This client is a family owned business. Two shareholders, each owning 19%, are retired and receiving W-2 wages of $20,000 for consulting. However, there are no hours reported and they are not deferring.

This plan is failing the ADP test and if these two shareholders are included, the test will pass. One owner retired in 2000. The service requirement for eligibility is 6 months with no prorated hours requirement.

Any suggestions?

Hmmm. No hours but a W-2. If I had any of the other 62%, I might wonder why the company is paying FICA tax on consulting work, which does not appear to be "wages" subject to FICA.

Is this "employee" an eligible participant?

The eligibility requirement is 6 months of service; with no prorated hours requirement.
If they are performing consulting service and receiving W-2 wages, they have met the requirements for eligibility and can be included in the ADP test.
Am I missing something?

Also consider the proposed 415 regs. definition of compensation which says that W-2 compensation for periods after you terminate (e.g. severance) isn't included in 415 compensation (unless it is for amounts earned before you left or accrued vacation, etc. and paid within 2 1/2 months) and can't be the basis of a 401(k) deferral. If you have no compensation that you can defer, I don't think you can be included in the ADP test because you're not eligible.

Is there real consulting going on, just no hourly records of it because it is for a fixed fee? Would you say that the "consultants" are really employees?

From your initial post, it sounds like they are not employees, but have an arrangement to get cash from the company because they are owners. (The IRS might look at this and say the payments are disguised dividends!) My reading of the proposed regs. is that non-employees can't defer even if they have W-2 compensation (except for the exceptions noted above).

You may have a compensation arrangement that is not being treated properly, so what you may be missing is an ability to get at the real problem.

If they are hces why do they need to have fixed hours of svc? An owner can agree to work any amount of hours in return for a fixed salary. If they meet the definition for participants (e.g. 5% owner with comp.) they can be included in the ADP testing. Owners frequently "retire" but continue to perform services for the business. I dont understand the difficulty that some people are having with the concept that owners don't punch time clocks or keep records of their time.

Locust could you please explain why the IRS would charaterize these payments as dividends which would not be subject to FICA tax instead of wages declared by the owners? My understanding of the law is that owners try to disguise wages as dividends to avoid paying fica taxes on the income.

mbozek - One thing is that wages are deductible to the corp, whereas dividends are not. May or may not be an issue. You might also get into corporate issues - are they trying to get around paying dividends to everyone? The FICA point is a good one - it goes to why the IRS would care, but if in fact the payment is not compensation but a dividend, other issues are raised.

Most small businesses are organzied as S corps which do not pay taxes.