Cut-back question

[J2D2]

A basic question from someone having severe brain cramps.

Discretionary profit sharing plan requires a participant to either complete 500 hours of service or be employed on last day of the plan year to receive an allocation. Employer now wants to increase hours of service requirement to 1,000.

Assuming there are participants who have completed more than 500 hours at the time the amendment is adopted, can the employer make the increase to 1,000 hours effective retroactive to the first day of the plan year?

[AndyH]

No. Why would you think that you could do that?

[jpod]

You can do it, as long as you do it before the end of the plan year. There will be no reduction in anyone's accrued benefit, because nothing in a discretionary profit sharing plan has accrued yet.

There would be a problem, I think, in amending the plan in this fashion after the close of the plan year. Not an anti-cutback problem, but a "definite allocation" problem.

[AndyH]

I don't agree. Somebody who has worked 501 hours as of the amendment date and then goes part time and doesn't make 1,000 hours would have experienced a cutback in the eyes of the IRS. This is because the person has accrued the right to a portion of any contribution made, and based upon the allocation formula then in effect.

You could only do it before anybody worked 500 hours in my opinion.

See TAM 8735001

[Guest merlin]

It's very much an anti-cutback issue.See PLR9735001,4th paragraph of the "Law" analysis. Once a participant has met the requirements for getting an allocation,those requirements can't be extended without violating 411(d)(6). You could make the amendment effective as of the 1st of the year,but anyone who had hit the 500-hour mark by the adoption date is protected.The fact that the plan is a profit-sharing plan and the allocation is discretionary is irrelevant.

[jpod]

The 97 TAM is somewhat controversial. Even accepting it as "law," however, I believe that the facts were that the alleged cut-back amendment was made AFTER the end of the year and AFTER the discretionary contribution was already made to the Plan.

A rule or interpretation whereby you cannot change the allocation formula or criteria in a discretionary profit sharing plan prior to the end of the year and prior to making any contributions for the year can be avoided, easily, by (1) skipping the profit sharing contribution for the year in question, (2) setting up a second profit sharing that contains the desired allocation requirements and make that year's contribution to the new plan, and (3) merge the two plans before anyone completes 500 hours in the next year and make sure that the surviving plan contains the desired allocation requirements. So, if you're really nervous about the direct approach, you can go for this indirect approach. However, the fact that you could skin the cat through this indirect approach suggests to me that there is no cut-back problem in taking the direct approach.

[Kirk Maldonado]

jpod:

Do you feel confident that the transitory nature of the second plan wouldn't violate the "permanence" requirement?

Here is the applicable language:

The term "plan" implies a permanent as distinguished from a temporary program. Thus, although the employer may reserve the right to change or terminate the plan, and to discontinue contributions thereunder, the abandonment of the plan for any reason other than business necessity within a few years after it has taken effect will be evidence that the plan from its inception was not a bona fide program for the exclusive benefit of employees in general. Treasury Regulation Section 1.401-1(B)(2).

It seems to me that there is at least some risk involved with your proposal.

[Mike Preston]

Merging the old plan out of existence though seems to skin the proverbial cat.

[Kirk Maldonado]

I think it sounds a bit too cute to work.

Another way in which such an arrangement could be challenged is the "step transaction" doctrine. In essence, it holds that you can't do in two step that which you can't do in one step.

I want to be clear that I'm not saying that the proposal is necessarily bad, but there seems to be some risk of getting in a fight with the IRS about it.

[Mike Preston]

I think it is one of those things that if you take the arrogant position, it can hurt you. I wouldn't want to see an advertisement on a website that annouces the way to avoid the TAM is to do this sort of thing. OTOH, if the conversion is done near the end of the year and the provider to the newly designed plan is different than the provider to the soon to be merged out of existence plan, then it would be a relatively simple matter to support the transaction on any number of levels. I would like to think that the IRS would need some indication that it was a step transaction to challenge it.

Nonetheless, your warning is not falling on deaf ears.

[jpod]

1. I don't think the permanency rule is implicated when plans are merged. And, even if it is, you could avoid any issue by merging the first plan into the second plan, rather than vice versa (assuming the first plan has been around for a while).

2. Show me where the step-transaction doctrine has been applied in any context analogous to what I was proposing.

3. Regardless, I don't think the 97 TAM applies to an amendment changing the allocation requirements that is adopted prior to the end of the year and prior to any contribution being made for the year.

[jpod]

Also, in response to Mike Preston, if you believe that the 97 TAM is limited to its facts, as I do, you can't get around it by setting up a second plan, because you can't set up a profit sharing plan after the close of a tax year and claim a deduction for that tax year.

[AndyH]

All of these comments are valid, but I still think that the generally accepted answer to the original question is no, the IRS views this as a cutback.

[jaemmons]

I agree with Andy H. that this would be viewed as a cutback in benefits to those participants who have worked over 500 hours, especially if the PS $'s are allocated under the same allocation method as in the prior plan.

The "step transaction" and establishing of another plan just to merge it out of existence within the same or prospective plan year just do not make practical sense in the real world (or at least the one in which I live). The costs alone to the client, unless you are going to waive them which would seem extremely charitable given the time you put in to thinking about it, would most of the time preclude them from even thinking of doing this. A new document has to be drafted, along with a merger resolution, a 5500 would need to be filed (and how could you avoid not causing a potential audit with a new filing in one year and a final the next?).

I would just not contribute for the current year and amend it for the next plan year. There is too much risk involved with other methods suggested.

[Guest merlin]

I can tell you from first-hand experience tht pre-dates the TAM that Andy is right. The basis is the parenthetical expression in 1.411(d)-4,Q&A 1(d)(8). The allocation to the 500- hour folke has to be protrected.

[Kirk Maldonado]

I agree with Mike Preston that you can do certain things to minimize your risk, but it will not completely eliminate it.