Rev. Rul. 69-398

Advice has been requested whether, under the circumstances described below, the coverage classification in a profit-sharing plan meets the requirements of section 401(a)(3)(B) of the Internal Revenue Code of 1954.

An employer established a profit-sharing plan for the benefit of its full-time salaried employees. The plan provided that all full-time salaried employees with three years of service were eligible to participate in the plan. The employer had fourteen full-time employees each of whom had completed three full years of service. However, only six of these employees were participants in the plan; the other eight employees were ineligible to participate because they were paid on an hourly basis.

The six participating employees included the president and sole stockholder, the vice president and supervisor of sales personnel, a foreman, two salesmen, and a bookkeeper. The compensation of each of the full-time employees is set out below:

Salaried Hourly-paid (participants) (excluded)

$30,000 $7,000 12,000 7,000 10,000 6,000 9,000 6,000 8,500 5,500 6,500 5,500 5,500 4,500

A plan intended to qualify under section 401(a) of the Code must cover either (1) a number of employees that is at least equal to that determined under the percentage provisions of section 401(a)(3)(A) of the Code, or (2) such employees who qualify under a nondiscriminatory classification within the purview of section 401(a)(3)(B). The latter section provides that a plan intended to qualify must benefit a classification of employees that is found not to discriminate in favor of employees who are officers, shareholders, supervisors, or highly compensated. Thus, a plan that does not meet the percentage tests may still meet the coverage requirements if the classification of employees actually covered does not result in the prohibited discrimination. The classification must be nondiscriminatory both on its face and in actual operation. See section 1.401-1(b)(3) of the Income Tax Regulations.

Section 401(a)(5) of the Code specifies certain classifications, such as salaried or clerical, which of themselves are not discriminatory. Thus, a classification is not considered discriminatory solely because it is limited to salaried or clerical employees. See Rev. Rul. 66-12, C.B. 1966-1, 72. Conversely, such a classification is not automatically nondiscriminatory. See Rev. Rul. 66-13, C.B. 1966-1, 73. All of the surrounding circumstances and attendant facts must be taken into account in determining whether the coverage classification is nondiscriminatory within the meaning of section 401(a)(3)(B) of the Code. See section 1.401-1(b)(3) of the regulations.

Revenue Ruling 56-497, C.B. 1956-2, 284, indicates that with regard to qualified plans the terms "highly compensated" and "lower compensated" are relative and the distinction between them must be based upon the facts and circumstances in each case. Thus, in a particular case, the compensation of all employees, those excluded from the plan as well as those included, is taken into account in determining what is meant by "highly compensated" under section 401(a)(3)(B) of the Code. See Commissioner v. Pepsi-Cola Niagara Bottling Corporation, 399 F. 2d 390 (1968).

The plan in the instant case does not meet the minimum percentage requirement of section 401(a)(3)(A) of the Code. Therefore, if the coverage requirements are to be met, the classification of participants must not discriminate in favor of employees enumerated in section 401(a)(3)(B).

Of the six participants in the plan under consideration, the highest paid five received substantially more compensation than the excluded employees, with the fifth highest paid covered employee receiving $1,500 more than the highest paid excluded employee. Thus, all participants except the one who is the lowest paid are highly compensated in this particular company and therefore members of the group in whose favor discrimination is prohibited.

It is held that the coverage classification in this profit-sharing plan does not meet the requirements of section 401(a)(3)(B) of the Code since it results in discrimination in favor of employees who are officers, shareholders, supervisors, or highly compensated.