Publications

July 1999

Favorable Profit Sharing Contribution Allocations Under 401(k) Plans

By Sheldon M. Geller Esq., Geller Group Ltd.

The IRS has provided guidance in Notice 98-52 on the design-based alternative or "safe harbor" method for satisfying the 401(k) and 401(m) nondiscrimination tests. The new safe harbor will enable 401(k) plans to automatically pass the nondiscrimination tests, satisfy the top-heavy test, and permit employers to favorably allocate profit-sharing contributions to firm principals.

This new plan design will enable partners in law firms, accounting firms, and other professional service firms, as well as shareholders in closely held corporations, to receive significantly more favorable employer contribution allocations utilizing new comparability and cross-tested formulae. The employer may make a contribution equal to three percent of compensation for all eligible non-highly compensated employees, without regard to whether they make 401(k) deferrals. This employer contribution needs to be fully and immediately vested, without regard to the number of hours of service and without regard to employment on the last day of the plan year.

A three percent employer contribution will cause the 401(k) cash deferred arrangement part of the profit-sharing plan to automatically pass the nondiscrimination tests. Thus, the 401(k) arrangement will avoid a return of excess 401(k) deferrals to highly compensated employees. Furthermore, if the plan is top-heavy, the three percent contribution may be used to satisfy the minimum contribution requirements for non-key employees.

A 401(k) plan will satisfy the nondiscrimination tests if the employer makes either matching or nonelective contributions and provides employees with a timely notice prescribing their rights and obligations under the plan. The Small Business Job Protection Act of 1996 (SBJPA) added the safe harbor methods effective for plan years beginning after December 31, 1998. Employee notices for the 1999 plan year were required by March l. Plan amendments needed to implement the safe harbor methods may be deferred until the date other plan amendments to comply with SBJPA are required (i.e., for calendar year plans. by December 31, 2000). The employee notice addresses the timing of the safe harbor contributions and the interaction of the safe harbor methods with other qualification requirements.

The safe harbor notice rules require that any matching contribution taken into account to satisfy the additional deferral percentage (ADP) test safe harbor must be made under the terms of the plan. Even though matching contributions made at the employer's discretion may not be taken into account for purposes of the safe harbor, a plan that satisfied the safe harbor contribution requirement will not fail solely because additional matching contributions are made at the employer's discretion.

Safe harbor, nonelective contributions may be counted toward the minimum contribution requirement for top-heavy plans. Thus, if a plan allocates to all eligible employees a three percent safe harbor nonelective contribution, the plan generally would also satisfy the top-heavy minimum contribution requirement. Safe harbor matching contributions may not be counted toward the minimum contribution requirement for top-heavy plans.

The multiple use test does not apply to a 401(k) cash or deferred arrangement that satisfies the ADP test safe harbor. A plan may not apply the ADP test safe harbor or actual contribution percentage (ACP) safe harbor for a plan year that is not at least 12 months long or, in the case of the first plan year of a newly established plan, the plan year is not at least three months long.

Although the safe harbors permit a plan sponsor to avoid cumbersome and expensive tests, the use of the safe harbors may also increase the employer's funding cost depending upon plan participation levels. The 401(k) plan sponsor needs to take into account whether the traditional 401(k) plan design or the safe harbor plan design meets its corporate objectives. Nevertheless, the safe harbor plan design permits highly compensated employees to contribute the full 401(k) dollar limit, which is $10,000 in 1999. A 401(k) sponsor may elect the safe harbor 401(k) plan design to accommodate highly compensated employees who wish to make the maximum annual contribution.