Comments of Richard Hochman at Treasury Hearing on Proposed 401(k) and (m) Regulations
Rev. 11/12/03, E-mall Alert 2003-22

My name is Richard Hochman. I am President and Chief Operating Officer of McKay Hochman Co., Inc., a division of Newkirk Products, Inc. McKay Hochman is a niche employee benefits consulting firm, serving as a Mass Submitter of Prototype Plan documents and sponsor of Volume Submitter documents. In this capacity, McKay Hochman represents hundreds of financial institutions and employee benefit consulting firms with the IRS. We also provide continuing education programs on a broad range of Employee Benefit topics at public forums and on the Internet. Through our educational programs we try to assure that attendees learn about compliance with the Code and underlying Regulations and proper administration and operation of qualified retirement plans. It is in these capacities that we come before you today. We appreciate the opportunity of addressing our concerns. Due to the time constraints of this hearing, we will briefly address each of our concerns, and hope that we can address them all.

The first issue we wish to address is the so-called “Gap Period” earnings on distributions. Since anti-discrimination testing is required to be performed only after the close of the specific test year, if there is a test failure it will not be determined until that time. One of the correction methods in both the existing and the new proposed regulations is the return of excess contributions to the appropriate Highly Compensated Employees. Since the re-release of the current Regulations in December 1994, we have not been required to include the GAP period earnings in the distribution amount. Most industry professionals would prefer if the existing policy continued in the proposed Regulations. In the event that Treasury and the Service do not accept that preference, I would like to address some specific concerns that should be addressed in the final version of the Regulations. The proposed Regulations better reflect the realities of plan administration. The current Regulations as originally promulgated in 1991, did not take into account the fact that many plans are administered on a “traditional or balance forward” basis, as opposed to daily accounting. The proposed Regulations do a better job with traditional plans by requiring that GAP period interest only be reflected in distributions to the extent actually accrued to participant accounts. This is more appropriate, from an administrative standpoint, than the existing method of assuming 10% investment growth for each month. However, there must be some flexibility; since the accrual for January 31st will likely not be determined by February 1st or even the 5th. If the distribution check is cut after the close of a specific month, but before the actual calculation is performed, there should be a mechanism whereby de-minimis amounts of earnings can be disregarded. To require otherwise is unworkable in the balance forward environment. Even in the daily accounting environment, there is an issue of timing of the distributions. Once the recordkeeper determines the principal distribution amount, there is no guarantee that the Trustee will actually distribute the amount on a specific date. The final Regulations must provide for some degree of timing flexibility.

The second issue is that of “flat dollar matching contributions” as impacted by the restrictions on bottom-up QNEC’s. We understand and agree with the need to address the potential discrimination problems created by so-called “bottom up QNECs” and the change in Code Section 415(c) allocation limits. Under commonly found demographic scenarios, by merely providing a high percentage contribution to a single participant with very low compensation, the employer can convert an otherwise failing ADP test to a passing one. This may allow a contribution of a few hundred dollars to substitute for a much larger contribution. However, we are concerned that the method promulgated is overly complex. For example, QNEC contributions in excess of the 5% level are possible under the existing Regulations and are not currently viewed as the root of the problem. Yet the proposed Regulations seem to imply that contributions in excess of this amount are problematic for discrimination testing purposes. Accordingly, we think that the allowable level should be raised to no less than 10% before other restrictive conditions are applicable. Additionally, the calculation of the “representative group” is just too contorted and difficult to perform. We would almost be forced to use the “employees employed on the last day” as the recommended approach to define the 50% group who must benefit. More importantly, the imposition of the two times standard applied to the non-highly compensated employee group is a problem with existing plan designs, which were not set up to be discriminatory. Since, it is normal for some non-highly compensated employees to earn more than twice what others do, based on nothing other than seniority and job function, the “flat dollar matching contribution” design is negatively impacted. This design has been in our approved prototype documents since the TEFRA/DEFRA/REA amendments. For an employer who provides a uniform match to 100% of their deferring employees to be told that this is an inappropriate, discriminatory design is unfathomable. There is nothing in the Code or Regulations that would prohibit an employer from giving a profit-sharing contribution of $1,000 to all their plan participants (assuming they earned at least that much). Most people would think this to be an overly fair allocation. However, we are now being told that an employer who tries to encourage deferrals by providing the same dollar match to all their employees is an “evil doer” with some discriminatory motive. We believe that this position must be reconsidered. Most people with a small scratch in their car door wouldn’t think of fixing it by buying a new car. In an attempt to fix a problem with a class of employers, an unfair result has been placed on an entirely separate group of employers. We lecture that a “flat dollar match” is an effective and nondiscriminatory way to design plans that don’t have testing problems. This design should be allowed to continue if offered to a majority if not all of the employer’ employees.

The third issue we would like to address is the “Pre-funding of Elective Deferrals”. We clearly understand that some employers and some promoters of tax schemes try to take advantage of the tax laws. These scams should be stopped. However, in bringing these folks to justice we do not want to snare innocent employers. The Treasury has already issued several rulings to stop inappropriate deductions in advance of actual accrual of plan benefits. Our concern, however, is for small employers who are trying their best to comply with a vast array of rules promulgated not only by Treasury but also by the Department of Labor. The DOL has been aggressively stipulating what a timely deposit of elective deferrals is. The guidance in these proposed Regulations could catch some employers between a rock and a hard place trying to comply with both Agencies’ positions. We are looking for some assurance that only clearly abusive situations will be followed or that de-minimis situations will not be pursued.

For example, a small employer uses their bookkeeper to do payroll functions. The bookkeeper will be going on vacation and prepares the next payroll which will occur during her vacation. All payments are by direct deposit so that there is no issue of timely payment to the employees. She has a choice of either depositing the deferrals before she leaves or after her return. If she waits then the deferrals will not be deposited to the trust within the normal deposit period of 5 days after payday. She decides to deposit the amounts before she leaves. Under the proposed Regulations, those amounts will not be deemed to be deferrals, but rather profit-sharing contributions and the employer will still owe deferral amounts to the plan.

The employer, in this case, should not be brought under a program that penalizes a timely deferral contribution. The employer was not trying to get a premature deduction on an earlier tax filing. The Regulations, however, provide for no exception in this type of situation. Seemingly, once again, the good guys get burned when actions are taken to stop abusive employers.

The fourth issue of concern to us is the use of a “Safe-Harbor” design and permitted disparity. One of the inconsistencies in the current Regulations that we hoped would be corrected in the new Regulations is that of the overlap of the non-elective Safe-Harbor contribution and other plan contribution types. Under the existing Regulations, an employer providing the 3% non-elective contribution could also use those same dollars in its calculation of the “gateway” for cross-testing and in determining whether or not a cross tested allocation was non-discriminatory. Thus, the same 3% can satisfy Safe-Harbor requirements, top-heavy minimums and still count for cross-tested purposes. However, the current Regulations specifically state that the 3% non-elective Safe-Harbor contribution can not be used as the base contribution for purposes of permitted disparity. This seems to an inappropriate inconsistency. Allocations using permitted disparity usually provide for a greater allocation to rank and file employees than alternative new comparability formulas. Yet, employers are required to utilize cross-tested and not permitted disparity allocation formulas. We would like to see the prohibition eliminated.

Our last issue, based on the comments we submitted for this hearing, is one that is not addressed in the proposed Regulations. Under both the existing and proposed Regulations, an employer will not actually test their plan for discrimination until after the close of the plan year being administered. The issue is which test method to use. After enactment of the Small Business Jobs Protection Act of 1996, plans were allowed to test on either a current or prior year basis. Historically, plans were always tested on a current year basis. After the law change, an alternative method was provided. Treasury, subsequently, provided guidance that employers would always be allowed to switch from prior year testing to current year. However, they would only be allowed to switch from current year to prior year, if they had been current for the lesser of 5 years or the entire history of the plan. During the GUST remedial amendment period, employers were given the ability to switch back and forth as desired with no penalty. With the end of the remedial amendment period, employers are now forced to comply with the more restrictive ‘plan history’ or 5 year rules. The imposition of these rules will prohibit employers from switching every year, just because it works to their advantage. The unaddressed issue is the timing of when the employer must make the actual decision to determine the specific test they will use for a given year. One of the things that complicates the issue, at this point in time, is that the plan document must specifically state the testing method being used. During the remedial amendment period, the employer merely needed to log the testing method they used each year and then record the history as part of its document amendment. Under the Regulations, the employer has twelve months from the close of the plan year to perform all the tests and make all the necessary corrections. Yet, the employer is required to fix the test method even before seeing the applicable data. In informal conversations with IRS representatives we have heard expressions of concern that the employer would always use the most favorable test methods. This is only partially the case. With the more restrictive rules in place, the employer can not just switch testing methods each year. If an employer fails coverage testing, they can retroactively amend the plan for eight and one-half months to fix the test failure. We believe that the employer in a 401(k) plan should have flexibility to decide, after the close of the test year, which testing method they want to use. While all different times frames have been suggested within the industry, a minimum of at least two and one-half to a maximum of 12 months following the end of the year would be appreciated.

One last, last issue relates to the concern expressed immediately above. The proposed Regulations have overly broad language about perceived abuses by the employer in applying both the ADP and ACP tests. Our first preference is to see this sort of broad and ambiguous language removed. If Treasury is not agreeable to removal, we would like to see some further discussion of how and when that language might be applied.

Thank you very much for making time available to us to share our concerns. McKay Hochman Co., Inc. stands ready to answer any questions or address any other issue that might be helpful in the finalization of these important Regulations.