Selective cash-balance offsets fail pension nondiscrimination and participation tests

Plain-English summary

An employer maintained a cash-balance pension plan and a profit-sharing plan. The cash-balance plan offset benefits for nonhighly compensated employees by their profit-sharing benefits, reducing those employees' cash-balance benefits to zero, while highly compensated owner-employees faced no offset. Chief Counsel advised that the combined plans were neither primarily defined benefit in character nor broadly available separate plans, so they had to satisfy the minimum aggregate allocation gateway before using equivalent-benefit testing under IRC Section 401(a)(4). Chief Counsel also concluded that the selective offset could not be ignored under the minimum-participation rules. The affected nonhighly compensated employees therefore did not count as benefiting or receiving meaningful benefits under IRC Section 401(a)(26).

Ruling snapshot

• Question: Can a selective floor-offset arrangement pass combined nondiscrimination testing and count zeroed-out employees under the minimum-participation rules?
• Outcome: advice given
• Key authorities: IRC §§ 401(a)(4), 401(a)(26), 410(b), 415(b); Treas. Reg. §§ 1.401(a)(4)-3, -9 and 1.401(a)(26)-2 through -5

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201810008
       Release Date: 3/9/2018
       CC:TEGE:EB:QP1                           Third Party Communication: None
       PRENO-103030-18                          Date of Communication: Not Applicable

UILC: 401.04-04, 401.20-00

date: February 07, 2018

 to:   David Conrad
       Area Counsel (Mountain States Area Denver)
       (Tax Exempt and Government Entities Division Counsel)

from: Stephen B. Tackney
Deputy Associate Chief Counsel, (Employee Benefits),
(Tax Exempt and Government Entities)

subject: Application of sections 401(a)(4) and 401(a)(26) to a cash balance plan that offsets
benefits with benefits under a defined contribution plan

       This Chief Counsel Advice responds to your request for assistance dated February 1,
       2018. This advice may not be used or cited as precedent.

       ISSUES

       You have asked the following questions regarding a floor-offset arrangement under
       which benefits under a defined benefit plan are offset by benefits under a defined
       contribution plan only for nonhighly compensated employees (NHCEs), so that for
       NHCEs who participate in both plans, but not for highly compensated employees
       (HCEs) who participate in both plans, benefits are eliminated under the defined benefit
       plan:

       (1) How may this combination of plans satisfy the conditions for combined testing on the
       basis of equivalent benefits under § 1.401(a)(4)-9(b)(2)(v)?

       (2) Are the NHCEs whose benefit under the defined benefit plan is entirely offset
       considered to be benefitting under the defined benefit plan, and to have a meaningful
       benefit under the defined benefit plan, for purposes of determining whether the plan
       satisfies the minimum participation requirement of § 401(a)(26)?

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CONCLUSIONS

(1) The special rule of § 1.401(a)(4)-3(f)(9) (under which an employee’s accrued
benefit under a plan includes that portion of the benefit that is offset by benefits
under another plan) applies only to the extent that the benefit is attributable to
pre-participation service or past service. Therefore, the offset is taken into
account in determining whether the DB/DC plan is primarily defined benefit in
character within the meaning of § 1.401(a)(4)-9(b)(2)(v)(B) or consists of broadly
available separate plans within the meaning of § 401(a)(4)-9(b)(2)(v)(C).
Because, after the offset, NHCEs receive no benefit under the defined benefit
plan, the DB/DC plan is not primarily defined benefit in character. Similarly, the
DB/DC plan does not consist of broadly available separate plans because the
defined benefit plan does not satisfy the applicable conditions set forth in
§ 1.401(a)(4)-9(b)(2)(v)(C). Accordingly, the DB/DC plan must satisfy the
minimum aggregate allocation gateway of § 1.401(a)(4)-9(b)(2)(v)(D) to be
eligible for testing for nondiscrimination on the basis of equivalent benefits.

(2) The special rule of § 1.401(a)(26)-5(a)(2)(iii) (under which an offset of benefits
under a defined benefit plan by benefits under another plan is disregarded) does
not apply to an offset that applies only to a subset of participants in the defined
benefit plan. Because the offset must be taken into account and reduces the
benefits of NHCEs under the defined benefit plan to zero, the NHCEs do not
benefit under the defined benefit plan within the meaning of § 401(a)(26)(A) and
§ 1.401(a)(26)-2(a) and do not have a meaningful benefit under the plan’s prior
benefit structure as specified in § 1.401(a)(26)-3(c). Accordingly, the NHCEs are
not taken into account for purposes of satisfying the requirements of
§ 401(a)(26).

FACTS

The employer maintains a cash balance plan and a defined contribution plan for the
benefit of its employees. The defined contribution plan is a profit sharing plan to which
the employer makes an annual contribution that is allocated ratably to all participants
based on compensation. All employees of the employer are eligible to participate in the
defined contribution plan.

The cash balance plan covers two groups of participants. The first group of participants
(all of whom are HCEs) consists of the owner-employees of the employer. This group
of participants receives the lesser of (1) the maximum pay credit so that the resulting
annual benefit will not exceed the limitations of § 415(b), and (2) the maximum pay
credit that enables the plan to comply with § 401(a)(4) (determined using a method
specified in the plan). The second group of participants (all of whom are NHCEs)
consists of the lowest-paid group of employees who are not owner-employees and who
perform at least one hour of service during the plan year. The lowest-paid group is
limited to the number of employees necessary so that the plan covers the lesser of 40%
PRENO-103030-18 3

of the total number of employees for the plan year or 50 employees. This second group
of participants receives an annual pay credit of 1% of compensation.

For an owner-employee, the accrued benefit under the cash balance plan is the single
life annuity payable at age 65 that is the actuarial equivalent of the current balance of
the cash balance account. For a participant who is not an owner-employee, the
accrued benefit under the cash balance plan is the single life annuity payable at age 65
that is the actuarial equivalent of the current balance of the cash balance account, offset
by the single life annuity payable at age 65 that is the actuarial equivalent of the
participant's vested account balance attributable to employer contributions under the
profit-sharing plan. Because the benefits for this second group of participants
attributable to employer contributions under the profit-sharing plan is larger than the
benefits payable under the cash balance plan absent the offset, the offset for this
second group of employees reduces the benefit under the cash balance plan to zero.

LAW AND ANALYSIS

Issue 1

Section 401(a)(4) provides that a plan is a qualified plan only if the contributions or the
benefits provided under the plan do not discriminate in favor of highly-compensated
employees (HCEs).

Section 1.401(a)(4)-1(b)(2) requires that either the contributions or the benefits provided
under the plan must be nondiscriminatory in amount. To be nondiscriminatory in
amount, either the contributions alone or the benefits alone must be nondiscriminatory
in amount; it is not required that both the contributions and the benefits be
nondiscriminatory in amount.

Section 1.401(a)(4)-3 describes the rules for determining nondiscrimination in amount of
employer provided benefits under a defined benefit plan. Section 1.401(a)(4)-3(b)
provides a number of safe harbors that apply to a plan that provides for uniform
benefits, and § 1.401(a)(4)-3(c) provides a general test that applies to a plan that does
not provide for uniform benefits.

Section 1.401(a)(4)-3(c) provides that the employer-provided benefits under a defined
benefit plan are nondiscriminatory in amount for a plan year if each rate group under the
plan satisfies section 410(b). For purposes of §1.401(a)(4)-3(c)(1), a rate group
generally consists of an HCE and all other employees with a normal accrual rate greater
than or equal to the HCE’s normal accrual rate and who also have a most valuable
accrual rate greater than or equal to the HCE’s most valuable accrual rate.

Section 1.401(a)(4)-3(f) provides special rules of application. Section 1.401(a)(4)-3(f)(9)
provides that an employee’s accrued benefit under a plan includes that portion of the
benefit that is offset under an offset described in § 1.401(a)(4)-11(d)(3)(i)(D) (pertaining
PRENO-103030-18 4

to offsets for pre-participation service). The rule applies only to the extent that the
benefit is attributable to periods for which the plan being tested credits pre-participation
service or past service. Section 1.401(a)(4)-3(f)(9)(ii), Example 1 illustrates that the rule
applies to an offset for pre-participation service but not to an offset for concurrently
earned benefits.

Section 1.401(a)(4)-9 provides the requirements for testing situations in which plan
aggregation or restructuring is used to satisfy nondiscrimination.

Section 1.401(a)(4)-9(b)(2)(v)(A) addresses a plan that consists of one or more defined
contribution plans and one or more defined benefit plans (a DB/DC plan). Specifically, it
provides that unless the DB/DC plan is primarily defined benefit in character or consists
of broadly available separate plans, the DB/DC plan must satisfy the minimum
aggregate allocation gateway of § 1.401(a)(4)-9(b)(2)(v)(D) for the plan year in order to
be permitted to demonstrate satisfaction of the nondiscrimination in amount requirement
of § 1.401(a)(4)-1(b)(2) on the basis of equivalent benefits.1

Section 1.401(a)(4)-9(b)(2)(v)(B) provides that a DB/DC plan is primarily defined benefit
in character if, for more than 50% of the non-highly compensated employees (NHCEs)
benefitting under the plan, the normal accrual rate for the NHCE attributable to benefits
provided under defined benefit plans that are part of the DB/DC plan exceeds the
equivalent accrual rate for the NHCE attributable to contributions under the defined
contribution plans that are part of the DB/DC plan.

Section 1.401(a)(4)-9(b)(2)(v)(C) provides that a DB/DC plan consists of broadly
available separate plans if the defined contribution plan and the defined benefit plan that
are part of the DB/DC plan each would satisfy the requirements of section 410(b) and
the nondiscrimination in amount requirement of § 1.401(a)(4)-1(b)(2) if each plan were
tested separately and assuming that the average benefit percentage test of § 1.410(b)-5
were satisfied. For this purpose, all defined contribution plans that are part of the
DB/DC plan are treated as a single defined contribution plan and all defined benefit
plans that are part of the DB/DC plan are treated as a single defined benefit plan.

Section 1.401(a)(4)-9(b)(2)(v)(D)(1) provides that a DB/DC plan satisfies the minimum
aggregate allocation gateway if each NHCE has an aggregate normal allocation rate
that is at least one third of the aggregate normal allocation rate of the HCE with the
highest such rate (HCE rate) or, if less, 5% of the NHCE's compensation, provided that
the HCE rate does not exceed 25% of compensation. If the HCE rate exceeds 25% of
compensation, then the aggregate normal allocation rate for each NHCE must be at

1
An additional exception from the minimum aggregate allocation gateway applies under some
circumstances to a DB/DC plan that contains a defined benefit plan that is closed to new entrants. See
Notice 2014-5, 2014-2 I.R.B. 276, and successor notices extending the relief in Notice 2014-5; see also
proposed amendments to § 1.401(a)(4)-9 in REG-125761-14, 81 FR 4976 (January 29, 2016). This
exception does not apply under these facts, and is not discussed further in this memorandum.
PRENO-103030-18 5

least 5% increased by one percentage point for each 5-percentage-point increment (or
portion thereof) by which the HCE rate exceeds 25%.

The employer intends to aggregate the cash balance plan and the profit-sharing plan for
purposes of nondiscrimination testing. Accordingly, in order to demonstrate satisfaction
of the nondiscrimination requirements on the basis of equivalent benefits without
satisfying the minimum aggregate gateway allocation, the aggregated plan must either
be primarily defined benefit in character or consist of broadly available separate plans.

The DB/DC plan resulting from aggregating the cash balance plan and the profit-sharing
plan is not primarily defined benefit in character within the meaning of § 1.401(a)(4)-
9(b)(2)(v)(B). That is because, for the NHCEs accruing pay credits under the plan, the
normal accrual rate attributable to benefits provided under the cash balance plan is zero
as a result of the offset by the larger benefit attributable to the defined contribution plan.
The offset may not be disregarded because it is an offset for concurrently earned
benefits and only an offset for pre-participation service may be disregarded. Therefore
the benefit for each NHCE does not exceed the equivalent accrual rate for the NHCE
attributable to contributions under the defined contribution plan.

The DB/DC plan resulting from aggregating the cash balance plan and the profit-sharing
plan does not consist of broadly available separate plans. Section 1.401(a)(4)-
9(b)(2)(v)(C) requires that to be considered broadly available separate plans, each plan
separately must satisfy the requirements of section 410(b) and the nondiscrimination in
amount requirement of § 1.401(a)(4)-1(b)(2) if each plan were tested separately and
assuming that the average benefit percentage test of § 1.410(b)-5 were satisfied. The
cash balance plan does not separately meet the coverage requirements, taking the
offset into account, because the benefits under the cash balance plan for participants
who are NHCEs are reduced to zero under the offset. As discussed above, this offset
may not be disregarded in testing the cash balance plan, because it is not an offset
attributable to pre-participation service and, under § 1.401(a)(4)-3(f)(9), the only offsets
that may be disregarded are offsets attributable to pre-participation service. After
applying the offset to determine the accrued benefit, the cash balance plan does not
satisfy the requirements of section 410(b) when tested separately, because an
insufficient number of employees have normal and most valuable accrual rates greater
than or equal to the rates of the HCEs.

Since the aggregated plan is not primarily defined benefit in character and does not
consist of broadly available separate plans, in order for the DB/DC plan to be permitted
to demonstrate satisfaction of the nondiscrimination requirements on the basis of
equivalent benefits, NHCEs must receive sufficient allocations under the profit-sharing
plan to satisfy the minimum aggregate allocation gateway of § 1.401(a)(4)-9(b)(2)(v)(D).

Issue 2
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Section 401(a)(26) provides that a trust that is part of defined benefit plan is a qualified
trust only if it benefits at least the lesser of (i) 50 employees of the employer, or (ii) the
greater of (I) 40 percent of all employees of the employer, or (II) 2 employees (or if there
is only 1 employee, such employee).

Section 1.401(a)(26)-1(a) provides that a plan is a qualified plan for a plan year only if
the plan satisfies section 401(a)(26) for the plan year. A plan that satisfies any of the
exceptions described in § 1.401(a)(26)-1(b) passes section 401(a)(26) automatically for
the plan year. A plan that does not satisfy one of those exceptions must satisfy §
1.401(a)(26)-2(a). In addition, a defined benefit plan must satisfy § 1.401(a)(26)-3 with
respect to its prior benefit structure. Finally, a defined benefit plan that benefits former
employees must separately satisfy § 1.401(a)(26)-4 with respect to its former
employees.

Section 1.401(a)(26)-1(b) provides exceptions for plans that do not benefit any highly
compensated employees, multiemployer plans, certain underfunded defined benefit
plans, and certain plans involved in acquisition or disposition transactions of the
employer.

Section 1.401(a)(26)-2(a) provides that a defined benefit plan that does not meet an
applicable exception must benefit at least the lesser of 50 employees or 40 percent of
the employer’s employees.

Section 1.401(a)(26)-3(a) provides that a defined benefit plan that does not meet one of
the exceptions in § 1.401(a)(26)-1(b) must satisfy § 1.401(a)(26)-3(c) with respect to its
prior benefit structure.

Section 1.401(a)(26)-3(c)(1) provides that a plan’s prior benefit structure satisfies
§ 1.401(a)(26)-3(c) if the plan provides meaningful benefits to a group of employees that
includes the lesser of 50 employees or 40 percent of the employer’s employees.

Section 1.401(a)(26)-3(c)(2) provides that whether a plan is providing meaningful
benefits, or whether individuals have meaningful accrued benefits under a plan, is
determined on the basis of all the facts and circumstances. The relevant factors in
making this determination include, but are not limited to: the level of current benefit
accruals; the comparative rate of accruals under the current benefit formula compared
to prior rates of accrual under the plan; the projected accrued benefits under the current
benefit formula compared to accrued benefits as of the close of the immediately
preceding plan year; the length of time the current benefit formula has been in effect;
the number of employees with accrued benefits under the plan; and the length of time
the plan has been in effect. A plan does not satisfy § 1.401(a)(26)-3(c) if it exists
primarily to preserve accrued benefits for a small group of employees and thereby
functions more as an individual plan for the small group of employees or for the
employer.
PRENO-103030-18 7

Section 1.401(a)(26)-5(a)(2) provides a rule for determining whether an offset plan
provides meaningful benefits. Section 1.401(a)(26)-5(a)(2)(i) provides that generally an
employee is treated as accruing a benefit under a plan that includes an offset or
reduction of benefits that satisfies § 1.401(a)(26)-5(a)(2)(ii) or (iii) if either the employee
accrues a benefit under the plan for the year or the employee would have accrued a
benefit under the plan if the offset or reduction of the benefit were disregarded.

Section 1.401(a)(26)-5(a)(2)(iii) states:

   An offset or reduction of benefits under a defined benefit plan satisfies the
   requirements of this paragraph (a)(2)(iii) if the benefit formula provides a benefit
   that is offset or reduced by contributions or benefits under another plan that is
   maintained by the same employer and the following additional requirements are
   met:

          (1) The contributions or benefits under a plan that are used to offset or
          reduce the benefits under the positive portion of the formula being tested
          accrued under such other plan;

          (2) The employees who benefit under the formula being tested also benefit
          under the other plan on a reasonable and uniform basis; and

          (3) The contributions or benefits under the plan that are used to offset or
          reduce the benefits under the formula being tested are not used to offset
          or reduce that employee's benefits under any other plan or any other
          formula.

In the present case, the cash balance plan does not meet any of the exceptions listed in
§ 1.401(a)(26)-1(b). Therefore it must satisfy § 1.401(a)(26)-2(a) by benefitting a group
of employees that includes the lesser of 50 employees or 40 percent of the employer’s
employees. Furthermore, the cash balance plan must satisfy § 1.401(a)(26)-3 with
respect to its prior benefit structure by providing meaningful benefits to a group of
employees that includes the lesser of 50 employees or 40 percent of the employer’s
employees.

In order for the offset to be disregarded in determining whether the cash balance plan
satisfies §§ 1.401(a)(26)-2 and -3 (so that NHCEs, who benefit under the cash balance
plan disregarding the offset but not if the offset is taken into account, are counted for
purposes of satisfying these requirements), the offset must fall within the exception of
§ 1.401(a)(26)-5(a)(2)(iii). That exception applies to a defined benefit plan only if the
benefit formula provides a “benefit that is offset or reduced by a contribution or benefit
under another plan.” In addition, the regulations provide that employees who benefit
under the formula being tested must also benefit under the other plan on a reasonable
and uniform basis. Since, as explained below, the benefit under the cash balance plan
is not fully offset or reduced by the benefit under another plan under which the
PRENO-103030-18 8

employees who benefit under the cash balance plan benefit on a reasonable and
uniform basis, the offset may not be disregarded in determining whether the cash
balance plan satisfies the minimum participation requirements of § 401(a)(26).

An employer may argue that the reasonable and uniform basis requirement applies only
to the coverage and benefits under the other plan, and that the exception for a “benefit
that is offset or reduced by a contribution or benefit under another plan” is not restricted
to full offsets that apply to all participants in the defined benefit plan. However, this is
an unreasonable interpretation of § 1.401(a)(26)-5(a)(2)(iii), because the effect of an
offset that does not apply fully to all participants is identical to the effect of an offset that
applies uniformly to reduce benefits under the defined benefit plan by non-uniform
benefits in the offsetting plan. For example, if each participant in an offsetting defined
contribution plan receives an allocation of 6% of compensation (and therefore each
participant has uniform benefits) and the benefit under the defined benefit plan is offset
by 100% of the benefit under the defined contribution plan, the offset applies uniformly
and may be disregarded under § 1.401(a)(26)-5(a)(2). But if the defined contribution
plan provides for an allocation of 6% of compensation to one group of participants and
3% of compensation to another group of participants (so that the employees do not
benefit under the defined contribution plan on a uniform basis), application of the 100%
offset results in the group with the 6% allocation experiencing a larger benefit reduction
as a result of the offset than the group with the 3% allocation. Under § 1.401(a)(26)-
5(a)(2), this offset may not be disregarded, because employees who benefit under the
defined benefit plan being tested do not also benefit under the offsetting defined
contribution plan on a reasonable and uniform basis. If instead all allocations to
participants under the defined contribution plan are 6% of compensation, but the offset
under the defined benefit plan is 100% of the defined contribution plan benefits for one
group of participants and 50% for another group, the reduction in the benefits in the
defined benefit plan being tested is identical to the reduction in the prior alternative
offset formulation, which does not satisfy the exception in § 1.401(a)(26)-5(a)(2).

The regulations under § 1.401(a)(26)-5 are intended to have a meaningful effect and
prohibit certain arrangements. This goal would not be accomplished if the regulations
could be applied to make the requirements so easily circumvented to achieve the
prohibited result. Accordingly, the only reasonable reading of § 1.401(a)(26)-5(a)(2)(iii)
is that “a benefit that is offset or reduced by a contribution or benefit under another plan”
refers to a benefit to the extent it is offset or reduced by contributions or benefits under
that other plan in the same manner for all participants. If the offset were not required to
be applied in the same manner for all participants in the defined benefit plan, then, as
demonstrated above, the uniformity provision with respect to the other plan would be
rendered meaningless. In addition, the effect of such a non-uniform offset would be that
the participants in the other plan do not, in effect, receive uniform benefits under that
plan (because the use of the defined contribution plan benefit to offset the defined
benefit plan benefit effectively diminishes the value of the defined contribution plan
benefit for some participants but not for others).
PRENO-103030-18 9

Under the terms of the cash balance plan, the benefits for NHCE participants are
reduced to zero by the offset of the profit-sharing plan benefit, while the benefits for
owner-employee participants are not offset. Since the offset does not apply to all of the
employees in the cash balance plan but only to NHCEs, it may not be disregarded. As
a result of the offset, NHCE participants do not benefit under the cash balance plan and
have not accrued a meaningful benefit under the cash balance plan. Moreover, the
operation of the offset causes the cash balance plan to exist primarily to preserve
accrued benefits for a small group of employees. Therefore, the NHCE participants in
the cash balance plan are not taken into account for purposes of determining whether
the cash balance plan satisfies the requirements of §§ 1.401(a)(26)-2 and -3.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call Laura Warshawsky at (202)-317-6799 or Linda Marshall at (202) 317-6700 if
you have any further questions.