IRS provides temporary relief for ‘closed plan’ nondiscrimination issue

In September we posted an article on the treatment of frozen plans under Tax Code nondiscrimination rules (Treasury/IRS highlight ‘closed plan’ DB issues in Priority Guidance Plan). In December 2013 IRS released Notice 2014-5, providing temporary relief from the ‘frozen plan problem’ for 2014 and 2015 for plans that meet certain conditions. In this article we briefly describe the relief.

Background

Our earlier article provides background on the frozen plan problem and the different issues it presents. Briefly, when a defined benefit plan is closed to new entrants, the group covered under the plan may become discriminatory over time. Quoting the notice: “This might occur for several reasons, including the tendency of NHCEs (non-highly compensated employees) to have higher rates of turnover than HCEs (highly compensated employees), as well as the potential for some of the NHCEs in the closed plan to become HCEs as they continue employment and their pay increases.”

Where new employees (those excluded from the DB plan) are covered under an ongoing defined contribution plan, one way to deal with this problem is to apply the Tax Code nondiscrimination test to both the (closed) DB plan and the DC plan on a combined basis. Usually this only works if, for purposes of the test, you ‘convert’ DC contributions to DB benefits (e.g., you project a contribution made for 30 year old to age 65). This is called testing on a ‘benefits basis.’

Current rules allow sponsors to test on a benefits basis only if the plan passes one of three ‘gateway’ tests – the (1) “primarily defined benefit in character,” (2) “broadly available separate plans,” or (3) “minimum aggregate allocation gateway” tests. While (1) and (2) are generally easier for a frozen DB plan to pass than a stand-alone test, eventually the same problem emerges. Again quoting the Notice: “the same demographic forces that drive the increase in the proportion of HCEs in the closed plan might also over time lead to the aggregated plans being neither primarily defined benefit in character nor consisting of broadly available separate plans.” Test (3) – the minimum aggregate allocation gateway – is viewed by many sponsors as a non-viable solution. The minimum allocation is often prohibitively expensive, and (for instance) matching contributions in the DC plan generally cannot be taken into account.

Relief

The Notice provides, generally, that (i) if the plan was frozen before December 13, 2013, and (ii) if the DB plan is able to pass nondiscrimination testing for 2013 on a stand-alone basis or on a combined/benefits basis under test (1) or (2) above then (iii) for the 2014 and 2015 plan years the plan may continue to test on a benefits basis even if it does not pass test (1), (2) or (3) for those years.

Other issues

The nondiscrimination issue addressed in the Notice is, generally, the ‘main’ frozen plan problem, but there are other issues presented by frozen plans, including whether ‘make whole’ contributions in a DC plan are discriminatory, whether there is discrimination with respect to benefits, rights and features and whether a frozen plan may violate the minimum participation rule under Tax Code section 401(a)(26). These issues are discussed in detail in our earlier article.

Permanent relief

In the Notice, the IRS also states that it is considering a regulation project to provide permanent relief for the frozen plan problem (and related problems). Many of the alternative approaches to a solution discussed in the Notice are more restrictive than the 2014-2015 temporary relief.

We will continue to follow this issue.