On May 18, 2009, the Internal Revenue Service (IRS) proposed a regulation that would permit employers that sponsor a safe harbor defined contribution plan to reduce or suspend employer nonelective contributions after the start of the plan year if the employer has incurred a substantial business hardship and certain other requirements are met. The proposed change liberalizes current restrictions on the suspension or reduction of a safe harbor plan’s nonelective contributions after the plan year has begun.
Safe Harbor Plan Background
Employers that sponsor 401(k) plans may, but are not required to, design their plans to satisfy safe harbor rules under sections 401(k) and (m) of the Internal Revenue Code. Compliance with these rules exempts the plan from the actual deferral percentage (ADP) and/or the actual contribution percentage (ACP) tests. To qualify as a safe harbor design, the plan must provide for prescribed levels of employer contributions for non-highly compensated employees. These contributions may take the form of either nonelective contributions or matching contributions. Under either approach, safe harbor contribution provisions must be included in the plan document.
Safe harbor-designed plans are intended to provide assurances to participants that the employer will make a specified level of contribution on their behalf. Consequently, the safe harbor rules require employers to send a notice to employees before the beginning of the plan year, explaining the plan’s contribution formula and other design features. In addition, these rules: (a) restrict an employer from reducing or suspending matching safe harbor contributions once the year has begun unless certain conditions are met, and (b) permit employers to reducing or suspend nonelective contributions only by terminating the plan.
New Ability to Reduce or Suspend Nonelective Contributions
The proposed regulation now permits employers that have experienced a “substantial business hardship” to reduce or suspend nonelective contributions under a safe harbor plan design if certain steps are taken. The substantial business hardship requirement is discussed further below. If an employer can meet that requirement, the following additional conditions must be met to reduce or suspend nonelective contributions:
- The employer must adopt a plan amendment that reflects the suspension or reduction in nonelective contributions.
- Eligible employees must be provided a supplemental notice informing them of the reduction or suspension. The notice must be provided at least 30 days prior to the effective date of the suspension or reduction.
- Eligible employees must be given a reasonable opportunity prior to the reduction or suspension to change their pre-tax deferral elections and, if applicable, any after-tax employee contribution elections.
- The plan amendment reducing or suspending contributions must provide that the ADP and/or ACP tests will be satisfied for the entire plan year in which the reduction or suspension occurs, using the current year testing method.
- The plan must continue to make the safe harbor nonelective contributions until the effective date of the amendment (which, as noted above, cannot be earlier than 30 days after the supplemental notice is distributed to employees).
The suspension or reduction can be effective no earlier than the later of: (1) 30 days after the supplemental notice is distributed, and (2) the date on which the plan amendment reflecting the suspension or reduction is adopted by the employer. The notice must specifically address the consequences of the amendment that reduces or suspends future nonelective contributions, such as the fact that employees will no longer be eligible to receive the same level of contributions that they could previously receive. In addition, the notice must explain the procedures that participants should follow to change their pre-tax deferral or after-tax contribution elections and must identify the date on which the suspension or reduction will take effect.
Substantial Business Hardship
As noted above, the ability to suspend or reduce nonelective contributions is conditioned on the employer having experienced a “substantial business hardship”. The proposed regulations define this standard as “comparable to” the substantial business hardship standard that applies to a request for a minimum funding waiver for a defined benefit plan under section 412(c) of the Code. Under section 412(c), the factors that the IRS takes into account in making such a determination include, but are not limited to, the following:
- Whether the employer is operating at an economic loss,
- Whether there is substantial unemployment or underemployment in the employer’s trade or business and in the industry concerned, and
- Whether the sales and profits of the industry concerned are depressed or declining.
Unlike funding waiver requests for defined benefit plans, the proposed regulations do not provide for a prior determination by the IRS that the employer has experienced a substantial business hardship. Instead, employers that wish to reduce or suspend of safe harbor nonelective contributions in reliance on the new regulation must make their own determination of the existence of a substantial business hardship by applying the section 412 standards to their own particular circumstances.
This analysis should not be undertaken lightly. The IRS traditionally has applied a relatively stringent level of review for minimum funding waiver requests. Employers and their advisers will need to carefully consider whether circumstances support the existence of such a business hardship and should be prepared to substantiate the specific bases for such a determination in the event of an IRS examination.
Consequences of Reducing or Suspending Safe Harbor Contributions
When an employer amends its plan to reduce or suspend either matching or nonelective safe harbor contributions during the plan year, the employer will be required to make three additional adjustments for that year.
- First, it will be required to satisfy all applicable ADP and ACP testing requirements for the entire year. Consequently, employers should anticipate how any testing failures would be corrected.
- Second, the plan will cease to be exempt from the Code section 416 top-heavy rules for that year, which will necessitate testing under those rules.
- Finally, the plan must also prorate the Code section 401(a)(17) compensation limit for the year in which the suspension or reduction is implemented. Such a proration may require correction of prior contributions if those contributions had been based on compensation in excess of the prorated annual compensation limit.
Effective Date
The proposed regulation may be relied upon for amendments adopted after May 18, 2009. Employers that wish to utilize the new rule should keep in mind that the plan amendment reflecting the suspension or reduction must be adopted, and the supplemental notice must be distributed, no less than 30 days before the date on which the suspension or reduction will take effect. The IRS has confirmed that if the final regulation imposes new restrictions not contained the proposed regulation, those new restrictions will not be applied retroactively.
For additional information on or assistance in reducing or suspending employer nonelective contributions under the new proposed regulation, please contact the authors or any member of the McGuireWoods Employee Benefits or Labor & Employment teams.