Individual class based New Comparability

I'm sure this topic has been beaten to death here, but this is an extreme case to ask how much flexibility do plan sponsors have with individual class based.   

Profit sharing only plan has the provision that each participant is in their own class for allocations.    Plan has immediate eligibility.   There are no compensation exclusions and no annual hours or last day condition.  The plan is not top heavy.

Client identifies the following who gets an allocations:

.  Owner employee (single HCE) maxes out

.  Owner identifies lowest paid individuals only statutory group and allocates just enough % of them to pass a4 including average benefits and gateway - yes, kind of like a bottom up qnec. Gateway is only given to these individuals.

.   A couple of those lower paid individuals were excluded because they didn't work at least 1,500 hours and employed on last day.

If individual class based has this much flexibility, why does any plan's profit sharing provision have an age/service, annual condition, compensation exclusions and employee class exclusions?  All you need is for the employer to fill out a formula questionnaire each year to instruct the plan administrator who gets an allocation and how much.    

It shouldn't.

you do realize there is a good chance the IRS frowns upon such a design as violating a reasonable interpretation of the discrimination rules

https://www.irs.gov/retirement-plans/discriminatory-plan-designs-using-short-service

Qualified retirement plans must ensure “the contributions or benefits provided under the plan do not discriminate in favor of highly compensated employees.” (Internal Revenue Code Section 401(a)(4)). A plan that meets statutory or regulatory checklists, but primarily or exclusively benefits highly compensated employees (HCEs) with little to no benefits for nonhighly compensated employees (NHCEs), may still discriminate and violate IRC Section 401(a)(4).

Discriminatory plan designs

We’ve recently found discriminatory plan designs in defined contribution plans (DC), defined benefit plans (DB) and DB/DC combination plans that:

• provide significant benefits to the HCEs and a specified group of NHCEs, who work very few hours or receive very little compensation, and
• exclude other NHCEs from plan participation.

The allocation to NHCEs is designed so this group receives the minimum to satisfy the mathematical portion of the nondiscrimination requirements of IRC Section 401(a)(4). For example, the plan may use a group of NHCEs who have at least one hour of service and received the least amount of compensation for the plan year.

The actual number of NHCEs included in the plan described above isn’t a set group, but instead is defined as the minimum number required to satisfy the requirements of IRC Sections 401(a)(4) and 410(b). Although this design isn’t new, we’ve seen more plans using it or variations producing the same result.

Examples of short service plan designs

Some plans limit NHCE benefits to a specific job classification. The result, for discrimination and coverage purposes, is the same because this classification includes only the lowest paid or shortest service group of NHCEs.

Another variation on this plan design provides coverage to NHCEs who work on an as-needed basis and earn very little each year.

Some plan designs require 1,000 hours to earn a year of service for vesting but not for allocation purposes. In these plans, the low paid or short service NHCEs receive an accrual or allocation but don’t vest in the benefit because they never complete a year of vesting service.

Other plan designs define a year of vesting service as the employee’s completion of 12-consecutive months of employment. This design allows the NHCE participant group to become vested in the very small plan benefit.

Plans may discriminate even though they allocate a larger percentage of compensation to NHCEs. With this design, NHCEs, on average, may seem to receive a misleadingly large accrual or allocation level. For example, an NHCE participant with $200 of annual compensation may receive a profit sharing allocation of $200 (a benefit equal to 100% of compensation), while an HCE with compensation of $200,000 may receive a benefit of only 25% of compensation or $50,000.

Although these designs may allow the plan to satisfy the vesting or numeric general tests for nondiscrimination and the associated regulations, they don’t satisfy Treas. Reg. Section 1.401(a)(4)-1(c)(2), which requires that the provisions of Sections 1.401(a)(4)-1 through 1.401(a)(4)-13 be reasonably interpreted to prevent discrimination in favor of HCEs.

Page Last Reviewed or Updated: 25-Jan-2018

Thanks Tom!

A few years ago the IRS almost required plans with individual groups to pass the ratio % test, they were so concerned about the issue. they took that requirement out of the proposed regs, but only for 'future' consideration. I suspect, though I could be wrong, they will eventually put it back in. And I greatly suspect there are others who have a 'bigger' name than I do who have no problem allocating things in the manner you mentioned, because mathematically it does work.

I honestly and truly merely mention it for consideration that there may be issues...but what is a 'reasonable' interpretation for one person may not be 'reasonable' for another, and I have heard others in the industry say since we can put everyone in their own group it is reasonable to allocate whatever to each person. so I am not saying you can't do things that way, just proceed with caution.

I tend towards cowardice on this issue when it comes to pushing the very edge of the envelope. I have visions of IRS auditors packing .44 magnums and saying, "Go ahead, make my day."

Belgarath and Tom, 

Do you believe there is some risk upon an audit based on the IRS publication? If so would the IRS have a leg to stand on?  What could they say to correct...allocate something to the rest of the plan's eligibles and if so, how much?  Could it snowball into multiple year corrections?

Impossible to say. I do believe there is a "risk" of, at the very least, an auditor giving a client a rough time. Our clients are mostly "small" (less than 100 employees) and have little to no tolerance for additional fees for us to fight/educate the IRS, much less any additional legal fees if it becomes necessary. Of course it is sometimes necessary, but we try to head off potential trouble as much as reasonably possible. As Tom mentions, others may take a much more aggressive stance. They may well be right - I haven't seen audit results for such a plan, 'cause we don't do them.

As an aside, I have rarely see a plan designed to be truly aggressive in this manner, or, depending upon your viewpoint, not being aggressive, but "utilizing this technique to reach the very limits of its applicability." 

agree. lets say the plan is non 401k and involved partners. at ASPPA Conference the IRS has voice the opinion "We would know abusive failure when we see it and probably treat such a plan as a CODA where none exists" and left it at that. so there is nothing written in stone.

it could be how aggressive it becomes. just had a takeover in which the 6 lowest  NHCEs were given 15% profit sharing. plan was tested on an allocation basis to avoid the gateway.

that already smells bad. 3 of the 6 were terminated, only 20% vested. so now it goes from simply smelling bad to outright skunk land. (my opinion) might have been one whose hours was less than 1000 hours and might now be part time.

did it pass everything mathematically? of course yes. 

client was actually happier with our allocation giving the gateway to all the NHCEs this year. go and figure. slightly more expensive, but they were more comfortable with the results. 

24 minutes ago, Tom Poje said:

client was actually happier with our allocation giving the gateway to all the NHCEs this year. go and figure. slightly more expensive, but they were more comfortable with the results. 

 

Many times, TPAs give clients the #'s the TPA thinks the client will want.  And the client thinks that the TPAs #'s are the ones that have to use.

I always ask, especially new clients, what they want to do for the year.  And I won't say, "do you want to do the same as last year."  I will summarize last year's allocation:  "Do you want to maximize the owners and only give a handful of staff a contribution, giving everyone else zero again this year?" (To use Tom's example).

Some companies actually want to share (some of) the profits with all their employees....

Clearly that is an abusive application of an otherwise permissible design, one which IRS would be all over. If the plan had eligibility requirements so that it wasn't exclusively short-term, low-paid NHCEs benefiting, that's a little different. Using short-term low-paid NHCEs to pass testing itself is not an abusive practice targeted by IRS, but it's the exclusion of longer service, higher paid NHCEs, whether from coverage or participation, that IRS looks to shut down.

From the OP... only mentions sufficient allocation percentage to pass a4.  I assume coverage for the statutory group passed 70% ratio?