The IRS has issued proposed (the "Proposed Regulations") and final regulations (the "Final Regulations") under Sec. 401(k) of the IRC. The Final Regulations, among other things, provide guidance regarding the definition of hardship for purposes of making withdrawals, the definition of compensation, the time when contributions must be made to be used in the actual deferral percentage test ("ADP"), and whether plans may recharacterize certain deferrals of highly compensated employees as employee contributions. The Proposed Regulations, among other things, implement certain of the TRA 86 changes effecting 401(k) plans including nondiscrimination requirements, employee and matching contributions, additional rules on recharacterization of excess elective contributions and safe-harbor income rules. Plan sponsors can rely on the Proposed Regulations until they are finalized. This article briefly reviews these regulations.

The Final Regulations

Hardship Withdrawals. The Final Regulations permit hardship distributions of pretax contributions to be made only if such distributions are made on account of immediate and heavy financial need of the employee and are necessary to satisfy such need.

The Final Regulations set forth certain safe-harbor expenses which are deemed to constitute immediate and heavy financial need. These are medical expenses incurred by the employee, his or her spouse or any dependents of the employee; purchase (excluding mortgage payments) of a principal residence for the employee; payment of tuition for the next semester or quarter of post-secondary education for the employee, his or her spouse, children or dependents; and payments of amounts necessary to prevent the eviction of the employee from his principal residence or foreclosure on the mortgage of the employee's principal residence.

The Final Regulations state that a distribution generally may be treated as necessary to satisfy an immediate and heavy financial need if the employer reasonably relies upon the employee's representation that the need cannot be relieved:

1. Through reimbursement or compensation by insurance or otherwise;

2. By reasonable liquidation of the employee's assets, to the extent such liquidation would not itself cause an immediate and heavy financial need;

3. By cessation of elective contributions or employee contributions under the plan; or

4. By other distributions or nontaxable (at the time of the loan) loans from plans maintained by the employer or by any other employer, or by borrowing from commercial sources on reasonable commercial terms.

The Final Regulations set forth a safe-harbor rule pursuant to which distributions will be deemed necessary to satisfy an immediate and necessary financial need. The following requirements must be satisfied to meet the safe-harbor rule:

1. The employee has obtained all distributions, other than hardship distributions, and all nontaxable loans available under all plans maintained by the employer;

2. The plan, and all other plans maintained by the employer, provide that the employee's elective contributions (and employee contributions) will be suspended for at least 12 months after receipt of the hardship distribution;

3. The plan, and all other plans maintained by the employer, provide that the employee may not make elective contributions for the employee's taxable year immediately following the taxable year in which the employee received the hardship distribution in excess of the applicable limit under Sec. 402(g) for such next taxable year less the amount of the employee's elective contributions for the taxable year in which the employee received the hardship distribution; and

4. The distribution is not in excess of the amount of the immediate and heavy financial need.

Employers should consider whether they intend to limit hardship distributions to only those situations where the safe-harbor rules are satisfied. Employers who wish to utilize these safe-harbor rules must generally amend their plans effective on or before the first day of the first plan year commencing on or after January 1, 1989 to avoid causing a prohibited cut-back in benefits. The plan amendment conforming a plan to the safe-harbor rules must be adopted by the last day of the first plan year beginning after December 31, 1988.

Employers who do not use the safe-harbor relating to financial resources must investigate the other resources available to the employee. The requirements that must be satisfied for the safe-harbor rule are arguably onerous, particularly the suspension of an employee's elective contributions so that employers may decide not to take advantage of these rules.

Clarifying Compensation. Prior to the issuance of the Final Regulations it was unclear whether annualizing compensation for 401(k) purposes was permissible and whether compensation could include amounts deferred when testing for discrimination.

The Final Regulations provide that plans may define compensation to include or exclude elective contributions. Actual compensation for a portion of a year may not be annualized for purposes of testing whether a plan meets the special discrimination tests (i.e., the ADP test).

When Contributions Must be Made. The Final Regulations extend the time period for making elective contributions that may be used in the ADP test for a plan year to the last day of the 12-month period immediately following the plan year to which the contributions relate (pursuant to the 1981 Regulations, elective contributions had to be received within 30 days after the end of the plan year). The contributions must be allocated to the participants' accounts for the plan year with respect to which the ADP test is performed.

Recharacterization. In January 1982 the IRS announced that excess contributions above the ADP limits could not be recharacterized. However, TRA permits such recharacterization for years after 1986. The Final Regulations permit employers to recharacterize such amounts for plan years which begin before January 1, 1987. The effect of recharacterization is to treat recharacterized amounts as employee contributions and, thus, these amounts are not subject to the anti- discrimination rules of Secs. 401(k)(4) and 401(k) that apply to employer contributions. The Final Regulations set forth the manner in which excess contributions are to be recharacterized. Plans may be amended to permit recharacterization for such plans years. Thus, plans under audit for compliance with the ADP limits for a prior year can utilize this retroactive change recharacterization provision.

Generally, excess contributions recharacterized as employee contributions are to be taxed to the employee in the year in which the contributions relate, rather than the year in which the recharacterization takes place. Plan administrators must report recharacterized excess contributions to IRS. However, if amounts recharacterized for any plan year were not previously included in income, they are to be treated as received by employees for income tax purposes on the first day of the first plan year ending after 1988.

The Proposed Regulations

A. Nondiscrimination Requirements for Employee Matching Contributions.

Sec. 401(m), which was added by TRA, contains new nondiscrimination rules for employee and matching contributions, which supplement the ADP tests applicable to cash or deferred arrangements. These new rules also apply to certain annuity plans and annuity contracts.

The Proposed Regulations define the term employee contribution to include both voluntary and mandatory contributions that are credited to a separate account to which gains or losses are allocated. The term also includes recharacterized elective contributions.

An employee contribution is taken into account under the nondiscrimination test for the plan year in which such amounts are contributed to the trust. Correction of excess aggregate contributions (i.e., generally matching and employee contributions in respect of a plan year in excess of the 401(m) limits) amounts contributed to a plan subject to the requirements of Sec. 401(m) is permitted and such correction must be made through a plan distribution. Recharacterization is not available as a method of correction. In addition, excess aggregate contributions may be avoided by making additional qualified nonelective or matching contributions. The Proposed Regulations provide rules for coordinating the correction of elective deferrals, excess contributions (i.e., amounts which exceed the ADP test limitation), and excess aggregate contributions.

The IRC imposes a 10% excise tax on excess aggregate contributions and excess contributions if such amounts are not corrected within 2 1/2 months following the close of the plan year to which they relate. A plan which does not correct these amounts by the end of the plan year following the plan year to which they relate is disqualified for the plan year to which they relate and all subsequent plan years that they remain in the plan.

B. $7,000 Limit on Elective Deferrals.

An employee may defer up to $7,000 (subject to cost of living adjustments, i.e., $7,313 for 1988) under a cash or deferred arrangement for any taxable year. The Proposed Regulations set forth the methods and requirements for correcting excess deferrals (i.e., in excess of $7,000 as adjusted). Such deferrals may be corrected in the taxable year in which made as well as during the period ending during the first April 15th of the subsequent taxable year. Excess deferrals are corrected through a plan distribution. Recharacterization is not available as a method or correction. If an employee fails to timely withdraw excess deferrals and income earned thereon, either because the withdrawal is not timely or because the plan does not so provide, the excess deferrals and income earned thereon are includible in income both in the year in which deferred and the year in which distributed. The Proposed Regulations also set forth the manner in which income is computed on excess deferrals.

C. Changes to 401(k) Arrangements.

TRA 86 made several changes affecting cash and deferred arrangement.

Distributions from cash or deferred arrangements are permitted upon termination of a plan without establishment of a successor plan, the sale by a corporation of substantially all of its assets used in its trade or business to another corporation, or the sale by a corporation of such corporation's interest in a subsidiary to an unrelated entity. The Proposed Regulations provide that a sale of 85% of the relevant assets will be deemed a sale of substantially all assets. The Proposed Regulations also provide that the establishment of a successor plan means the existence at the time the plan, including the cash or deferred arrangement, is terminated or within the period ending 12 months after distribution of all assets from the arrangement of any other defined contribution plan other than a leveraged employee stock ownership plan maintained by the employer.

Distribution or recharacterization of excess contributions which would otherwise cause an employer's plan not to meet the ADP test are permitted. The Proposed Regulations provide that, for nondiscrimination purposes, recharacterized amounts are treated as employee contributions for the year in which the elective contributions would have been received (but for the deferral election) and must, therefore, be tested under Sec. 401(m) for that year. The Proposed Regulations also provide that, whether distributed or recharacterized, excess contributions are annual additions in the year of the deferral.

Effective Dates and Plan Amendments

The Final Regulations are generally effective for plan years which begin after December 31, 1979. The provisions on the Final Regulations relating to changes made by TRA are generally effective for plan years which begin after December 31, 1986. For plan years beginning after December 31, 1979 and before January 1, 1988, a reasonable interpretation of the rules set forth in Sec. 401(k), (as in effect during those years) may be relied upon to determine whether a cash deferred arrangement was qualified during those years. For years beginning prior to January 1, 1987, operation in accordance with the 1981 Regulations is a reasonable interpretation of Sec. 401(k). The Proposed Regulations are generally proposed to be effective for plan years beginning after December 31, 1986. Special effective dates apply to certain plans maintained pursuant to one or more collective bargaining agreements.

Plan amendments to effect the changes contained in the Proposed and Final Regulations need not be made until the earlier of plan termination or the last day of the first plan year beginning after December 31, 1988, provided the amendment is effective retroactively to the statutory effective date and the plan is operated in accordance with the requirements of the provision as of its effective date with respect to the plan. Thus, these adjustments may be made when the plan is completely amended and restated to comply with the changes made by TRA, which is effective on or before December 31, 1989 for calendar year plans.