The Internal Revenue Service recently issued proposed regulations that may provide relief to plan sponsors that have been forced to look for ways to reduce costs by considering reducing or suspending employer contributions to their 401(k) plans.

If the plan is not a safe harbor 401(k) plan, this may be as easy as amending the plan to reflect the reduced or eliminated contribution and providing sufficient notice to the plan participants. However, if the plan is a safe harbor 401(k) plan, the issue becomes more complicated.

A 401(k) plan must meet certain nondiscrimination tests to ensure that highly compensated employees cannot elect to defer a disproportionately higher amount of their salary than the non-highly compensated employees are deferring.

If the 401(k) plan does not meet these special nondiscrimination requirements, refunds may need to be made to correct the test failure, and if not corrected, the plan could be disqualified. To avoid nondiscrimination testing for salary deferrals, a plan may choose to satisfy one of the "safe harbor" plan options.

There are two common safe harbor options. One option requires the plan sponsor to provide a qualified matching contribution at least equal to 100% of employee deferrals up to 3% of compensation, plus 50% of employee deferrals on the next 2% of compensation (effectively a 4% matching commitment per employee deferring 5% of compensation). The second option requires a plan sponsor to provide a qualified non-elective contribution equal to at least 3% of compensation.

Matching contributions are a specified percentage of participants' salary deferrals, while non-elective contributions are a flat percentage of participants' compensation, similar to a profit-sharing contribution.

Midstream changes

Generally, the safe harbor option needs to be in effect for the entire plan year, but what happens if the plan sponsor changes its mind regarding either the matching or non-elective contributions, either for economic or other reasons?

Long-standing regulations provide that plan sponsors maintaining a plan that offers the safe harbor matching contributions described above have the ability to reduce or eliminate those contributions during the plan year if certain conditions were met. These conditions include the following:

* The plan sponsor must provide a notice to all eligible employees regarding the reduction or suspension of safe harbor matching contributions.

* The reduction or suspension of safe harbor matching contributions must be effective no earlier than the later of 30 days after eligible employees are provided the notice, or the date the amendment is adopted.

* Eligible employees must be given a reasonable opportunity prior to the suspension of safe harbor matching contributions to change their employee contribution elections.

* The plan must be amended to provide that the applicable nondiscrimination tests will be satisfied for the entire plan year.

* The plan must satisfy the requirements of the safe harbor rules with respect to amounts deferred through the effective date of the amendment.

While options may have been available to plan sponsors that maintain a plan offering safe harbor matching contributions, prior to the issuance of the proposed regulations in May, there was no authority that allowed safe harbor non-elective contributions to be suspended or reduced in the middle of the plan year.

The proposed regulations provide that safe harbor non-elective contributions may now be suspended after the beginning of the plan year, provided certain rules are met.

Those rules are the same as the rules governing the suspension of safe harbor matching contributions, with one major exception. The safe harbor non-elective contributions can only be suspended if a plan sponsor incurs what the regulations call a "substantial business hardship."

Easier said than done

This exception, while in theory easy to determine, is difficult to administer. The problem in determining whether a plan sponsor is suffering from a "substantial business hardship" is that the proposed regulations do not describe the circumstances surrounding what would constitute a "substantial business hardship."

The regulations do offer us a view into the thinking of the IRS, because they refer to the use of the term "substantial business hardship" in another context, i.e., a request for a waiver of the minimum funding requirement under section 412(c).

Under section 412(c), the factors taken into account in determining if a "substantial business hardship" has occurred include, but are not limited to, whether or not:

* the employer is operating at an economic loss;

* there is substantial unemployment or underemployment in the trade or business and in the industry concerned;

* the sales and profits of the industry concerned are depressed or declining; and

* it is reasonable to expect that the plan will be continued only if the relief is granted.

Based on the current economic climate, it appears likely that many plan sponsors would meet the first three factors; however, the last factor may not apply in many cases.

Therefore, it is important for a plan sponsor to document the decision-making process to properly support the reduction or suspension of the safe harbor non-elective contribution.

Another rule established by the proposed regulations that may affect any suspension of safe harbor contributions, regardless of whether they are matching contributions or non-elective contributions, is that if safe harbor contributions are reduced or suspended during the plan year, the compensation limit under section 401(a)(17) of the Internal Revenue Code must be prorated.

This rule could pose a problem to those plan sponsors that elect to make contributions periodically throughout the plan year and subsequently decide to eliminate the contributions after the effective date of the regulations, since contributions might already have been made to the plan based on the full compensation limit.

Finally, keep in mind, in determining how much time is necessary for implementing a reduction or suspension of non-elective contributions, plan sponsors need to consider the "reasonable opportunity" required for participants to change their deferral elections.

This time frame will likely depend on the administrative systems currently in place and may vary from plan sponsor to plan sponsor. As such, the supplemental notice must explain:

* the consequences of the amendment;

* the procedures for changing deferral elections; and

* the effective date of the amendment.

Remember that while these regulations were designed to provide some level of relief to plan sponsors seeking to limit their financial obligation in a down economy, there are some complicated factors that need to be reviewed and addressed before electing to suspend safe harbor non-elective contributions.