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During the hearings on the Proposed 401(k) Regulation hearings, Rich commented on the approach being proposed to address the problem of “bottom-up QNECs” and its potential negative impact on existing plan designs using “Flat Dollar QNEC” or “Flat Dollar Matching” contributions.

We have been asked to provide data on a real case (or cases), where the employer might fail non-discrimination testing by applying the new proposed rules. Those rules provide that if any NHCE receives a QNEC allocation in excess of 5% of Compensation, the excess allocation amount may not be used in discrimination testing, unless at least 50% of the NHCEs (a “representative group”) or all employees employed on the last day of the plan year also receive a QNEC contribution. Additionally, no NHCE may receive, in percentage terms, an allocation in excess of twice that of any other NHCE.

While Congress was worried about making “Bottom-Up” contributions to satisfy an otherwise failing test; we have tried to assert that employers, who have a “hard coded formula” based contribution that is both allocated to all, or almost all, eligible participants and given without regard to actual test results, should not be treated in the same manner as an employer making “targeted contributions” to one or more NHCEs, for the sole purpose of passing the non-discrimination test.

If you have a case where an employer is making a flat dollar contribution that will exceed 5% being allocated to any NHCE and who would be negatively impacted by the new proposed regulations, we would appreciate your sending the data for that case to us. We would then pass it on to the folks at Treasury. They are looking for proof, to back up the testimony, that employers using flat dollar contributions could be detrimentally impacted by the application of the proposed rules.

We would appreciate your assistance if you have such a case. Please e-mail rhochman@mhco.com with information about any such case(s).

Below, for your reference, is an overview of the proposed 401(k) regulations for bottom-up QNECs.

Background
In the legislative history to EGTRRA, Congress requested the Secretary of the Treasury to exercise his regulatory authority to eliminate situations where a high percentage of compensation QNEC is targeted to a small number of participants who have a low income in the affected year. A bottom-up or targeted QNEC allows an employer to make a relatively small contribution that inflates the targeted participants’ ADR to an extremely high level which dramatically improves the average of the entire NHCE group’s ADP and allows the plan to cure an ADP failure. It was Congress’ opinion that this tactic circumvented the spirit of the law. Note that because the IRS did not impose its new rules as a “temporary rule,” plans with documents that permit their use may continue to use a bottom-up QNEC until the effective date in the final regulations.

If finalized as proposed, the IRS would treat the plan as providing impermissible targeted QNECs if QNECs are provided in excess of the following IRS rules:

The proposed targeted QNEC rules for ADP Testing

1. QNECs of up to 5% of compensation are not targeted QNECs

2. In order to exceed a 5% QNEC to a NHCE and have it included in the ADP test, the QNEC may not be more than two times the plan’s representative contribution rate.

3. The plan’s representative contribution rate is defined as the greater of:

a. The lowest applicable contribution rate of any eligible NHCE among a group of eligible NHCEs that consists of half of all the eligible NHCEs, OR

b. The lowest applicable contribution rate of any eligible NHCE in the group of all eligible NHCEs for the plan year and who is employed by the employer on the last day of the year.

i. The definition of applicable contribution rate for an eligible NHCE is the sum of the QMAC and QNEC taken into account for ADP testing for that eligible NHCE for the plan year, divided by that eligible NHCEs compensation for the same period.

McKay Hochman Commentary: Flat dollar QNEC and flat dollar matching would be subject to the new targeted QNEC rules for ADP and ACP testing and may not pass.

The proposed targeted QNEC rules for ACP testing

1. The 5% of compensation QNEC limit is applied separately to the ADP and ACP test. Therefore, the employer may make a 5% of compensation QNEC for ADP test purposes and a 5% QNEC for ACP test purposes to the same NHCEs without regard to who or how many receive each 5%.

2. The proposed regulations restrict the ability to exceed 5% of compensation QNEC for ACP testing purposes by providing that matching contributions are not to be taken into account in the ACP test to the extent the representative matching rate (defined in item 3. below) for the contribution exceeds the greater of 100% or 2 times the plan’s representative contribution rate.

3. The plan’s representative matching rate is defined as the greater of:

a.
The lowest matching rate for any eligible NHCE among a group of eligible NHCEs that consists of half of all the eligible NHCEs, OR

b. The lowest matching rate of any eligible NHCE in the group of all eligible NHCEs for the plan year and who is employed by the employer on the last day of the year.

. i The definition of matching rate for an employee is the matching contributions made for such employee divided by the elective deferrals or employee contributions being matched.

4. Differences in the tests include:

a. For the ACP test, the lowest contribution for NHCEs would be based on the sum of QNECs and those matching contributions taken into account for the ACP test. (For the ADP test, QNECs and QMACs were taken into account.)

b. QNECs taken into account in the parallel ADP test may not be used in this ACP test.

c. Only employees actually deferring may be counted in the ACP test.