Employee Benefits-IRS Cautions Against Discriminatory Plan Designs Using Short Service

In Employee Plans News, Issue No. 2016-5, April 4, 2016, the IRS cautions against the use of certain discriminatory plan designs. Here is what the IRS says:

Qualified retirement plans must ensure “the contributions or benefits provided under the plan do not discriminate in favor of highly compensated employees.” (Internal Revenue Code Section 401(a)(4)). A plan that meets statutory or regulatory checklists, but primarily or exclusively benefits highly compensated employees (HCEs) with little to no benefits for nonhighly compensated employees (NHCEs), may still discriminate and violate IRC Section 401(a)(4).

Discriminatory plan designs

We’ve recently found discriminatory plan designs in defined contribution plans (DC), defined benefit plans (DB) and DB/DC combination plans that:

  • provide significant benefits to the HCEs and a specified group of NHCEs, who work very few hours or receive very little compensation, and
  • exclude other NHCEs from plan participation.

The allocation to NHCEs is designed so this group receives the minimum to satisfy the mathematical portion of the nondiscrimination requirements of IRC Section 401(a)(4). For example, the plan may use a group of NHCEs who have at least one hour of service and received the least amount of compensation for the plan year.

The actual number of NHCEs included in the plan described above isn’t a set group, but instead is defined as the minimum number required to satisfy the requirements of IRC Sections 401(a)(4) and 410(b). Although this design isn’t new, we’ve seen more plans using it or variations producing the same result.

Examples of short service plan designs

Some plans limit NHCE benefits to a specific job classification. The result, for discrimination and coverage purposes, is the same because this classification includes only the lowest paid or shortest service group of NHCEs.

Another variation on this plan design provides coverage to NHCEs who work on an as-needed basis and earn very little each year.

Some plan designs require 1,000 hours to earn a year of service for vesting but not for allocation purposes. In these plans, the low paid or short service NHCEs receive an accrual or allocation but don’t vest in the benefit because they never complete a year of vesting service.

Other plan designs define a year of vesting service as the employee’s completion of 12-consecutive months of employment. This design allows the NHCE participant group to become vested in the very small plan benefit.

Plans may discriminate even though they allocate a larger percentage of compensation to NHCEs. With this design, NHCEs, on average, may seem to receive a misleadingly large accrual or allocation level. For example, an NHCE participant with $200 of annual compensation may receive a profit sharing allocation of $200 (a benefit equal to 100% of compensation), while an HCE with compensation of $200,000 may receive a benefit of only 25% of compensation or $50,000.

Although these designs may allow the plan to satisfy the vesting or numeric general tests for nondiscrimination and the associated regulations, they don’t satisfy Treas. Reg. Section 1.401(a)(4)-1(c)(2), which requires that the provisions of Sections 1.401(a)(4)-1 through 1.401(a)(4)-13 be reasonably interpreted to prevent discrimination in favor of HCEs.