The IRS issued a warning to plan sponsors whose plan designs satisfy numeric antidiscrimination tests, yet still have the effect of steering a disproportionate amount of benefits to highly compensated employees (HCEs). The IRS’s message: Simply satisfying numeric tests doesn’t guarantee that you’re complying with antidiscrimination regulations.
IRS findings and examples
In a recent announcement, the IRS reported seeing an uptick in plan designs that provide significant benefits to HCEs. Specifically, it noticed plans benefiting a group of non-highly compensated employees (NHCEs) who work few hours and receive little compensation. These plans tend to exclude other NHCEs from plan participation.
The IRS provided some examples of such designs. In one, the plan bases participation eligibility on job classification, and the classification formula covers a small group of low-pay or short-tenure employees. In another, coverage is available to only NHCEs who work on an as-needed basis and earn a meager salary each year.
Another example: Plans that require 1,000 hours to earn a year of service for vesting purposes, but not for allocation purposes. “In these plans,” the IRS explains, “the low paid or short service NHCEs receive an accrual or allocation, but don’t vest because they never complete a year of vesting service.” A variation on that theme is requiring 12 consecutive months of employment to satisfy a vesting requirement, allowing the NHCEs to vest, but only “in the very small plan benefit.”
The IRS also provides an extreme example in which a participant who earns only $200 in annual compensation receives a $200 profit sharing allocation — 100% of compensation. To allow the plan to clear the antidiscrimination test, an HCE earning $200,000 would receive a $50,000 benefit, or 25% of compensation.
The IRS warns that these plan designs don’t pass muster. The relevant regulations require that all antidiscrimination rules be reasonably interpreted to prevent discrimination in favor of HCEs.