The Revenue Service has issued proposed regulations to clarify the application of the coverage rules to a 401(k) plan or an associated “401(m) plan” to an employer that includes a tax-exempt organization under Code §501(c)(3) whose employees are eligible to make salary reduction contributions under a 403(b) plan. The proposed regulations respond to a Congressional mandate, included in EGTRRA, directing the Revenue Service to issue the regulations.

Historical Background. TRA 86 prohibited nongovernmental tax-exempt employers from maintaining a 401(k) plan. However, 501(c)(3) tax-exempt organizations could maintain a 403(b) plan. TRA 86 also prohibited State and local governmental entities (except Indian tribes) from maintaining 401(k) plans. SBJPA repealed the prohibition against nongovernmental tax-exempt employers maintaining a 401(k) plan, but did not repeal the prohibition applicable to State and local governmental entities. Current coverage regulations treat as excludable employees, for coverage testing of a 401(k) plan or a 401(m) plan provided under the same general arrangement as the 401(k) plan, employees of a nongovernmental tax-exempt organization who could not participate in the 401(k) plan because of the TRA 86 prohibition, provided that more than 95% of the employees who are statutorily eligible benefit under the plan for the plan year.

The Proposed Regulations. After SBJPA, a 501(c)(3) tax-exempt organization can maintain a 401(k) plan, a 403(b) plan, or both. The proposed regulations provide that employees of a 501(c)(3) tax-exempt organization who are eligible to make salary reduction contributions under a 403(b) plan are excludable employees for purposes of testing whether a 401(k) plan or an associated 401(m) plan satisfies the coverage requirements, provided:

1. no employee of the 501(c)(3) organization is eligible to participate in the 401(k) plan or the 401(m) plan; and
   
   
2. at least 95% of the employees of the employer who are not employees of the 501(c)(3) organization are eligible to participate in the 401(k) plan or the 401(m) plan.

For example, assume a controlled group consists of a hospital that is a 501(c)(3) organization, and a for-profit clinic. The hospital maintains a 403(b) plan. The clinic maintains a 401(k) plan for all of its employees. Under the proposed regulations, in testing coverage for the 401(k) plan, the hospital employees are excludable employees.

Effect of the Regulations. The regulatory change allows an employer (that includes a 501(c)(3) tax-exempt organization) with both a 401(k) plan and a 403(b) plan to continue maintaining the 403(b) plan without requiring the same employees to be covered under the 401(k) plan and the 403(b) plan. The proposed regulations are proposed to be effective for post-1996 plan years (consistent with the SBJPA effective date). Taxpayers may rely on the proposed regulations pending final regulations. Any future guidance that is more restrictive than the proposed regulations will not have retroactive effect.

Application to Governmental Employers. The proposed regulations maintain the provision that employees of a governmental employer ineligible to maintain a 401(k) plan are excludable for purposes of a 401(k) plan’s coverage testing if more than 95% of the employer’s employees who are not employees of an ineligible governmental employer benefit under the 401(k) plan for the plan year. Note that a TRA 97 provision exempts State and local governmental plans from the coverage requirements.

The text of the IRS proposed regulation may be found here.