Current developments in employee benefits.

• Author: Walker, Deborah

Qualified Plan Qualification and Distribution Rules, DOL and IRS Positions on Qualified Plans

This two-part article provides an overview of recent developments in employee benefits, including qualified retirement plans, executive compensation and welfare benefit plans. Part I, published in November, focused on executive compensation and welfare benefit plans, including the special rules that apply to tax-exempt organizations and employee business expense arrangements. Part II, below, will focus on the recently released final nondiscrimination and coverage regulations under Secs. 401(a)(4) and 410(b); the final regulations on cash or deferred arrangements (CODAs) and employer matching plans; recent programs instituted by the IRS National Office to restore the qualified status to certain plans that inadvertently become disqualified; and new developments in the deduction for qualified plan contributions and the taxation of qualified plan distributions. The Revenue Reconciliation Act of 1990 (RRA) provided certain employers with overfunded defined benefit plans that currently provide retiree medical benefits with the ability to increase cash flow by using retirement plan assets to fund these medical benefits. At the same time, the excise tax on the reversion of plan assets was increased. These provisions will be discussed. The activities at the Department of Labor (DOL) regarding plan investments and recent court decisions on prohibited transactions between qualified plans and the employer will also be addressed.

Nondiscrimination Rules

On Sept. 9, 1991, final regulations outlining in detail the coverage and discrimination tests for qualified retirement plans were released. Known collectively as the nondiscrimination regulation package, regulations under Secs. 401(a)(4), 410(b), 401(a)(17), 401(1) and 414(s) were released together. Many practitioners have asked why it was necessary to release over 600 pages of regulations to interpret less than three lines of the Code, lines that have remained essentially unchanged for decades. The regulations represent an effort by the Service to impose consistency within government enforcement offices and among practitioners in the application of nondiscrimination rules for qualified retirement plans. Although practitioners will find the regulations voluminous, they are presented logically and their format will facilitate the researching of specific questions.

While a complete review of these regulations is beyond the scope of this article, the new rules on the following topics will be discussed: defined contribution plans; coverage (which is where most practitioners will focus their attention to determine whether a plan or component of a plan satisfies these rules); plan benefits, rights and features; allowing discrimination and coverage violations to be retroactively corrected; and age-weighted profit-sharing plans, an important type of retirement plan whose use will become much more prevalent as a result of these regulations.

* Defined contribution plans In general, a plan is qualified only if the contributions or the benefits provided under the plan do not discriminate in favor of highly compensated employees.(58) This test applies both to the form of the plan document and to the plan's operation.

A plan must meet the following three requirements to be considered nondiscriminatory. 1. Either the contributions or the benefits provided under the plan must be nondiscriminatory in amount.(59) 2. The benefits, rights and features of the plan must be available to employees in a nondiscriminatory manner.(60) 3. The effect of plan amendments (including amendments granting past service credit) and plan terminations must be nondiscriminatory.(61)

The regulations provide that certain employee groups (such as former employees) and certain benefits (such as those provided by employee contributions and health benefits under Sec. 401(h)) must be separately tested for discrimination.

Generally, the definition of a plan subject to testing under Sec. 401(a)(4) is the same as the definition of a plan under Sec. 410(b), applying the same permissive aggregation and mandatory disaggregation rules. A plan may be restructured into two or more plans based on employee groups, as long as each of the restructured plans independently satisfies the requirements of Secs. 401(a)(4) and 410(b).

A defined contribution plan generally will satisfy the nondiscriminatory amount requirement by showing that the contributions provided under the plan satisfy either the safe harbors in Regs. Sec. 1.401(a)(4)-2(b) or the general test in Regs. Sec. 1.401(a)(4)-2(c). Except in the case of an employee stock ownership plan (ESOP), a Sec. 401(k) plan or a Sec. 401(m) plan, a defined contribution plan can also satisfy the nondiscriminatory amount requirement by showing that the equivalent benefits provided under the plan are nondiscriminatory in amount under the cross-testing rules of Regs. Sec. 1.401(a)(4)-8. This results in higher contribution allocations for older employees, a technique that is becoming known as an age-weighted profit-sharing plan.

Using the cross-testing approach for testing discrimination, the older employee receives a larger allocation of the annual contribution because the amount provided to such an employee will not have as long a period to accumulate income to provide the prescribed benefit as an allocation provided for a younger employee. This test uses the length of time until retirement benefits are paid to favor the older employees. The allocation of larger amounts for older employees to achieve a retirement benefit that is a consistent percentage of compensation for all employees is not considered discriminatory.

Planning: To take advantage of the rule that allows an employer to consider the time until benefits will be paid out in testing for discrimination, the employer can design an allocation schedule that provides a uniform allocation of benefits as a percentage of compensation for each participant. The plan can be designed with a discretionary contribution or by specifying that a given percentage of compensation will be contributed annually for each participant. A defined contribution plan that converts contributions to benefits to test for discrimination in benefits can take advantage of the permitted disparity rules and include a vesting schedule.

In general, the contribution allocated to each employee is projected to the future value at the employee's retirement age using an interest rate of 7 1/2% to 8 1/2%. This amount is then converted to a life annuity, using a standard mortality table and an interest rate between 7 1/2% and 8 1/2%. The annuity is then expressed as a percentage of current compensation. As long as employees receiving equivalent percentages of compensation satisfy the Sec. 410(b) rules, the plan is nondiscriminatory. In adopting these plans, the employer will need to take care that no employee receives an allocation of more than $30,000, or 25% of compensation. In addition, if the plan is top heavy, a minimum benefit must be provided.

Alternative methods: Plans may use certain alternative methods to demonstrate that contributions are nondiscriminatory in amount. For example, plans may satisfy the nondiscriminatory amount requirement on a restructured basis by separating one plan into component plans that provide different benefits. The regulations also permit plans with multiple formulas to satisfy the nondiscriminatory amount requirement on the basis of each separate formula, provided that each formula separately satisfies the safe harbor requirements in Regs. Sec. 1.401(a)(4)-2(b).

Safe harbors: The safe harbors require that the plan have a uniform normal retirement age for all employees and a uniform benefit formula for allocations, and base allocations or benefits on a nondiscriminatory definition of compensation. In addition, uniform vesting and service crediting rules apply under the safe harbors, although plans may use different methods of calculating service for different purposes, provided they are uniform within each application.

There are two safe harbor tests for defined contribution plans. The first is design-based and permits a defined contribution plan with a uniform allocation formula to satisfy the nondiscriminatory amounts test without calculating allocation rates for individual employees. This test is satisfied if all employees receive an allocation of a uniform percentage of compensation or a uniform dollar amount.(62)

The second safe harbor permits a defined contribution plan with a uniform allocation formula weighted for age or service to satisfy the nondiscriminatory amount test if the average allocation rate for highly compensated employees does not exceed the average allocation rate for nonhighly compensated employees. Plans using this safe harbor must provide the same number of points for each age, year of service and unit of compensation, not to exceed $200. This safe harbor applies only to plans in which (1) points are provided on a uniform basis for compensation and for age or service and (2) an employee's allocation for a plan year is determined by multiplying the total amount to be allocated to all employees by a fraction, the numerator of which is the employee's points for the plan year, and the denominator of which is the sum of the points of all employees in the plan for the plan year.(63)

Rate-segment restructuring: The final regulations reformulate the general (non-safe harbor) test to incorporate the concept of rate-segment restructuring. In applying the general test, the employer must identify, for each highly compensated employee, the group of employees consisting of that highly compensated employee and all other employees (both highly compensated and nonhighly compensated) with equal or greater allocation rates (a "rate group"). Thus, depending on their allocation rates, employees may be included in more than...