One might be led to believe that the current administration is in favor of expanding retirement savings opportunities. After all, the DOL has somewhat apologetically subverted ERISA to allow the States to sponsor employer-based savings plans. And the President’s recently proposed budget endeavors to provide a national retirement savings program. (See page 135 of the General Explanations of the Administration’s Fiscal Year 2017 Revenue Proposals) So why then would the IRS reverse two decades of regulation that favors cross-tested plans in small businesses, an action that might cause many small employers to terminate their qualified plans or amend them to reduce the employer contribution to employee’s accounts?
Some background may be in order. Cross-tested defined contribution plans are allowed to test equivalent benefit accrual rate (EBAR) groups separately using the ratio percentage test or the average benefits test. Unlike testing for coverage, application of the average benefits test here does not include testing for a reasonable business classification. This has permitted cross-tested plans to create small rate groups each of which meets the modified average benefits test and permits greater relative nonelective contribution (NEC) amounts for HCEs. Typically, the average benefits test for cross-testing finds that the EBARs for HCEs are the same or less than the EBARs for NHCEs. Notwithstanding this EBAR comparison, this allows for a sizeable difference in nonelective contribution allocation rates that benefit the HCEs who are often older and certainly more highly compensated. To take advantage of this otherwise seeming-to-discriminate structure, the plan must provide a gateway NEC of at least 5% of compensation for all eligible NHCEs, a rather generous employer minimum contribution. This trade-off was seen as a fair differentiation that would allow small business owners the opportunity to “skew” contribution allocation rates in their favor while at the same time providing their employees with a meaningful account addition. This has led to adoption of thousands of cross-tested plans benefitting many NHCEs around the country.
The proposed rule upends the trade-off. By adding the reasonable business classification requirement to the average benefits test for cross-testing purposes (and, of course, leaving the gateway contribution in place), the IRS, in proposed regulation §1.401(a)(4)-13, will force many cross-tested plans to use the ratio percentage test at a far greater cost since the small rate group approach will be eliminated. That will require an increase in the EBARs for the NHCEs in order for a larger rate group to pass the ratio percentage test if the EBAR for the specified HCE is static. That will require a greater NEC for NHCEs, an increased cost that many small businesses simply cannot afford or will not want to contribute for other business reasons (like the high cost of health insurance). And the average benefits test will not be palatable since small rate groups that often include only one NHCE will not be based on a reasonable business classification. A reasonable business classification is based on “all the facts and circumstances . . ., is reasonable and is established under objective business criteria that identify the category of employees who benefit under the plan. Reasonable classifications generally include specified job categories, nature of compensation (i.e., salaried or hourly), geographic location, and similar bona fide business criteria. An enumeration of employees by name or other specific criteria having substantially the same effect as enumeration by name is not considered a reasonable classification.” Treas. Reg. §1.410(b)-4(b). Of course, a “facts and circumstances” test often presents an unknown, one that small businesses are not likely to embrace.
So, why, after all these years, would the IRS change the rule to make it more expensive to sponsor a cross-tested plan, possibly causing many small employers to amend their plans to eliminate NECs or even terminate their plans? The answer may lie in looking at who most adopts these plans. Although there are no available statistics, it is commonly understood that many, possibly the majority of, cross-tested plans have been adopted by professional practices including those dastardly doctors and lawyers, seemingly high earners that the IRS may believe want nothing more than to take advantage of their employees. If the rule is finalized, the affect will likely be a reduction in the size of employer contributions to the accounts of those NHCEs fortunate enough to be participants in cross-tested plans. The impact of the new rule would seem to be contrary to the policy goal of expanding coverage for NHCEs. When looking at annual contribution limits under current law and the President’s goal of limiting the size of a tax-favored account (see the Proposal beginning on page 167 of the General Explanations of the Administration’s Fiscal Year 2017 Revenue Proposals) that would prevent the doctors and lawyers from getting a perceived too large a share of the tax advantage, it doesn’t seem to make policy sense to disrupt a plan structure that provides the gateway contribution for NHCEs.