New client with an idea

[buckaroo]

I have a new client that has a 401(k) plan that has elective deferrals and match.  After some discussion, it appears that have spoken with an outside consultant who suggested that they added a new comp allocation with each person in their own group.  Based on this set-up, they want to offer the NEC to a very select number of participants in the following fashion.  There are 5 HCEs and 50 NHCEs.  They are going to ask the plan sponsor, annually, which HCEs are to receive the NEC and then gage who and how many NHCEs are to receive an NEC to pass the ratio test.  A quick general example, let's say that 1 HCE says yes.  Based on that, the HCE coverage ratio would be 20%.  Based on that, the NHCE coverage ration would need to be 14%.  Based on that, only 7 NHCEs (14% of the 50 NHCEs) would need to receive an NEC.  This would pass the ratio test for coverage.  The next issue would be 401(a)(4).  Based on this, they could select the 7 youngest NHCEs and provide them with a contribution that would cause them to satisfy the gateway and pass the 401(a)(4) testing. 

While I know that this does "smell" right, I am having trouble finding a reason that it wont work.  There is no reasonable classification requirement as the contribution level can be high enough to pass all testing at the 70%.  Can anyone tell me why this won't work? 

I am sure that I am missing something simple.  Comments are greatly appreciated. 

[ESOP Guy]

If the HCE's get to decide if they want a NEC and if one of them says "no" what happens?

If they are simply given that amount on their pay check then don't you have a back door 401(k) deferral instead of a NEC?  (I might not be using the exact term here)  Once you give a person a choice between having money put into a plan or paid to them that is NOT a non-ELECTIVE contribution. 

Once it is elective doesn't it have to be tested on the ADP test not as a new comp allocation? 

If an HCE who says "no" simply gets no extra cash in either the plan or outside of it then why would any of them say "no"?  At which time I doubt you pass the test will you? 

[RatherBeGolfing]

I agree, it would be a deemed CODA. 

[ESOP Guy]

CODA was the term I was thinking of and went blank on it! 

[Kevin C]

Age discrimination is the phrase I had come to mind.  I also wonder if it would smell close enough to the plan design described in the Carol Gold memo to face a risk of the IRS deciding it was a discriminatory plan design.

 

I wouldn't be comfortable with a plan design that aggressive.  We typically pair the new comp allocation with a 3% SH, so the gateway requirement would prevent them from doing what the OP discusses. It would be interesting to see the difference in employer contributions between the OP design and new comp + 3% SH + max deferrals.

[buckaroo]

While I agree that there could be an issue with a deemed CODA if the individual HCEs make the choice, this is an issue with most new comp plans.  Change it from the HCE says yes, to the "plan committee" determined that only one HCE should receive the NEC.  Other than the Deemed CODA, what other issues are of concern? 

I agree that the Carol Gold memo is a concern, but not sure if that is the only one. 

As far as age discrimination is concerned, does your opinion change if the NHCEs selected are not all the youngest eligible NHCEs? 

[hr for me]

who's on the "plan committee"? HCEs who are deciding whether they give themselves a contribution? Or peers with HCEs are telling the committee what they personally would choose?   Or subordinates to HCEs who could be influenced? Is the plan committee truly arm's length away when deciding which HCEs get the contribution?

As for age, as long as there isn't disparate impact (say you chose the lowest comps and those are all or mostly youngest, that would still be age discrimination just indirectly).   Because changing the group of NHCEs can still get discriminatory if you aren't very very careful.

But honestly I think is too aggressive and wouldn't suggest it.   Just too many places for this to go wrong.

 

[buckaroo]

Thanks for the comments.  I am in agreement that this seems too aggressive (hence my comment in the OP that it does smell right), but I am still trying to wrap my arms around the best way to convey this to the plan sponsor.  The vast majority of the time, I can point to a regulation or a plan document provision.  In this case, based on my thought and my reading of the above comments, there does not appear to be a regulation or a plan document provision.  I can certainly convey to the plan sponsor that it could be viewed as a deemed CODA or an age discrimination issue.  I can also point to the Carol Gold memo as an example of what the IRS is looking out for.  Are there any other suggestions on ways to dissuade the plan sponsor? 

[Tom Poje]

another example can be found in the LRM (Language Requirement Modifications)  p.128

 

In the case of self-employed individuals (i.e., sole proprietorships or partnerships), the requirements of §1.401(k)-1(a)(6) continue to apply, and the allocation method, including the determination of participant allocation groups, should not be such that a cash or deferred election is created for a self-employed individual as a result of application of the allocation method.

 

the LRM can be found at (it is the 6th one on the list dated 10-2011 so is fairly recent) 

https://www.irs.gov/retirement-plans/listing-of-required-modifications-lrms