In late 1998, the Internal Revenue Service ("IRS") issued Notice 98-52, which provides long-awaited guidance on the use of the so-called contribution "safe harbors" for tax qualified plans (primarily section 401(k) plans). The safe harbor contribution provisions, which go into effect in 1999, provide an alternate means for plan sponsors to satisfy the nondiscrimination tests for elective deferrals and matching contributions.

These provisions, which were enacted as part of the Small Business Job Protection Act of 1996, establish two contribution "safe harbors" for satisfying the actual deferral percentage ("ADP") and the actual contribution percentage ("ACP") tests. To fit within the safe harbors, certain contribution and notice requirements must be satisfied.(fn1) The more significant aspects of the agency’s interpretation of the safe harbor’s contribution and notice requirements are discussed below.

Under the safe harbor rules, the employer has the option of making either:

• An annual contribution of at least 3% of compensation for each eligible nonhighly compensated employee (which must be made without regard to whether the employee makes any contributions), or
• Matching contributions on behalf of each nonhighly compensated employee of at least (i) 100% of the employee’s elective contributions up to 3% of the employee’s compensation, and (ii) 50% of such contributions in excess of 3% (up to 5%) of the employee’s compensation.

These contributions must be fully vested when contributed and subject to the same distribution restrictions applicable to section 401(k) elective deferrals.

Unfortunately, the IRS Notice imposes additional restrictions that complicate the use of the safe harbor. These restrictions include the following:

No Discretionary Contributions. The Notice provides that discretionary contributions cannot be used to satisfy the contribution requirements. Consequently, only those contributions, be it matching or nonelective, that are required under the terms of the plan can be counted.(fn2)

Contributions Must Be Based on Full Year Compensation. The IRS takes the position that the safe harbor contributions must be based upon eligible participants’ compensation for the entire plan year (although the agency does permit a participant’s pre-eligibility compensation to be disregarded). This requirement may be troublesome for plans using matching contributions to satisfy the safe harbor as the matching contribution formula must be applied on an annualized basis, and not on a pay-period-by-pay-period basis. Therefore, for plans using a pay-period-by-pay-period match, it is possible that (depending on what participants elect to defer and the deferral changes they make during the year) the matching contributions made during the year may not equal the amount of participants’ annualized compensation that ultimately must be contributed under the safe harbor rules. To satisfy the safe harbor in these circumstances, the employer would have the option of either –

• Converting the plan to an annualized matching program, or
• Continuing to use a pay period-based matching scheme and making a "true up" contribution at year-end to the extent necessary to provide the required annual matching contribution for each participant.

To determine what "true up" would be necessary, an employer would need to compare at year-end the amount contributed for each participant with the required annualized matching amount for the participant (using his or her compensation for the entire year). To meet the matching contribution safe harbor, the employer would have to contribute any shortfall for each participant.

Broad Compensation Definition Required. Under the IRS Notice, a broad-based definition of compensation (such as total W-2 compensation) must generally be used in making safe harbor contributions. Many plans use "base compensation" or a similar definition for determining contributions. While this type of definition can be used in certain circumstances under the safe harbor rules, it is permissible to do so only if the definition is reasonable and does not favor the highly compensated employees in application.(fn3)

Contributions to Be Made for All Eligible Employees. In general, the IRS Notice provides that safe harbor contributions must be available to all nonhighly compensated participants for any period for which they are eligible to participate in the plan. Consequently, it is impermissible to place any limits on which eligible employees can receive such contributions, such as a minimum service (e.g., completion of a 1,000 hours) or year-end employment requirement.

No Limits on Employee Deferrals. The IRS Notice also prohibits the use of any restrictions that may unduly limit an employee’s ability to receive matching contributions. It is the agency’s position that eligible nonhighly compensated employees must be permitted to elect to make elective deferrals not only at the highest rate matched under the plan, but at any lesser rate as well. Thus, a minimum contribution requirement for participation will ordinarily be unacceptable. However, it is possible that the IRS would permit some reasonable limitations to be imposed on what such employees can elect to defer under the plan (e.g., require that deferral elections be made in whole percentages or limit when deferral elections can be changed during the year).

To be eligible to use the safe harbor in any year, the employer must provide an "accurate and comprehensive" explanation of the plan’s safe harbor provisions to eligible employees prior to the beginning of the year. The IRS has interpreted this to mean that the notice include a description of, among other things:

• The safe harbor contribution formula
• Any other employer contributions that could be made under the plan
• The type and amount of compensation that can be deferred by employees
• Any vesting provisions
• The plan’s withdrawal provisions

As to the timing of such notices, the IRS guidance generally provides that the notice is timely issued if it is given no more than 90 and no less than 30 days before the plan year involved. Fortunately, however, the IRS has also provided limited relief for 1999 for those plans using a plan year that begins before April 1st. These plans will be deemed to meet the timing requirement for the 1999 plan year if the required notice is issued by March 1, 1999.

The IRS has also placed some limits on the plan years for which the safe harbor can used. The Notice provides that except in the case of the first year of a newly established plan, the contribution safe harbor cannot be used for a "short" plan year (i.e., a year that is less than 12 months long). This would typically occur for an ongoing plan when the plan year is changed to a different fiscal period or the plan is merged into another plan mid-year. According to the IRS, the safe harbor could not be used for an ongoing plan in any short plan year arising in these or any other circumstances.

As interpreted by the IRS, the contribution "safe harbor" provides a mixed blessing. While the safe harbor was intended to (and still does) allow employers to avoid the annual burden and expense of ADP/ACP testing by "anteing up" generous contributions, compliance with the safe harbor requirements is not without its own complexities and limitations.