UPDATE:  The Treasury and the IRS announced on April 14 that the proposed rules we wrote about below are being withdrawn at this time.  Yay!  We will post a separate article about the withdrawal of these proposed regulations in the coming weeks.

It’s not panic time just yet, but some proposed regulations are out which, if finalized as currently understood, could have a severe negative effect on cross-tested profit sharing and 401(k) plans.

Cross-tested plans are popular because companies are allowed considerable freedom as to how contributions may be divided among employees. Other types of plans such as integrated and uniform allocation require all employees to receive the same or nearly the same percentage of pay or dollar amount.  This can get expensive; if owners receive large contributions, so must everyone else.

Here is some background about the proposed reg and what it is that has everyone so concerned. (Warning:  technical discussion ahead.)  When performing cross-testing, there are two ways the rate groups can satisfy Code Section 410(b):  the ratio percentage test (which we’ll call the “ratio test”) or the average benefits test.  The ratio test is harder to pass.  Usually, plans try to pass the average benefits test.  If the ratio test does pass for all rate groups, then there is a good chance the employer has contributed more money for staff than it needs to.

The proposed regulation includes a change which says that in order to use the average benefits test in cross-testing, the allocation formula to a Highly Compensated Employee must apply to a group of employees that satisfies the reasonable classification requirement. “Reasonable classification” is not defined in the regulations – it is one of the dreaded “facts and circumstances” determinations – but the regs say that classifying employees by name or in such a way that has the effect of classifying them by name is not a reasonable classification.

To be clear, just because a classification of employees is not a “reasonable classification” doesn’t mean you can’t have it in your plan. You just have to jump through certain hoops that you might not have to if you were using a reasonable classification.

What is a reasonable classification and what is not?

• Job category, nature of compensation, and geographic location are reasonable classifications.
• Grouping employees by name (Group A = Barry Bonds, Group B = Meryl Streep, etc.) would not be considered a reasonable classification.
• A blanket statement that “each employee shall constitute a separate classification” would not be considered a reasonable classification because it has the effect of classifying by name.

The last bullet point is problematic because virtually all of our cross-tested plans define allocation groups in this manner. You can never go wrong with this language.  It’s easy.  It provides the employer with maximum flexibility in allocating contributions and never has to be amended.

If we knew we could just change some plan document language and end up in the same place we are now, we would not be having this conversation. However, consider a more traditional classification of employees:  Group A = Owners, Group B = Senior Managers, Group C = All Others.  Is this a reasonable classification?  Sure seems so.  But what if there is only one owner?  Would this be tantamount to using names for our employee classification?  An example in the proposed regulation gives the impression that it might be.  What if a company has five employees, all of whom have different job titles?  Reasonable classification?  No one really knows.

It is not clear just how heavy-handed these regulations will be if and when they are finalized. What is clear is that as of now it looks like (i) cross-tested plans could become more cumbersome at best and much more expensive at worst, and (ii) the proposal seems to be biased against small businesses.  Larger organizations are more likely to have numerous people holding any given job title and would seem less of a threat to run afoul of the reasonable classification rule.

It seems like there are three possible things that could happen:

• Nothing. Maybe enough people will write in and convince Treasury not to enact these regulations, or we’ll wake up and determine this was all just a bad dream.
• Plans will have to be amended, groups will have to be consolidated. It may be that having all employees in their own allocation groups will go the way of the dodo bird and we’ll have to list specific groups like we used to do. That is annoying, but not a backbreaker. What would be problematic is if it is determined that an allocation group with one or two employees will not fly under any circumstances, which would mean…
• The ratio test will have to be used when testing rate groups. This is the worst outcome because it does nothing but raise the contribution costs for staff. Suppose that in order to pass the ratio test an employee making $30,000 has to be increased from a 5%-of-pay contribution to 10%. That’s $1,500 extra that the company does not have to contribute under current rules. Imagine if such an increase has to be given to someone making $80,000 instead of $30,000, or to 10 employees and not just one, or if the contribution must increase by even more than five percentage points. The extra expense would add up.

In fairness, we should point out that there are other provisions in the proposed regulations. Some of them could actually be considered helpful.  The regulation is titled, “Nondiscrimination Relief for Closed Defined Benefit Pension Plans and Additional Changes to the Retirement Plan Nondiscrimination Requirements.” It seems that the “additional changes” have drawn the most attention so far.  We understand what we are discussing in this article caught many by surprise, including those who follow these matters in Washington.

We will monitor the developments as they occur and notify our clients individually as to how the proposed rule changes might affect them. There may be opportunities to submit testimonials to Congress with the hope that our elected leaders could have some sway over the Treasury officials writing the rules.  Stay tuned.  There will be much more to this story.