Proposed Regulations Provide Nondiscrimination Relief for Closed Defined Benefit Plans and Other Changes to the Nondiscrimination Requirements | Practical Law

Proposed Regulations Provide Nondiscrimination Relief for Closed Defined Benefit Plans and Other Changes to the Nondiscrimination Requirements | Practical Law

The Internal Revenue Service (IRS) issued proposed regulations providing nondiscrimination relief for closed defined benefit plans and making other changes to the nondiscrimination rules not limited to closed defined benefit plans.

Proposed Regulations Provide Nondiscrimination Relief for Closed Defined Benefit Plans and Other Changes to the Nondiscrimination Requirements

by Practical Law Employee Benefits & Executive Compensation
Published on 03 Feb 2016 • USA (National/Federal)
The Internal Revenue Service (IRS) issued proposed regulations providing nondiscrimination relief for closed defined benefit plans and making other changes to the nondiscrimination rules not limited to closed defined benefit plans.
On January 29, 2016, the Internal Revenue Service (IRS) issued proposed regulations:
  • Providing nondiscrimination relief for closed defined benefit plans.
  • Modifying the nondiscrimination requirements applicable to closed defined benefit plans that provide additional benefits to a grandfathered group of employees following certain changes in the coverage of a defined benefit plan or a defined plan formula.
  • Making certain other changes to the nondiscrimination rules that are not limited to these plans.
(81 Fed. Reg. 4976.)

Background

Under the Internal Revenue Code (Code), defined benefit plans must meet the minimum coverage requirements of Code Section 410(b) (26 U.S.C. § 410(b)) and the nondiscrimination requirements of Code Section 401(a)(4) (26 U.S.C. § 401(a)(4)).
Coverage testing rules under Code Section 410(b) require that a plan satisfy one of following tests:
  • Ratio Percentage Test. The plan benefits a percentage of non-highly compensated employees (NHCEs) which is at least 70% of the percentage of highly compensated employees (HCEs) benefiting under the plan (Code § 410(b)(1)(B); Treas. Reg. § 1.410(b)-2(b)).
  • Average Benefits Test. The plan benefits a classification of employees that does not discriminate in favor of HCEs (reasonable classification test) and the average benefit percentage of the NHCEs must be at least 70% of the average benefit percentage of the HCEs.
(26 U.S.C. § 410(b).)
A defined benefit plan may be aggregated with a defined contribution plan to meet the ratio percentage test and "cross tested" on the basis of equivalent benefits if the plans:
  • Are primarily defined benefit in character.
  • Consist of broadly available allocation rates (Treas. Reg. § 1.401(a)(4)-4(b)(iii)). This means that each plan when tested separately must satisfy the nondiscriminatory classification test. However, an allocation can be disregarded if it is a:
    • defined benefit replacement allocation (DBRA);
    • pre-existing replacement allocation; or
    • pre-existing merger or acquisition allocation.
    (Treas. Reg. § 1.401(a)(4)-8(b)(iii)(B).)
  • Meet the "minimum aggregate allocation gateway." This means that all NHCEs must have an allocation rate of at least 5%, and is automatically satisfied if the allocation rate for NHCEs is 7.5% (Treas. Reg. § 1.401(a)(4)-9).
Nondiscrimination testing under Code Section 401(a)(4) requires that contributions and benefits under a plan not discriminate in favor of HCEs. Code Section 401(a)(4) contains three requirements to satisfy nondiscrimination testing:
  • Contributions or benefits must be nondiscriminatory. A defined benefit plan satisfies this requirement using rate group testing which divides up employees into groups that must meet Code Section 410(b) coverage testing. Each rate group:
    • contains an HCE and employees whose benefit accrual rates are as high as the HCE; and
    • must pass either the ratio percentage test or the average benefits test.
  • All benefits, rights, and features (BRFs) of a plan must be currently and effectively available to all participants. The current availability requirement is generally satisfied if the group of employees to whom a BRF is currently available during the plan year satisfies the ratio percentage test (Treas. Reg. § 1.401(a)(4)-4).
  • Special circumstances of the plan (for example, plan amendments and terminations) must be nondiscriminatory.

Closed Plans

In this economic climate, many employers have chosen to freeze or close their defined benefit plans to new participants and establish a defined contribution plan for new employees. Over time, it becomes difficult for the closed plan to satisfy the coverage requirements of Code Section 410(b) unless the closed plan is aggregated with the new defined contribution plan to be "cross-tested" to demonstrate compliance with the nondiscrimination rules on the basis of equivalent benefits. However, closed plans will generally not meet these requirements because:
  • Benefits continue to accrue for the participants in the closed plan but are limited to some or all of the employees who participated in the plan on a specified date.
  • The proportion of HCEs in the closed plan increases over time, due to:
    • NHCEs becoming HCEs due to pay raises; and
    • a higher turnover rate for NHCEs as compared to HCEs.
To meet these requirements, closed plans must either:
  • Reduce the proportion of HCEs in the closed defined benefit plan (by either opening it to some new NHCEs or by stopping participation by some HCEs).
  • Change the structure and amount of contributions under the defined contribution plan so that it meets the minimum aggregate allocation gateway (one of the conditions for testing on the basis of equivalent benefits).
  • Completely cease benefit accruals in the closed plan.
In response to concerns that many employers are choosing to completely cease benefit accruals in closed plans, on January 6, 2014, the IRS published Notice 2014-5 which provides temporary relief permitting sponsors of a closed defined benefit plan that is aggregated with a new defined contribution plan (DB/DC plan) to demonstrate compliance with the nondiscrimination requirements on the basis of equivalent benefits, even if the DB/DC plan does not satisfy any of the existing eligibility conditions for testing on that basis (see Legal Update, IRS Notice 2014-5 Provides Temporary Nondiscrimination Relief for Closed Defined Benefit Plans).

Proposed Regulations

The proposed regulations would implement permanent changes to the nondiscrimination rules. Prior relief was in the form of temporary changes for 2014 and 2015. The changes usually apply to situations in which the proportion of the grandfathered group of employees who are HCEs has increased due to ordinary demographic changes.
Specifically, the proposed regulations:

Rules Related to Closed Plans and Other Similar Arrangements

The proposed regulations would:

Modifications to the DBRA Rules

The proposed regulations would change the rules applicable to DBRAs to:
  • Allow employers to provide certain allocations to replace defined benefit plan retirement benefits without being required to satisfy the minimum aggregate allocation gateway test. The allocation must be reasonably designed to replace some or all of the benefits that would have been provided under the closed plan.
  • Allow a DBRA to replace the benefit provided under a defined benefit plan with a benefit formula that generated equivalent normal allocation rates that increased from year to year as employees are credited with additional years of service (rather than only as the employees attained higher ages).
  • Limit the requirement that the group of employees who receive a DBRA satisfy the minimum coverage requirements to the first five years after the plan's closure date.
  • Require a closed plan to be in effect for five years before the closure date with no substantial change to the plan during that time (except for certain permitted amendments).
  • Expand the list of permitted amendments to a closed plan that do not prevent allocations under a plan from being DBRAs. For example, an amendment to a closed plan during the five year period before it is closed would be permitted as long as it does not:
    • increase the accrued benefit or future accruals for any employee;
    • expand coverage; and
    • reduce the ratio-percentage under any applicable nondiscrimination test.
  • Expand the list of general plan amendments related to a DBRA.

The Closed Plan Rule

The proposed regulations would add a new exception to the requirement that a DB/DC plan must satisfy the minimum aggregate allocation gateway once other conditions under Treas. Reg. Section 1.401(a)(4)-9 are not met (closed plan rule). The exemption would apply to DB/DC plans that include a closed plan, if the closed plan:
  • Was in effect for five years before the closure date.
  • Has had no significant change during or since that time (except for certain permitted amendments under the proposed regulations).
The DB/DC plan may use the closed plan rule for a plan year that begins five years after the closure date or later if either:
  • The DB/DC plan satisfies nondiscrimination testing without using the minimum aggregate allocation gateway.
  • The closed plan satisfies nondiscrimination testing without aggregation with any defined contribution plan.

Special Nondiscrimination Testing Rule

The proposed regulations establish a special nondiscrimination testing rule under Treas. Reg. Section 1.401(a)(4)-4. This rule:
  • Applies if a BRF is made available only to a grandfathered group of employees for a closed plan.
  • Provides relief:
    • in certain circumstances from certain nondiscrimination testing for a BRF provided under the closed plan; or
    • for a rate of matching contributions provided to a grandfathered group under a defined contribution plan.
If certain eligibility conditions are satisfied, the special testing rule treats a BRF that is available only to a grandfathered group of employees as satisfying the current regulations (Treas. Reg. § 1.401(a)(4)-4). This rule:
  • Is available only if the restriction resulted in a significant change in the type of the defined benefit plan's formula.
  • Applies to plan years beginning five years after the closure date or later and will generally apply indefinitely.
  • Ceases to apply if a plan amendment changes the eligibility for the BRF after the closure date.
  • Requires the BRF that is available solely to a grandfathered group of employees under a defined benefit plan to be provided under the closed plan and not a different plan.
  • Requires that the rate of matching contributions to a defined contribution plan must be:
    • reasonably designed so that the matching contributions will replace some or all of the value of the benefit accruals that each employee in the grandfathered group of employees would have been provided under the closed plan in the absence of a closure amendment; and
    • provided in a consistent manner to all similarly situated employees.

Modifications of Testing Options for DB/DC Plans, Including DB/DC Plans That Do Not Include a Closed Plan

The proposed regulations ease the rules under which any DB/DC plan (including DB/DC plans that do not include a closed plan) can satisfy the nondiscrimination in amount requirement on the basis of benefits. The proposed regulations:
  • Permit the averaging of allocation rates for NHCEs under the plan, to better accommodate plan sponsors that have a defined contribution plan with service or age based allocation formulas.
  • Limit the averaging of rates that applies to both defined benefit and defined contribution plans in order to minimize the impact of outliers.
  • Provide that the average of the matching contributions actually made for NHCEs may be up to 3% of compensation to determine whether each NHCE satisfies the minimum aggregate allocation gateway test.
  • Provide a new alternative to the minimum aggregate allocation gateway if the DB/DC plan can satisfy the nondiscrimination in amount requirement on the basis of equivalent benefits using an interest rate of 6%.

Special Benefit Formula for Individual Employees or Groups Without a Reasonable Business Purpose

Under the average benefits test, the group of employees must be determined using a classification that is reasonable and that is established under objective business criteria (reasonable business classification) and must have a ratio percentage that is described in Treas. Reg. Section 1.410(b)-4(c) (which includes safe harbor and unsafe harbor percentages) (Treas. Reg. § 1.410(b)-4).
If a plan satisfies the average benefits test, the rate group for each HCE is treated as meeting the minimum coverage requirements if the ratio percentage for the rate group is equal to the midpoint between the safe harbor and the unsafe harbor percentages. The proposed regulations indicate that this rule recognizes that the composition of a rate group may be unpredictable and so the rate group should not be subject to a reasonable business classification standard. However, that same consideration is not relevant if the group of employees to whom the allocation formula under a defined contribution plan applies is not a reasonable business classification.
The proposed regulations limit the existing rule, under which a rate group for an HCE is treated as satisfying the average benefits test, to those situations in which the allocation formula (or benefit formula) that applies to the HCE also applies to a reasonable business classification. In this case, the proposed regulations require that the rate group for that individual satisfy the ratio percentage test.

Effective Date

The proposed regulations would be applicable to plan years beginning on or after the date of publication of the final regulations in the Federal Register. However, employers may apply the provisions of the proposed regulations for plan years beginning on or after January 1, 2014 until the final regulations become applicable.

Practical Implications

Plan sponsors of closed plans with a grandfathered group of employees who are HCEs should take note of these proposed regulations and determine whether their plans may take advantage of these rules. They also should decide whether to apply the provisions before final regulations are published.
While many of the changes under the proposed regulations make satisfying nondiscrimination testing easier for closed plans, the change in the proposed regulations that applies the reasonable classification requirement under the average benefits test to nondiscrimination testing could make satisfying nondiscrimination testing more difficult. This could be especially troublesome to small plan practitioners and plan sponsors of small plans.
Additionally, the IRS is requesting comments on all aspects of the proposed regulations, and specifically on whether:
  • Guidance needs to be developed for a plan that has more than one closure or closure amendment.
  • The rules regarding transition allocations and successor employers are still needed in light of the modifications to the DBRA rules.
Comments are due by April 28, 2016.