Nest Assets (February 1999)

Article
February 1999

Nest Assets

EMPLOYMENT LAW: A new IRS notice allows law firms to reduce 401(k) plan costs and simplify administration. However, firms adopting this new type of plan must give their employees notice by March 1.

Effective Jan. 1, law firms are able to take advantage of a new “safe-harbor” alternative for the design of their 401(k) plans. For many firms, this new design will help the partners or shareholder-employees receive the maximum benefits while reducing overall plan costs and simplifying administration.

Last year, the Internal Revenue Service issued IRS Notice 98-52, 1998-46 I.R.B.(Oct. 29, 1998), which provided guidance about the new plan design. In the notice, the IRS gave a favorable interpretation to the interplay of the safe-harbor provisions of Internal Revenue Code Section 401(k)(12) with the "top-heavy" and general nondiscrimination provisions of IRC Section 401(a)(4). Because of this interpretation, safe-harbor 401(k) plans will possibly become the favored retirement plan vehicle for most law firms.

For purposes of testing 401(k) plans to make sure that they meet the special nondiscrimination requirements, employees fall into two categories: the highly compensated employees (generally those who make more than $80,000 a year, which would typically include most of the attorneys and all of the partners or shareholder-employees of the firm) and the nonhighly compensated employees (everyone else, typically the staff).

There is a special group, called the "key employees," who for most law firms are those partners who own more than 1 percent of the firm and earn more than $150,000, and any partner who owns more than 5 percent of the firm. There can also be highly compensated employees who are not key employees. This group would primarily consist of the associate attorneys.

Without the safe-harbor design, each partner can defer up to $10,000 of his compensation to the 401(k) plan—if the staff employees defer at a high enough rate. The percentage that the partners can defer is limited by the percentage that the staff defers. These percentages for each group are called the "actual deferral percentages," or ADPs, and have to be tested each year for compliance using a nondiscrimination test called the "ADP test." To pass the ADP test, the actual deferral percentage of the partner group must be either not more than 1.25 times the staff ADP or must not exceed the staff ADP by more than 2 percentage points.

If a plan fails the ADP test, the plan must either return some of the deferrals to the partners to reduce the actual partner-deferral percentage or the firm must make a special, fully invested contribution to the plan for the benefit of the staff employees. This is called a "qualified nonelective contribution" or QNEC.

If more than 60 percent of the benefits in the plan are attributable to the key employees, the plan is top-heavy. If the key-employee partners defer to the plan, the firm has to contribute a minimum of 3 percent of pay for all nonkey employees. This top-heavy contribution can be treated as a QNEC to help the plan pass the ADP test if it is 100 percent vested.

The maximum amount that can be contributed to the plan for each participant is the lesser of 25 percent of pay, or $30,000. The maximum compensation that may be taken into for these purposes is $160,000. For partners, the maximum contribution would be made up of their $10,000 deferral, plus a $20,000 profit-sharing contribution (or 12½ percent of pay). In its simplest form, the plan would also need to make a 12½ percent of pay contribution for the staff to support the partner contribution.

Law firms that have done sophisticated planning have adopted plans that use a design feature called "cross-testing." This permits the maximum contributions to be made for the partners while reducing the contribution for the staff, typically in the range of 3 percent to 5 percent of pay. This contribution must be in addition to any QNECs. (There are different ways of cross-testing, but the basic concept is to base the contributions on the employee's age and compensation, which favors the partners because of their age and compensation.)

If a nonsafe-harbor plan fails the ADP test and is both top-heavy and cross-tested, the firm may wind up contributing 6 percent or more of pay for the staff in order to make a maximum contribution for the partners.

A safe-harbor 401(k) plan automatically passes the ADP test. This means that the partners can defer up to the maximum of $10,000 without having to worry about the level of staff deferrals. To get this automatic pass, the firm must make a contribution to the plan equal to 3 percent of pay for all eligible staff employees. Unlike a nonsafe-harbor plan, this 3 percent contribution supports the cross-testing. In addition, the 3 percent contribution satisfies the need for top-heavy contributions. This ability to count the same dollars for all three purposes (sometimes referred to as "triple-dipping”) is what makes the safe-harbor plan so attractive.

There is a second way to satisfy the safe harbor. The firm can make a matching contribution equal to 100 percent of deferrals up to 3 percent of pay plus 50 percent of the deferrals on the next 2 percent of pay. Since the matching contributions cannot be used to satisfy the top-heavy and cross-testing requirements, they will have little application in the typical law firm plan.

As a result, in the typical law firm, a safe-harbor 401(k) plan will allow the firm's partners to receive a $20,000 profitsharing allocation—plus their own $10,000 in deferrals—for an annual total of $30,000. This can often be done for a total cost of 3 percent of pay for the staff employees (instead of 6 percent or more) and without any discrimination testing.

In using the safe harbor, the plan loses some flexibility. The 3 percent contribution must be 100 percent vested. This means that when employees leave, there are no forfeitures that can be used to offset future employer contributions or plan costs. The contribution must be made for all eligible staff employees, even those who don't defer to the plan, and including those otherwise eligible employees who leave during the year.

Because the safe-harbor contribution is only made for the staff, the firm will still be required to make the top-heavy minimum contribution for any non-key employees who are highly compensated—generally the associates. But that is not an additional cost because it exists in a nonsafe-harbor plan as well.

Some larger firms set up a separate plan that is not top-heavy for associates only, so that the firm is not required to make the 3 percent top-heavy contribution for the associates. In smaller firms, where it is difficult to justify the cost of administering two plans, the associates are either carved out of the plan altogether or, if they are included, the cost is reflected in their compensation or absorbed by the firm.

Implementing a safe-harbor design for 1999 will require prompt action. The firm and its pension plan advisers will need to perform a cost-benefit analysis, comparing the differences in costs and benefits between the current plan design and the safe harbor, within the next few weeks.

The urgency is required by the fact that employees must be given notice of the employer's intent to use the safe harbor before the beginning of the plan year. But since 1999 is the first year this design is available, the notice can be given up until March 1 for existing plans. (For a new plan to use the safe harbor for 1999, it must be established and the notice given to employees by Oct 1.) After that, a firm will have to wait until next year to begin implementing the cost savings that the new design can provide.

The notice to employees must be given each year that the employer intends to use the safe-harbor design. Notice must be given not more than 90 nor less than 30 days before the beginning of the next plan year. The plan document also will need to be amended to provide for the safe harbor. Existing plans can adopt the safe harbor for 1999 before the end of the plan year; but generally, the amendment must be adopted before the year in which the safe harbor will be used.

A safe-harbor plan can provide a significant cost savings. However, because the firm does lose some flexibility in plan design—especially the 100 percent vesting and the requirement that the safe-harbor contribution be made for everyone who is eligible, not just employees who stick around—the tradeoff between the loss of flexibility and the benefits of "triple dipping" needs to be analyzed before the safe harbor is adopted. Nevertheless, within the next two to three years, safe-harbor plans should become the plans of choice for law firms, especially those with top-heavy plans.

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