High 25 HCE Restricted Employees (1.401(a)(4)-5(b))

Since 1994, defined benefit plans have regulation 1.401(a)(4)-5(b) as a required aspect of retirement plan administration to restrict certain distributions for the top 25 highly compensated employees. (Before 1994 there was 1.401-1(c) which was similar.) This regulation is aimed at ensuring defined benefit plans do not discriminate against Non-Highly Compensated Employees (NHCEs) due to insufficient plan funds to pay accelerated forms of benefits, like lump sum benefits. If a Highly Compensated Employee (HCE), or former HCE, elects to receive a lump sum benefit payment, the plan may need to restrict the benefit payment to help protect the benefits of NHCEs, or in theory, potential future NHCEs. This article outlines the general requirements and provides key considerations when administering the High 25 HCE restrictions. Because this article doesn't cover all the details, it is recommended that readers review the cited sources in detail to understand how the guidance applies to their qualified retirement pension plan and please see the disclaimer below too.

Who are the High 25 Restricted HCEs?

An employee or former employee is a restricted employee for this regulatory requirement if they are a Highly Compensated Employee (HCE) as defined by 1.410(b)-9 Definitions, or were an HCE in any plan year, and were among the highest 25 compensated employees based on their highest paid plan year. Note, there is no reference to IRC 401(a)(17) maximum compensation limit; as such, compensation is not limited for this purpose. If the plan document allows, an employer may increase the number of restricted employees above 25. This may be a consideration for employers to provide equality among HCEs or to further protect the plan from potentially becoming underfunded by expanding the number of restricted HCEs.

What are the Restricted Benefits?

In general, all distributions besides insured death benefits may be subject to this restriction. IRC 72(p) Loans (retirement plan loans not in excess of the loan limit) are not subject to this restriction. By default, Restricted HCEs' benefit payments are limited to an actuarial equivalent single life annuity each plan year. (If their benefit includes a social security supplement, that can be included too.) This restriction doesn't prohibit an HCE from making a lump sum election. However, a plan may only be permitted to make payments that would not exceed a single life annuity during each plan year for that HCE's lump sum election until restrictions no longer apply, thus making a plan pay a single lump sum benefit over potentially many years. Note, in general, benefits that were not able to be paid timely by the plan generally receive actuarial adjustments for payment delays of the restricted amounts.

When These Restrictions No Longer Apply

• 110% Funded: If after the benefit payment to the Restricted HCEs is paid and the plan would be at least 110 percent funded of current liabilities over plan assets available to pay pension benefits, then the full elected benefit can be paid. Any reasonable and consistent method may be used for determining the value of current liabilities and the value of plan assets. However, as cited in the Denise M. Clark v. Feder Semo Bard P court case, not using a funded percent based on the latest 5500 Schedule SB "...creates a genuine issue of material fact as to whether the Retirement Plan had sufficient assets..."
• Q: What are current liabilities?

  A: This regulation refers to IRC 412(l)(7) for current liabilities. IRC 412 was reorganized, and the reference to 412(l)(7) no longer exists. (For reference, as it was written in 1994 when this regulation became effective: IRC 412.) Given that IRC 412 is for Minimum Funding Standards and at the time 412(l)(7) referenced methods that use IRS-prescribed interest rates and mortality tables, it suggests current liabilities are calculated similarly to the 5500 Schedule SB purposes. Benefits included could be as accrued on the latest valuation date or as of the distribution date, pending interpretation and application. However, it is open to interpretation because 1.401(a)(4)-5 regulation states, "(v) Determination of current liabilities. For purposes of this paragraph (b), any reasonable and consistent method may be used for determining the value of current liabilities and the value of plan assets." Each plan administrator can make a determination. As mentioned in the Denise M. Clark v. Feder Semo Bard P court case, not using the funded percent as reported on the 5500 Schedule SB "...creates a genuine issue of material fact as to whether the Retirement Plan had sufficient assets..."

  Note, whereas the Joint Board of Enrolled Actuaries exams are not considered guidance, the 2019 EA-2L Exam example question 19 does use funding target as current liabilities. Note the answer is D to make the plan 110% funded.

• Q: What happens if, after the distribution to the restricted HCE, there are zero assets and zero liabilities to calculate if the plan is 110% funded? Or if there are some assets and no liabilities for an "infinitely" percent funded plan?
  A: As these questions are currently unanswered, you may request a private letter ruling and let us know. How would I obtain a private letter ruling?
• Q: What if the plan isn't 110% funded? Can the employer provide a contribution to make it 110% funded?
  A: Yes. To avoid correction methods and complications, this contribution should be made before the distribution is paid. Use a reasonable method for valuing that contribution for assets when calculating current liabilities.
• Example: Calculating a contribution to get the plan to 110% funded for a hypothetical HCE.

  Facts and Circumstances:
  A restricted HCE is entitled to a $1.2 million lump sum distribution on 7/1/2024. As of the latest valuation date, 1/1/2024, the plan's funding target (current liabilities) is $9.5 million. Of that, $1 million is for the restricted HCE's funding target (current liabilities). If this was a 12/31/2023 end-of-year valuation, this plan would consider both funding target and target normal costs for its current liability. Instead of using liabilities and assets as of the latest valuation date, this plan is projecting using the Effective Interest Rate (EIR) of 5.50% to the proposed distribution date. As of 7/1/2024, the plan's assets are valued at $10 million.

  Step 1: Confirm Post Distribution Would Have the Plan Less than 110% Funded.
  Post Distribution Funding Percentage = (Plan assets - Distribution) / ((Plan's Current liabilities - Participant Current Liability) x EIR Interest)
  = ($10,000,000 - $1,200,000) / (($9,500,000 - $1,000,000) x 1.055^0.5) = 100.79%
  Restrictions applies because the plan would be less than 110% funded if distribution was paid. If 110% or greater, this restriction would not apply.

  Step 2: Determine the amount needed to reach 110% funding.
  Contribution to Fund to 110% = 110% x (Plan's Current liabilities - Participant Current Liability) x EIR Interest + Distribution - Plan Assets
  = 110% x ($9,500,000 - $1,000,000) x 1.055^0.5 + $1,200,000 - $10,000,000 = $803,684

  Conclusion: The employer may contribute an additional $803,684 to the plan before the distribution so the restricted HCE can receive their lump sum to ensure the plan is 110% funded.

  Note: Different valuation methods for plan assets and liabilities, as well as subtle interpretation differences, may impact the results, but this general method applies to calculating the necessary contribution to reach 110% funding. For example, instead of projecting liabilities to the distribution date, the distribution could have been valued as of the valuation date.

• Calculator: Is there a 110% Funded Calculator?

  110% Funding Calculator Below is a 110% Funding Calculator. There can be many variations. Review the results with the Plan Administrator and Actuary to ensure the results are appropriate for the plan.
  

  110% × (

  Plan's Current Liabilities ($):

  Plan's Current Liabilities should be greater than Participant's Liabilities.

  It is generally unexpected to have assets over 2.5 times larger than plan liabilities.

  −

  Participant Current Liability ($):

  Participant Liabilities should not be greater than Plan Liabilities.

  It is generally unexpected to have Participant liabilities to have less than half of their distribution.

  ) × (1 +

  EIR (%):

  EIR generally should be less than 7.5%.

  If you enter a value above zero but below 1, use percent, not decimal.

  ) ^ (

  Valuation Date:

  Valuation Date should be on or before the Distribution Date.

  to

  Distribution Date:

  Distribution Date should be on or after the Valuation Date.

  ) +

  Distribution ($):

  Distribution generally should not be larger than Assets.

  It is generally unexpected to have a distribution that is twice that of their Current Liability.

  −

  Plan Assets ($):

  Assets should generally not be smaller than Distribution.

  = Contribution to Fund to 110%
• Less than 1% of Current Liabilities: If before the benefit payment to the Restricted HCEs is less than one percent of the current liabilities, then restrictions do not apply. As noted with over 110% Funded, if not considering liabilities as reported on the latest 5500 Schedule SB, it may cause confusion and doubt due to the potential arbitrary liabilities considered.
  • Q: What are current liabilities?

    A: This regulation refers to IRC 412(l)(7) for current liabilities. IRC 412 was reorganized, and the reference to 412(l)(7) no longer exists. (For reference, as it was written in 1994 when this regulation became effective: IRC 412.) Given that IRC 412 is for Minimum Funding Standards and at the time 412(l)(7) referenced methods that use IRS-prescribed interest rates and mortality tables, it suggests current liabilities are calculated similarly to the 5500 Schedule SB purposes. Benefits included could be as accrued on the latest valuation date or as of the distribution date, pending interpretation and application. However, it is open to interpretation because 1.401(a)(4)-5 regulation states, "(v) Determination of current liabilities. For purposes of this paragraph (b), any reasonable and consistent method may be used for determining the value of current liabilities and the value of plan assets." Each plan administrator can make a determination. As mentioned in the Denise M. Clark v. Feder Semo Bard P court case, not using the funded percent as reported on the 5500 Schedule SB "...creates a genuine issue of material fact as to whether the Retirement Plan had sufficient assets..."

    Note, whereas the Joint Board of Enrolled Actuaries exams are not considered guidance, the 2019 EA-2L Exam example question 19 does use funding target as current liabilities. Note the answer is D to make the plan 110% funded.

  • Q: For this 1%, is it based on the employee's distribution or the value of benefits in the plan?
    A: Presumably, it is the value of benefits that could be payable to the restricted HCE from the plan, regardless of the amount elected to be distributed.
• Less Than Cash Out Threshold: If the benefit payment to the Restricted HCE equals the cash-out threshold or is less, then the restrictions do not apply. Starting year 2024, the Cash Out Threshold is $7,000.
  • Q: Can the cash-out exemption be applied separately for a restricted employee to process multiple distributions without restriction?
    A: No. The cash-out threshold is based on the total value of the benefit payable, this considers their entire benefit in the plan. If the value of their benefit in the plan exceeds the cash-out threshold, then this option wouldn't apply. Further, taking partial distributions that are under the cash-out threshold to circumvent this requirement would be considered a violation with the intent of the rule.
• Plan Termination: Instead of the High 25 restricted HCEs, if the plan is undergoing plan termination, the plan must provide that the benefit of any HCE (and any former HCE) is limited to a benefit that is nondiscriminatory under section 401(a)(4). This applies to both, when a plan is underfunded where participants may not be receiving full benefits, and when a plan is allocating excess assets to participants.
• No Longer in High 25: If the restricted HCE is no longer among the high 25 HCEs, then the restrictions no longer apply. For example, the 25th HCE becomes the 26th most highly compensated employee due to another earning more.
• Restricted Employee Provides Repayment Security: As provided with Revenue Ruling 92-76, a plan may offer the option for the restricted employee to acquire security on the restricted amount of the distribution for potentially repaying the plan upon plan termination to ensure the plan termination is non-discriminatory. The restricted amount is the excess amount distributed to the employee over a single life annuity. Over time, less of the lump sum distribution would be considered restricted. The three options, plus a fourth via private letter rulings, are:
  • Escrow for 125% of the restricted amount. Excess amounts over 125% may be withdrawn, however, if the value in escrow drops below 110% of the restricted amount, the employee is required to provide additional property to bring the account back up to 125% of the restricted amount. The employee has the right to receive any income from the property placed in escrow. See the fourth option below regarding using two IRAs with custodial agreements.
  • Posting a bond of at least 100% of the restricted amount. Amounts over 100% of the restricted amount may be withdrawn.
  • Bank letter of credit of at least 100% of the restricted amount. Amounts over 100% of the restricted amount may be withdrawn.
  • IRAs with Custodial Agreement Consistent with the escrow option above, the IRS has permitted many plans to use IRAs that have agreements with the custodian to return the restricted amounts to the plan in the event of an underfunded termination. See Private Letter Ruling 200606051 and Private Letter Ruling 200414048.

    This option is more intuitive and practical than the three above. Given that private letter rulings (PLRs) are specific to the plan, a plan administrator should consider obtaining a PLR if utilizing this option. Note, in Private Letter Ruling 9514028, the IRS approved the two-IRA approach but declined to comment on whether it was a prohibited transaction, stating that it was up to the Department of Labor to determine and has yet (as of 1995) to provide an opinion.

    However, in Private Letter Ruling 8945009, the IRS did provide an opinion that using two IRAs to comply with the high 25 restricted employees was not a prohibited transaction for disqualified persons. (Sections 1.401-1(c) and Revenue Ruling 81-135 are the predecessors of 1.401(a)(4)-5(b) and Revenue Ruling 92-76 that are referenced is this PLR).

  To release these securities as offered with Revenue Ruling 92-76, freeing the distribution completely to the employee, the plan administrator may certify to the depositary, surety, bank, or custodian that the employee is no longer obligated to repay the amounts. The five options available for this certification to release the securities are:

  • The value of plan assets exceeds 110% funded of current liabilities
  • The future value of the non-restricted amounts (single life annuity value) constitutes less than 1 percent of current liabilities. (Since overtime the restricted amount is reducing, this should be checked periodically.)
  • The future value of the non-restricted amount does not exceed $3,500
  • The plan has terminated and the benefits received by the employee were nondiscriminatory
  • The employee is no longer among the high 25 restricted employees

What are the correction options if a restriction wasn't applied?

The Employee Plans Compliance Resolution System ("EPCRS") permits plan sponsors to correct failures and thereby continue to provide their employees with retirement benefits on a tax-favored basis. Revenue Procedure 2019-19, and as expanded by Revenue Procedure 2021-30, provide the general guidelines for plan corrections. [These revenue procedures are updated regularly. At the time of your correction, check to see if new or updated EPCRS revenue procedures have been issued.] Depending on the severity of the issue, corrections can be self-corrected (without filing with the IRS), submitted to the IRS' Voluntary Correction Program (VCP) with an applicable user fee, or processed by the IRS' Audit CAP with negotiated sanctions. The determination of which program to use is outside the scope of this article. Corrections for 1.401(a)(4)-5(b) High 25 Restricted Employees are not explicitly stated how to fix in EPCRS; however, corrections consistent with these procedures will be considered by the IRS to a higher degree.

Before researching which correction method to consider, note that regulation 1.401(a)(4)-11(g)(2) prohibits the use of a retroactive amendment to fix 1.401(a)(4)-5(b) failures.

Because correcting 1.401(a)(4)-5(b) failures is not explicitly included in EPCRS, plan sponsors should consider the general intent and methods used for similar correction methods.

EPCRS allows plan sponsors to fix Qualification Failures. Because 1.401(a)(4)-5(b) restricted employees is a required plan document provision, failures under this regulation are considered Operational Failures. The specific type of Operational Failure is Overpayment. Revenue Procedure 2019-19 section 6.06(3) states, "An Overpayment from a defined benefit plan is corrected in accordance with rules similar to the Return of Overpayment and Adjustment of Future Payments correction methods described in section 2.04(1) of Appendix B or any other appropriate correction method. Depending on the nature of the Overpayment, an appropriate correction method may include having the employer or another person contribute the amount of the Overpayment (with appropriate interest) to the plan instead of seeking recoupment from a participant or beneficiary."

Given that 1.401(a)(4)-5(b) distributions are lump sum distributions with generally no future payments to consider and are not permitted to be corrected via amendment, returning the distribution (with an interest adjustment using the rate used to calculate the lump sum) to the plan is a possible correction method. Because 1.401(a)(4)-5(b) involves limitations on lump sums and 436(d) also involves limitations on lump sums (accelerated distributions), it would be reasonable to consider similar correction methods offered for 436(d) in EPCRS with 1.401(a)(4)-5(b) corrections.

Given the differences between IRC 436 and 1.401(a)(4)-5(b), a contribution to bring the plan to 110% funded would generally be the corrective action taken instead of the 60%, 80%, or 100% considered in 436. It is debatable whether a corrective contribution to address 1.401(a)(4)-5(b) needs to be classified as a 436 contribution (and not be applied to the minimum required contributions of IRC 430), but classifying it as a 436 contribution would report that corrective action was taken.

For Restricted HCEs who are not also a Disqualified Person, , returning the distribution would not be considered a Prohibited Transaction. However, for Disqualified Persons, the prohibited transaction exemption that allows benefits to be paid to them is: "4975(d)(9) receipt by a disqualified person of any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries."

Depending on the interpretation of that definition, corrections (or payments made without complying with 1.401(a)(4)-5(b)) for disqualified persons may or may not be a prohibited transaction subject to a 15% tax or 100% of the amount involved. For example, it says "may be entitled" instead of "are entitled." And is "consistent" generally consistent or strictly consistent with all terms of the plan? A court case was not located where these arguments were resolved.

Assuming returning the distribution for a disqualified person is being entertained and 4975(d)(9) isn’t going to be relied on as a defense, let’s dig deeper to determine if prohibited transactions apply. 4975(c)(1) for prohibited transactions include transactions that (B)lending of money or other extension of credit between a plan and a disqualified person; and (D)transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;

This suggests a 1.401(a)(4)-5(b) distribution to a disqualified person is eligible for correction and if timely corrected would be exempt from 4975.

4975(f)(5) Correction: The terms "correction" and "correct" mean, with respect to a prohibited transaction, undoing the transaction to the extent possible, but in any case, placing the plan in a financial position not worse than if the disqualified person were acting under the highest fiduciary standards.

4975(f)(11) (11) Correction period:

• (A) In general: The term "correction period" means the 14-day period beginning on the date on which the disqualified person discovers, or reasonably should have discovered, that the transaction would constitute a prohibited transaction.
• (B) Exceptions:
  • (i) Employer securities: Subsection (d)(23) does not apply to transactions involving employer securities or real property.
  • (ii) Knowing prohibited transaction: Subsection (d)(23) does not apply if the disqualified person knew the transaction would constitute a prohibited transaction.
  • (C) Abatement of tax: If a transaction is corrected, no tax shall be assessed with respect to such transaction, and if assessed, the assessment shall be abated, and if collected, refunded as an overpayment.

Even with a corrected prohibited transaction, as illustrated by Revenue Ruling 2002-43, there is a deemed prohibited transaction when money is loaned to a disqualified person, with the excise tax based on the interest of the loan. Depending on the facts and circumstances, if the correction under 1.401(a)(4)-5(b) for the disqualified person involves returning the distribution to the plan and that is classified as a loan, then excise tax may be due on the interest. Arguably, the interest would be the actuarial adjustment on the timing for repayment of the so-called loan. For example, if the distribution was rolled over to another retirement plan instead of being paid to the participant, it would be harder to claim it as a loan to a disqualified person. In the case it is considered a loan, the deemed prohibited transaction excise tax would be based on the loan interest.

If you don't want to hang your hat on 4975(d)(9) Exemption and want to avoid the debate (or locating supporting facts and circumstances for the defense) whether a loan was created by returning a distribution to the plan by disqualified person which have created a deemed prohibited transaction, instead of having the distribution returned to the plan, the employer can contribute to the plan to bring the plan's funding to 110%. It is worthwhile to mention that Revenue Procedure 2021-30 specifically states that the less cumbersome correction methods, such as funding exceptions and contribution credit methods, are not available for 436 issues associated with disqualified persons. As such, it is safe to assume 1.401(a)(4)-5(b)(1) corrections for disqualified persons are more scrutinized and should be more difficult to fix.

Guidance for Compliance

To ensure compliance with regulation 1.401(a)(4)-5(b), plan administrators should incorporate a review into their distribution processes to check if participants are subject to the High 25 Restricted HCEs. This step will help ensure that all distributions comply with the regulation and avoid needing to take corrective action.

References

Copyright 2024. Last Edited 07/2024.