The IRS Responds to Sponsors' Cries

During these economically difficult times, many plan sponsors have been forced to consider extreme measures with respect to their retirement plans. In the January-February 2009 issue of PLANADVISER, I addressed the rules surrounding the mid-year suspension or reduction of employer matching contributions under a safe harbor 401(k) plan. As many readers know, in addition to the technique of making a safe harbor matching contribution, an alternative method of meeting the safe harbor 401(k) requirements is through the use of employer nonelective contributions equal to at least 3% of compensation.

While rules exist on the suspension or reduction of employer matching contributions under a safe harbor 401(k) plan, until recently, no such rules existed for the suspension or reduction of employer nonelective contributions. More specifically, if a plan sponsor wanted to suspend or reduce its nonelective contributions under a safe harbor 401(k) plan mid-year, the only option was to terminate the plan.

The Internal Revenue Service (IRS) heard the collective cries of plan sponsors. On May 18, 2009, the IRS issued proposed regulations that will enable plan sponsors to initiate a mid-year suspension or reduction of the nonelective contributions under safe harbor 401(k) plans without terminating such plans. Unlike the rules associated with the suspension or reduction of matching contributions, a plan sponsor must incur a “substantial business hardship” in order to suspend or reduce safe harbor nonelective contributions during the plan year. For these purposes, “substantial business hardship” includes, but is not limited to, the following factors: (1) whether the plan sponsor is operating at an economic loss; (2) whether there is substantial unemployment or underemployment in the plan sponsor’s industry; and (3) whether the sales and profits of the plan sponsor’s industry are depressed or declining.

If the plan sponsor is able to establish that it has a substantial business hardship and, then, wishes to prospectively suspend or decrease its safe harbor nonelective contributions, it may do so after May 18, 2009, provided: (1) a written supplemental notice is distributed to all eligible employees; (2) the reduction or suspension of the safe harbor nonelective contribution is effective no earlier than 30 days after eligible employees are provided the notice or, if later, the date the amendment to reduce or suspend the nonelective contribution is adopted; (3) eligible employees are given a reasonable opportunity (including a reasonable period after receipt of the supplemental notice), prior to the reduction or suspension of safe harbor nonelective contributions, to change their deferral elections; (4) the plan document is amended to provide that the nondiscrimination tests (the ADP and ACP tests, as applicable) will be satisfied for the entire plan year in which the reduction or suspension occurs using the current year testing method; and (5) the plan satisfies the safe harbor nonelective contribution requirement with respect to compensation paid through the effective date of the amendment.

Significantly, the preamble to the proposed rules provides that a safe harbor 401(k) plan that is amended during the plan year to reduce or suspend the nonelective contributions must prorate the compensation limit under Code Section 401(a)(17). In addition, if the safe harbor 401(k) plan is amended mid-year such that the plan is no longer a safe harbor plan for the entire year, then the plan is subject to the top-heavy rules.

Although the proposed rules are welcome relief to plan sponsors incurring a substantial business hardship, there are a number of issues that should be considered before proceeding with the suspension or reduction of the safe harbor nonelective contribution. First, the service agreement with the recordkeeper may need to be amended to reflect annual nondiscrimination and top-heavy testing; the plan sponsor also should ensure that it has considered any additional costs associated with such testing. Second, in addition to the adoption of an amendment to reflect the suspension of the nonelective contribution, the plan also should be reviewed to ensure that, notwithstanding its prior safe harbor status, required testing provisions also are contained in the plan document and, if not, that the plan is amended to include such testing provisions. Finally, consideration should be given to the likelihood of passing the nondiscrimination/top-heavy tests and the economic consequences of failing such tests.