IRS CAUTIONS EMPLOYERS ON SHORT SERVICE PLAN DESIGNS

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Retirement plans that limit the benefits that are available to non-highly compensated employees to those who work few hours or for little pay may violate the tax code’s nondiscrimination rules, the Internal Revenue Service said.

The agency took aim at these plan designs—known as short service plans—in its latest edition of Employee Plans News posted online on April 1.

The fact that these plans might technically meet the general tests for nondiscrimination plans does not mean that they pass nondiscrimination testing, which requires that the plans not primarily or exclusively benefit highly compensated employees with little to no benefit for NHCEs, the IRS said.

However, IRS shouldn’t complain about companies using the mathematical formulas that Congress and the agency created, David Godofsky, a partner with Alston & Bird, Washington, D.C., and leader of its Employee Benefits and Executive Compensation practice group, told Bloomberg BNA.

The IRS zeroed in on discriminatory plan designs it said it had recently found in defined contribution, defined benefit, and defined benefit/defined contribution combination plans.

The designs “provide significant benefits to the HCEs and a specified group of NHCEs, who work very few hours or receive very little compensation, and exclude other NHCEs from plan participation,” the IRS said.

In this plan design, this group of NHCEs “receives the minimum to satisfy the mathematical portion of the nondiscrimination requirements of IRC Section 401(a)(4),” the IRS said. “For example, the plan may use a group of NHCEs who have at least one hour of service and received the least amount of compensation for the plan year,” it said.

Rather than a set group, the actual number of NHCEs in this plan “is defined as the minimum number required to satisfy the requirements of IRC Sections 401(a)(4) and 410(b),” the IRS said. Those tax code sections, respectively, prohibit qualified plans from discriminating in favor of HCEs in retirement contributions or benefits and impose minimum coverage requirements for retirement plans.

Other Examples

The IRS also touched on other short service plan designs that it said might pass general nondiscrimination testing but not the more specific provisions of the nondiscrimination rules.

One example, it said, are plans that limit NHCE benefits to a specific job classification. “The result, for discrimination and coverage purposes, is the same because this classification includes only the lowest paid or shortest service group of NHCEs,” it said.

Yet other plan designs might pass general vesting or numeric tests under the nondiscrimination rules but would not prevent discrimination in favor of HCEs, the IRS said. This includes providing coverage to NHCEs who work on an as-needed basis and earn very little each year; requiring 1,000 hours to earn a year of service for vesting purposes but not for contribution allocation purposes; and defining a year of vesting service as the employee’s completion of 12-consecutive months of employment.

Existing Formulas

Plan sponsors using these short-service designs are merely making use of the mathematical formulas that Congress and the IRS have provided to determine the tax implication of certain forms of compensation, Godofsky said.

In a potential rewrite of the rules, “it might make sense to consider counting non-vested contributions somewhat differently from vested benefits,” he said. 

“Similarly, it may not be very logical to base these tests on the basis that each person counts as 1.0 in the mathematical formula,” Godofsky said.  “Weighting people by pay or hours or full-time equivalent or some other measure might make sense, but that is not the basis that Congress or Treasury or IRS chose when writing these rules. So, it makes little sense for the IRS to complain about the natural consequences of the formulas they devised.”

“The end result is that employers will use the mathematical formulas the way they are designed, and until Treasury and IRS write different formulas, they can expect to get results that do not divide benefits the way they would like employers to divide up benefits,” he said.

In the meantime, Godofsky had this advice for plan sponsors.

“When you use designs that technically qualify, but look and feel artificial, you are inviting the IRS to try to find something wrong with your plan,” he said. “Given how complex the regulations are, that is a risk. I think it is fine to use the mathematical rules to your advantage, but you are on much stronger ground if your plan provides substantial benefits to non-highly compensated employees.”

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