibility purposes, he said. There may be very different factors that need to be addressed with respect to retirement plans and health benefit plans in achieving this goal, Friedman added.

Eligibility for 401(k) participation. Under a 401(k) plan, once employees become eligible to participate, they often will remain eligible regardless of whether their employee status changes. The 401(k) plan can require that an employee work for one year before becoming eligible to participate in the plan, and the tax code permits employers to define one year as 1,000 hours of service (although many plans now allow immediate participation). The 1,000-hour threshold is easy to meet for full-time workers, but it may affect part-time workers.

However, new employees who are put on furlough could see an impact on their eligibility to participate in the plan or to receive matching contributions from the employer, Friedman said.

If a furlough affects an employee's hours to the extent that he or she doesn't meet the 1,000-hour requirement, that employee might have to wait until the next eligibility period to begin participating in the plan (or to be eligible for certain types of plan contributions), Friedman said. However, employers may be able to amend the plan to provide that the furlough period is considered a period of active employment, alleviating the negative effect on the plan benefit for furloughed employees.

The same issue applies to profit-sharing plans, which often provide that an employee receives a benefit for a particular year if he or she reaches a certain hour requirement (usually the same 1,000-hour requirement).

Employer matches, nondiscrimination rules. Another issue with 401(k) plans and profit-sharing plans is the employer match, Greta Cowart, a partner in the Dallas office of Haynes and Boone, told us. "If you don't have compensation for working, you can't have a salary deferral election, then there won't be the match and there wouldn't be a profit sharing contribution," she said.

Regarding plan requirements, any time an employer changes a match, the employer has to look at plan documents, Cowart said.

To compensate for a reduction in salary, employees can increase their contribution levels, if the plan allows it, said Scott Macey, senior vice president and director of government affairs at Aon Consulting in Washington, D.C.

However, companies should be careful that the increased contributions do not skew anti-discrim-ination testing, Macey said. 401(k) nondiscrimination rules prohibit highly compensated employees (HCEs) from deferring too great a percentage of their salary compared to nonhighly compensated employees (NHCEs). In a furlough situation, HCEs might be the only employees able to increase contributions. In the meantime, NHCEs on furlough might have to reduce or stop their contributions. As a result, the percentages might shift, causing a company to fail the anti-discrimination testing.

If this is the case, a company can cut back the amount the HCEs can contribute for the rest of the year, Macey said. If, at the end of the year, the HCEs have contributed too much money, the company would have to give that money back to the HCEs, and that money would become taxable as income, he added. This situation could occur in a small plan, or a large plan with a significant number of HCEs, Macey said.

401(k) plan loan repayments could also be affected, Cowart said. Loans from 401(k) plans are usually paid through salary reductions. If there is no salary to take the repayment from, the employee has to write a check, because otherwise he or she could go into default, Cowart said. Even if there is still a salary, but it is less because of reduced hours, the employee still has to pay back the same amount, she said. This means less money in the employee's paycheck, Cowart said. Finally, if the employee misses a payment one quarter and does not make up the payment by the end of the following quarter, the loan would be deemed distributed, and the entire amount of the loan would be taxable to the employee on Form 1099, she warned.

Some employees with reduced hours may not work enough hours during the plan year to earn vesting credit in their pension plans for the year, Cowart said.

To fix this problem, an employer could amend its plan on a nondiscriminatory basis, Cowart said. For example, a plan could provide that all employees who take unpaid leave get credit for the hours they are on such leave, as if they worked their regular schedules. These amendments have to be in place by the end of the plan year in which they occur because they are discretionary amendments, she added.

Maintaining health plan eligibility. The impact of furloughs on eligibility for health benefits is similar to the impact regarding 401(k) plans, Friedman said, although generally, employers have more latitude when setting health care eligibility requirements.

For example, employers can provide that everyone who is regularly scheduled to work 20 hours per week is eligible to participate in the company's health plan. An employee who has reduced hours due to a furlough could drop below the threshold, Friedman said.

There are a couple of ways employers could deal with this, Friedman said. First, an employer could treat the furloughed employees as if they are active, even on days they are furloughed. Second, an employer could lower the eligibility threshold, so that even after taking into account the furloughed hours, furloughed employees still qualify to participate in the health plan. The employer might have to amend the plan to provide for these situations, Friedman said.

In addition, if the health plan is insured, the employer might also have to get the insurer on board, Friedman said.

COBRA considerations. In enacting the American Recovery and Reinvestment Act (ARRA), Congress added a temporary subsidy to help individuals who have lost their jobs to pay Consolidated Omnibus Budget Reconciliation Act premiums for group health care coverage. Individuals who become eligible for COBRA continuation rights because of an involuntary termination of employment between Sept. 1, 2008, and Dec. 31, 2009, pay only 35 percent of the COBRA premium. Initially, the remaining 65 percent of the premium is subsidized by the employer and reimbursed by the federal government through a credit to the employer's payroll taxes. The premium reduction applies to periods of health coverage beginning on or after Feb. 17, 2009, and may last for up to nine months.

IRS subsequently released Notice 2009-27, which provides, among other things, that "an involuntary reduction to zero hours, such as a layoff, furlough, or other suspension of employment, resulting in a loss of health coverage is an involuntary termination for purposes of the premium reduction."

Cowart said under Notice 2009-27, if reduced hours or unpaid leave results in an employee's moving off the employer's health plan, it could be considered an involuntary termination if the employee is forced to quit in response to the reduction in hours. The reduction in hours without the employment termination can be a qualifying event to trigger COBRA but would not make the individual eligible for the COBRA subsidy. Thus, if the reduction in hours forces an employee to lose coverage, but the employee does not terminate employment, then the employee would be eligible for COBRA but not the COBRA subsidy, she said.

Furloughs also can affect flexible spending accounts--which allow employees to set aside pre-tax money to pay for things such as day care expenses, health care expenses, or commuter benefits.

For day care expenses, employees make their elections assuming they are going to work a certain number of hours; if that amount is reduced, they may need less day care, Cowart said.

An employee may want to adjust the amount he or she is contributing to an FSA toward dependent care, but that depends on whether that employee qualifies as having a change in status under tax code Section 125. Taking an unpaid absence could be a change in status triggering an opportunity to change elections, Cowart said. The plan must be designed to include the taking of an unpaid leave of absence as a change of status, however, as employers are not required to recognize all of the change in status options.