Certain Cash or Deferred Arrangements and Employee and Matching Contributions Under Employee Plans

DEPARTMENT OF THE TREASURY

26 CFR Part 1

[TD 8581]

RIN 1545-AQ87

Certain Cash or Deferred Arrangements and Employee and Matching

Contributions Under Employee Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document amends final regulations governing certain cash

or deferred arrangements and employee and matching contributions under

employee plans. The amendments add cross-references to final

regulations relating to nondiscrimination, minimum coverage, and

related requirements, since the publication of the final regulations

relating to cash or deferred arrangements and employee and matching

contributions. The amendments also make various technical corrections

to and clarifications of the final regulations governing cash or

deferred arrangements and employee and matching contributions under

employee plans, the final regulations relating to plan amendments

reducing accrued benefits, and the final regulations relating to

maximum contributions and benefits.

EFFECTIVE DATE: These regulations are effective August 15, 1991.

FOR FURTHER INFORMATION CONTACT: Catherine Livingston Fernandez at 202-

622-4606 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Final regulations under sections 401(a)(30), 401(k), 401(m),

402(a)(8), 402(g), 411(d)(6), 415(c), 416, and 4979 of the Internal

Revenue Code (Code) were published in the Federal Register on August

15, 1991 (56 FR 40507). Amendments to the final regulations were

published in the Federal Register on December 4, 1991 (56 FR 63420).

Minor corrections to the final regulations were published in the

Federal Register on March 25, 1992 (57 FR 10289), on December 17, 1992

(57 FR 59915), and on March 16, 1993 (58 FR 14150). The final

regulations published on August 15, 1991, as amended and corrected on

or before March 16, 1993, are referred to herein as ``the 1991 Final

Regulations.''

Proposed amendments to the 1991 Final Regulations were published in

the Federal Register on August 10, 1992 (57 FR 35536), and on January

4, 1993 (58 FR 43). A minor correction to the amendment proposed on

January 4, 1993, was published in the Federal Register on March 22,

1993 (58 FR 15312). The amendments made by this document include these

previously proposed amendments.

Explanation of Provisions

1. Coordination With Regulations Under Sections 401(a)(4), 401(a)(17),

410(b), and 414(s)

Final regulations under section 401(a)(4) were published in the

Federal Register on September 3, 1993 (58 FR 46773). Final regulations

under section 401(a)(17) were published in the Federal Register on June

27, 1994 (59 FR 32903). Final regulations under section 410(b) were

published in the Federal Register on September 19, 1991 (56 FR 47638).

Amendments to the regulations under section 410(b) were published in

the Federal Register on December 4, 1991 (56 FR 63420), September 3,

1993 (58 FR 46835), and June 27, 1994 (59 FR 32911). Final regulations

under section 414(s) were published in the Federal Register on

September 19, 1991 (56 FR 47659). Amendments to the regulations under

section 414(s) were published in the Federal Register on September 7,

1993 (58 FR 47061).

A number of provisions of the final regulations under sections

401(a)(4) and (17), 410(b), and 414(s) affect plans subject to the

regulations governing cash or deferred arrangements and employee and

matching contributions. The preamble to the 1991 Final Regulations

states that ``when final regulations are issued under section 410(b),

these [section 410(k) and (m)] regulations will be revised to cross-

refer to definitions of common applicability under sections 410(b),

401(k), and 401(m).'' (56 FR 40507, 40511 (August 15, 1991)).

Therefore, this document amends final regulations under sections 401(k)

and (m), 402(g), and 4979 by inserting cross-references to the relevant

provisions of the regulations under sections 401(a)(4) and (17),

410(b), and 414(s).

2. Scope of These Amendments

Questions and comments received with respect to the 1991 Final

Regulations have suggested that some technical corrections or

clarifications would be helpful. Accordingly, in addition to inserting

cross-references as described above, the amendments made by this

document (referred to herein as the 1994 Amendments) make a number of

technical corrections and clarifications. More significant changes are

beyond the scope of this package, but may be considered at a later

date. Treasury and the IRS continue to welcome comments concerning the

regulations.

3. Use of Term ``Section 401(k) Plan'' to Reflect Special

Nondiscrimination Testing Requirements for QNECs Under Sections

401(a)(4) and 410(b)

Among the terms of common applicability under sections 410(b),

401(k), and 401(m) is the term ``section 401(k) plan,'' which is

defined in the regulations under sections 401(a)(4) and 410(b). Those

regulations define a ``section 401(k) plan'' as consisting only of the

elective contributions under a qualified cash or deferred arrangement

(CODA). See Sec. 1.410(b)-9. Qualified nonelective contributions

(QNECs) that are used to pass the actual deferral percentage (ADP) test

are not treated as part of a section 401(k) plan under those

regulations and must be tested separately for nondiscrimination under

sections 401(a)(4) and 410(b). See Secs. 1.401(a)(4)-1(b)(2)(ii)(B) and

1.410(b)-7(c)(1). Thus, while QNECs may be used to pass the ADP test

(and in fact are included in the definition of a CODA under the section

401(k) regulations at Sec. 1.401(k)-1(b)(4)), they are nonetheless part

of a plan separate from the section 401(k) plan for purposes of section

401(a)(4) and 410(b) testing.

These 1994 Amendments incorporate the term ``section 401(k) plan''

(defined as described above) into several provisions of the 1991 Final

Regulations. This is to reflect the requirement (which is unchanged by

the 1994 Amendments) for separate testing of QNECs under sections

401(a)(4) and 410(b). Except in the few places in these regulations

where the term ``section 401(k) plan'' has been used, the regulations

continue to use the existing term ``cash or deferred arrangement'' or

``CODA'' with its current meaning. Thus, incorporation of the term

``section 401(k) plan'' in selected provisions of the 1994 Amendments

does not affect the testing requirements for qualified CODAs, including

the two special nondiscrimination testing rules for QNECs in

Sec. 1.401(k)-1(b)(5) (i) and (ii).

Under the first of these tests, the QNECs used in the ADP test are

aggregated with other nonelective contributions as they would be if

they had not been used in the ADP test. In accordance with the final

regulations under section 410(b), permitted disparity under section

401(l) may be used to demonstrate that these plan contributions satisfy

section 401(a)(4). Under the second test, only those QNECs that are not

used in the ADP and actual contribution percentage (ACP) tests are

taken into account, together with other nonelective contributions, in

determining whether section 401(a)(4) is satisfied. Here too permitted

disparity may be used.

A similar term, ``section 401(m) plan,'' has been added by the 1994

Amendments to reflect that QNECs used to pass the ACP test are part of

a separate plan for purposes of the nondiscrimination testing required

under sections 401(a)(4) and 410(b). Incorporation of the term

``section 401(m) plan'' does not affect the testing requirements

governing employee and matching contributions, including the two

special nondiscrimination testing rules in Sec. 1.401(m)-1(b)(5) (i)

and (ii) for QNECs used in the ACP test. These testing rules are

similar to the special testing rules which apply to QNECs that are used

in the ADP test. Thus under the first test, the QNECs used in the ACP

test must be tested under section 401(a)(4) by aggregating them with

other nonelective contributions. Under the second test, only those

QNECs that are not used in the ACP and ADP tests are taken into

account, together with other nonelective contributions, for section

401(a)(4) testing purposes. Permitted disparity may also be used under

both tests.

As an additional matter, the 1994 Amendments specifically state the

rule implicit in the 1991 Final Regulations that the same QNECs may not

be used to satisfy both the ADP and the ACP tests. See Sec. 1.401(m)-

1(b)(4)(ii)(B).

4. Plans Benefiting Otherwise Excludable Employees

Final regulations under section 410(b) permit separate testing of

the portion of a plan benefiting employees who have not satisfied the

greatest minimum age and service requirements permitted under section

410(a). See Sec. 1.410(b)-6(b)(3). The 1994 Amendments make clear that

a plan may separately test these employees under section 401 (k) or (m)

without violating the 1991 Final Regulations' prohibition on

restructuring, because this separate testing does not constitute

restructuring within the meaning of the section 401(a)(4) regulations.

Thus, an employer may treat a plan that benefits employees including

otherwise excludable employees as two separate plans (one for the

otherwise excludable employees and one for all other eligible

employees) for purposes of sections 401 (k) and (m) and 410(b). See

Secs. 1.401(k)-1(b)(3)(ii) and 1.401(m)-1(b)(3)(ii).

5. Retroactive Correction of Certain Defects

The 1994 Amendments add references to Sec. 1.401(a)(4)-

11(g)(3)(vii), which allows retroactive correction of certain

prohibited discrimination in section 401 (k) and (m) plans. Section

1.401(a)(4)-11(g)(3)(vii)(A) permits the sponsor of a section 401(k) or

401(m) plan to amend the plan retroactively to satisfy the section

410(b) minimum coverage requirements by allocating QNECs to nonhighly

compensated employees who were not eligible under the plan. Section

1.401(a)(4)-11(g)(3)(vii)(B) permits a plan to allocate QNECs to

nonhighly compensated employees pursuant to a retroactive amendment in

order to satisfy the nondiscriminatory current availability requirement

of Sec. 1.401(a)(4)-4(b) with respect to the right to a rate of

matching contributions. Since the amount of the added QNECs is based on

the ADP or ACP of the group of nonhighly compensated employees who were

eligible before the correction, the addition of these QNECs does not

change the calculation of the ADP or ACP or the plan's compliance with

the ADP or ACP requirements.

Consistent with the limitations contained in the retroactive

correction provisions of Sec. 1.401(a)(4)-11(g), the 1994 Amendments

affirm that this section 401(a)(4) retroactive correction method cannot

be used to correct excess contributions (amounts that exceed the limits

under section 401(k)) or excess aggregate contributions (amounts that

exceed the limits under section 401(m)). These contributions may be

corrected only in accordance with Sec. 1.401(k)- 1(f)(1)(iii) or

1.401(m)-1(e)(1)(iii), respectively. Similarly, excess deferrals

(amounts that exceed the limits under section 402(g)) may be corrected

only in accordance with Sec. 1.402(g)-1(e).

6. Distributions Upon Plan Termination

Sections 401(k)(2)(B)(i)(II) and 401(k)(10)(A)(i) permit

distributions from a qualified CODA after termination of the plan

without the establishment or maintenance of a successor plan by the

employer. Section 1.401(k)-1(d)(3) provides that if fewer than two

percent of the employees who were eligible under the terminated defined

contribution plan that included the CODA are eligible under another

plan of the employer during a specified 24-month period, the other plan

is not a successor plan. The 1994 Amendments clarify that the number of

employees who were eligible under the terminated plan and the identity

of the employer are determined as of the date of plan termination. See

Rev. Rul. 89-87, 1989-2 C.B. 81, regarding the date of plan

termination. Thus, for example, if a plan is terminated as of December

31, 1994, and the plan assets are timely distributed thereafter, then

the number of employees who were eligible under the plan is determined

as of December 31, 1994. The clarifications of the language relating to

these successor plan rules, including the two percent test, are not

intended to change the rules governing that test in any way.

7. Other Benefits Not Contingent Upon Elective Contributions

Section 401(k)(4)(A) and Sec. 1.401(k)-1(e)(6) of the 1991 Final

Regulations provide that a CODA is a qualified CODA only if no other

benefit (other than a matching contribution under section 401(m)) is

conditioned (directly or indirectly) upon the employee's electing to

make or not to make elective contributions. The 1994 Amendments add two

examples to Sec. 1.401(k)-1(e)(6) to respond to frequent questions

concerning the application of the contingent benefit rule to two

specific arrangements involving relationships between a nonqualified

deferred compensation plan and a qualified CODA. These examples

illustrate the existing rules, and are not intended to change those

rules in any way.

8. Coordination of Excess Deferrals With Excess Contributions

The 1994 Amendments amend Example 2 in Sec. 1.402(g)-1(e)(11) to

reflect more accurately the rules that coordinate the correction of

excess deferrals and excess contributions. Under these rules, excess

deferrals that have been distributed to a highly compensated employee

serve the purpose of reducing the amount to be distributed as an excess

deferral and excess contribution. See Secs. 1.401(k)- 1(f)(5);

1.402(g)-1(e)(1)(ii). Conversely, excess contributions that have been

distributed to a highly compensated employee reduce both the excess

contribution and the amount to be distributed as an excess deferral.

See Secs. 1.401(k)-1(f)(5); 1.402(g)-1(e)(6). The statement in Example

2 that further correction was required to pass the ADP test under the

facts of the example was inaccurate and has been deleted.

9. Distribution of Matching Contributions Related to Excess Deferrals,

Excess Contributions, and Excess Aggregate Contributions

Questions have been raised about the extent to which a matching

contribution may be distributed if it relates to an amount that is

distributed as an excess contribution, excess deferral, or excess

aggregate contribution. Distribution of excess deferrals, excess

contributions, or excess aggregate contributions may cause matching

contributions related to the distributed amounts to be discriminatory

by producing an effective rate of match that discriminates in favor of

highly compensated employees. See Sec. 1.401(a)(4)-4(e)(3)(G).

There are two circumstances under which a matching contribution may

be distributed. First, it may be distributed if it is an excess

aggregate contribution. In this case, the matching contribution will

not be taken into account under section 401(a)(4). Thus, it will not be

considered in determining whether there is a discriminatory rate of

match. Second, the matching contribution may be distributed on some

other permissible basis under the general plan qualification rules

applicable to the type of plan under which the matching contribution

was made, e.g., attainment of age 59\1/2\ under a profit-sharing or

stock bonus plan. However, in that case, the amount contributed would

still be taken into account under section 401(a)(4), and therefore the

distribution, even if timely made, would not correct any failure to

satisfy a nondiscrimination requirement, including a discriminatory

rate of match. Section 1.401(m)-1(e)(4) has been amended to make this

explicit. The 1994 Amendments also explicitly state that a matching

contribution may not be distributed simply because it relates to an

excess deferral, an excess contribution, or an excess aggregate

contribution that is distributed. See Sec. 1.401(m)-1(e)(3)(vii).

Where a matching contribution relates to an excess deferral, an

excess contribution, or an excess aggregate contribution that is

distributed, a discriminatory rate of match may result, unless the

matching contribution is distributed as an excess aggregate

contribution. If the matching contribution cannot be distributed as an

excess aggregate contribution, so that the discriminatory rate of match

cannot be corrected by distribution, a plan may provide that the

matching contributions are forfeited, as permitted by sections

411(a)(3)(G) and 401(k)(8)(E). See Secs. 1.401(k)-1(f)(5)(iii);

1.401(m)-1(e)(4); 1.411(a)-4(b)(7). Alternatively, the discriminatory

rate of match can be corrected by additional allocations to the

accounts of nonhighly compensated employees, under Sec. 1.401(a)(4)-

11(g)(3)(vii)(B).

10. Multiple Use Test

The 1991 Final Regulations, as amended by the 1994 Amendments,

continue to provide that if any highly compensated employee is eligible

to participate in both a section 401(k) plan and a section 401(m) plan

of an employer, the plans must satisfy the limitation on multiple use

of the alternative methods of compliance with the ADP and ACP tests

(the 200%/two-percentage-point method, as opposed to the 125% method)

that are contained in sections 401(k)(3)(A)(ii)(II) and

401(m)(2)(A)(ii), respectively. Language has been added to

Sec. 1.401(m)-1(a)(1) to clarify that if the plans fail to satisfy the

multiple use limitation in operation, and the failure is not corrected

as permitted by Sec. 1.401(m)-2(c), the section 401(m) plan fails to

satisfy section 401 (a)(4) and (m).

An additional clarification in the multiple use rules has been

added to Sec. 1.401(m)-2(c)(1). The 1991 Final Regulations provide that

multiple use may be corrected by reducing either the ADP or the ACP of

the highly compensated employees. The 1994 Amendments clarify that

multiple use may also be corrected by reducing a combination of the ADP

and the ACP of the highly compensated employees.

11. Safe Harbor Hardship Withdrawal Provisions

In response to suggestions, the 1994 Amendments expand the safe

harbor hardship withdrawal provisions to provide that, in addition to

tuition and related educational fees, amounts distributed for the

payment of room and board expenses for the next 12 months of post-

secondary education will be deemed to be on account of an immediate and

heavy financial need. See Sec. 1.401(k)-1(d)(2)(iv)(A)(3).

12. Hardship Distributions Under Profit-Sharing or Stock Bonus Plans

The 1991 Final Regulations added Sec. 1.411(d)-4, Q&A-2(b)(2)(x) to

make an exception to the protections of section 411(d)(6) and allow a

qualified CODA that permits hardship distributions to be amended to

specify or modify its standards for making such distributions, or to

eliminate hardship distributions. In response to suggestions, the 1994

Amendments now amend this section to allow the same flexibility to any

profit-sharing or stock bonus plan that permits hardship distributions.

Under this amendment, a profit-sharing or stock bonus plan has this

flexibility whether or not the plan limits hardship distributions

(either before or after the plan amendment) to the types of hardship

distributions that are permitted to be made from a qualified CODA.

Hardship distributions under a portion of the plan that is a qualified

CODA must be restricted in accordance with section 401(k) and the

regulations.

13. Excise Tax Transition Relief for Collectively Bargained and

Governmental Plans

In accordance with the applicable provisions of the Code, the 1991

Final Regulations provide that elective contributions under a CODA that

is part of a collectively bargained plan and that fails the ADP test

are includible in employees' gross incomes because the CODA is not

qualified. The 1991 Final Regulations provided transition relief by not

making this income inclusion effective for plan years beginning before

January 1, 1993.

The question has arisen whether this transition relief from income

inclusion for collectively bargained plans would be expanded to cover

the section 4979 excise tax on excess contributions. The 1994

Amendments respond by amending Sec. 54.4979-1(d)(3) to provide that the

excise tax does not apply to a collectively bargained plan for plan

years beginning before January 1, 1993. Thus, for these plan years, a

collectively bargained plan need not perform the ADP test for any

purpose. Furthermore, the 1994 Amendments explicitly provide that the

excise tax does not apply to employee and matching contributions under

a collectively bargained plan.

For governmental plans, the nondiscrimination rules, including the

nondiscrimination requirements under sections 401(k) and 401(m),

generally do not apply for plan years beginning before January 1, 1996.

The proposed amendments to the 1991 Final Regulations reflected this

extended effective date. The 1994 Amendments adopt the proposed

amendments and also apply the same extended effective date to the

section 4979 excise tax.

14. One-Time Irrevocable Elections

The 1991 Final Regulations provide that an employer may allow each

of its employees to make a one-time irrevocable election, upon

commencement of employment or initial eligibility under any plan of the

employer, to have a specified amount or percentage of compensation

(including no amount) contributed by the employer throughout the

employee's employment. This type of election is not treated as a cash

or deferred election. See Sec. 1.401(k)-1(a)(3)(iv).

The question has occasionally been raised as to whether such an

election could conceivably be made by an employee upon first becoming

eligible under a plan even though the employee had previously become

eligible under any other ongoing or terminated plan of the employer.

The 1994 Amendments make clear that the answer to this question is in

the negative. They confirm that the one-time irrevocable election

provision was intended to preclude an election from constituting a non-

cash-or-deferred election (and thus avoiding the rules governing

qualified CODAs) in any case where the electing employee had previously

become eligible under another plan of the employer, including a

terminated plan, even if the employee is making an election with

respect to a plan under which the employee is just then becoming

eligible. Thus, an employee can make an election under Sec. 1.401(k)-

1(a)(3)(iv) only once during employment with a particular employer

(even if, over time, the employee becomes eligible under more than one

plan of the employer). This election can be made either (1) upon

commencement of employment with the employer, or (2) upon becoming

eligible under the plan of the employer under which the employee

becomes eligible first.

The 1991 Final Regulations reiterated a special, additional, one-

time election transition rule for plans maintained by partnerships. See

Sec. 1.401(k)-1(a)(6)(ii)(C). This transition relief originally had

been provided for under Notice 88-127, 1988-2 C.B. 538. See also Rev.

Proc. 91-47, 1991-2 C.B. 757. As an alternative to compliance by a plan

with the qualified CODA rules, the transition rule was intended to give

existing partnership plans a limited period of time (until the later of

the first day of the first plan year beginning after December 31, 1988,

or March 31, 1989) for employees and partners to make one-time

irrevocable elections, even after their commencement of employment or

their initial eligibility under the plan or any other plan of the

employer. However, occasional questions have been raised since 1989 as

to whether this could nonetheless be interpreted as a continuing

transition rule for partnerships that might permit such one-time

irrevocable elections to be made in the future. The 1994 Amendments

explicitly confirm that such elections under the special partnership

transition rule may not be made in the future. A partnership may, of

course, continue to allow partners and employees to make one-time

irrevocable elections under the general rule of Sec. 1.401(k)-

1(a)(3)(iv) in the same limited circumstances as any other employer.

15. Limit on Annual Additions

a. Corrective Distribution of Elective Deferrals

The 1991 Final Regulations amended Sec. 1.415-6(b)(6) to allow

plans to distribute elective deferrals to correct excess annual

additions resulting from a reasonable error in determining the amount

of elective deferrals that a participant may make under the limits of

section 415. A question has arisen as to whether gains (investment

gains and other income) attributable to the distributed elective

deferrals are treated for section 415 purposes in a manner similar to

gains attributable to employee contributions that are returned pursuant

to Sec. 1.415-6(b)(6) (which have been explicitly addressed in that

regulation since before 1991). The 1994 Amendments make clear that

similar treatment is intended, by providing that if gains attributable

to the distributed elective deferrals are not also distributed to the

employee, the gains will be considered as employer contributions for

the limitation year in which the distributed elective deferrals were

made. This provision of the 1994 Amendments is effective for limitation

years beginning after December 31, 1995.

b. Plan Amendments Reducing Accrued Benefits to Comply With Tax Reform

Act of 1986

The Tax Reform Act of 1986 (TRA '86) generally reduced the amount

of benefits that could be provided by a defined benefit plan under the

section 415 benefit limitations. The changes generally were effective

for limitation years beginning after December 31, 1986. However,

section 1106(i)(3) of TRA '86 protected the ``current accrued benefit''

of an individual who was a participant in a defined benefit plan

meeting certain requirements. The ``current accrued benefit'' was

defined as the benefit that accrued before the effective date, not

including any benefits under new plans or any benefits resulting from

changes in existing plans after May 5, 1986. These additional accruals

generally caused plan disqualification when the new limits applied.

Notice 87-21, 1987-1 C.B. 458, Q&A-13, illustrated this effect and

stated that future regulations would provide section 411(d)(6) relief

allowing defined benefit plans to reduce accrued benefits that

otherwise would violate the applicable limit. This relief would create

an exception to the general section 411(d)(6) prohibition against plan

amendments reducing accrued benefits.

Q&A-17 of Notice 87-21 illustrated that these additional accruals

could also result in a violation of the combined limit on contributions

and benefits under section 415(e). The combined limit applies to

participants covered by both a defined benefit plan and a defined

contribution plan. Such a violation could occur even if the defined

benefit plan was terminated before the effective date of the section

415 changes, and even if no contributions were made to the defined

contribution plan after the effective date.

The 1991 Final Regulations added Sec. 1.411(d)-4, Q&A-2(b)(2)(xi)

to permit a defined benefit plan to reduce benefits that otherwise

would violate the lower section 415(b) limit under TRA '86. These 1994

Amendments now expand this relief by allowing a reduction in benefits

under either a defined benefit plan or a defined contribution plan to

satisfy the combined limit under section 415(e), which also was reduced

as a result of the changes made by TRA '86. This amendment to

Sec. 1.411(d)-4, Q&A-2(b)(2)(xi), will also allow a defined

contribution plan to reduce a participant's account balance where the

defined benefit plan has been terminated and thus can no longer be

amended to reduce the participant's benefits. See also Sec. 1.415-

6(b)(6), providing methods for correcting excess annual additions to

defined contribution plans in certain circumstances.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to

these regulations, and, therefore, a Regulatory Flexibility Analysis is

not required. Pursuant to section 7805(f)(3) of the Internal Revenue

Code, these regulations were submitted to the Chief Counsel for

Advocacy of the Small Business Administration for comment on their

impact on small business.

Drafting Information

The principal author of these regulations is Catherine Livingston

Fernandez, Office of the Associate Chief Counsel (Employee Benefits and

Exempt Organizations), IRS. However, personnel from other offices of

the IRS and Treasury Department participated in their development.