401(a)(26) Problem?

[Dougsbpc]

Suppose you have a small defined benefit plan with 6 participants that has existed for 5 years. The benefit formula is 5% of FAC x YOP. All participants have accrued a benefit of 25% of their average salary.

The 100% shareholder of the company (also a plan participant) wants to start a 401(k) plan for all employees and provide a mandatory employer contribution of at least 7.5% of salary every year.

If the defined benefit plan were amended to continue 5% for shareholders and .5% for all others, would the plan fail 401(a)(26) going forward if there were no new participants? Both plans together would easily pass 401(a)(4).

I know the safest way to go is a fresh start with each employees frozen accrued benefit + .5% going forward. This is the way we will go, but if the plan instead did not have an A+B formula, would it fail 401(a)(26)? No employee other than the owner would have a positive accrual going forward for quite some time. However, all employees would have accrued a benefit of at least .5% for each year of participation under the plan.

[FAPInJax]

There was an interesting discussion on the ACOPA site regarding this topic. It was basically that a plan provided 5% of compensation the first year and nothing for next nine. Would the plan pass 401(a)(26) as the employees would always have .5% per year? The general consensus if I remember correctly was Yes.

[Dougsbpc]

It would sure seem that a plan would pass 401(a)(26) if at least 40% of eligible participants had accrued benefits that were at least .5% per year.

The problem may be in 1.401(a)(26)-3©(2) Prior benefit structure. Part of this states " a plan will not satisfy this paragraph © if it exists primarily to preserve accrued benefits for a small group of employees and thereby functions more as an individual plan for a small group of employees".