Pension simplification finally arrives: the employee benefit provisions of the Small Business Job Protection Act of 1996.

The Small Business Job Protection Act of 1996' (the Act), which was signed by President Clinton on August 20, 1996, eliminates some of the complexities and restrictions involved in maintaining and administering 401(k) and other qualified plans. These changes should encourage employers to establish new qualified plans and continue to maintain existing plans, as well as enable highly compensated individuals to utilize more fully the benefits associated with these plans.

Although some of the provisions affecting the operation of qualified plans have effective dates deferred until 1998 and 1999, many employee benefit provisions of the Act are effective January 1, 1997. Thus, employers should review their benefit programs at an early date in order to determine the extent to' which the new law may have an salutary effect on their programs.

The Act also contains important changes potentially affecting the retirement and financial planning of executives. Most significant, beginning in 1997, the Act creates a three-year window during which individuals with large accumulations in qualified plans and individual retirement accounts (IRAs) may receive distributions without having to pay the 15-percent excise tax on "excess distributions."

This article guides tax executives through the labyrinth of changes the Act makes in the employee benefit provisions of the Internal Revenue Code. The following specific areas are addressed: (1) cash or deferred arrangements under section 401(k) (so-called 401(k) plans), (2) the treatment of distributions from qualified plans, (3) the temporary suspension of the excise tax on excess distributions, (4) nondiscrimination requirements for qualified plans, (5) modifications to the benefit and contribution limitations under qualified plans, (6) employee stock ownership plans, and (7) other pension and employee benefit changes.

401(k) Plans -- Cash or Deferred Arrangements

Under current law, there are two complex nondiscrimination tests for qualified 401(k) plans. These tests are generally designed to ensure that the plan does not significantly discriminate in favor of highly compensated employees. The first test relates to elective 401(k) deferrals and is commonly referred to as the "ADP Test." The second test, relating to employer matching contributions and after-tax employee contributions, is commonly referred to as the "ACP Test."

1. Safe Harbor Nondiscrimination Rules

   1. Elective Deferral Safe Harbors as Alternative to ADP Testing

      The Act provides special safe harbor rules under which plan sponsors may opt to avoid ADP testing if certain levels of employer contributions are provided. Under these special rules, if a 401(k) plan complies with one of the two safe harbors described below for a plan year, the ADP Test will automatically be satisfied for that plan year.

      1. Nonelective Contribution Safe Harbor. The first safe harbor for 401(k) plans is satisfied if the employer makes a contribution to the plan of at least three percent of compensation on behalf of each non-highly compensated employee (non-HCE) eligible to participate in the 401(k) plan, without regard to whether or not the non-HCE makes elective deferrals to the plan.

      2. Matching Contribution Safe Harbor. The second safe harbor requires that the employer make a matching contribution on behalf of each non-HCE equal to (i) 100 percent of the non-HCE's elective deferrals up to three percent of compensation and (ii) 50 percent of the non-HCE's elective deferrals from three to five percent of compensation. This safe harbor also requires that the rate of the matching contributions for any highly compensated employee (HCE) not exceed the rate of the matching contributions for any non-HCE.

         Even if the rate of matching contributions does not satisfy the specified percentage requirements, this safe harbor will nevertheless be satisfied if (i) the matching contribution rate does not increase as the elective deferral rate increases and (ii) the aggregate amount of matching contributions equals at least the aggregate amount of matching contributions that would have been made if the matching contribution safe harbor percentage requirements were satisfied.

         Unlike the nonelective contribution safe harbor that requires employer contributions for all eligible non-HCEs without regard to whether they make elective deferrals to the plan, this matching contribution safe harbor requires employer contributions only for those non-HCEs who actually make elective deferrals to the plan.

      3. Requirements of Safe Harbors. All employer matching contributions and nonelective contributions that are used to satisfy the safe harbor rules must be nonforfeitable and subject to the restrictions on withdrawals and distributions that apply to an employee's elective deferrals under a 401(k) plan.(2) Since all such contributions must be fully vested when made, an employer that utilizes the safe harbors will generally be unable to reduce future employer contributions through the use of forfeitures.

         Under both the nonelective contribution and matching contribution safe harbors, each employee eligible to participate in the plan must be given written notice, within a reasonable period before any year, of the employee's rights and obligations under the plan.

   2. Matching Contribution Safe Harbor as Alternative to ACP Testing

      The Act also provides a safe harbor method for satisfying the ACP Test applicable to employer matching contributions. A plan satisfies the matching contribution safe harbor if it (a) meets the contribution and notice requirements applicable under the elective deferral safe harbor (described above) and (b) meets a special limitation on matching contributions (described below).

      The special limitation on matching contributions is satisfied if (a) matching contributions are not made with respect to elective deferrals or after-tax employee contributions in excess of six percent of compensation, (b) the matching contribution rate does not increase as the elective deferral or employee contribution rate increases, and (c) the rate of matching contributions for any HCE is not greater than the rate of matching contributions for any non-HCE.

   3. After-Tax Employee Contributions

      No safe harbors apply to after-tax employee contributions made under a qualified plan. Therefore, such after-tax contributions will continue to be tested under the ACP Test. In performing the ACP Test...