June 11, 1998
Hon. Charles O. Rossotti
Commissioner of Internal Revenue
CC:DOM:CORP:T:R (Announcement 95-48, Notice 96-64)
Room 5226
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044
Dear Commissioner Rossotti:
This letter provides suggestions for supplementing the sections 401(a)(4), 401(a)(26), 410 and 414(r) regulations to deal with Federal government nonappropriated fund defined benefit plans in response to Announcement 95-48, 1995-23 I.R.B. 13, and Notice 96-64, 1996-2 C.B. 229. Sections 401(a)(4), 401(a)(26) and 410 encompass rules intended to prevent qualified plans from providing benefits discriminating in favor of higher paid employees; they are referred to in this memorandum generally as the "nondiscrimination rules." Section 1505 of the Taxpayer Relief Act of 1997 exempted state and local government plans from the nondiscrimination rules. /1/
We provide (a) a summary of our suggestions, (b) an overview of the plans making up the Navy Exchange Service Command Retirement Plan and associated Trust and their sponsors, the moratorium on the rules and the Federal plans affected by the rules, (c) a proposed safe harbor from the nondiscrimination rules for Federal nonappropriated fund ("NAF") defined benefit plans, (d) specific suggestions on application of the nondiscrimination rules to Federal NAF defined benefit plans, and (e) a recommendation that the moratorium be extended beyond 31 December 1998 to the date final regulations for Federal plans are adopted and made effective.
A. SUMMARY
1. The regulations should provide a safe harbor
under which a Federal NAF defined benefit plan will be deemed to be in
compliance with sections 401(a)(4) and 410 if the number of active participants
who are HCEs is less than 1% of the number of NHCE participants. (pp. 6-7,
below).
2. The regulations should provide that the
sponsor of a Federal NAF plan may exclude all of its AF employees for purposes
of sections 401(a)(4) and 410 (pp. 8-9, below).
3. The regulations should provide that the
sponsor of a NAF Federal plan will be deemed to be the employer if the
sponsor is an operating entity having substantial activities other than
the sponsorship of the plan, so that the sponsor may exclude all employees
of other Federal agencies for the purposes of 401(a)(4) and 410 (pp. 9-10,
below).
4. The regulations or a Revenue Procedure
should provide that the NAF activities of a NAF plan sponsor should be
deemed to be a qualified separate line of business under section 414(r),
and that the notice requirement will be satisfied by the plan sponsor electing
to be tested on a separate line or business basis in filing its determination
letter requests (pp. 10-12, below).
5. The regulations should permit the sponsor
of a Federal NAF plan to apply the section 401(a)(3) (pre-1974) "reasonable
classification" test by designating HCEs (rather than using officers, supervisors
and highly compensated employees) (pp. 12-13, below).
6. The regulations should provide that a Federal
NAF plan that satisfies the coverage test of section 401(a)(3) (pre-1974)
at the plan level will be deemed to satisfy section 401(a)(4) (pp. 13-15,
below).
7. The regulations should provide that the
sponsor of a Federal NAF plan has the option of applying the section 410(b)
tests to the plan's rate groups (p. 15, below).
8. Regulation section 1.401(a)(4)-6(b)(5)
should be expanded to permit the sponsor of a Federal NAF plan to treat
a participant's total benefit as derived from employer contributions, and
thus to permit the plan to disregard employee contributions for purposes
of section 401(a)(4) (p. 16, below).
9. The moratorium on the application of the
nondiscrimination rules should be continued after 31 December 1998 and
until the final regulations for Federal government plans are adopted and
made effective (p. 16, below).
Attachment A is a flow chart showing the testing process and where the foregoing proposals apply.
B. BACKGROUND
1. THE PLANS
The Navy Exchange Service Command Retirement Plan
and related Trust consists of three voluntary, contributory defined benefit
plans:
(a) Navy Exchange
Service Command Retirement Plan (the "NEXCOM Plan"), covering as of 1 January
1997 6,409 active exchange and other NAF employees of the Navy Exchange
Service Command, an agency of the U.S. Department of Defense ("DoD");
(b) Bureau of
Naval Personnel Retirement Plan (the "BUPERS Plan"), covering as of such
date 2,352 active NAF morale, welfare and recreation employees of the Bureau
of Naval Personnel, a DoD agency; and
(c) U.S. Coast
Guard Resale Activities Retirement Plan (the "Coast Guard Plan"), covering
487 active exchange and other NAF employees of the U.S. Coast Guard, an
agency of the U.S. Department of Transportation ("DoT").
Included in the participant count are a modest number of former NAF employees who participated in the Plans as NAF employees, subsequently moved to appropriated fund ("AF") positions and have elected to continue to participate, or to return to participate, in the Plans. /2/
The total number of active, retired and terminated vested participants in all of the Plans as of 1 January 1997 was 18,326. (The Plans will be referred to collectively as the "Plans" or generically as a "Plan".)
While the Plans are administered under a single plan document and the assets are managed collectively under a single trust agreement, their assets and liabilities are accounted for separately and consequently they are treated as separate plans for section 401(a) qualification purposes.
NAF activities of the Federal government are distinguished from those funded with appropriated funds because they are funded with revenues earned from activities of the exchanges and related business activities and from recreation and related activities. /3/
To be eligible to participate in a Plan, a person must be a NAF employee of the sponsoring agency or be an employee under its cognizance. For example,
NEXCOM NAF employees consist principally of personnel employed by NEXCOM at its headquarters in Virginia Beach, VA. Employees under its cognizance include the NAF employees of the local base exchanges and related activities; those employees are under the command of the local base commander, but receive technical support, including payroll and personnel functions, from NEXCOM in Virginia Beach.
An agency may have employees other than NAF employees. For example, NEXCOM has about 20 military officers assigned to it, including its commanding officer. Such military personnel are AF employees; they receive payroll and personnel support from sources other than NEXCOM; and they participate in the Military Retirement System. NEXCOM presently has a limited number of civilian AF employees, chiefly personnel assigned to it from the Navy Office of General Counsel. They receive payroll and personnel support from sources other than NEXCOM, and participate in the Federal Employees Retirement System ("FERS") or the Civil Service Retirement System ("CSRS").
By contrast, BUPERS and the U.S. Coast Guard have a substantial number of military and civilian AF employees; military personnel participate in the Military Retirement and Coast Guard Retirement Systems and civilian personnel participate in FERS or CSRS.
A regular fulltime or parttime NAF employee who is employed by a Plan sponsor or who is under the cognizance of the Plan sponsor and who has one year of service may participate in the sponsor's Plan by electing to participate and agreeing to make employee contributions of 1% of pay annually. If the employee elects to join within 30 days following completion of one year of service, the employee becomes a participant with credit for the year waiting period without being required to make contributions for that year.
The Plans have been administered with the intention that they be qualified pension plans under section 401(a) since their inception prior to 1970. The most recent determination letters for the Plans are dated 29 April 1997.
The Plans collectively file an annual report under P.L. 95-595 (31 U.S.C. sections 9501 9504) with the Office of Management and Budget which includes their separate financial and actuarial reports.
Plan participants benefit from the tax-qualified status of the Plans because they are taxed on their benefits when benefits are received following retirement, and not as they earn vested portions of such benefits during employment -- benefits enjoyed by employees participating in FERS and CSRS and in private sector qualified plans. Participants are also exempt from the employee portion of FICA taxes on their Plan benefits, rather than being taxed on such benefits as they are earned.
In recruiting and retaining its employees, the sponsoring employer also benefits by being able to offer employment that includes participation in a pension plan with the tax benefits for participants summarized above. The sponsoring employer also benefits by being relieved of the employer portion of FICA taxes on contributions to the Plans.
2. NONDISCRIMINATION RULES MORATORIUM
The administrators of the Plans have been operating under the nondiscrimination rule moratorium applicable to all state and local government plans since 1977 and to all government plans since 1986. The administrators anticipated that the Plans would be included in the legislation considered by Congress last year. The separate bills approved by the House and Senate in June and July 1997 excluded all governmental plans, including Federal plans, from the nondiscrimination rules. However, as enacted section 1505 of the Taxpayer Relief Act of 1997 limited the exclusion to state and local government plans; the accompanying conference report provided no explanation for the change. As a result, the expiration of the moratorium as of 1 January 1999 provided in Announcement 95-48 will make the nondiscrimination rules applicable to the Plans as of that date.
3. FEDERAL PLANS AFFECTED BY THE EXPIRATION OF THE MORATORIUM
Treasury and the IRS, in adopting the final nondiscrimination regulations in 1993, recognized the need for special rules for government plans, and solicited comments and suggestions from the government plan sector then and in subsequent notices. /4/
All Federal plans are probably exempt from the direct application of the qualified plan requirements of section 401(a). /5/ However, Federal government plan administrators must either comply with the qualification requirements or confirm that their plan is deemed to be a qualified plan so that their participants, who are taxable persons subject to tax on the value of any nonqualified pension benefits as they vest, /6/ may be taxed only when they receive benefit payments from their plan.
Congress has expressly provided that the Federal Thrift Savings Plan is deemed to be a qualified plan and is expressly exempt from the nondiscrimination rules (section 7701(j)). In addition, the IRS has administratively deemed the principal AF plans (FERS, CSRS, and the plans covering military, foreign service and judicial personnel) to be qualified plans.
As a result, apparently only sponsors of NAF plans
must rely on their plans being qualified under section 401(a) in order
to have their plan participants receive the same tax treatment as that
provided to participants in the AF plans and private sector qualified plans.
Based on a 1996 General Accounting Office study of Federal plans, this
group consists of about 100,000 active participants in 19 defined benefit
plans, including the Plans, and about 54,000 active participants in defined
contribution plans. With retired and terminated vested participants, the
number of persons participating in these plans is substantially greater.
Of course, there is some overlap in
participation because some employees participating in an agency's NAF
defined benefit plan may also be participants in its section 401(k) plan.
/7/ Attachment B is a list of Federal government plans reported in the
1996 GAO Study, the number of active participants reported in the Study
and those AF plans for which we have found IRS administrative rulings.
/8/
C. GENERAL IMPACT; PROPOSED SAFE HARBOR EXEMPTION
1. GENERAL IMPACT
These comments focus on (a) nondiscriminatory coverage, including the control group rules and the definition of highly compensated employees, and (b) nondiscriminatory benefits. Each of the Plans covers more than 50 active employees and thus currently complies with section 401(a)(26).
As a practical matter the Plans should pass the coverage and benefit requirements easily because they cover very few highly compensated employees as defined in section 414(q), i.e., those earning more than $ 80,000 (indexed) in the prior year ("HCEs"). They range from the NEXCOM Plan, with 31 active HCE participants out of 6,409 active participants as of 1 January 1997, to the Coast Guard Plan, with no active HCE participants. /9/
However, all of the Plans will need to be monitored for whether they have HCEs. Plans with HCEs will incur on-going actuarial, legal and administrative costs to comply with the nondiscrimination rules. Nondiscrimination coverage and benefits testing will need to be performed by the Plan's actuaries at least every three years in the absence of significant changes in the participant group. /10/ Amendment of Plan provisions will also need to take into account compliance with the regulations dealing with nondiscriminatory availability of benefits, rights and features and amendments.
2. PROPOSED SAFE HARBOR EXEMPTION
We urge the adoption of a safe harbor under which a Federal government defined benefit plan will be deemed to be in compliance with sections 401(a)(4) and 410 if the number of active participants who are HCEs is less than 1% of the number of non-highly compensated employee ("NHCE") active participants.
There is little opportunity in the Plans for HCE participants to manipulate benefits in their favor. The executives of the agencies sponsoring the Plans do not participate in the Plans; the DoD executives are military officers who participate in the Military Retirement System, and the DoT executives are military and civilian AF employees who participate in the Coast Guard Military Retirement System and CSRS/FERS. NEXCOM, BUPERS and the Coast Guard are subject to the control and review of the Executive Branch and to Congressional oversight. Participant compensation is not substantial relative to the private sector, and is bunched at the lower end of the compensation scale. The IRS moratorium on application of the nondiscrimination rules has not prompted complaint. Accordingly, the suggested safe harbor would save considerable compliance expense without exposing participants in the Plans to the concerns underlying the nondiscrimination rules. /11/ And, such an exemption would eliminate the need to deal with the following specific comments.
D. SPECIFIC COMMENTS
1. COVERAGE -- SECTION 410; CONTROL GROUPS -- 414(b) AND (c); SEPARATE LINES OF BUSINESS -- 414(r); HIGHLY COMPENSATED EMPLOYEES -- 414(q)
(a) COVERAGE -- SECTION 410(c)
Under section 410(c)(2) a Plan, as a contributory,
voluntary government plan, must cover either (section 401(a)(3) (pre- 1974);
Reg. section 1.401-3(a)-(d)) --
(i) 80% of all employees who are eligible to benefit under the plan if
70% of all employees of the employer are
eligible to benefit under the plan (excluding employees who have not
been employed for the eligibility period and whose principal duties consist
of supervising the work of other employees or highly compensated employees."
/12/
These pre-1974 tests were administered with reference to the employees of the employer sponsoring the plan, whether a holding company or a subsidiary, and not with respect to the parent company and all of its subsidiaries. Under this approach a Plan could meet the 70%/80% test by taking into account all of the employees of the sponsoring agency (including AF employees participating in AF plans) only if its NAF employees constituted the major part of its employees and a sufficient percentage participated in the Plan. It would be more appropriate if only NAF employees were taken into account, thus relieving plan administrators of accessing information on AF employees to determine who was excludible (short service, parttime, etc.).
The alternative "reasonable classification" test
should permit a Plan to pass because:
(i) The Plans are in each case available to employees by reason of NAF
organizational structures adopted by DoD or DoT to carry out organizational
functions (and not to manipulate plan participation), and
(ii) A reasonable cross-section of NAF employees (i.e., lower, middle and
higher paid employees) participate in a given Plan.
To demonstrate satisfaction of the "reasonable classification" test, the IRS has required the employer to submit a schedule indicating (a) the number of employees, by salary levels in, say, $ 10,000 increments, participating in the plan, (b) the number, by such salary levels, not participating, and (c) the number in each level of participants and non-participants who were "officers", supervisors or "highly compensated employees". /13/
As applied to a Plan, the schedule requires substantial payroll and personnel information that is not easily available for both AF and NAF employees because different payroll and personnel systems are maintained for them. And, since the AF employees are mandatory participants in the Military Retirement and Coast Guard Military Retirement Systems, and in FERS or CSRS, as the case may be, it is unclear how their inclusion in the schedule as nonparticipants is relevant to deciding whether the coverage of a Plan meets the "reasonable classification" test. And it would be complicated to aggregate them under comparability rules, such as those provided by Rev. Rul. 81 202, 1981-2 C.B. 93.
Alternatively, Reg. section 1.410(b)-2(e) provides that a Plan is deemed to satisfy section 401(a)(3) (pre-1974) if it satisfies section 410(b). For example, the NEXCOM Plan would meet the ratio percentage test of section 410(b) based on its NAF coverage and exclusion of its AF employees as of 1 January 1997 (detailed below) because its ratio percentage is 75.4%. /14/
We urge the adoption of a regulation permitting a Federal NAF plan sponsor to exclude its employees who participate in pension plans established by Congress for sections 401(a)(4) and 410 purposes. The NAF plan sponsor has no control over the terms of the AF plans its AF employees participate in, and it has limited if [sic] any payroll and personnel information about them. /15/
(b) CONTROL GROUP RULES -- SECTION 414(b) AND (c)
Notice 96-64 allows governments until the 2001 plan year to apply, for nondiscrimination testing purposes, a reasonable, good faith interpretation of existing law in determining which entities must be aggregated under the section 414 control group rules, with any further guidance applying prospectively for plan years beginning in or after 2001.
There has developed a sense among practitioners, in part due to the provision in Section V.B.2.b of Notice 89-23 for aggregating government educational entities for section 403(b) plan purposes, /16/ and in part due to comments of IRS pension spokespersons, that the control group rules may be carried over to governments. Clearly, NAF plan sponsors are controlled by the Federal government. However, application of those rules to NAF plan sponsors would make meeting the nondiscriminatory coverage tests unduly complicated and expensive. NAF agencies should be permitted to apply the coverage tests to their NAF employees without regard to the employees of other agencies of the Federal government.
Sections 414(b) and (c), adopted in 1974, clearly provide guidance, by drawing on the consolidated return regulations applicable to taxable entities, for aggregating 80% owned business entities and business entities under common stock ownership in the for-profit portion of the private sector, and the Service has extended that approach to non-profit organizations in the private sector based on voting control at the board of directors level. /17/ However, no legislation directly applies those rules to governments for section 401(a) purposes. Indeed, application of those rules to government entities would be inconsistent with the Congressional continuation in section 410(c) of the pre-1974 coverage tests for government plans.
Regulations should be adopted that permit Federal plan sponsors to continue to apply pre 1974 concepts of who the employer agency is. Consider the difficulties of providing a schedule under the "reasonable classification" test if the Federal government were deemed to be the employer of the NAF employees participating in one of the Plans. While the participant side of the schedule would remain unchanged, the nonparticipant column, after somehow determining excludible employees on a Federal government-wide basis, would reflect all of the AF and NAF employees of all other agencies of the Federal government, as well as requiring the designation of the number of officers, supervisors and highly compensated employees in each salary category. Such information is simply not available, and efforts to make such information available through some mnechanism using the Office of Management and Budget or the Office of Personnel Management would be complicated and expensive -- all without discernable benefit to Plan participants.
In addition, the regulations should permit the employer to be an operating subagency. As Attachment B indicates, in DoD there are NAF plans sponsored by agencies of each of the Armed Services (i.e., Army, Navy, Air Force and Marine Corps), and two combined agencies (the Army Air Force Exchange Service and the Uniformed Services University of Health Sciences). Providing a schedule at the DoD level or at the Department of the Navy level, even if limited to NAF employees, would be difficult because different payroll and personnel systems are maintained for each agency and often within each subagency. For example, while the Navy exchanges have a NAF common payroll and personnel system, NAF activities administered by BUPERS and the Marine Corps have separate and multiple NAF payroll and personnel systems.
Consequently, we urge the adoption of a regulation providing that the plan sponsor of a Federal government plan will be deemed to be the employer where the sponsor is an operating entity having substantial activities other than the sponsorship of the plan, so that the sponsor may exclude all employees of other agencies of the Federal government for the purposes of sections 401(a)(4) and 410.
(c) SEPARATE LINES OF BUSINESS RULES -- SECTION 414(r)
Relief from the control group rules may be obtained under section 414(r). That provision permits an "employer" to disaggregate its activities into lines of business and, if they are qualified separate lines of business ("QSLOBs"), to apply the nondiscrimination rules to each QSLOB without regard to other employees and plans in the control group. While the regulations provide that the QSLOB rules can be used by governments, including for purposes of applying section 401(a)(3) (pre-1974), no implementing regulations have been provided. Reg. section 1.414(r) 1(d)(5). If these rules could be made useable for NAF plan, they could permit NEXCOM and other NAF plan sponsors to exclude all Federal employees (AF and NAF) of other Federal agencies and thus solve the problem outlined above under the control group rules.
Generally speaking, the QSLOB rules provide
the following steps:
(i) The "employer" designates each of its different service, product and/or
geographical activities into lines of business (its "LOBs") at its discretion
(section 1.414(r)-2). Dividing the NAF agencies into LOBs should not be
difficult; at least within DoD they are focused on each of the Armed Services
and on the provision of exchange and related sales or the provision of
morale, welfare and recreational activities. Thus, they have separate products
and separate customers.
(ii) The "employer" determines that each of its LOBs meets certain tests
(separate organizational unit or
division, separate financial accountability, separate workforce and
separate management) to establish that each is a separate line of business
(a "SLOB"). The separate organizational unit and separate financial accountability
requirements are probably met; NAFs are organized as divisions or other
units, and they have financial accounting requirements because of their
use of nonappropriated funds.
To meet the separate workforce requirement, at least 90% of the employees providing services to the LOB are employees who work 75% or more of their time for the LOB (section 1.414(r)-3(b)(4)). Because of the NAF character of the LOB, intuitively this should be true, but NAF plan administrators lack detailed information.
To meet the separate management requirement,
80% or more of the employees of the LOB who are in the top 10% by compensation
of employees providing services to the LOB work 75% or more of their time
for the LOB (section 1.414(r)-3(b)(5)). For larger NAFs, separate management
should not be a problem. However, for smaller NAFs their top-paid employees
are likely to be AF personnel shared with AF activities. For example, the
Coast Guard has no NAF HCEs; its management personnel are AF employees
who also have AF responsibilities. A solution is needed for such cases.
(iii) The "employer" further determines that each of its SLOBs meets at
least one administrative scrutiny
requirement (six alternatives) or obtains an IRS determination (section
1.414(r)-5). These requirements are very technical. A NEXCOM "SLOB" would
not meet the statutory safe harbor because of its high proportion of NHCEs.
However, it can meet the alternative "minimum/maximum benefits" test in
section 1.414(r)-5(g). /18/ Other NAFs may have problems with this step.
(iv) The "employer" confirms that each SLOB has at least 50 employees (section
1.414(r)-4(b)); this would be met by all of the NAFs on Attachment B with
one exception.
(v) The "employer" gives notice to the IRS, listing all of its SLOBS and
its plans, and thereby completes the
requirements for constituting them as qualified separate lines of business
("QSLOBs"). /19/ In the context of the
Federal government, who gives the notice and, indeed, who makes the
determinations listed in steps (i)-(v)? We know of the existence of NAFs
outside of DoD and DoT only through the 1996 GAO Study. There is some coordination
of benefits issues within DoD. A common notice is simply not practical.
(vi) Each plan in each QSLOB plan meets the two "gateway" tests (section
1.414(r)-8(b)): (1) the QSLOB
plan, on an employer-wide basis, must pass either the ratio percentage
test or the reasonable classification portion of the reasonable classification/average
benefits test of Section 410(b), and (2) the plan, on a QSLOB basis, must
either satisfy the ratio percentage test or the reasonable classification/average
benefits test of Section 410(b).
We have no information on the percentage of employees employed by the Federal government who are NHCEs, or the percentage of NAF employees who are NHCEs. Applying the employer-wide test by taking into account all NAF employees (and excluding all AF employees) and assuming that 90% of all NAF employees are NHCEs (99.6% of NEXCOM's emnployees are NHCEs), the NEXCOM Plan would meet the ratio percentage alternative of the employer-wide "gateway" test. /20/
In addition, the NEXCOM Plan would meet the ratio percentage test alternative of the QSLOB "gateway" test, as discussed in footnote 14 and related text, above.
We urge that the adoption of a regulation or Revenue Procedure providing that the NAF activities of a NAF plan sponsor will be deemed to be a QSLOB, and that the notice requirement will be deemed to have been completed if the plan sponsor elects to be tested on a QSLOB basis in filing its determination letter requests for the plan.
(d) HIGHLY COMPENSATED EMPLOYEES -- SECTION 414(q)
As discussed above, the schedule provided under the "reasonable classification" test would also indicate which employees were "officers", supervisors or "highly compensated employees", categories described in section 401(a)(3) (pre-1974) but not defined in Reg. section 1.401-3.
In the context of NAF plans, probably no NAF employee is an "officer" within the meaning of section 401(a)(3) (pre-1974), a term that in later pension legislation is usually used to refer to an employee with policy making authority). /21/
We use the term "supervisors" here as a shorthand for a group that section 401(a)(3) (pre 1974) describes as "persons whose principal duties consist in supervising the work of other employees". This was probably intended to include upper compensation employees who were not strictly "officers".
Finally, section 401(a)(3) (pre-1974) referred to, but did not define, "highly compensated employees." Practitioners typically considered that IRS pension technicians had wide discretion about its meaning.
Since these categories lack precision, we urge the adoption of a section 410 regulation providing to Federal plan sponsors the option of using the section 414(q) test for HCES, i.e., those earning more than $ 80,000 (indexed) in the prior plan year, in lieu of listing officers, supervisors and highly compensated employees. With plans limited to taking into account only compensation up to $ 160,000 (indexed) (section 401(a)(17)) and with NAF compensation limited to about $ 130,000, the over $ 80,000 level should include all individuals who would be considered "officers", supervisors and "highly compensated employees" as those terms were used in section 401(a)(3) (pre-1974). The section 414(q) test is apparently applicable under section 401(a)(4), as discussed below. Such an option would be also useful to the Service in auditing the administration of such plans. And, Congress has taken this step for church plans also subject to section 401(a)(3) (pre-1974) by enacting section 414(q)(9) in the 1996 tax legislation.
2. NONDISCRIMINATORY BENEFITS -- SECTION 401(a)(4)
(a) GENERAL TEST FOR RATE GROUPS
Under the "general test" for defined benefit plans, Reg. section 1.401(a)(4)-3(c)(1) provides that each rate group under the plan must "satisfy section 410(b)", and section 1.401(a)(4)-3(c)(2) directs one to section 1.401(a)(4)-2(c)(3) for the rules applicable to determining whether a rate group satisfies section 410(b). A "rate group" exists for each HCE and all other participants in the plan (both HCEs and NHCES) having a normal accrual rate equal to or greater than the HCE's normal accrual rate and who also have a most valuable accrual rate equal to or greater than the HCE's most valuable accrual rate.
Reg. section 1.401(a)(4)-2(c)(3) provides that in determining whether a rate group satisfies section 410(b) the rate group is treated as if it were a separate plan benefiting only the employees included in the rate group.
Reg. section 1.401(a)(4)-1(c)(4)(vi)
provides that, "except as otherwise specifically provided, references to
satisfying section 410(b) in [the 401(a)(4) regulations] mean satisfying
section 1.410(b)-2 . . ." However, that clause
then goes on to state --
"In the case of a plan described in section
410(c)(1) [government and certain church plans] that has not made the
election described in section 410(d) and is
not subject to section 403(b)(12)(A)(i) [section 403(b) plans],
references in [the 401(a)(4) regulations
to satisfying section 410(b) mean satisfying section 410(c)(2)."
This final sentence clearly provides that a government plan applies to its rate groups the pre ERISA coverage requirement of section 401(a)(3). That requirement, as discussed above in Paragraph D(1)(a) (pp. 7-8, above), is that a voluntary plan cover either --
(i) 80% of all employees who are eligible to benefit under the plan if
70% of all employees of the sponsoring
employer are eligible to benefit under the plan (excluding employees
who have not been employed for the eligibility
period and certain part-time and seasonal employees), or
(ii) such employees as qualify under "a classification set up by the employer
and found by the [IRS] not to be
discriminatory in favor of officers, shareholders, persons whose principal
duties consist of supervising the work of
other employees or highly compensated employees." Reg. section 1.401-3(a)-(d).
The NEXCOM Plan has six rate
groups with HCEs; the number of HCEs and NHCEs in each rate group, and
the aggregate number deemed to be in each rate group because their benefit
accruals are the same or higher are as follows: /22/
| (1) | (2) | (3) | (4) | (5) | (6) | (7) | (8) |
| Accrual
levels |
No. of
HCEs |
No. of
NHCEs |
Rate
Total |
Agg.
Groups |
Agg.
HCEs |
Agg.
NCHEs |
Total |
| 0 | 0 | 2,079 | 2,079 | 31 | 8,457 | 8,488 | |
| 1 | 0 | 1,222 | 1,222 | 31 | 6,378 | 6,409 | |
| 2 | 5 | 719 | 724 | RG 1 | 31 | 5,156 | 5,187 |
| 3 | 0 | 42 | 42 | 26 | 4,437 | 4,463 | |
| 4 | 5 | 509 | 514 | RG 2 | 26 | 4,395 | 4,421 |
| 5 | 0 | 495 | 495 | 21 | 3,886 | 3,907 | |
| 6 | 3 | 82 | 85 | RG 3 | 21 | 3,391 | 3,412 |
| 7 | 1 | 954 | 955 | RG 4 | 18 | 3,309 | 3,327 |
| 8 | 0 | 449 | 449 | 17 | 2,355 | 2,372 | |
| 9 | 7 | 206 | 213 | RG 5 | 17 | 1,906 | 1,923 |
| 10 | 10 | 1,142 | 1,152 | RG 6 | 10 | 1,700 | 1,710 |
| 11 | 0 | 558 | 558 | 0 | 588 | 588 | |
| Total: | 31 | 8,457 | 8,488 |
Testing a given rate group under the 80%/70% test will lead to certain failure for the same reasons as were outlined in Paragraph D(1)(a) (pp. 7-8, above), in applying the test to the entire Plan, unless only NAF employees of the sponsoring agency are taken into account. Even then, there still will be certain failure for most rate groups because of the number of participants in other rate groups. For example, all of the NEXCOM Plan's rate groups (RG 1 through RG 6) fail to meet the percentage test; even RG 1, with 5,187 active participants, is only 61% of the 8,488 eligible NAF employees.
Testing the rate groups with
the alternate "reasonable classification" test, which will apply to the
Plan as a whole for purposes of meeting section 410(c) as discussed above
in Paragraph D(1)(a) (pp. 7-8, above), has
uncertainties that must be cleared up in the regulations:
(i) Is the "reasonable classification" schedule for each rate group in
the plan prepared according to the
officers, supervisors and highly compensated employees as provided
in section 401(a)(3) (pre-1974) or the HCEs as defined in section 414(q)?
The answer should be that section 401(a)(3) (pre-1974) is used, but we
urge that the regulations permit a Federal plan to employ the HCE test
for the reasons discussed above in Paragraph D(1)(d) (pp.
12-13, above).
(ii) How does the "reasonable classification" test schedule for each of
a plan's rate groups take into account nonparticipants? The plan administrator
would apparently list in the schedule the participants in the rate group
by compensation. However, it is not clear how the administrator would prepare
the portion of the schedule dealing with nonparticipants -- do they appear
in all of the rate groups, are they allocated in some fashion among the
rate groups are they ignored in a plan of this size?
Since the language of section 401(a)(4) itself has continued with little change since before 1974 and since the current section 401(a)(4) regulations are derived principally from language in the 1986 committee reports as well as the need of the IRS and plan sponsors to have objective rules, Treasury and the IRS have considerable discretion to adopt workable regulations for Federal NAF plans. One alternative would be to apply the section 401(a)(4) regulations and rulings in effect before 1974 or possibly before the Tax Reform Act of 1986 which gave rise to the current section 401(a)(4) regulations. The better alternative, we suggest, is that the regulations would simply provide that a Federal NAF plan that satisfies the section 401(a)(3) (pre-1974) test on a plan-wide basis is deemed to satisfy the section 401(a)(4) requirements.
In any event, it would be useful to afford Federal NAF plan sponsors the option of applying the section 410(b) tests to their rate groups. Actuarial firms have since the adoption of the regulations in 1993 developed software and know-how in dealing with private sector plans and can carry their expertise over to Federal plans. /23/
(b) Disregard of Employee Contributions -- section 401(a)(4)-6(b)(5)
Generally, in establishing the accrual rates and rate groups under contributory defined benefit plans for purposes of nondiscrimination testing, the accrual rates must be adjusted to exclude the portion of a participant's accrued benefit that is attributable to employee contributions using the procedures under section 411(c). Reg. section 1.401(a)(4)-1(c)(7). However, certain alternative procedures are provided in section 1.401(a)(4)-6(b), including --
"(5) GOVERNMENT-PLAN METHOD. A contributory
DB plan that is
established and maintained for its employees
by the government
of any state or political subdivision or by
any agency or
instrumentality thereof may treat an employee's
total benefit as
entirely employer-provided."
We urge that this provision be expanded to include Federal government plans. This provision first appeared in the proposed regulations issued May 14, 1990 (55 Fed. Reg. 19897). Federal plans, as well as state and local government plans, are not subject to section 411(c). The Plans impose a flat 1% of compensation contribution rate on all participants, a relatively modest amount. Substantial expense will be involved in performing the "general test" if the accrual rates of participants must be adjusted to exclude a portion of the accrued benefit as attributable to employee contributions. Federal plans should receive the same treatment that the regulations accord to state and local government plans.
E. EXTENSION OF THE MORATORIUM
In view of the significant
issues discussed above which require resolution by regulation before Federal
NAF
plans can comply with the nondiscrimination rules, we urge that the moratorium
be extended for such plans beyond 31 December 1998 and until final regulations
are issued and made effective. /24/
* * *
Please call me if you have
any questions ((718) 727-5453 or (973) 643-7282).
Respectfully submitted,
J. Edward Shillingburg
Trust Advisor
Department Of The Navy
Navy Exchange Service Command
Staten Island, New York
Attachments A and B may be obtained by sending an email message with your snail mail address to J. Edward Shillingburg at jes@exec-comp.com
/1/ Unless otherwise indicated, "section" references are to the Internal Revenue Code of 1986, as amended (26 U.S.C.); and "Reg." references are to the Treasury Regulations on Income Taxation (26 C.F.R.).
/2/ Congress has provided benefit portability rules for DOD and DOT employees transferred from a NAF position to an AF position and vice versa in the Portability of Benefits for Nonappropriated Fund Employees Act of 1990 (P.L. 100-508), and Section 1043 of the National Defense Authorization Act for Fiscal 1996 (P.L. 104-106). See 5 CFR section 847.101, et seq. Since these participants are modest in number, they are included in the NAF headcounts and are otherwise included in references to NAF participants.
/3/ A nonappropriated fund instrumentality is "one which does not receive its monies by congressional appropriation." United States v. Hopkins, 427 U.S. 123, 125 fn. 2 (1976). NAF activities are described in Standard Oil Co. of California v. Johnson, 316 U.S. 481 (1942) (Army post exchange activities); Rev. Rul. 70-71, 1970-1 C.B. 1 (Army Air Force Exchange Service retirement plan); GCM 37780 (Dec. 5, 1978) (pension plan established by NAF agency action does not preclude a favorable IRS determination letter); United States v. American International Group, Inc., 94 Civ. 7621 (LMM) (S. Dist N.Y. Feb. 11, 1997),
1997 U.S. Dist. LEXIS 1613 (Navy Exchange Service Command activities).
/4/ Preamble, Treasury Decision 8485, 58 Fed. Reg. 46773 (Sep. 3, 1993); Announcement 95 48, supra; Notice 96-64, supra.
/5/ While no provision of the Code provides such an exemption, the usual rule is that Congress does not impose a tax or regulatory provision on Federal agencies and instrumentalities unless it does so expressly. E.g., Rev. Rul. 67-249, 1967-2 C.B. 179 (morale, welfare and recreational nonappropriated fund established under Armed Forces regulations held exempt from Federal income tax and not required to file an exemption application to establish that conclusion); PLR 9411011 (Dec. 13, 1993) (government corporation created by Act of Congress to conduct research held to be exempt from Federal income tax and not required to file an application under section 501(c)(3) to establish such exemption). Examples of taxes imposed on Federal agencies include sections 3112 (FICA) and 3308 (FUTA).
/6/ I.R.C., sections 61, 402(b), 403(c).
/7/ See General Accounting Office, "Public Pensions: Summary of Federal Pension Plan Data" (GAO/AIMD-96-6) (Feb. 1996). The report (hereafter the "1996 GAO Study") is available in the LEXIS/NEXIS federal tax data base in the Tax Analysts Tax Notes Today library at 96 TNT 61-10 (March 27, 1996).
/8/ Aside from the Code provision for the Federal Thrift
Plan, no statutory provision has been found that provides for the qualified
status of CSRS and other Federal AF plans. All of the IRS rulings on AF
plans referred to in Attachment B conclude that participants in the plan
in question is [sic] to be accorded the Federal income tax treatment that
a participant in a qualified plan would receive without indicating the
reasoning for that conclusion. The unstated rationale may be that Congress,
in adopting such plans, assumed that
participants would be accorded the same tax treatment as participants
in private sector qualified plans, and the IRS was simply recognizing that
assumption. If so, all AF plans adopted by Congress are probably deemed
to be qualified plans by the IRS and thus not subject to any of the qualifications
requirements of section 401(a).
/9/ Consequently, the Coast Guard Plan is exempt from both
the
nondiscriminatory coverage and benefits requirements of sections 401(a)(4)
and 410 as of such date. Reg. section 1.410(b)-2(b)(6), (e).
/10/ Rev. Proc. 93-42, 1993-2 C.B. 540, Section 5.
/11/ See generally section 1462(b) of the Small Business Job Protection Act of 1996, which authorizes Treasury to design nondiscrimination benefit and coverage safe harbors for church plans.
/12/ As amended by section 1505 of the Taxpayer Relief Act of 1997, section 410(c)(2) literally exempts all government plans from the section 410 nondiscriminatory coverage requirements. However, such a broad exclusion is inconsistent with the narrowing of section 1505 to state and local government plans that was adopted in the Conference Report and consequently section 410(c)(2) may be subject to a more narrow interpretation or be subject to technical correction. Consequently, we discuss section 410(c) as if a Federal plan were required to meet section 401(a)(3) (pre-1974).
/13/ See Rev. Rul. 70-200, 1970-1 C.B. 101, for an illustration of the schedule.
/14/ The ratio of the NEXCOM NAF NHCEs participating in the Plan to its total NAF NHCEs is 75.4% (6,378/8,457), the ratio of its NAF HCEs participating in the Plan to its total NAF HCEs is 100% (31/31); the ratio of the NHCE ratio to the HCE ratio is 75.4% (75.4%/100%) -- and the NEXCOM Plan passes because that ratio at least 70%. Reg. 1.410(b)-2(b)(2). For the purposes of these ratios, all AF employees of NEXCOM have been excluded and all other employees of the Federal government have been excluded. Such exclusions rely on regulation modifications recommended above, or on modifications of the separate line of business regulations, discussed below.
/15/ For example, such an exclusion is presently permitted for collectively bargained employees under section 410(b)(3)(A).
/16/ See also IRS general information letter to August D. Fields dated August 20, 1991, Q&A 9, reprinted in 18 BNA Pension Reporter No. 34, p. 1552 (August 26, 1991) (good faith interpretation of section 414 aggregation rules to be applied in the case of the aggregation requirement in section 415(f)).
/17/ See GCM 39616 (June 27, 1986) (section 401(a) plans of tax- exempt organizations); Notice 89-23, 1898-1 C.B. 654, Section V.B.2.a (section 403(b) plans); PLR 9722039 (March 4, 1997) (section 401(a) plans of tax-exempt organizations).
/18/ Under the alternative "minimum/maximum benefit" safe harbor, at least 60% of the NHCEs of a SLOB must accrue an annual benefit of at least 0.75% (that is true for 75% of the NEXCOM "SLOB"), and the average accrual rate for NHCEs of the SLOB must be at least 0.75% (Watson Wyatt determined that it was 1.32% as of January 1, 1997).
/19/ Reg. section 1.414(r)-4(c); Rev. Proc. 93-40, 1993-2 C.B. 535.
/20/ Assume that there are a total of 100,000 eligible active NAF employees as of 1 January 1997, that NEXCOM employees 31 HCEs (all of whom participate in the Plan) and 8,457 NHCEs (6,378 of whom participate), and that there are 81,543 and 9,969 NHCEs and HCES, respectively, employed by other NAFs. The ratio of NHCEs participating in the NEXCOM Plan is 7.08% (6,378/90,000), the ratio of HCEs participating is 0.31% (31/10,000) and the ratio of the ratios is 2286% (7.08%/0.31%), a percentage that substantially exceeds 70%. If the test were applied by taking into account all Federal employees, the results will not be dissimilar because of the predominance of NHCEs.
/21/ See, e.g., sections 162(m), 416(i), and 414(q)((pre-1996).
/22/ The rate groupings have been determined by the Plans' actuarial firm, the New York office of Watson Wyatt & Company.
/23/ Cf. Reg. section 1.410(b)-2(e) (permitting government plans an election to use section 410(b) to satisfy its coverage requirements under section 410(c)). Under section 410(b), a plan's rate groups must meet either the "ratio percentage" test or the "nondiscriminatory classification/average benefits" test.
The ratio percentage test is a comparison of two ratios: (a) the ratio of the number of NHCEs in the rate group to the total number of NHCEs of the employer, and (b) the ratio of the number of HCEs in the rate group to the total number of HCEs of the employer. If ratio (a) is at least 70% of (b), the rate group passes. Reg. sections 1.401(a)(4)- 2(c)(3), 1.410(b)-2(b)(2). For NAF plans, assuming that the employer is the plan sponsor and that its AF employees are excluded, this test can be applied, provided that payroll and personnel information can be obtained for the nonparticipant employees. For example, in the NEXCOM Plan's rate group RG 4, ratio (a) is 39.1% (3,309/8,457), ratio (b) is 58% (18/31), the ratio of (a) to (b) is 67.4% (39.1%/58%), and the rate group fails.
Under the alternative test, two requirements must be met:
(a) a
nondiscriminatory classification test, and (b) an average benefits
test. Reg. section 1.410(b) 2(b)(3).
For purposes of the nondiscriminatory classification test (modified substantially from the test applicable under section 401(a)(3) (pre-1974) outlined above), a safe harbor is provided under which each rate group must have a ratio percentage at least equal to the lesser of (i) the midpoint between the safe and unsafe harbors for the plan (which is driven by the ratio of NHCEs of the employer to its total employees), and (ii) the ratio percentage of the plan. Reg. sections 1.401(a)(4)-2(c)(3)(ii), 1.410(b)-4. Assuming that NEXCOM's employees consist only of its NAF employees who are not excludible employees (short service, parttime, etc., employees), its ratio is 99.6% (8,457/8,848) and its safe harbor percentage is 20.28%, while its ratio percentage is 75.4% (see fn. 14, above). The ratio percentage for each rate group in the Plan is greater than 20.28%; the lowest as determined by Watson Wyatt & Company is RG 5 with 41%.
Under the average benefits test, the ratio of the average of the employee benefit percentages of the NHCEs in the plan as a whole to the average of the employee benefit percentages of the HCEs in the plan must be at least 70%. Reg. sections 1.401(a)(4)-2(c)(3)(iii), 1.410(b)-5. Watson Wyatt & Company has determined that the NEXCOM Plan meets this test based on its benefit accruals as of 1 January 1997, excluding its AF employees and all employees of other Federal agencies. On that basis, the NEXCOM Plan's rate groups as of such date satisfied section 401(a)(4).
/24/ Similarly, see letter dated November 18, 1997, from Senators Rick Santorum and Arlen Spector to Secretary Robert E. Rubin, reprinted by Tax Analysts as 97 EOT 50-15 (December 10, 1997) (urging extension of the current time for compliance for church plans).