Cross-tested Prototype Plans
Rev. 12/20/07, E-mail Alert 2007-17

Cross-tested plans will be available as prototype plans for the first time ever in 2008. In order to accommodate this, the IRS has created plan document language and rules for a cross-tested prototype.

The IRS LRM limited the plan’s HCEs to 25 different allocation rates. While unexpected, we do not see any real problem with this limit.

The IRS also allows each nonhighly compensated employee (NHCE) to be in his or her own group, but wanted to limit the number of NHCE allocation rates made available under the plan. (The number of NHCE allocation rates is based on the number of NHCEs in the plan and is also limited to a maximum of 25.) The number of eligible NHCEs to which a particular allocation rate applies must reflect a reasonable classification of employees; and no employee can be assigned to more than one group for a plan year.

Reasonable classification of employees is a classification method that has been put forth by the IRS. Methods include classification by job category, by geographic location, by compensation (hourly versus salaried), and by “similar bona fide business criteria.” Nonetheless, the LRM permits a plan to put each person in his or her own rate group.

Reviewers were instructed to check whether the allowable number of allocation rates is distributed among the eligible NHCEs in a reasonable manner and that reasonable classifications were used. The major document providers didn’t know what reasonable manner and reasonable classification meant in this context. And, unless the terms were clarified, they felt this was a limitation that would again keep employers from being able to use the prototype cross-tested plan.

As a result of pracititoner discussions, the IRS issued two FAQs on its website that clarified and, essentially, limited the reasonable classification requirement in the adoption agreement.

IRS Addresses Participant Group Allocation
By selecting the participant group allocation method, the employer agrees to divide plan participants into a limited number of allocation rates (groups). Within each rate group participants will have the same allocation ratio. The number of groups will be limited as provided in the sample plan language.

The determination of the allocation rates under the plan and the division of participants into groups must occur on or before the due date of the employer’s tax return, including extensions, for the year of allocation.

For this reason, the blank/fill-in of the sample adoption agreement language should be filled in with the following phrase or something similar thereto:

“on or before the due date of the employer’s tax return for the year of allocation through written instructions from the employer to the plan administrator or trustee.”

This language eliminates the need to spell out the actual allocation groups in the adoption agreement. However, there will be some possibly confusing advisory language in the adoption agreement. The second IRS FAQ was issued to address concerns about this language.

Note: While the purpose of LRMs is to assist sponsors of master and prototype plans in drafting plan language that conforms to applicable law and regulations, the exact langague is generally not mandated. However, in order to effect consistent application of cross-testing for nondiscrimination purposes in master and prototype plans, the Service has taken the position that nonstandardized master and prototype plans must follow the language contained in LRM #94 in order to receive an opinion letter.

IRS Addresses Required Language
The cautionary language is required language for a nonstandardized master and prototype plan. Since the participant group allocation method provides that each eligible employee will constitute a separate allocation group, the last sentence of regulation 1.410(b)-4(b) will be disregarded for purposes of meeting such classification standards.

After many e-mails back and forth, a group of the major industry document providers decided that this language was sufficient for us to agree to continue to negotiate with the IRS on other document issues and close out the submissions. Thus, the receipt of the preliminary e-mails as discussed in the other article herein. It still remains to be seen how this will play out on audit, but we have been assured that IRS agents have been advised of this interpretation.

Maximum Number of Groups for HCEs
HCEs may have up to 25 groups and may name as few as one HCE to a group.

Minimum Gateway Requirement
Any allocation of contributions must satisfy a minimum allocation gateway: the 5% or one-third standard. Theoretically, other gateways are available, such as the “broadly available allocation rate,” but to be used they must be specified in the plan document. No fail-safe language may be provided in the plan, in the event that the plan fails nondiscrimination testing under Internal Revenue Code Section 401(a)(4).

Recap
The problem with the cross-tested prototype plan language in the sample adoption agreement provisions is believed to have been overcome. Very few practitioner sponsors should find it necessary to switch from prototype to volume submitter documents — and even fewer to individually designed plans.

Bill Grossman, QPA