IRS Chief Counsel Memorandum 201615013 (Jan. 8, 2016)
Available at https://www.irs.gov/pub/irs-wd/201615013.pdf
The IRS Chief Counsel’s Office has released a memorandum that clarifies how plans (including 401(k) plans) may define the group of “otherwise excludable” employees for certain nondiscrimination testing purposes. As background, the minimum participation rules of Code § 410(a) allow plans to require that employees reach age 21 and complete one year of service before they are allowed to participate, but actual participation can be delayed until the earlier of the first day of the following plan year or six months after the age and service criteria are met (here, we refer to that additional delay as the “additional waiting period”). For nondiscrimination testing purposes, “otherwise excludable” employees can be tested separately when performing minimum coverage testing under Code § 410(b), and may be excluded (or tested separately) when performing the ADP and ACP nondiscrimination tests. It has long been uncertain, however, whether individuals who have attained age 21 and completed one year of service could continue to be tested separately or excluded (i.e., treated as “otherwise excludable”) until the end of the additional waiting period permitted by the participation rules.
The memo notes that the Code’s description of the coverage testing rule is ambiguous but could be read as allowing plans to take the additional waiting period into account. The memo finds that the regulations’ reference to the “greatest” minimum age and service conditions permissible under Code § 410(a) is consistent with that reading, and references in the legislative history to the “statutorily permitted entry dates” provide additional support. Looking at the ADP test, the memo reasons that the statutory language favors using the same cut-off point for identifying who is otherwise excludable for coverage testing purposes and which non-highly compensated employees can be excluded when performing the ADP test. In light of these considerations, the memo concludes that—for purposes of disaggregation under the coverage testing rules and the identification of excludable individuals under the ADP test—the otherwise excludable group may include individuals who have attained age 21 and completed one year of service, but who have not yet completed the additional waiting period permitted under the participation rules. The memo goes on to say that this is not the only permissible interpretation. Alternatively, plans could disregard the additional waiting period or they could use only the plan’s actual waiting period, if that is less than the maximum permitted under Code § 410(a).
EBIA Comment: While this memo is not guidance that can be used or cited as precedent, it does indicate that the IRS has decided to adopt a flexible approach to resolving the longstanding uncertainty about the interaction between the entry date rules under Code § 410(a), the permissive disaggregation rule under the coverage testing rules, and the exclusion and separate testing rules for ADP and ACP nondiscrimination testing. Plan sponsors who have adopted a narrower reading of the rules may want to reconsider their practices in light of this memo, as this approach might allow some plans to simplify their testing procedures and could, in some cases, have a favorable effect on testing. For more information, see EBIA’s 401(k) Plans manual at Sections VII.E (“Eligibility Condition #4: Participation Delayed Until Plan Entry Date”), XIX.F.2 (“Optional Disaggregation of Plans That Benefit Otherwise Excludable Employees”), and XXI.M.1 (“Testing Otherwise Excludable Employees Separately”).
Contributing Editors: EBIA Staff.