IRS Papers

How Do You Spell Relief? Closed Defined Benefit Plans Say “I.R.S.”- Others Are Not in That Classification

New Rule Changes for Nondiscrimination Testing may affect profit sharing, cash balance and corporate QSERP arrangements.

Feb 09, 2016

New Rule Changes for Nondiscrimination Testing

The IRS recently issued some proposed rule changes with respect to coverage and nondiscrimination testing for qualified plans. This included permanent relief with respect to defined benefit plans that previously froze participation and shifted benefit delivery for new employees to a defined contribution approach. Temporary two-year relief was granted under Notice 2014-5 and then extended another year through 2016 by Notice 2015-28.

Consequently, the permanent relief was somewhat expected and certainly welcomed by the closed defined benefit plan marketplace. These folks are likely cheering the IRS right now, as much as one might cheer the IRS.

However, in an unrelated and unexpected move, the IRS took this opportunity to slam the nondiscrimination testing door on the fingers of plan sponsors with perfectly legal plan designs. This is because the IRS feels that these plans circumvent the intent of nondiscrimination testing regulations.

Understanding Nondiscrimination Testing Regulations

First, the IRS came out with complicated nondiscrimination testing regulations in 1991. These regulations included the ability to demonstrate that defined contributions were nondiscriminatory on a retirement benefit/defined benefit basis (cross-testing). This allowed older business owners to maximize their contributions, while leveraging the time value of money and the youth of their employees.

The IRS didn’t like that math, even though it’s essentially the same way defined benefit plan funding is determined. Then in 2002 the IRS effectuated their elaborate cross-testing prerequisites requiring plans (or combined plans) to be primarily defined benefit in nature, have broadly available allocation rates, or provide a minimum allocation gateway. Except for larger corporate benefit programs, it’s usually the gateway option that is satisfied.

This does make sense. If business owners are going to benefit significantly from these plans, then they must provide a “not insignificant” minimum level of contribution to their employees. This is just for the privilege of being able to cross-test; contributions still have to be sufficient to pass testing.

Apparently the IRS still does not like the “new” (since 1991) comparability. It also does not like plans that put participants in individual allocation groups, even though they gave their blessing for such in pre-approved prototype and volume submitter documents. They also do not like cash balance plans that favor business owners, and they don’t even like the corporate QSERP that provides enhanced executive benefits in a qualified plan and still satisfies nondiscrimination testing.

A Reasonable Classification Standard?

In its infinite wisdom, the IRS has now decided that under general nondiscrimination testing, individual rate groups must satisfy either (1) the reasonable classification standard of the average benefits (coverage) test, in addition to the nondiscriminatory classification test, with the plan in total satisfying the average benefits percentage test, or (2) the ratio percentage test.

It is the reasonable classification standard, if adopted in the final regulations, that could bring many profit sharing, cash balance and corporate QSERP arrangements to a screeching halt. Why? Any formula where a highly compensated employee (HCE) is in a rate group by naming convention (or any manner that could be deemed similar) would fail that standard and such a rate group would have to satisfy the ratio percentage test. That means the percentage of non-highly compensated employees (NHCEs) (with benefits comparable to the HCE) must be at least 70% of the percentage of HCEs in that rate group. In other words, a plan sponsor would have to have all older HCEs and a large percentage of very young NHCEs or cough up a lot more money for NHCE contributions.

The worst part is that the “reasonable classification” is a facts and circumstances determination that is deemed reasonable under objective business criteria. From the current regulations:

(b) Reasonable classification established by the employer. 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.

We know what would not be a reasonable classification, but what would be? Owner(s), Non-owners? HCEs/NHCEs? Can these further be classified by age, service, level of compensation? What if there is only one person in a group – is that automatically unreasonable? I expect industry groups representing plan sponsors and practitioners to protest this unexpected bombshell. If a reversal is not obtained, hopefully at a minimum we’ll see a delay and some specific guidance on what would be and would not be considered a reasonable classification.

A Detrimental Proposal

This is far-reaching, affecting profit sharing, cash balance and certain defined benefit plans alike, and another example of how the IRS just doesn’t get it. If business owners cannot substantially benefit from retirement plans at a reasonable level of employee cost, then they won’t sponsor them.

I’ve said it before and I’ll say it again, the “trickle down” concept works in small business retirement plans. I say go the other way; throw out all the nondiscrimination rules and allow HCEs to earn maximum benefits under all plans (which are already limited by IRS) provided they contribute a safe harbor percentage of pay annually for their NHCEs of either 5% (defined contribution only) or 10% (defined contribution and defined benefit). That would serve to make more people retirement ready, rather than driving small businesses out of retirement plans altogether and forcing their employees into miniscule government starter plans.