In the wake of the financial crisis and the resulting recession, many plan sponsors have been reducing or suspending contributions to their qualified retirement plans. For sponsors of safe harbor 401(k) plans who make a non-elective employer contribution rather than a matching contribution, the ability to suspend contributions was not available under existing regulations unless the plan was terminated. Accordingly, on May 18, 2009 the IRS issued proposed regulations that will permit employers who are experiencing a "substantial business hardship" and who maintain a safe harbor 401(k) plan to reduce or suspend the safe harbor non-elective contribution without losing the tax-qualified status of the 401(k) arrangement. A 401(k) safe harbor non-elective contribution is, generally, a fully vested, 3 percent of compensation contribution on behalf of all non-highly compensated plan participants. The new proposed regulations apply immediately to all types of safe harbor plans and respond to a perceived omission in the existing regulations raised by many practitioners.
Safe Harbor Plans
For a cash or deferred arrangement (generally a 401(k) plan) to be tax qualified under the Internal Revenue Code (IRC), elective contributions (i.e., employee salary deferral contributions) must satisfy either the actual deferral percentage (ADP) nondiscrimination test or one of the permitted safe harbor plan design-based alternatives in IRC Section 401(k) under which a 401(k) plan is treated as satisfying the ADP test if the arrangement meets certain contribution and notice requirements.
Similarly, 401(k) plans that provide for matching contributions must satisfy either the actual contribution percentage (ACP) nondiscrimination test or one of the safe harbor plan design-based alternatives permitted in IRC Section 401(m) under which a 401(k) plan satisfies the ACP test with respect to matching contributions if the plan satisfies the ADP safe harbor and certain other requirements are satisfied.
Generally, the above safe harbor plan designs must be adopted and communicated to employees prior to the year in which they will be effective. Specifically, the plan sponsor is committing itself to making a certain level of contribution to plan participants, either matching or non-elective, for the subsequent plan year. However, as a result of the current severe recession, many employers that have adopted a safe harbor plan design are looking to reduce employment related costs, including contributions to their 401(k) plans. Under the existing regulations, an employer was permitted to reduce or suspend its safe harbor matching contributions during the plan year; however, there was no method for reducing or suspending employer safe harbor non-elective contributions unless the employer terminated its 401(k) plan. Such terminations have been seen by plan sponsors and professional advisors as draconian and counterproductive.
Alternatives for Managing Safe Harbor Contributions under the Existing Regulations
Under the existing regulations, a plan using the safe harbor matching contribution method to satisfy the safe harbor rules has the ability to reduce or suspend the safe harbor match at any time during the plan year, provided the plan sponsor satisfies several regulatory requirements (substantially identical to those listed below under the "Proposed Reliance Regulations" heading). However, the existing regulations do not permit a plan sponsor maintaining a safe harbor plan using the non-elective contribution method to reduce or suspend the safe harbor non-elective contribution during the plan year under the same rules that apply to the safe harbor matching contribution.
The existing regulations do provide that a plan sponsor that maintains a 401(k) plan using the current year testing method and provides the required notice to participants may decide at some point during the plan year that the plan will become a safe harbor plan for the entire plan year using the non-elective contribution alternative. The plan sponsor would first have to provide a notice to plan participants at least 30 days prior to the beginning of the plan year indicating that a safe harbor contribution might be made to the plan. If the plan sponsor subsequently decides to make a safe harbor contribution, it will have to timely amend the plan to add safe harbor provisions making the plan a safe harbor plan for the current and subsequent plan years, as well as provide a notice to plan participants at least 30 days prior to the plan's year end. Thus, the notice is frequently referred to as the "maybe" notice. Although the maybe notice accommodates a plan sponsor that anticipates a potential inability to make a plan contribution for the next plan year, it does not permit a plan sponsor that encounters unexpected adverse financial consequences during a plan year in which it is a safe harbor plan to reduce or suspend the non-elective contribution requirement. This leaves plan termination as the only option to end the plan sponsor's contribution obligation.
Proposed Reliance Regulations
Under the proposed regulations, a plan sponsor that incurs a "substantial business hardship" (see discussion below) may now reduce or suspend employer non-elective contributions during the current plan year, without being forced to terminate the plan. The new rules for reducing or suspending employer non-elective contributions are comparable to existing requirements for reducing or suspending employer matching contributions. To do so, the plan sponsor must:
1. Give all eligible employees a supplemental notice of the reduction or suspension of employer contributions.
2. Make the reduction or suspension of the contribution effective no earlier than 30 days after issuing the notice or, if later, 30 days after the reduction is formally adopted by the employer.
3. Give all eligible employees a reasonable opportunity prior to the reduction or suspension to change their salary deferral elections.
4. Amend the plan to provide that the ADP test will be satisfied for the entire plan year in which the reduction or suspension occurs, using the current year testing method.
5. Meet the safe harbor non-elective contribution rule through the date of the plan's amendment.
Substantial Business Hardship
For purposes of determining a substantial business hardship, the proposed regulations provide that the plan sponsor must apply criteria comparable to a substantial business hardship described under the statutory criteria in IRC Section 412(d) for a pension plan funding deficiency waiver. Under that section, the criteria for determining a substantial business hardship include (but are not limited to) whether:
1. The employer is operating at an economic loss;
2. There is substantial unemployment or underemployment in the employer's trade or business; and
3. The sales and profits of the employer's industry are depressed or declining.
In practice, the preceding and related criteria as well as all surrounding facts and circumstances should be considered in determining whether a substantial business hardship exists.
Plan sponsors may rely on the proposed regulations immediately. However, because of the specific timing rules that require amendment in advance of the amendment's effective date as discussed above, the plan sponsor may not wait until the end of the plan year to amend the plan to comply with the proposed regulations, even though amendment by the last day of the plan year generally would be acceptable under other existing IRS guidance to make a discretionary amendment effective during a plan year.
The preamble to the proposed regulations note that a plan that is amended to suspend or reduce either the safe harbor non-elective or the safe harbor matching contribution must prorate the otherwise applicable compensation limit under IRC Section 401(a)(17) for the plan year, and that the plan will not be exempt from the top-heavy rules under IRC Section 416.
The proposed reliance regulations provide an opportunity to reduce or suspend a safe harbor non-elective contribution during the current plan year, however, plan sponsors should note that the proposed rules for suspending a non-elective contribution are narrower than the safe harbor rules for matching contributions. The matching contribution rules do not require the plan sponsor to have any particular business reason to reduce or suspend the safe harbor match, whereas the rules for reducing or suspending a non-elective contribution are available only to plan sponsors suffering a substantial business hardship. Thus, if a plan sponsor considering implementing a 401(k) safe harbor non-elective contribution wishes to have complete flexibility to use the safe harbor non-elective contribution during the plan year, they will have to use the maybe notice, which permits the sponsor full discretion regarding whether to commit to the safe harbor non-elective contribution during the plan year. The proposed rules for the reduction or suspension of a non-elective contribution, therefore, complement and work in tandem with, but do not replace, the maybe notice option under the existing regulations.
Plan sponsors that need to take advantage of the proposed regulations should act quickly as the analysis with respect to whether the criteria for a "substantial business hardship" have been met, the drafting of plan amendments, and the requirement to give plan participants 30 days notice will require time to implement, during which the plan sponsor continues to be obligated to make safe harbor contributions to its plan.
Peter Alwardt, CPA, is Partner-in-Charge of Eisner LLP's employee benefits group. He has 20 years of consulting experience, specializing in employee benefits, tax and ERISA issues. He has an extensive background in consulting on qualified and non-qualified plan design, operational compliance, equity-based plans, employee communications, and representation before the IRS, DOL and PBGC.