In a recent internal memo, Carol Gold, Director Employee Plans, has directed IRS personnel to scrutinize certain potentially discriminatory plan designs and hiring practices. Although the memo examples describe cross-tested defined contribution plans, the IRS analysis applies to other plans with characteristics similar to those the memo describes. This memo is causing considerable concern among benefit practitioners because of the uncertainty it creates in applying the nondiscrimination rules of IRC §401(a)(4) to certain cross-tested plan designs.
The memo was issued to address certain abusive practices that were taking place in applying the nondiscrimination rules under IRC §401(a)(4). The regulations under IRC 401(a)(4) generally contain objective tests that can be used to demonstrate that a plan provides nondiscriminatory contributions or benefits. The IRS has become aware of situations where questionable plan designs or hiring practices are utilized to provide benefits to lower paid NHCEs in order to make it easier to pass the nondiscrimination rules. In some cases, these lower paid employees are hired for a short period of time solely because of the extremely favorable impact they will have on nondiscrimination tested.
The concept works in the same manner as bottom-up (or targeted) QNECs that a 401(k) plan uses to pass a failed ADP or ACP test. It is less expensive and more “testing efficient” for an employer to provide higher benefits to the lowest paid NHCEs. In a cross-tested plan, additional testing efficiencies are gained where the lowest paid NHCEs also are the youngest employees. Although the short-service NHCEs may receive allocations equal to a significant percentage of their compensation, in dollar terms, such amounts are small since the effected NHCEs’ compensation is also small. In addition, the short-service NHCEs may never vest in their benefits. Such plans arguably provide little or no actual benefits to NHCEs.
The memo indicates that defined contribution or defined benefit plans which limit benefits to HCEs and to “short-service” NHCEs (employed for only a few days or weeks), while literally complying with coverage, minimum participation and nondiscrimination requirements, do not satisfy the requirement in the nondiscrimination regulations to reasonably interpret the rules. These rules must be interpreted in a reasonable manner consistent with the purpose of preventing discrimination in favor of HCEs. (See Treasury Regulation §1.401(a)(4)-1(c)(2).)
Unfortunately, the memo is not limited to questionable hiring practices. It provides that a plan formula and/or employer hiring practices resulting in substantial plan benefits to HCEs, while severely limiting allocations to NHCEs by targeting coverage to short-service NHCEs, does not satisfy the nondiscrimination rules. The memo cites four elements, which if present, would indicate that the plan does not interpret the nondiscrimination rules in a reasonable manner. These elements are: 1) the plan excludes most or all “permanent” NHCEs; 2) the plan covers NHCEs who were hired temporarily for short periods of time; 3) the plan allocates a higher percentage of compensation to HCEs than to covered NHCEs [a feature of nearly all cross-tested plans]; and 4) the compensation of the covered NHCEs is significantly less than the compensation of the NHCEs who are not covered under the plan. According to the memo, the results of the general nondiscrimination test are “distorted” and the plan does not satisfy the nondiscrimination requirements.
The IRS notes that not all of the above elements need be present for the IRS to challenge a plan as not having satisfied the nondiscrimination requirements. For example, a plan that provides the same percentage allocation to the HCEs as it provides to temporary NHCEs, does not satisfy the nondiscrimination requirements where there is “no reasonable business reason” for hiring the NHCEs on a short-term basis. In addition, a plan may violate nondiscrimination rules, even in the absence of questionable hiring practices, where the plan limits benefits to selected HCEs (owner(s) only) and to the lowest paid NHCEs, covering only enough of the NHCEs to pass coverage. The memo states these examples are not the only cases where the IRS may assert that a plan does not comply reasonably with the nondiscrimination rules, but the memo does not provide other examples.
The memo directs IRS personnel to issue adverse determination letters with respect to the above and similar plan designs and to address such plans and hiring practices on a case-by-case basis, in determining whether such plans satisfy nondiscrimination requirements. This should be a concern to most retirement plan practitioners. Opening up the IRC §401(a)(4) regulations to a facts and circumstances test means that there will no longer be certainty as to whether a plan satisfies nondiscrimination requirements where: 1) the plan limits NHCE allocations to the lowest paid NHCEs only; or 2) the plan provides for greater allocations to the lowest paid NHCEs versus the rest of the NHCEs (i.e., uses a strict or modified bottom-up allocation). Apparently, this bottom-up type of plan is at risk even if the NHCEs receiving these allocations are not merely short-term employees. However, in a typical cross-tested plan where all of the statutorily includible NHCEs receive the same allocation rate (subject to allocation conditions), 3 of the 4 IRS identified “elements” will not be present. Such plans should not be subject to IRS challenge. To conclude otherwise would be to disallow virtually all cross-tested plans in contravention of existing regulations.
Although not scheduled in the original agenda for our upcoming ERISA Workshops, due to the importance of this just-released IRS memo, we will discuss memo and the implications it has for plan design and operation in these programs being held in November and December.
View the IRS Directive. |
