IRS Gives Distressed Employers Flexibility With Safe Harbor PlansMay 28, 2009
On May 18, 2009, the Internal Revenue Service ("IRS") issued proposed regulations under Sections 401(k) and 401(m) of the Internal Revenue Code of 1986, as amended (the "Code") that allow distressed employers (who have incurred a substantial business hardship) to reduce or suspend their safe harbor nonelective contributions to their 401(k) retirement plans mid-year (this will also be allowed for certain 403(b) plans). Although only proposed, the new rules can be relied upon immediately for plan amendments adopted after May 18, 2009.
Background Regarding Safe Harbor 401(k) Plans
Retirement plans that meet the requirements of Section 401(k) of the Code—that is, 401(k) Plans—allow employees to elect to defer part of their salary, before taxes, into a plan account (and can also allow for other types of employee contributions). Often, employers provide additional account contributions either based on a percentage of what the employee elects to contribute (that is, employer matching contributions) or as an outright employer contribution for each participant (such as nonelective contributions). Pre-tax contributions in the 401(k) account are not taxable to the plan participant until distributions are paid from the plan. In order for this type of arrangement to maintain its tax-qualified status under the Code, the Code and Treasury regulations set forth certain requirements that must be followed, including annual testing to:
· Keep retirement plans from providing better benefits or rights to highly compensated employees than to non-highly compensated employees (commonly referred to as "nondiscrimination testing"). In 2009, an employee that earns more than $110,000 generally is considered highly compensated.
· Require minimum contributions for a year to non-key employees if the account balances of key employees become 60 percent or more of the total plan assets—that is, the plan is "top heavy" under Section 416 of the Code. Key employees include owners of 5 percent of the employer, owners of 1 percent of the employer with annual compensation of more than $150,000, or any employee who at any time during the plan year is an officer with annual compensation greater than $160,000 in 2009 (as adjusted by the IRS).
To avoid nondiscrimination testing and being subject to top heavy rules, employers may design their 401(k) plans to include certain "safe harbors." The following are examples of safe harbor designs:
· Contribution Safe Harbors under Section 401(k)(12) of the Code—Employer provides certain minimum levels of qualified matching contributions (QMACs) under a basic or enhanced matching formula, or qualified nonelective contributions (QNECs) equal to 3 percent of compensation for all eligible non-highly compensated employees. This safe harbor also requires that notice be provided to each eligible employee within a reasonable period before the beginning of the plan year of the employee's rights under the plan; or
· Automatic Contribution Safe Harbor under Section 401(k)(13) of the Code—This "alternative safe harbor" requires qualified automatic employee salary reduction contributions (QACAs) that the employer must match under a basic or enhanced matching formula or that are coupled with employer nonelective contributions equal to 3 percent of compensation for all eligible non-highly compensated employees. A similar notice requirement as to the one mentioned above also applies for this safe harbor.
Generally, a plan that utilizes a "safe harbor" design must specify in advance of the beginning of the plan year which safe harbor method will be used and cannot provide that nondiscrimination testing will be used if the safe harbor requirements are not met (i.e., the plan may not be amended to revert to performing the actual deferral percentage (ADP) or actual contribution percentage (ACP) testing for the plan year unless an exception is available). Plans that use "current year" ADP or ACP testing methods can be amended after the first day of the plan year to provide for safe harbor nonelective contributions, provided certain amendment timing and notice requirements are also followed. Further, plans that provide for safe harbor matching contributions can be amended during a plan year to reduce or suspend safe harbor matching or future elective contributions, so long as certain requirements are met. However, prior to the issuance of the new proposed regulations, there was no provision for reducing safe harbor nonelective contributions unless the employer terminated the whole plan.
New Proposed Rules
Under the proposed regulations, an employer that sponsors a safe harbor plan under Section 401(k)(12) or 401(k)(13) of the Code who incurs a "substantial business hardship" can now reduce or suspend safe harbor nonelective contributions during a plan year without actually terminating the plan. At a minimum, the following factors would need to be considered in determining whether the employer has incurred a substantial business hardship: the employer is operating at an economic loss, there is substantial unemployment or under-employment in the trade or business and in the industry concerned, the sales and profits of the industry concerned are depressed or declining and it is reasonable to expect that the plan will be continued only if the relief is granted. These factors are similar to those considered under Section 412(c) of the Code with respect to waivers of the minimum funding standard for defined benefit plans, money purchase plans and multiemployer plans. However, for safe harbor 401(k) plans, an application to the IRS to obtain relief from making a required nonelective contribution does not appear to be necessary.
The new terms for reducing employer safe harbor nonelective contributions are comparable to existing requirements for reducing safe harbor employer matching contributions. The employer must:
1. Give all employees a supplemental notice of the reduction or suspension of employer contributions.
2. Make the reduction or suspension effective no earlier than the later of 30 days after issuing the supplemental notice and the date the amendment is adopted.
3. Give all eligible employees a reasonable opportunity prior to the reduction or suspension of the safe harbor nonelective contribution to change their salary deferral elections (and employee contribution elections, if any).
4. Amend the plan to use the current year ADP nondiscrimination test (or ACP test, as applicable) for salary deferrals for the entire year.
5. Meet the safe harbor nonelective contribution rule with regard to the safe harbor compensation paid through the date of the amendment.
The IRS is also contemplating requiring that an explanation of these rules become part of the regular safe harbor notice that is provided before the beginning of the plan year, but this would not apply for plan years beginning before January 1, 2010.
Effect on Employers
A distressed employer that adopted a safe harbor plan design under Section 401(k)(12) or 401(k)(13) of the Code can now reduce or suspend any safe harbor nonelective contributions without the need to terminate the entire plan. A suspension of employer contributions to a safe harbor 401(k) plan is not without consequences. For example:
· The plan is no longer a safe harbor design for the entire year, so the top heavy rules will apply. If the employer must make a minimum contribution for non-key employees, all or part of the benefit of eliminating the match or nonelective contributions could be lost.
· In calculating the safe-harbor contribution levels up to the point of the amendment, the compensation limit ($245,000 for 2009) must be prorated for the actual period the safe harbor applies.
· Nondiscrimination testing is required for the full year, even though safe-harbor contributions were made for part of the year.
When a business is in distress, however, these trade-offs could be acceptable. Keep in mind, however, that employers cannot wait until the end of the plan year to suspend or reduce these nonelective contributions due to the notice requirements. Thus, careful planning within the next few months can provide additional relief to affected employers facing substantial business hardship.