Can you separately test terminated employees who are eligible to defer into a 401(k) plan, if they have less than 500 hours, under the otherwise excludable rule in 410(b)?

Nope. "Otherwise excludable" is defined, under Code Section 410(b)(4), to mean participants with less than one year of service and under age 21. Regulation Section 1.410(b)-6(f)(1) (below) says, " An employee may be treated as an excludable employee for a plan year with respect to a particular plan if the employee does not benefit under the plan for the plan year,…and…". If a terminated participant was eligible to defer, he or she was benefiting, and therefore is not excludable under 410(b), and cannot be "otherwise excludable".

401(k)(3)(F) Special rule for early participation. - If an employer elects to apply section 410(b)(4)(B) in determining whether a cash or deferred arrangement meets the requirements of subparagraph (A)(i), the employer may, in determining whether the arrangement meets the requirements of subparagraph (A)(ii), exclude from consideration all eligible employees (other than highly compensated employees) who have not met the minimum age and service requirements of section 410(a)(1)(A).

410(b)(4)(B) Requirements may be met separately with respect to excluded group. - If employees not meeting the minimum age or service requirements of subsection (a)(1) (without regard to subparagraph (B) thereof) are covered under a plan of the employer which meets the requirements of paragraph (1) separately with respect to such employees, such employees may be excluded from consideration in determining whether any plan of the employer meets the requirements of paragraph (1).

SEC. 410. MINIMUM PARTICIPATION STANDARDS

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10(a) PARTICIPATION.

410(a)(1) MINIMUM AGE AND SERVICE CONDITIONS.

410(a)(1)(A) GENERAL RULE. - A trust shall not constitute a qualified trust under section 401(a) if the plan of which it is a part requires, as a condition of participation in the plan, that an employee complete a period of service with the employer or employers maintaining the plan extending beyond the later of the following dates

410(a)(1)(A)(i) the date on which the employee attains the age of 21; or

410(a)(1)(A)(ii) the date on which he completes 1 year of service.

§1.410(b)-6. Excludable employees

(a) Employees - (1) In general. For purposes of applying section 410(b) with respect to employees, all employees of the employer, other than the excludable employees described in paragraphs (b) through (i) of this section, are taken into account. Excludable employees are not taken into account with respect to a plan even if they are benefiting under the plan, except as otherwise provided in paragraph (b) of this section.

(2) Rules of application. Except as specifically provided otherwise, excludable employees are determined separately with respect to each plan for purposes of testing that plan under section 410(b). Thus, in determining whether a particular plan satisfies the ratio percentage test of §1.410(b)-2(b)(2), paragraphs (b) through (i) of this section are applied solely with reference to that plan. Similarly, in determining whether two or more plans that are permissively aggregated and treated as a single plan under §1.410(b)-7(d) satisfy the ratio percentage test of §1.410(b)-2(b)(2), paragraphs (b) through (i) of this section are applied solely with reference to the deemed single plan. In determining whether a plan satisfies the average benefit percentage test of §1.410(b)-5, the rules of this section are applied by treating all plans in the testing group as a single plan.

(b) Minimum age and service exclusions -

(f) Certain terminating employees

(1) In general. An employee may be treated as an excludable employee for a plan year with respect to a particular plan if

(i) The employee does not benefit under the plan for the plan year,...

(ii) The employee is eligible to participate in the plan,

(iii) The plan has a minimum period of service requirement or a requirement that an employee be employed on the last day of the plan year (last-day requirement) in order for an employee to accrue a benefit or receive an allocation for the plan year,

(iv) The employee fails to accrue a benefit or receive an allocation under the plan solely because of the failure to satisfy the minimum period of service or last-day requirement,

(v) The employee terminates employment during the plan year with no more than 500 hours of service, and the employee is not an employee as of the last day of the plan year (for purposes of this paragraph (f)(1)(v), a plan that uses the elapsed time method of determining years of service may use either 91 consecutive calendar days or 3 consecutive calendar months instead of 500 hours of service, provided it uses the same convention for all employees during a plan year), and

(vi) If this paragraph (f) is applied with respect to any employee with respect to a plan for a plan year, it is applied with respect to all employees with respect to the plan for the plan year.