The IRS on Friday issued regulations on the relationship between §§403(b) and 401(k)/(m). The regulations change was to the §410(b) definition of excludible employees, and although it technically affects only the related §401(k)/(m) plans, it clearly affects both the design and the operation of §403(b) plans and arrangements.
The change was originated by §664 of EGTRRA, which says the following:
“SEC. 664. EMPLOYEES OF TAX-EXEMPT ENTITIES.
(a) In General.--The Secretary of the Treasury shall modify Treasury Regulations section 1.410(b)-6(g) to provide that employees of an organization described in section 403(b)(1)(A)(i) of the Internal Revenue Code of 1986 who are eligible to make contributions under section 403(b) of such Code pursuant to a salary reduction agreement may be treated as excludable with respect to a plan under section 401(k) or (m) of such Code that is provided under the same general arrangement as a plan under such section 401(k), if (1) no employee of an organization described in section 403(b)(1)(A)(i) of such Code is eligible to participate in such section 401(k) plan or section 401(m) plan; and (2) 95 percent of the employees who are not employees of an organization described in section 403(b)(1)(A)(i) of such Code are eligible to participate in such plan under such section 401(k) or (m).
(b) Effective Date.--The modification required by subsection (a) shall apply as of the same date set forth in section 1426(b) of the Small Business Job Protection Act of 1996.”
A few key points here before looking at the regulation. First, it applies only to employees of §403(b)()(A)(i) organizations, not to public education employees described in §403(N)(1)(A)(ii). Second, it excludes them from §401(m) testing under the qualified plan (“the same general arrangement” acts to differentiate the qualified plan form the §403(b) arrangement, including any component subject to §401(m) testing). Second, the employees include all eligible to make deferrals into the §403(b), not just those making them. Third, there cannot be any employees of any §501(c)(3) organizations in the qualified plan. Last, 95% of the employees who are not employed by §501(c)(3) organizations have to be eligible to make deferrals into the qualified plan; the statue simply does not address whether statutory exclusions or the excludible employee definitions apply under the 95% requirement.
Now to the Final Regulations:
“Sec. 1.410(b)-6 Excludable employees.
(g) Employees of certain governmental or tax-exempt entities (1) Plans covered. For purposes of testing either a section 401(k) plan, or a section 401(m) plan that is provided under the same general arrangement as a section 401(k) plan, an employer may treat as excludable those employees described in paragraphs (g)(2) and (3) of this section.
(2) Employees of governmental entities. Employees of governmental entities who are precluded from being eligible employees under a section 401(k) plan by reason of section 401(k)(4)(B)(ii) may be treated as excludable employees if more than 95 percent of the employees of the employer who are not precluded from being eligible employees by reason of section 401(k)(4)(B)(ii) benefit under the plan for the year.
(3) Employees of tax-exempt entities. Employees of an organization described in section 403(b)(1)(A)(i) who are eligible to make salary reduction contributions under section 403(b) may be treated as excludable with respect to a section 401(k) plan, or a section 401(m) plan that is provided under the same general arrangement as a section 401(k) plan, if (i) No employee of an organization described in section 403(b)(1)(A)(i) is eligible to participate in such section 401(k) plan or section 401(m) plan; and (ii) At least 95 percent of the employees who are neither employees of an organization described in section 403(b)(1)(A)(i) nor employees of a governmental entity who are precluded from being eligible employees under a section 401(k) plan by reason of section 401(k)(4)(B)(ii) are eligible to participate in such section 401(k) plan or section 401(m) plan.”
The most obvious change is the addition of an exclusion for employees of governmental employers that cannot offer §401(k) plans. While not mandated by EGTRRA §664, this is a reasonable measure. I would argue that given the absolute inability of the §401(k)(4)(B)(ii) employer to participate maintain a §401(k) plan, the 95% coverage requirement is not appropriate here. In addition, note that subsection (2) does not explicitly exclude employees of §501(c)(3) employers at all.
Subsection (3) is, at first glance, simply parallel to subsection (2). However, note that in applying the 95% test under subsection (3), employees of governmental employers that cannot maintain §401(k) plans at all are excluded. This means that, in a very rare occurrence, the rules for nongovernmental employers are more liberal than those for governmental employers because subsection (2) does not allow exclusion of employees of charities excluded under subsection (3).
Last, there is a very problematic paragraph in the preamble, as follows: “Commentators asked whether employees of a tax-exempt organization described in section 501(c)(3) who would be eligible to make salary reduction contributions under a section 403(b) plan but for the exclusions permitted under section 403(b)(12), such as nonresident aliens and employees who normally work less than 20 hours per week, are taken into account as employees who are eligible to make salary reduction contributions for purposes of these regulations. These regulations provide that such employees are not taken into account unless they are actually eligible to make salary reduction contributions to the section 403(b) plan.” (Let’s set aside for the moment how regulation by legislative history, special provision not reflected in the Code and preambles makes for the sort of sloppiness evident here and makes the job of running plan too exciting.) This makes it that much harder for these employees to be excluded in testing the qualified plan; although at the least the §401(k) plan does not need to rewrite its entire set of exclusions to reflect both §§401(k) and 403(b) exclusions, it may mean that the calculations have to be done manually to apply §401(k) exclusions to the entire employee population minus the number of persons actually eligible within that non-excludible population.
More broadly, the paragraph in the preamble gives no hint on the application of statutory exclusions generally under the two 95% rules. Do the pre-ERISA rules apply to employees of governmental employers ineligible to maintain plans? Do the §410(b) rules for excludible employees, aggregation or disaggregation apply? And, if they do, under which plans? Governmental? ERISA? Section 403(b)? One analysis would say that these issues should be handled in parallel to the treatment of §403(b) exclusions (i.e., ignored). The second analysis would be that the IRS could have said that, so that in applying qualified plan exclusions §410(b) applies in all its glorious complexity, and by analogy to governmental plans with appropriate modifications. I, for one, have no idea which approach to use, and am hoping others will have some ideas.
