FIS Relius
IRS Releases Proposed Regulations on New Comparability (Cross-testing) Plans 10/18/2000
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The IRS released proposed regulations on new comparability plans. The new regulations establish limits on the amount of disparity a defined contribution plan may provide between highly compensated employees (HCEs) and nonhighly compensated employees (NHCEs). For a defined contribution plan to utilize cross-testing to comply with the nondiscrimination requirements, the plan would need to satisfy a "minimum allocation gateway" requirement or provide "broadly available allocation rates."

Minimum allocation gateway. A defined contribution plan will satisfy the minimum allocation gateway if (1) each NHCE receives an allocation which is not less than one-third of the highest allocation rate provided to an HCE, or (2) each NHCE receives a minimum allocation of 5% of compensation. For example, if an employer maintained a new comparability plan in which the highest allocation rate for an HCE is 18%, the plan must provide each NHCE a minimum allocation of 5% to satisfy the minimum allocation gateway. In calculating the allocation rates, the employer does not take into consideration 401(k) elective deferrals and matching contributions. However, an employer maintaining a safe harbor 401(k) plan using the 3% nonelective contribution alternative will take into consideration the 3% nonelective contribution in determining allocation rates. In fact, an employer who combines a new comparability plan with a 401(k) plan is more likely to satisfy the minimum allocation gateway because the HCEs allocation rates do not include the elective deferrals. Therefore, the HCE allocation rates in a 401(k) plan will be lower than in a non-401(k) plan.

Broadly available allocation rates. A defined contribution plan will not need to satisfy the minimum allocation gateway if each allocation rate under the plan is available to a sufficient percentage of NHCEs to satisfy the nondiscriminatory classification test of Treas. Reg. §1.410(b)-4 (the first step in the average benefits test). In effect, the broadly available allocation requirement treats each allocation rate like a benefit, right or feature of a plan. A new comparability plan generally will not satisfy this requirement because its purpose is to provide different allocation rates to HCEs and NHCEs. For example, a plan that allocates 16% of compensation to HCEs and 4% of compensation to NHCEs will fail the broadly available requirement because the 16% rate is not available to the NHCEs. Note, the plan also will fail the minimum allocation gateway requirement because 4% is less than one-third of the highest allocation provided to an HCE.

Disregarding age and service conditions. A plan may disregard age and service conditions in determining whether an allocation rate is broadly available if: (1) the plan's allocation formula applies to all employees who benefit under the plan, (2) the plan provides a single schedule of rates which it bases on age or service (but not both), and (3) the plan's allocation rates increase smoothly as an employee increases in age or accumulates service (i.e., regular intervals). In effect, the plan would need to permit an employee to "grow into" the higher allocation rates as he/she increases in age or accumulates service. The typical age-weighted plan should be able to satisfy the requirement that allocation rates increase smoothly. However, the typical new comparability plan would not satisfy the increasing smoothly requirement because the plan does not permit NHCEs to "grow into" the HCE allocation rate.

In determining whether a plan's allocation rates increase smoothly, the employer must group its employees in age or service brackets. Each age or service bracket must be of the same length except for the last bracket. If the plan bases a bracket on age, the employer may treat the first age bracket as the same length as the others if it ends on or before age 25. For example, if the plan provides for allocation rates based on age, the first bracket would be for participants under age 25 and subsequent age brackets in 10 year groups (e.g., 25-34, 35-44, 45-54, 55-64 and 65 and older).

Allocation rates increase smoothly if each age or service bracket is not more than (1) 5 percentage points greater than the immediately preceding age or service bracket, and (2) twice the immediately preceding age or service bracket. In addition, the allocation rates will not increase smoothly if the ratio of the allocation rate for any age or service bracket to the rate for the immediately preceding bracket is more than two or if the ratio exceeds the ratio of allocation rates between the two immediately preceding brackets. In general, the plan does not incorporate the age or service brackets into its plan design. Rather, the employer uses the brackets for testing. The purpose of the age and service brackets is to prevent an employer from designing a new comparability plan which backloads the allocation rates.

Combination defined contribution and defined benefit plans. The proposed regulations also limit the disparity an employer may create when it aggregates a defined benefit plan and a defined contribution plan ("DB/DC plans") for nondiscrimination testing. An employer maintaining DB/DC plans may continue to satisfy the nondiscrimination requirements on the basis of benefits if the combined plan is (1) primarily defined benefit in character, (2) consists of broadly available separate plans, or (3) satisfies a gateway requirement.

DB/DC plans are primarily defined benefit in character if more than 50% of the NHCEs have an accrual rate attributable to the defined benefit plan greater then the accrual rate attributable to contributions under the defined contribution plan. DB/DC plans will satisfy the broadly available requirement of the regulations if each plan could satisfy the nondiscriminatory classification test and the nondiscrimination in amount requirement (Treas. Reg. §1.401(a)(4)-1(b)(2)) tested separately. The gateway test for DB/DC plans would require each NHCE's combined allocation rate (the sum of the NHCE's allocation rate under the defined contribution plan and the NHCE's equivalent allocation rate under the defined benefit plan) not be less than a minimum allocation rate determined by the highest allocation rate of an HCE. If the highest allocation for an HCE does not exceed 25%, the minimum for the NHCEs is 5%. If the highest HCE allocation rate is more than 25%, the minimum allocation rate the NHCEs would be 5% plus 1% for each 5 percentage points (or portion thereof) that the highest allocation rate for an HCE exceeds 25%. For example, if the highest HCE allocation rate were 27%, the minimum allocation rate would need to be 6%. If the DB/DC plan could not satisfy any of these tests, the combined plans could not be tested on the basis of benefits.

Effective dates. The regulations apply to plan years beginning on or after January 1, 2002. Accordingly, the IRS has abandoned the idea of making the regulations retroactively effective for plans which were established after the issuance of Notice 2000-14 (February 24, 2000).