IRS Audit

[John Feldt ERPA CPC QPA]

A prospect is under an IRS Audit. They have asked us to look at the situation.

1. The IRS Agent's review states the merger of a Profit Sharing plan into a 401(k) plan constitutes a plan termination. They use Rev Ruling 2002-42 and they say that because the Profit Sharing plan had a 5-year vesting schedule 20, 40, 60, 80, 100 but the plan it was merged into (the 401(k) plan) had a 6-year graded schedule, 0, 20, 40, 60, 80, 100, that this a complete termination of the PS plan. At the time of the merger, language was added to the 401(k) to maintain the vested percent from the PS plan but only for purposes of the merged PS balances only, so the reports show everyone's prior PS balance continued upward on that old schedule.

2. Also, the PS plan excluded some employees, but still passed the 70% coverage (ratio percent) test. But, the IRS agent writes "there are no provisions under the Code that allow you to include only employees who have certain job titles", stating that we cannot use language that says "The following Employees are not eligible: All employees other than Employees with job title a)___, Employees with job title b)___, and Employees with job title c)___" even though this passed the 70% coverage test. This document is a Age Weighted formula document (volume submitter).

Any comments/thoughts would be great.

[WDIK]

With respect to part 2 of your post:

First, I didn't think the reasonable classifications test came into play if you passed coverage using the ratio percentage test.

Second, Treasury Regulation 1.410(b)-4(b) states the following -

(b) REASONABLE CLASSIFICATION ESTABLISHED BY THE EMPLOYER.

A classification is established by the employer in accordance with this paragraph (b) if and only if, based on all the facts and circumstances, the classification is reasonable and is established under objective business criteria that identify the category of employees who benefit under the plan. Reasonable classifications generally include specified job categories, nature of compensation (i.e., salaried or hourly), geographic location, and similar bona fide business criteria. An enumeration of employees by name or other specific criteria having substantially the same effect as an enumeration by name is not considered a reasonable classification.

This regulation does not necessarily mean that all job category classifications would be reasonable. It is a facts and circumstances test.

[WDIK]

With respect to part 1 of your post:

It appears that the pertinent wording in Rev. Proc. 2002-42 in determining whether or not a partial termination has occurred in this situation is "the employees vest in the continuing profit-sharing plan under the same vesting schedule that existed[.]" It further appears that the word of emphasis in this phrase is continuing.

On the other hand, this Rev. Proc. specifically applies to the merger or conversion of a money purchase plan.

[John Feldt ERPA CPC QPA]

Thanks, that's very helpful.

As we looked further at the documentation, it appears that the language to continue the PS vesting schedule for the prior balances was only placed into the Merger Resolution, but it never got into the plan document of the 401(k) plan. This could be a problem then, and cause perhaps one employee to receive an additional distribution.

[PLAN MAN]

Concerning part 2 of your post:

I think the IRS agent is trying to say that the plan cannot be written to only include certain employees, but it must be written to EXCLUDE employees with certain job titles or job categories. Remember, a qualified plan is set up to benefit the employees and can only exclude certain employees as allowed under the statutes or if the plan passes the 410(b) coverage requirements.

The following is taken from the IRS Employee Plans Determinations Quality Assurance Bulletin 2006-3 and might explain the reasonable classification issue:

"Section 410(b) of the Code provides certain minimum coverage requirements that were introduced in ERISA. Under section 410(b), a plan could satisfy these requirements by benefiting such employees that qualify under a classification set up by the employer that did not discriminate in favor of employees who are officers, shareholders, or highly compensated. Although the Tax Reform Act of 1986 (TRA 86) made significant changes in the coverage requirements of section 410(b) of the Code, it retained the concept of nondiscriminatory classifications. Section 410(b) now provides, in general, that a trust will not be qualified unless the plan of which it is a part benefits a minimum percentage of nonhighly compensated employees. One prong of the average benefit percentage test described in section 410(b)(2) of the Code, provides that if a plan benefits a reasonable classification of employees set up by the employer that is not found to be discriminatory in favor of highly compensated employees, then the plan has, in part, satisfied section 410(b)."

[John Feldt ERPA CPC QPA]

Plan Man,

I understand your point, but I must disagree with "the plan cannot be written to only include certain employees".

If that is true, then you would be making a ruling based on how the plan's document words are ordered and phrased, not based on what the words mean in total and their end result (the action needed to operate the plan).

Here's an example, 2 highly, 2 nonhighly. Suppose we want to benefit only Jill and Bob:

Jill (Sales) HCE

Joe (Admin) HCE

Bob (Sales) NHCE

Fred (Admin) NHCE

Wording #1 (you say is ok): "Employees who are Administrators are excluded" - thus Jill and Bob are in the plan.

Wording #2 (you say is NOT ok): "All Employees other than Salespeople are excluded" - thus Jill and Bob are in the plan - same result.

The end result of the wording is to exclude certain employee groups - as you stated "a qualified plan is set up to benefit the employees and can only exclude certain employees". Please look at the regulations in addition to the Code and see what you think. I do not yet see a problem with either number 1 or number 2 above.

Anybody else?

[zimbo]

With regards to item #2, I think the IRS agent is grasping at straws. If the plan language is clear and the ratio percentage test is met, there is absolutely no prohibition about picking and choosing job classes or even naming eligible employes (or ineligibles I suppose) by name.

The reasonable business related classifications are only relevant when doing the Average Benefit Test portion of 410(b).

[John Feldt ERPA CPC QPA]

Thanks, we agree. Yes, we could tell right away that the agent was attempting to use the Avg Bft test rules when they were clearly not appropriate. The agent only quoted the code and we will be replying with references to the regulations.

[John Feldt ERPA CPC QPA]

To close this out:

We replied to the IRS examiner and explained how 2002-42 applies to the merger of a money purchase plan, not a profit sharing plan, and further provided an example from 1.411(d)-3(a)(3), example 4(i), and included language from the conclusion after 4(ii) to support our position.

For the 410(b) issue, we gently encouraged him to rely on the regulations to interpret the meaning of the code, specifically 1.410(b)-2 in this instance. We quoted 1.410(b)-2(a) and pointed out 1.410(b)-2(b)(1), which requires just one of (b)(2) to (b)(7) to be satisfied. We explained that 1.410(b)-2(b)(2) supports our position and we provided him with the definition of "ratio percentage" as found under 1.410(b)-9.

The case then went to his supervisor, we received a 'no change' letter from the supervisor stating that they have closed the audit, accepted the returns as filed, and that no action was needed. At least we didn't have to get an ERISA attorney involved.

Score!

WDIK - correct

zimbo - correct