One of the most popular ways of designing cross-tested retirement plans is to put each participant in a separate allocation group.  This method allows the employer to customize allocations, to reward individual participants based on merit, or to find cost effective solutions for nondiscrimination issues.  Moreover, this method affords Plan Sponsors significant flexibility in terms of allocations without the need to amend the plan.

Newly proposed regulations would change the way these plans are tested. The regulations would apply to any design where one or more HCEs has an allocation formula that is not part of a “reasonable classification.”

This is merely a proposed regulation and does not change anything today.  It would go into effect for plan years beginning after the date the Treasury issues the final regulation.

What is a “reasonable classification”?  That term comes from the nondiscriminatory classification test (which is part of the average benefit test) which today is only used for coverage.  Treas. Reg. §1.410(b)-4(b) says:

A classification is established by the employer in accordance with this paragraph (b) if and only if, based on all the facts and circumstances, the classification is reasonable and is established under objective business criteria that identify the category of employees who benefit under the plan. Reasonable classifications generally include specified job categories, nature of compensation (i.e., salaried or hourly), geographic location, and similar bona fide business criteria. An enumeration of employees by name or other specific criteria having substantially the same effect as an enumeration by name is not considered a reasonable classification.

To meet this standard, the classification must be:

·         Reasonable,

·         Based on objective, bona fide business criteria, and

·         Neither an enumeration by name nor something having the same effect.

Whether criteria meet this standard is a “facts and circumstances” test, which means that there is little way to know whether the plan’s allocation formulas are using reasonable business criteria until the IRS audits the plan.  However, we can say for certain:

·         If the same allocation formula applies to everyone, such as in a “super-integrated plan” the classification should be reasonable and the new regulation should not adversely affect the plan.

·         If every employee is in a separate allocation group, as is frequently the case, then the classification is substantially the same as enumeration by name and is not reasonable.

If there is a single HCE whose allocation formula under the plan does not satisfy this reasonable classification test, then that HCE’s rate group cannot use the average benefit test to pass the general nondiscrimination test.  Instead the group must pass the ratio percentage test. 

Specifically, the proposed regulation provides that a rate group cannot pass the average benefit test unless “The formula that is used to determine the allocation for the HCE with respect to whom the rate group is established applies to a group of employees that satisfies the reasonable classification requirement of §1.410(b)-4(b).”

Passing the ratio percentage in rate group testing a cross-tested plan frequently will require most contributions to one or more NHCE participants.  For example, consider the following fact pattern:

Today, this plan easily passes the general test.  There are two out of four NHCE employees in the owner’s rate group, EE 2 and EE 4.  That provides a coverage fraction of 50%.  That is insufficient to pass the 70% threshold of the ratio percentage test, but it easily passes the nondiscriminatory classification portion of the average benefit test.  The plan also satisfies the average benefit percentage test.

But, suppose the proposed regulation were in place, and the plan provided that each employee is in a separate classification.  The plan would be unable to use the average benefit test, and would need to pass the ratio percentage test, because the allocation formula giving the owner 35.3% of compensation applies only to the owner.  The least expensive way to pass under that scenario would be to allocate a total of $4,415 to EE 3.  This would bring EE 3 into the owner’s rate group and the plan would pass the ratio percentage test, but only after spending an extra $1,915 for one employee.

Suppose the plan provided that there were only two classifications: owners and staff members.  It is entirely possible that this would not pass the reasonable classification test because a group with a single member is arguably the same as designation by name.  If it would not pass the reasonable classification test, the remedy would not simply involve EE 3.  All the staff members are in the same group which means they all have the same allocation formula.  Each employee would receive a higher allocation, costing the owner an additional $9,177 overall to cover the staff members.

There are several responses an employer could have to this proposal if it becomes final, depending on the situation:

1.     Ignore it because each rate group already passes the ratio percentage test.

2.     Make additional allocations as needed to pass the ratio percentage test.

3.     Redesign the allocation formula to ensure the reasonable classification test is satisfied.  This could be done through an age weighted formula (which has the advantage of avoiding minimum gateway contributions but is very heavily age dependent), through a “super-integrated” design, or by restructuring allocation classes.

4.     Add other plan features, such as a safe harbor 401(k) feature with a 3% nonelective contribution (which can count towards minimum gateway contributions).  Doing so in the first example above would reduce the added cost for EE 3 to $415, a savings of $1,500.

5.     Assume that the plan’s grouping of employees will satisfy the reasonable classification test and run the risk that the IRS will disagree under audit.

Again, let us stress that there is no action an employer needs to take today in response to this proposal.  Some practitioners may wish to submit comments to the Treasury about the proposal, and professional organizations, such as ASPPA, are sure to do so.

Join us for a Webcast on this topic scheduled for March 22 at 12:00 pm ET, called “Cross-testing Forecast: Clouds Overhead.” See below for details.

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Orlando Advanced Pension Conference – Feb. 10-12 – Seats are still available

See program highlights, agenda, event details, and register online, here:

http://www.relius.net/Events/seminardetail.aspx?CID=26749

Just for ERPAs Workshop, Orlando FL – February 9, 2016

View event details and register online, here:

http://www.relius.net/Events/seminardetail.aspx?EID=26867

Pensions on Peachtree, Atlanta, GA – April 25-26 – Registration is now open!  

The professional educators at FIS are joining forces with the Ferenczy Benefits Law Center, LLP, based in Atlanta and Knoxville, to bring you their third annual conference. Program details and online registration is now available, here.

Live Web Seminars –

457(b) Plans for 401(k) Practitioners, 2/16, 12:00 PM ET

Safe Harbor Midyear Amendments:  Yes You Can!, 2/17, 12:00 PM ET

Fundamental Series 03: Compensation and HCEs, 2/18, 12:00 PM ET

DC Plan Restatement FAQs, 2/24, 12:00 PM ET

Multiple Employer Plans: How MEPs Work for Private Employers, 3/1, 12:00 PM ET

Fundamentals 04: Coverage Test, 3/3, 12:00 PM ET

MEPs, IRAs, and More: DOL Guidance on State Plans, 3/8, 12:00 PM ET

Fundamentals 05: Elective Deferrals, 3/10, 12:00 PM ET

Church Plans: The Retirement Benefits Are Better Than Ever, 3/15, 12:00 PM ET

Fundamental 06: ADP/ACP Test, 3/17, 12:00 PM ET

New - Cross-testing Forecast: Clouds Overhead, 3/22, 12:00 PM ET (registration will open soon)

Practical Corrections Series 01: Elective Deferral Failures, 3/29, 12:00 PM ET

Fundamentals Series 07: Safe Harbor 401(k) Plans, 3/31, 12:00 PM ET

Practical Corrections 02: Plan Document Failures, 4/5, 12:00 PM ET

For more details about these programs, and to register online: www.relius.net/events/events.aspx?Web

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