IRS Withdraws Certain Provisions of Proposed Nondiscrimination Regulations | Practical Law

IRS Withdraws Certain Provisions of Proposed Nondiscrimination Regulations | Practical Law

In Announcement 2016-16, the Department of the Treasury and Internal Revenue Service (IRS) announced that they will withdraw certain provisions of proposed regulations published on January 29, 2016 relating to nondiscrimination requirements for qualified retirement plans. The proposed regulations that were withdrawn addressed certain plan formulas that take advantage of flexibility in the nondiscrimination rules by providing a special benefit formula for certain employees without extending that formula to a classification of employees that is reasonable and established under objective business criteria.

IRS Withdraws Certain Provisions of Proposed Nondiscrimination Regulations

Practical Law Legal Update w-001-8947 (Approx. 6 pages)

IRS Withdraws Certain Provisions of Proposed Nondiscrimination Regulations

by Practical Law Employee Benefits & Executive Compensation
Published on 19 Apr 2016 • USA (National/Federal)
In Announcement 2016-16, the Department of the Treasury and Internal Revenue Service (IRS) announced that they will withdraw certain provisions of proposed regulations published on January 29, 2016 relating to nondiscrimination requirements for qualified retirement plans. The proposed regulations that were withdrawn addressed certain plan formulas that take advantage of flexibility in the nondiscrimination rules by providing a special benefit formula for certain employees without extending that formula to a classification of employees that is reasonable and established under objective business criteria.
On April 14, 2016, in Announcement 2016-16, the Department of the Treasury and Internal Revenue Service (IRS) (the Departments) announced that they will withdraw certain provisions of proposed regulations published on January 29, 2016 relating to nondiscrimination requirements for qualified retirement plans (see Legal Update, Proposed Regulations Provide Nondiscrimination Relief for Closed Defined Benefit Plans and Other Changes to the Nondiscrimination Requirements).
The Departments will withdraw certain provisions of the proposed regulations that would modify Treas. Reg. Sections 1.401(a)(4)-2(c) and 1.401(a)(4)-3(c). The proposed regulations that were withdrawn addressed certain plan formulas that take advantage of the flexibility in the nondiscrimination rules by providing a special benefit formula for certain employees without extending that formula to a classification of employees that is reasonable and established under objective business criteria. Most of the other provisions in the proposed regulations remain unchanged.

Background

Under the Internal Revenue Code (Code), defined benefit plans must meet the nondiscrimination requirements of Code Section 401(a)(4) (26 U.S.C. § 401(a)(4)) and the minimum coverage requirements of Code Section 410(b) (26 U.S.C. § 410(b)).
Nondiscrimination testing under Code Section 401(a)(4) requires that contributions and benefits under a plan not discriminate in favor of highly compensation employees (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 satisfy 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.
To pass the ratio percentage test, each rate group must benefit a percentage of non-highly compensated employees (NHCEs) which is at least 70% of the percentage of HCEs benefiting under the plan (26 U.S.C. § 410(b)(1)(B); Treas. Reg. § 1.410(b)-2(b)). The ratio percentage test is difficult to pass for many plans that have separate allocation formulas for different HCEs (different rate groups for different HCEs) or that list specific supplemental benefits for executives by name (including qualified supplemental executive retirement plans (QSERPs)).
If a plan cannot pass the ratio percentage test, it must pass the average benefits test. To pass the average benefits test, each rate group must meet two requirements:
  • The average benefit for NHCEs must be at least 70% of the average benefit for HCEs.
  • The rate group's ratio percentage equals or exceeds the lesser of:
    • the midpoint between the safe harbor and the unsafe harbor percentages for the plan; and
    • the ratio percentage for the plan (Nondiscriminatory Classification Test).
  • Passing the average benefits test under the current rules is easier than the ratio percentage test because the Nondiscriminatory Classification Test under the average benefits test requires a lower ratio percentage than the ratio percentage test. The current rules do not require a rate group to meet the reasonable business classification standard which is a test that requires the classification of employees who benefit under the plan to be reasonable and established under objective business criteria (Reasonable Business Classification Test). This requirement currently only applies to the average benefits test as it applies to the minimum coverage testing of Code Section 410(b) and not nondiscrimination testing under Code Section 401(a)(4).

Proposed Regulations

On January 29, 2016, the 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. One of those other changes was to require a plan to meet the Reasonable Business Classification Test to pass the average benefits test for nondiscrimination testing under Code Section 401(a)(4). Under the proposed regulations, a plan must either meet either:
  • The ratio percentage test.
  • The average benefits test, including the Reasonable Business Classification Test.
This proposed requirement would make it difficult to pass the average benefits test for many plans that have different allocations or rate groups for different HCEs or name HCEs for specific benefits to pass the average benefits test for purposes of nondiscrimination testing under Code Section 401(a)(4). These plans would not be able to meet the Reasonable Business Classification Test and would be required to meet the ratio percentage test. However, to meet the ratio percentage test, additional contributions would be required for NHCEs which would require plan redesign for many types of plans, including certain profit sharing plans and cash balance plans.
For more information on the proposed regulations, see Legal Update, Proposed Regulations Provide Nondiscrimination Relief for Closed Defined Benefit Plans and Other Changes to the Nondiscrimination Requirements.

Provisions to be Withdrawn

Announcement 2016-16 withdraws certain provisions that would have made the Reasonable Business Classification Test part of the average benefits test for purposes of the nondiscrimination requirements of Code Section 401(a)(4).
The announcement explains that, following publication of the proposed regulations, the Departments gave additional consideration to the potential effects of the provisions at issue on the adoption and continued maintenance of qualified retirement plans with a variety of designs. The Departments concluded that further consideration relating to these provisions is needed and that the provisions will be withdrawn.
The Departments note that the announcement does not affect the other provisions included in the proposed regulations, including provisions that would:
  • Provide nondiscrimination relief for certain plans providing additional benefits to a grandfathered group of employees following certain changes in the coverage of a defined benefit plan or a defined benefit plan formula.
  • Make other changes to the nondiscrimination rules.

Practical Implications

If the proposed regulations were finalized, many plan sponsors of small retirement plans would have been required to make unwanted changes to their plans in order to pass nondiscrimination testing which could include changing allocation formulas which would thereby increase employer costs. Announcement 2016-16 is welcomed guidance for many plan sponsors, especially those that sponsor small retirement plans. In Announcement 2016-16, the Departments also indicated that further consideration is needed for issues relating to the withdrawn provisions, which means the Departments could issue additional guidance in the future on these issues.