IRS revokes "mirror" sec. 401(k) ruling.

In Letter Ruling 9414051, the IRS has revoked Letter Ruling 9317037, which would have allowed employers and their highly compensated employees (HCEs) a unique opportunity to maximize contributions to a Sec. 401 (k) plan after the plan year had ended. This ruling would have allowed employers and their HCEs to adjust deferrals and contributions to qualified plans by pairing them with nonqualified deferred compensation plans. Benefits that otherwise would be lost to the HCEs could be restored; the employer could safely comply with the nondiscrimination rules without worrying about potential violations or complications associated with correcting excess deferrals and contributions to a plan.

Letter Ruling 9317037 approved an employer's plan to establish a nonqualified deferred compensation plan covering selected managers and HCEs. The nonqualified plan was to be treated as a grantor trust for tax purposes and the selected employees could make elective salary deferrals, with the employer matching up to 3% of the employee's annual salary. The employer matching in the nonqualified plan mirrored the employer matching available in the company's qualified profitsharing/sec. 401(k) plan.

Each January, the employer would perform preliminary average deferral percentage and average contribution percentage testing for the qualified plan for the prior plan year. if HCEs could have elected a higher deferral percentage for the plan year, they could elect, no later than January 31, to have that additional amount transferred from the nonqualified plan to the Sec. 401(k) plan. Those HCEs who elected not to make the additional deferral contribution would receive that additional amount between March 1 and March 15.

In addition, employer matching contributions to the nonqualified plan would also be transferable to the Sec. 401(k) plan to the extent allowable under the average contribution percentage test. Earnings on the funds transferred to the qualified plan would remain in the nonqualified plan.

The IRS stated that amounts originally contributed to the nonqualified plan that were transferred to the qualified Sec. 401(k) plan were excludible from the HCE's gross income. This amount transferred after year-end would also be used to compute the Sec. 402(g) annual deferral limit for the prior plan year.

In Letter Ruling 9414051, the Service did not provide a reason for its change in position, other than stating that it believed its original ruling was not proper with regard to the Code's definition of unfunded nonqualified plans. Presumably, the IRS felt that the employee's ability to transfer the funds, or to receive cash, raised an issue of constructive receipt. To establish a trust to hold employee contributions in a nonqualified arrangement that allows the employee a current tax deferral on contributions, the employees' rights must be nontransferable and subject to a substantial risk of forfeiture.

The Service did not provide any suggestions or alternatives for structuring the plan to accomplish the employer's goal while complying with the intent of the Code for nonqualified unfunded plans. Employers that wish to take advantage of nonqualified deferred compensation plans should consider the use of a "rabbi trust" and use Rev. Proc. 92-64's model trust language to ensure that the plan does not have a problem with constructive receipt.

From Jennifer J. Bowers, CPA, J.D., White, Petrov, McHone, P.C., Houston, Tex.