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IRS rules on retirement plan that offsets benefits of low-paid employees

In Chief Counsel Advice (CCA), IRS has ruled on whether an employer’s combined defined-benefit/defined contribution retirement plan, under which benefits under the defined benefit plan are offset by benefits under the defined contribution plan only for nonhighly compensated employees (NHCEs), meets plan discrimination and minimum participation requirements.

Background—discrimination rules.  Code Sec. 401(a)(4) provides that a plan is a qualified plan only if the contributions or the benefits provided under the plan do not discriminate in favor of highly-compensated employees (HCEs).

Reg. § 1.401(a)(4)-1(b)(2) requires that either the contributions or the benefits provided under the plan must be nondiscriminatory in amount. To be nondiscriminatory in amount, either the contributions alone or the benefits alone must be nondiscriminatory in amount.

Reg. § 1.401(a)(4)-3(c) provides that the employer-provided benefits under a defined benefit plan are nondiscriminatory in amount for a plan year if each rate group under the plan satisfies Code Sec. 410(b). For purposes of Reg. § 1.401(a)(4)-3(c)(1), a rate group generally consists of an HCE and all other employees with a normal accrual rate greater than or equal to the HCE’s normal accrual rate and who also have a most valuable accrual rate greater than or equal to the HCE’s most valuable accrual rate.

Reg. § 1.401(a)(4)-3(f) provides special rules of application. Reg. § 1.401(a)-4(3)(f)(9) provides that an employee’s accrued benefit under a plan includes that portion of the benefit that is offset under an offset described in Reg. § 1.401(a)(4)-11(d)(3)(i)(D) (pertaining to offsets for pre-participation service). The rule applies only to the extent that the benefit is attributable to periods for which the plan being tested credits pre-participation service or past service. Reg. § 1.401(a)(4)-3(f)(9)(ii), Example 1 illustrates that the rule applies to an offset for pre-participation service but not to an offset for concurrently earned benefits.

Reg. § 1.401(a)(4)-9 sets out the requirements for testing situations in which plan aggregation or restructuring is used to satisfy nondiscrimination.

Reg. § 1.401(a)(4)-9(b)(2)(v)(A) addresses a plan that consists of one or more defined contribution plans and one or more defined benefit plans (a DB/DC plan). Specifically, it provides that unless the DB/DC plan is primarily defined benefit in character or consists of broadly available separate plans, the DB/DC plan must satisfy the minimum aggregate allocation gateway of Reg. § 1.401(a)(4)-9(b)(2)(v)(D) for the plan year in order to be permitted to demonstrate satisfaction of the nondiscrimination in amount requirement of Reg. § 1.401(a)(4)-1(b)(2) on the basis of equivalent benefits.

Reg. § 1.401(a)(4)-9(b)(2)(v)(B) provides that a DB/DC plan is primarily defined benefit in character if, for more than 50% of the non-highly compensated employees (NHCEs) benefitting under the plan, the normal accrual rate for the NHCE attributable to benefits provided under defined benefit plans that are part of the DB/DC plan exceeds the equivalent accrual rate for the NHCE attributable to contributions under the defined contribution plans that are part of the DB/DC plan.

Under Reg. § 1.401(a)(4)-9(b)(2)(v)(C), a DB/DC plan consists of broadly available separate plans if the defined contribution plan and the defined benefit plan that are part of the DB/DC plan each would satisfy the requirements of Code Sec. 410(b) and the nondiscrimination in amount requirement of Reg. § 1.401(a)(4)-1(b)(2) if each plan were tested separately and assuming that the average benefit percentage test of Reg. § 1.410(b)-5 were satisfied.

Reg. § 1.401(a)(4)-9(b)(2)(v)(D)(1) provides the rules for how a DB/DC plan satisfies the minimum aggregate allocation gateway.

Background—minimum participation rules.  Code Sec. 401(a)(26) provides a minimum participation rule. It provides that a trust that is part of defined benefit plan is a qualified trust only if it benefits at least the lesser of (i) 50 employees of the employer, or (ii) the greater of (A) 40% of all employees of the employer, or (B) two employees (or if there is only one employee, such employee).

A plan that satisfies any of the exceptions described in Reg. § 1.401(a)(26)-1(b) passes   Code Sec. 401(a)(26) automatically for the plan year. A plan that does not satisfy one of those exceptions must satisfy Reg. § 1.401(a)(26)-2(a). In addition, a defined benefit plan must satisfy Reg. § 1.401(a)(26)-3 with respect to its prior benefit structure.

Reg. § 1.401(a)(26)-1(b) provides exceptions for plans that do not benefit any highly compensated employees, multiemployer plans, certain underfunded defined benefit plans, and certain plans involved in acquisition or disposition transactions of the employer.

Under Reg. § 1.401(a)(26)-2(a), a defined benefit plan that does not meet one of these exceptions must benefit at least the lesser of 50 employees or 40% of the employer’s employees. And under Reg. § 1.401(a)(26)-3(a), a defined benefit plan that does not meet one of these exceptions in must satisfy Reg. § 1.401(a)(26)-3(c) with respect to its prior benefit structure.

Reg. § 1.401(a)(26)-3(c)(1) provides that a plan’s prior benefit structure satisfies Reg. § 1.401(a)(26)-3(c) if the plan provides meaningful benefits to a group of employees that includes the lesser of 50 employees or 40% of the employer’s employees.

Reg. § 1.401(a)(26)-5(a)(2) provides a rule for determining whether an offset plan provides meaningful benefits.  Reg. § 1.401(a)(26)-5(a)(2)(i) provides that generally an employee is treated as accruing a benefit under a plan that includes an offset or reduction of benefits that satisfies Reg. § 1.401(a)(26)-5(a)(2)(ii) or Reg. § 1.401(a)(26)-5(a)(2)(iii) if either the employee accrues a benefit under the plan for the year or the employee would have accrued a benefit under the plan if the offset or reduction of the benefit were disregarded.

Reg. § 1.401(a)(26)-5(a)(2)(iii) states: “An offset or reduction of benefits under a defined benefit plan satisfies the requirements of this paragraph (a)(2)(iii) if the benefit formula provides a benefit that is offset or reduced by contributions or benefits under another plan that is maintained by the same employer and several requirements are met, including that the employees who benefit under the formula being tested also benefit under the other plan on a reasonable and uniform basis.”

Facts.  The employer maintains a cash balance plan and a defined contribution plan for the benefit of its employees.

The defined contribution plan is a profit sharing plan to which the employer makes an annual contribution that is allocated ratably to all participants based on compensation. All employees of the employer are eligible to participate in the defined contribution plan.

The cash balance plan covers two groups of participants. The first group of participants (all of whom are HCEs) consists of the owner-employees of the employer. This group of participants receives the lesser of (1) the maximum pay credit so that the resulting annual benefit will not exceed the limitations of Code Sec. 415(b), and (2) the maximum pay credit that enables the plan to comply with  Code Sec. 401(a)(4) (determined using a method specified in the plan).

The second group of participants (all of whom are NHCEs) consists of the lowest-paid group of employees who are not owner-employees and who perform at least one hour of service during the plan year. The lowest-paid group is limited to the number of employees necessary so that the plan covers the lesser of 40% of the total number of employees for the plan year or 50 employees. This second group of participants receives an annual pay credit of 1% of compensation. Because the benefits for this second group of participants attributable to employer contributions under the profit-sharing plan is larger than the benefits payable under the cash balance plan absent the offset, the offset for this second group of employees reduces the benefit under the cash balance plan to zero.

The employer intends to aggregate the cash balance plan and the profit-sharing plan for purposes of nondiscrimination testing. Thus, the aggregated plans are considered a defined benefit/defined contribution (DB/DC) plan.

Issues.  (1) How may the employer’s combination of plans satisfy the conditions for combined testing on the basis of equivalent benefits under Reg. § 1.401(a)(4)-9(b)(2)(v)? (2) Are the NHCEs whose benefit under the defined benefit plan is entirely offset considered to be benefitting under the defined benefit plan, and to have a meaningful benefit under the defined benefit plan, for purposes of determining whether the plan satisfies the minimum participation requirement of  Code Sec. 401(a)(26)?

IRS rules on discrimination issue. In order to demonstrate satisfaction of the nondiscrimination requirements on the basis of equivalent benefits without satisfying the minimum aggregate gateway allocation, the aggregated plan must either be primarily defined benefit in character or consist of broadly available separate plans.

The DB/DC plan resulting from aggregating the cash balance plan and the profit-sharing plan is not primarily defined benefit in character within the meaning of Reg. § 1.401(a)(4)-9(b)(2)(v)(B). That is because, for the NHCEs accruing pay credits under the plan, the normal accrual rate attributable to benefits provided under the cash balance plan is zero as a result of the offset by the larger benefit attributable to the defined contribution plan. The offset may not be disregarded because it is an offset for concurrently earned benefits and only an offset for pre-participation service may be disregarded. Therefore the benefit for each NHCE does not exceed the equivalent accrual rate for the NHCE attributable to contributions under the defined contribution plan.

The DB/DC plan resulting from aggregating the cash balance plan and the profit-sharing plan does not consist of broadly available separate plans. Reg. § 1.401(a)(4)-9(b)(2)(v)(C) requires that to be considered broadly available separate plans, each plan separately must satisfy the requirements of Code Sec. 410(b) and the nondiscrimination-in-amount requirement of Reg. § 1.401(a)(4)-1(b)(2) if each plan were tested separately and assuming that the average benefit percentage test of Reg. § 1.410(b)-5 were satisfied. The cash balance plan does not separately meet the coverage requirements, taking the offset into account, because the benefits under the cash balance plan for participants who are NHCEs are reduced to zero under the offset. As discussed above, this offset may not be disregarded in testing the cash balance plan, because it is not an offset attributable to pre-participation service and, under Reg. § 1.401(a)(4)-3(f)(9), the only offsets that may be disregarded are offsets attributable to pre-participation service. After applying the offset to determine the accrued benefit, the cash balance plan does not satisfy the requirements of Code Sec. 410(b) when tested separately, because an insufficient number of employees have normal and most valuable accrual rates greater than or equal to the rates of the HCEs.

Since the aggregated plan is not primarily defined benefit in character and does not consist of broadly available separate plans, in order for the DB/DC plan to be permitted to demonstrate satisfaction of the nondiscrimination requirements on the basis of equivalent benefits, NHCEs must receive sufficient allocations under the profit-sharing plan to satisfy the minimum aggregate allocation gateway of Reg. § 1.401(a)(4)-9(b)(2)(v)(D).

IRS rules on minimum participation requirement issue. The NHCE participants in the cash balance plan are not taken into account for purposes of determining whether the cash balance plan satisfies the requirements of Reg. § 1.401(a)(26)-2 and Reg. 1.401(a)(26)-3.

The cash balance plan does not meet any of the exceptions listed in Reg. § 1.401(a)(26)-1(b). Therefore it must satisfy Reg. § 1.401(a)(26)-2(a) by benefitting a group of employees that includes the lesser of 50 employees or 40% of the employer’s employees. Furthermore, the cash balance plan must satisfy Reg. § 1.401(a)(26)-3 with respect to its prior benefit structure by providing meaningful benefits to a group of employees that includes the lesser of 50 employees or 40% of the employer’s employees.

In order for the offset to be disregarded in determining whether the cash balance plan satisfies Reg. § 1.401(a)(26)-2 and Reg. § 1.401(a)(26)-3 (so that NHCEs, who benefit under the cash balance plan disregarding the offset but not if the offset is taken into account, are counted for purposes of satisfying these requirements), the offset must fall within the exception of Reg. § 1.401(a)(26)-5(a)(2)(iii). That exception applies to a defined benefit plan only if the benefit formula provides a “benefit that is offset or reduced by a contribution or benefit under another plan.” In addition, the rreg provide that employees who benefit under the formula being tested must also benefit under the other plan on a reasonable and uniform basis. Since, as explained below, the benefit under the cash balance plan is not fully offset or reduced by the benefit under another plan under which the employees who benefit under the cash balance plan benefit on a reasonable and uniform basis, the offset may not be disregarded in determining whether the cash balance plan satisfies the minimum participation requirements of  Code Sec. 401(a)(26).

An employer may argue that the “reasonable and uniform basis” requirement applies only to the coverage and benefits under the other plan, and that the exception for a “benefit that is offset or reduced by a contribution or benefit under another plan” is not restricted to full offsets that apply to all participants in the defined benefit plan. However, this is an unreasonable interpretation of Reg. § 1.401(a)(26)-5(a)(2)(iii), because the effect of an offset that does not apply fully to all participants is identical to the effect of an offset that applies uniformly to reduce benefits under the defined benefit plan by non-uniform benefits in the offsetting plan.

For example, if each participant in an offsetting defined contribution plan receives an allocation of 6% of compensation (and therefore each participant has uniform benefits), and the benefit under the defined benefit plan is offset by 100% of the benefit under the defined contribution plan, the offset applies uniformly and may be disregarded under Reg. § 1.401(a)(26)-5(a)(2). But if the defined contribution plan provides for an allocation of 6% of compensation to one group of participants and 3% of compensation to another group of participants (so that the employees do not benefit under the defined contribution plan on a uniform basis), application of the 100% offset results in the group with the 6% allocation experiencing a larger benefit reduction as a result of the offset than the group with the 3% allocation. Under Reg. § 1.401(a)(26)-5(a)(2), this offset may not be disregarded, because employees who benefit under the defined benefit plan being tested do not also benefit under the offsetting defined contribution plan on a reasonable and uniform basis. If instead all allocations to participants under the defined contribution plan are 6% of compensation, but the offset under the defined benefit plan is 100% of the defined contribution plan benefits for one group of participants and 50% for another group, the reduction in the benefits in the defined benefit plan being tested is identical to the reduction in the prior alternative offset formulation, which does not satisfy the exception in Reg. § 1.401(a)(26)-5(a)(2).

The regs under Reg. § 1.401(a)(26)-5 are intended to have a meaningful effect and prohibit certain arrangements. This goal would not be accomplished if the reg could be applied to make the requirements so easily circumvented to achieve the prohibited result. Accordingly, the only reasonable reading of Reg. § 1.401(a)(26)-5(a)(2)(iii) is that “a benefit that is offset or reduced by a contribution or benefit under another plan” refers to a benefit to the extent it is offset or reduced by contributions or benefits under that other plan in the same manner for all participants. If the offset were not required to be applied in the same manner for all participants in the defined benefit plan, then, as demonstrated above, the uniformity provision with respect to the other plan would be rendered meaningless. In addition, the effect of such a non-uniform offset would be that the participants in the other plan do not, in effect, receive uniform benefits under that plan (because the use of the defined contribution plan benefit to offset the defined benefit plan benefit effectively diminishes the value of the defined contribution plan benefit for some participants but not for others).

Under the terms of the cash balance plan, the benefits for NHCE participants are reduced to zero by the offset of the profit-sharing plan benefit, while the benefits for owner-employee participants are not offset. Since the offset does not apply to all of the employees in the cash balance plan but only to NHCEs, it may not be disregarded. As a result of the offset, NHCE participants do not benefit under the cash balance plan and have not accrued a meaningful benefit under the cash balance plan. Moreover, the operation of the offset causes the cash balance plan to exist primarily to preserve accrued benefits for a small group of employees.

References: For qualified plan nondiscrimination rules, see FTC 2d/FIN ¶ H-6100 et seq.; United States Tax Reporter ¶ 4014.14. Chief Counsel Advice 201810008

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