IRS To Stop Abusive Nondiscrimination Schemes
Rev. 11/18/04, E-mail Alert 2004-23

The IRS Employee Plan News, November issue, reports that Carol Gold, Director of Employee Plans recently issued an internal memorandum regarding abusive plan designs that make use of allocations to short service employees to satisfy nondiscrimination requirements applicable to cross-tested plans. This memorandum was addressed to IRS agents monitoring determination letter applications and plan audits. It cautioned those agents to be aware of this type of scenario and to take appropriate action to deny plan designs that appear to comply with the “mechanics” of the nondiscrimination regulations, but flagrantly disregard the spirit of the regulations.

In her memorandum, Ms. Gold raises examples of nominal allocations made to short service employees that enable a plan to pass nondiscrimination testing. While this permits a nondiscrimination test to pass numerically, the effect is to limit most of the contribution to the HCEs.

Ms. Gold provides examples of design methods which indicate that a plan is violating Regulation 1.401(a)(4)-8. Such designs represent an unreasonable interpretation of the regulation according to the IRS. The suspect plan designs include:

1. a plan excluding most or all permanent NHCEs;
2. a plan covering a group of NHCEs who were hired temporarily for short periods of time (without a supporting, reasonable business justification);
3. a plan allocating a higher percentage of compensation to the accounts of HCEs covered by the plan; and
4. a plan in which the compensation earned by the NHCEs covered by the plan is significantly less than the compensation earned by the NHCEs not covered by the plan .

Example: A single employer of 55 employees (5 HCEs and 50 NHCEs) sponsors a new comparability plan. Fifteen permanent NHCEs earning between $20,000 and $50,000 are excluded from participation, but 35 NHCEs who earn less than $1,000 are covered. The HCEs receive contributions of 20% while the eligible NHCEs receive 5%. The plan passes nondiscrimination testing numerically, but fails the spirit and intent of the nondiscrimination rules because the results of the general test are distorted by the allocations of relatively small amounts to short-term employees.

The IRS lists other examples of abusive plan designs and states that these are not the only scenarios that violate the spirit of the nondiscrimination rules.

The IRS is stopping these practices by issuing adverse determination letters for plan designs similar to those above. The IRS is finding plans in violation of the nondiscrimination rules if employers discriminate in favor of highly compensated employees even if numerically satisfying the nondiscrimination rules.

MHC Comment: We are not sure what number 3 above means; since a different allocation rate is the basis of cross-tested plans and seems to be permitted by the gateway tests.

To view the entire memorandum click here for the November IRS Employee Plan News.. (The memorandum is linked to the newsletter.)