Final Permitted Disparity Rules for Pension Plans

 [4830-01-u]

 ACTION: Final regulations.

 SUMMARY: This document contains amendments to the final regulations under section 401(l) of the Internal Revenue Code of 1986, which provides for permitted disparity in employer contributions to,, and employer-provided benefits under, qualified plans. The regulations reflect changes made by the Tax Reform Act of 1986 and the Technical and Miscellaneous Revenue Act of 1988. The regulations provide guidance necessary to comply with the law and affect sponsors of, and participants in, tax-qualified retirement plans.

 DATES: These regulations are effective January 1, 1994, and apply to plan years beginning on or after January 1, 1994, except as provided in the transition rules of section 1.401(l)-6.

 FOR FURTHER INFORMATION CONTACT: Patricia McDermott at (202) 622-4606 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

BACKGROUND

On September 19, 1991, final regulations under sections 401(a)(5) and 401(l) (T.D. 8359) were published in the Federal Register (56 FR 47610). In the Federal Register of August 10, 1992, (57 FR 35536), the Internal Revenue Service published proposed regulations to extend the effective date of the final regulations under section 401(a)(4), section 401(a)(5), section 401(l), and related regulations generally to plan years beginning on or after January 1, 1994.

 On April 21, 1993, proposed regulations amending the final regulations were published in the Federal Register (58 FR 21426). Written comments were received from the public on the proposed regulations, and a public hearing was held on June 7, 1993. After consideration of all of the written comments received and the statements made at the public hearing, these regulations are adopted as modified by this Treasury decision.

EXPLANATION OF PROVISIONS

1. OVERVIEW

 Section 401(a)(4) requires that contributions or benefits not discriminate in favor of highly compensated employees. Section 401(a)(5) provides that a plan does not discriminate merely because the contributions or benefits under the plan bear a uniform relationship to compensation, taking into account the permitted disparity under section 401(l). The regulations under section 401(a)(4) provide certain safe harbor plan designs that use the permitted disparity under section 401(l).

 The April 1993 proposed regulations amend the September 1991 regulations generally to address issues raised since the publication of the 1991 regulations. In addition, the proposed regulations make coordinating amendments to the September 1991 regulations under section 401(l) to take into account the changes proposed in the January 1993 proposed section 401(a)(4) regulations. Major changes in the proposed regulations include the following:

• Allowing a defined benefit plan that offsets an employee's benefit by a percentage of the employee's primary insurance amount (PIA offset plan) to satisfy section 401(l) if the offset is limited to the maximum offset permitted under section 401(l).

• Allowing application of the cumulative disparity limit on a formula-by-formula basis in the case of a defined benefit plan providing the greater of the benefits under two formulas and allowing similar treatment in plan offset arrangements.

• Expanding the exception for optional forms of benefit subject to section 417(e) to allow the employer to use the same interest rates for all such forms.

• Allowing a plan to provide a qualified disability benefit within the meaning of section 411(a)(9) without having to use a reduced disparity rate.

2. OVERALL DISPARITY

a. BACKGROUND

 Section 401(l) of the Code limits the disparity permitted with respect to any year of service and with respect to all years of service. The September 1991 regulations provide annual and cumulative overall permitted disparity limits, that is, limits on the disparity that can be provided to an employee for one year under more than one plan and for the employee's total years of service. For purposes of the overall disparity limits, all plans of the employer are taken into account. In addition, plans of another employer are taken into account for years of service with the other employer which are also credited by the current employer. The reason for taking the other employer's plan into account is to assure that the current employer does not duplicate the disparity provided for years of service with the other employer, thus exceeding the disparity limits.

 The overall disparity limits are applied by determining an annual disparity fraction for the employee for each year of service under a plan, reflecting the portion of the disparity maximum used under the plan for that year. The cumulative disparity limit prohibits the sum of the employee's annual disparity fractions from exceeding 35. Generally, if a defined benefit plan provides a benefit equal to the greater of the benefits under two formulas, or if the benefits under the plan are offset by benefits under another defined benefit plan (offset arrangement), the annual disparity fraction for a given year is the larger of the fractions determined separately under each formula or under each plan in an offset arrangement. In addition, because of the difficulty in measuring the amount of disparity used prior to the 1989 effective date of section 401(l), the September 1991 regulations set the disparity fraction equal to one for any year of service before 1989.

b. GREATER OF TWO FORMULAS

 The proposed regulations provide a special rule under which a defined benefit plan providing the greater of the benefits under two or more formulas is deemed to satisfy the cumulative disparity limit if each formula separately satisfies the cumulative limit. In order to avoid the complexity of coordinating the annual disparity fractions under each formula with disparity provided under another plan, the special rule applies only if an employee never benefited under another plan using permitted disparity.

 Commentators asked that the special rule be expanded to apply in the case where an employee has benefited under another plan using permitted disparity, but where neither plan provides service credit for the period of service credited under the other plan. (In the case of plans covering nonoverlapping years of service, the annual disparity fractions under each plan are determined without regard to the disparity provided under the other plan.) The final regulations expand the special rule to cover that case, provided that certain conditions are satisfied.

c. MERGERS AND ACQUISITIONS

 Commentators requested certain changes to the overall disparity rules when an employer acquires a business and gives the employees of that business credit under the employer's defined benefit plan for years of service with the business. Under the regulations, if the employees were credited with the same service under a plan of the previous owner of the business (previous owner's plan), that plan must be taken into account in applying the overall disparity limits.

 Commentators asked that the provisions for applying the overall disparity limits in an offset arrangement be available when the new employer credits past service with the business and offsets benefits under its plan by the benefits accrued under the previous owner's plan. Commentators also asked that the overall disparity limits be applied to the current employer's plan without regard to any plan maintained by a previous owner because in many cases the current employer does not know the level of disparity provided in a previous owner's plan or even whether such a plan exists.

 The final regulations change the rule for offset arrangements to apply to an offset by benefits under a previous owner's plan. However, the regulations do not allow a previous owner's plan to be disregarded in applying the overall disparity limits. The Treasury and the Service recognize that information on a previous owner's plan is not always available to the current employer. However, allowing the current plan to provide disparity for years of service with the previous owner, without regard to whether the previous owner's plan also provided disparity for those years, would be inconsistent with the statutory disparity limits. Moreover, as a result of the change noted above, the current employer can comply with the overall disparity limits by offsetting benefits under its plan by benefits under the previous owner's plan, thus avoiding in most cases the need to determine disparity fractions under the previous owner's plan, or by limiting the service taken into account under its plan to service after the date of acquisition.

d. DISPARITY FRACTION FOR PRE-1989 YEARS

 Commentators have stated that application of a disparity fraction of one for an employee's years of service before 1989 is inappropriate in the case of a new plan that applies a formula satisfying section 401(l) to all years of service because no other disparity has been provided for those years. The regulations clarify that the deemed one rule applies to plans in existence as of the end of the 1988 plan year. Thus, if, before the first plan year beginning on or after January 1, 1989, an employee never participated in or benefited under any other plan of the employer, the employee's total annual disparity fractions are determined under the generally applicable overall permitted disparity rules (and without regard to the deemed one rule).

3. RELATIONSHIP TO OTHER REQUIREMENTS

 The regulations provide that compliance with section 401(l) does not allow a plan to decrease any employee's accrued benefit in violation of section 411(d)(6) and section 411(b)(l)(G). Commentators requested removal of the reference in the proposed regulations to an increase in covered compensation as an example of a decrease in accrued benefit. They believe section 411 does not prohibit a decrease in accrued benefit resulting solely from an increase in covered compensation.

 After considering the comments, the Treasury and the Service have determined that the regulations under section 401(l) are not the proper vehicle for addressing the correct application of section 411 to this situation. Accordingly, the reference to an increase in covered compensation has been removed from the regulations, but no inference should be drawn from this revision as to the correct interpretation of section 411.

4. PIA OFFSET SAFE HARBOR

 These regulations implement the PIA offset safe harbor described in Notice 92-32, 1992-2 C.B. 362. The regulations allow a PIA offset plan to satisfy section 401(l) (and thus to satisfy the nondiscriminatory amount requirement under section 401(a)(4) on a safe harbor basis) if the plan limits the offset to the maximum offset permitted under section 401(l) (the section 401(l) overlay), which is determined as a percentage of covered compensation rather than PIA.

 Commentators asked that certain PIA offset plan designs be allowed to satisfy section 401(a)(4) on a safe harbor basis without having to apply the section 401(l) overlay. They stated that these plans (i.e., those with low offset percentages relative to the gross benefit) easily satisfy the general test for defined benefit plans under section 401(a)(4) and should be spared the necessity of actually performing the test.

 The Treasury and the Service have carefully considered these comments regarding PIA offset plans, but believe that application of the section 401(l) overlay is essential to carrying out the statutory purpose of section 401(l) in a safe harbor context. In addition, the fact that such a plan passes the general test today does not ensure that it will pass in the future. Future changes in the relationship between covered compensation and PIA may change the results of the general test. Finally, the section 401(l) overlay eliminates the need to limit the PIA offset percentage to take into account early retirement benefits and other distribution alternatives under the plan, thus permitting the obsolescence of many revenue rulings issued under prior law. However, Rev. Rul. 84A5, 1984-1 C.B. 115, continues to apply in determining the compensation history on which an employee's PIA can be based.

EFFECTIVE DATES

 The regulations generally are effective for plan years beginning on or after January 1, 1994, or, in the case of plans maintained by tax-exempt organizations, for plan years beginning on or after January 1, 1996. For plan years beginning on or after January 1989, and before the applicable regulatory effective date, section 1.401(l)-6(c) provides that a plan must be operated in accordance with a reasonable, good faith interpretation of section 401(l). Whether a plan is operated in accordance with a reasonable, good faith interpretation of section 401(l) will generally be determined based on all of the relevant facts and circumstances, including the extent to which an employer has resolved unclear issues in its favor. A plan will be deemed to be operated in accordance with a reasonable, good faith interpretation of section 401(l) if it is operated in accordance with these final regulations, the April 1993 proposed regulations, the September 1991 regulations, the May 1990 proposed section 401(l) regulations, or the November 1988 proposed section 401(l) regulations.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking was submitted to the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these final regulations is Patricia McDermott of the Office of the Associate Chief Counsel (Employee Benefits and Exempt Organizations), Internal Revenue Service. However, personnel from other offices of the Service and the Treasury Department participated in their development.

LIST OF SUBJECTS IN 26 CFR PART 1

 Income taxes, Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.401(a)(5)-1 is amended by:

1. Removing paragraph (e)(7);

2. Redesignating paragraph (e)(8) as (e)(7);

3. Adding paragraph (h) to read as follows:

SECTION 1.401(a)(5)-1 SPECIAL RULES RELATING TO NONDISCRIMINATION REQUIREMENTS

(h) EFFECTIVE DATE -- (1) IN GENERAL. Except as provided in paragraph (h)(2) of this section, this section is effective for plan years beginning on or after January 1, 1994.

(2) PLANS OF TAX-EXEMPT ORGANIZATIONS. In the case of plans maintained by organizations exempt from income taxation under section 501(a), including plans subject to section 403(b)(12)(A)(i) (nonelective plans), this section is effective for plan years beginning on or after January 1, 1996.

(3) COMPLIANCE DURING TRANSITION PERIOD. For plan years beginning before the effective date of these regulations, as set forth in paragraphs (h)(1) and (h)(2) of this section, and on or after the first day of the first plan year to which the amendments made to section 401(a)(5) by section 1111(b) of the Tax Reform Act of 1986 (TRA '86) apply, a plan must be operated in accordance with a reasonable, good faith interpretation of section 401(a)(5), taking into account pre-existing guidance and the amendments made by TRA '86 to related provisions of the Code. Whether a plan is operated in accordance with a reasonable, good faith interpretation of section 401(a)(5) will generally be determined based on all of the relevant facts and circumstances, including the extent to which an employer has resolved unclear issues in its favor. A plan will be deemed to be operated in accordance with a reasonable, good faith interpretation of section 401(a)(5) if it is operated in accordance with the terms of this section.

Par. 3. Section 1.401(l)-0 is amended by:

1. Removing the entries for section 1.401(l)-1, paragraphs (b)(l) and (2).

2. Revising the entry for section 1.401(l)-1, paragraph (c)(6).

3. Redesignating the entries for section 1.401(l)-1, paragraphs (c)(22) through (c)(24) and paragraphs (c)(25) through (c)(33), as section 1.401(l)-1, paragraphs (c)(23) through (c)(25) and (c)(27) through (c)(35) respectively.

4. Adding entries for section 1.401(l)-1, new paragraphs (c)(22) and (c)(26).

5. Adding entries for section 1.401(l)-3, paragraphs (c)(2)(vi)(A), (B) and (C), (c)(2)(ix), and (d)(8)(iii)(D).

6. Removing the entry for section 1.401(l)-3, paragraph (e)(4), and redesignating the entries for section 1.401(l)-3, paragraphs (e)(5) and (e)(6), as section 1.401(l)-3, paragraphs (e)(4) and (e)(5), respectively.

7. Revising the entry for section 1.401(l)-3, paragraph (g).

8. Adding entries for section 1.401(l)-5, paragraphs (b)(5)(i) and (ii), (b)(8)(v), and (c)(1)(v) and (vi).

9. Removing the entries for section 1.401(l)-5, paragraphs (c)(3)(i) and (ii).

10. Redesignating the entry for section 1.401(l)-5, paragraph (c)(4), as section 1.401(l)-5, paragraph (c)(5).

11. Adding entries for section 1.401(l)-5, new paragraphs (c)(4), (c)(4)(i), (c)(4)(i)(A), (c)(4)(i)(B), (c)(4)(i)(C), (c)(4) (ii), (c)(4)(ii)(A), (c)(4)(ii)(B), and (c)(4)(ii)(C).

12. Revising the entries for section 1.401(l)-6, paragraphs (a) through (c).

13. Removing the entry for section 1.401(l)-6, paragraph (d).

14. The added and revised entries read as follows:

SECTION 1.401(l)-0 TABLE OF CONTENTS.

* * * * *

SECTION 1.401(l)-1 PERMITTED DISPARITY WITH RESPECT TO EMPLOYER- PROVIDED CONTRIBUTIONS OR BENEFITS.

* * * * *

(c) * * *

(6) Benefit, right, or feature.

* * * * *

(22) Nonhighly compensated employee.

* * * * *

(26) PIA.

* * * * *

SECTION 1.401(l)-3 PERMITTED DISPARITY FOR DEFINED BENEFIT PLANS.

* * * * *

(c) * * *

(2) * * *

(vi) * * *

(A) In general.

(B) Unit credit plans.

(C) Fractional accrual plans.

* * * * *

(ix) PIA offsets.

* * * * *

(d) * * *

(8) * * *

(iii) * * *

(D) Individual disparity reductions.

* * * * *

(g) No reductions in 0.75-percent factor for ancillary benefits.

* * * * *

SECTION 1.401(l)-5 OVERALL PERMITTED DISPARITY LIMITS.

* * * * *

(b) * * *

(5) * * *

(i) In general.

(ii) PIA offset plans.

* * * * *

(8) * * *

(v) Fractional accrual plans.

* * * * *

(c) * * *

(1) * * *

(v) Applicable plan years.

(vi) Transition rule for defined contribution plans.

* * * * *

(4) Special rules for greater of formulas and offset arrangements.

(i) Greater of formulas.

(A) In general.

(B) Separate satisfaction by formulas.

(C) Single plan.

(ii) Offset arrangements.

(A) In general.

(B) Separate satisfaction by plans.

(C) No other plan.

* * * * *

SECTION 1.401(l)-6 EFFECTIVE DATES AND TRANSITION RULES.

(a) Statutory effective date.

(1) In general.

(2) Collectively bargained plans.

(b) Regulatory effective date.

(1) In general.

(2) Plans of tax-exempt organizations.

(3) Defined contribution plans.

(4) Defined benefit plans.

(c) Compliance during transition period.

Par. 4. Section 1.401(l)-1 is amended as follows:

1. The fourth sentence of paragraph (a)(1) is amended by removing the reference "1.401(a)(4)-2(b)(3)" and adding "1.401(a)(4)- 2(b)(2)" in its place.

2. The last sentence of paragraph (a)(3) is removed.

3. Paragraph (b) is revised.

4. Paragraphs (c)(2), (c)(6), (c)(9), (c)(17)(i), (c)(19), and (c)(21) are revised.

5. Paragraphs (c)(22) through (c)(24) and paragraphs (c)(25) through (c)(33) are redesignated as (c)(23) through (c)(25) and (c)(27) through (c)(35) respectively, and new paragraphs (c)(22) and (c)(26) are added.

6. Newly designated paragraph (c)(35) is revised.

7. The additions and revisions read as follows:

SECTION 1.401(l)-1 PERMITTED DISPARITY IN EMPLOYER-PROVIDED CONTRIBUTIONS OR BENEFITS.

* * * * *

(b) RELATIONSHIP TO OTHER REQUIREMENTS. Unless explicitly provided otherwise, section 401(l) does not provide an exception to any other requirement under section 401(a). Thus, for example, even if the plan complies with section 401(l), the plan may not provide a benefit lower than the minimum benefit required under section 416. Moreover, a plan may not adjust benefits in any manner that results in a decrease in any employee's accrued benefit in violation of section 41 1(d)(6) and section 411(b)(1)(G). However, a plan does not fail to satisfy section 401(l) merely because, in order to ensure compliance with section 411, an employee's accrued benefit under the plan is defined as the greater of the employee's previously accrued benefit and the benefit determined under a strict application of the plan's benefit formula and accrual method. See section 401(a)(15) for additional rules relating to circumstances under which plan benefits may not be decreased because of increases in social security benefits.

(c) * * *

(2) AVERAGE ANNUAL COMPENSATION. AVERAGE ANNUAL COMPENSATION means average annual compensation within the meaning of section 1.401(a)(4)-3(e)(2).

(6) BENEFIT, RIGHT, OR FEATURE. BENEFIT, RIGHT, OR FEATURE means a benefit, right, or feature within the meaning of section 1.401(a)(4)-12.

* * * * *

(9) DEFINED CONTRIBUTION PLAN. DEFINED CONTRIBUTION PLAN means a defined contribution plan within the meaning of section 1.410(b)-9. In addition, for purposes of sections 1.401(l)-1 through 1.401(l)-6, a defined contribution plan includes a simplified employee pension as defined in section 408(k) (SEP), other than a SEP (or portion or a SEP) that is a salary reduction arrangement described in section 408(k)(6) (SARSEP).

* * * * *

(17) FINAL AVERAGE COMPENSATION -- (i) IN GENERAL. FINAL AVERAGE COMPENSATION for an employee means the average of the employee's annual section 414(s) compensation for the 3-consecutive-year period ending with or within the plan year or for the employee's period of employment if shorter. The year in which an employee terminates employment may be disregarded in determining final average compensation. The definition of final average compensation used in the plan must be applied consistently with respect to all employees. For example, if the plan provides that the year in which the employee terminates employment is disregarded in determining final average compensation, the year must be disregarded for all employees who terminate employment in that year. The plan may specify any 3-consecutive-year period ending in the plan year, provided the period is determined consistently for all employees. See section 1.401(a)(4)-11(d)(3)(iii) and section 1.414(s)-1(f) for rules permitting service and compensation with another employer to be taken into account for purposes of nondiscrimination testing, including satisfying section 401(l).

* * * * *

(19) HIGHLY COMPENSATED EMPLOYEE. HIGHLY COMPENSATED EMPLOYEE means HCE within the meaning of section 1.401(a)(4)-12.

* * * * *

(21) NONEXCLUDABLE EMPLOYEE. NONEXCLUDABLE EMPLOYEE means nonexcludable employee within the meaning of section 1.401(a)(4)-12.

(22) NONHIGHLY COMPENSATED EMPLOYEE. NONHIGHLY COMPENSATED EMPLOYEE means NHCE within the meaning of section 1.401(a)(4)-12.

* * * * *

(26) PIA. PIA or PRIMARY INSURANCE AMOUNT means the old-age insurance benefit under section 202 of the Social Security Act (42 U.S.C. 402) payable to each employee at a single age that is not earlier than age 62 and not later than age 65. PIA must be determined under the Social Security Act as in effect at the time the employee's offset is determined. Thus, it is determined without assuming any future increases in compensation, any future increases in the taxable wage base, any changes in the formulas used under the Social Security Act to determine PIA (for example, changes in the breakpoints), or any future increases m the consumer price index. However, it may be assumed that the employee will continue to receive compensation at the same rate as that received at the time the offset is being determined, until reaching the single age described in the first sentence of this paragraph (c)(26). PIA must be determined in a consistent manner for all employees and in accordance with revenue rulings or other guidance provided by the Commissioner.

* * * * *

(35) YEAR OF SERVICE. YEAR OF SERVICE means a year of service as defined in the plan for purposes of the benefit formula and the accrual method under the plan, unless the context clearly indicates otherwise. See section 1.401(a)(4)-11(d)(3) for rules on years of service that may be taken into account for purposes of nondiscrimination testing, including satisfying section 401(l).

Par. 5. Section 1.401(l)-2 is amended as follows:

1. The second sentence of paragraph (a)(1) is amended by removing the reference "1.401(a)(4)-2(b)(5)" and adding "1.401(a)(4)- 2(b)(4)" in its place.

2. The third sentence of paragraph (a)(1) is amended by removing the reference "1.401(a)(4)-8(b)(3)(i)(E)" and adding "1.401 (a)(4)- 8(b)(3)(i)(C)" in its place.

Par. 6. Section 1.401(l)-3 is amended as follows:

1. The second sentence of paragraph (a)(1) is amended by removing the reference "1.401(a)(4)-3(b)(8)" and adding "1.401(a)(4)- 3(b)(6)" in its place.

2. The third sentence of paragraph (a)(1) is amended by removing the reference "1.401(a)(4)-3(b)(7)(viii)" and adding "1.401(a)(4)- 3(b)(5)(viii)" in its place.

3. The first sentence of paragraph (b)(4)(iii)(C) is amended by removing the reference "1.401(a)(4)-3(d)(5)(iv)" and adding "1.401(a)(4)-12" in its place.

4. Paragraph (b)(4)(iii)(E) is revised.

5. Example 9 in paragraph (b)(5) is revised.

6. Paragraph (c)(2)(i) is amended by removing the reference "paragraphs (c)(2)(ii) through (viii)" and adding "paragraphs (c)(2)(ii) through (ix)" in its place.

7. Paragraph (c)(2)(ii) is amended by removing the reference "or 1.401(a)(4)-3(b)(5)(i)(B)".

8. Paragraph (c)(2)(iii) is amended by removing the reference "or 1.401(a)(4)-3(b)(5)(i)(B)".

9. Paragraph (c)(2)(vi) is revised.

10. Paragraph (c)(2)(ix) is added.

11. EXAMPLE 2 in paragraph (c)(3) is amended by removing the reference "1.401(a)(4)-3(b)(5)(i)(B)" and adding "1.401(a)(4)- 3(b)(4)(i)(B)" in its place.

12. Paragraph (d)(8)(iii) introductory text is revised.

13. Paragraph (d)(8)(iii)(D) is added.

14. Paragraph (e)(1) is amended by removing the reference "(e)(4)" from the second sentence and adding "(g)" in its place and by removing the reference "(e)(5)" from the fourth sentence and adding "(e)(4)" in its place.

15. Paragraph (e)(4) is removed and paragraphs (e)(5) and (e)(6) are redesignated as paragraphs (e)(4) and (e)(5) respectively.

16. Newly designated paragraph (e)(4)(i) is amended by removing the reference "(e)(5)(ii)" and adding "(e)(4)(ii)" in its place.

17. Newly designated paragraph (e)(4)(ii) is amended by removing the reference "(e)(5)(ii)" and adding "(e)(4)(ii)" in its place.

18. EXAMPLE 6 in newly designated paragraph (e)(5) is amended by removing the phrase "(other than a temporary disability benefit)" from the seventh sentence.

19. Paragraph (g) and paragraph (h) are revised.

20. The added and revised provisions read as follows:

SECTION 1.401(l)-3 PERMITTED DISPARITY FOR DEFINED BENEFIT PLANS.

* * * * *

(b) * * *

(4) * * *

(iii) * * *

(E) SECTION 417(e) EXCEPTION. A plan will not fail to satisfy this paragraph (b) merely because the disparity in a benefit that is subject to the interest rate restrictions of sections 401(a)(11) and 417(e) exceeds the maximum disparity that would otherwise be allowed under this paragraph (b) if the increase in disparity is required to satisfy section 1.417(e)-1(d). In applying the exception in this paragraph (b)(4)(iii)(E), for purposes of determining what is required under section 1.417(e)-1(d), a plan may use the rate described in section 1.417(e)-1(d)(2)(i) for all employees, without regard to whether the present value of an employee's vested benefit exceeds $25,000.

(5) * * *

EXAMPLE 9. Plan U is a defined benefit excess plan that provides a normal retirement benefit of 1.0 percent of average annual compensation up to the integration level, plus 1.7 percent of average annual compensation in excess of the integration level, for each year of service up to 35, payable in the form of a straight life annuity. Plan U provides a single sum optional form of benefit at normal retirement age equal to 100 times the monthly annuity payable at that age. Thus, if an employee elects the single sum optional form of benefit, the base portion of the single sum benefit is 8.33 percent (100 times 1.0 percent/12) of average annual compensation up to the integration level per year of service, and the excess portion of the single sum benefit is 14. 17 percent (100 times 1.7 percent/12) of average annual compensation in excess of the integration level per year of service. Each respective portion of the single sum option is normalized to a straight life annuity commencing at normal retirement age, using 8-percent interest and the UP-84 mortality table. After normalization, the base portion of the benefit is 1.02 percent of average annual compensation up to the integration level, and the excess portion of the benefit is 1.73 percent of average annual compensation in excess of the integration level. The single sum optional form of benefit satisfies this paragraph (b) because the disparity provided in the optional form of benefit does not exceed the maximum excess allowance.

(c) * * *

(2) * * *

(vi) OVERALL PERMITTED DISPARITY -- (A) IN GENERAL. The benefit formula provides that, with respect to each employee's years of service after reaching the cumulative permitted disparity limit applicable to the employee under section 1.401(l)-5(c), employer- provided benefits are determined with respect to the employee's total average annual compensation at a rate equal to the nondisparate percentage. For purposes of this paragraph (c)(2)(vi), the nondisparate percentage is generally the excess benefit percentage or gross benefit percentage otherwise applicable under the benefit formula to an employee with the same number of years of service.

(B) UNIT CREDIT PLANS. In the case of a unit credit plan described in section 1.401(a)(4)-3(b)(3), if the 411(b)(1)(B) limit percentage is less than the nondisparate percentage, the 41 1(b)(1)(B) limit percentage must be substituted for the nondisparate percentage. For this purpose, the 41 1(b)(1)(B) limit percentage is 133-1/3 percent of the smallest base benefit percentage, or 133-1/3 percent of the smallest difference between the gross benefit percentage and the offset percentage, whichever is applicable, where the smallest base benefit percentage or difference is determined by reference to the benefit formula as applied to employees with no more years of service than the employee.

(C) FRACTIONAL ACCRUAL PLANS. In the case of a fractional accrual plan described in section 1.401(a)(4)-3(b)(4), the benefit formula must provide for the nondisparate percentage with respect to years of service after the employee would reach the cumulative permitted disparity limit applicable to the employee under section 1.401(l)-5(c) as modified by this paragraph (c)(2)(vi)(C). Solely for purposes of this paragraph (c)(2)(vi)(C), the employee's annual disparity fractions (and thus the year in which the employee would reach the cumulative permitted disparity limit) are determined using the disparity provided under the benefit formula (rather than the special rule for fractional accrual plans in section 1.401(l)- 5(b)(8)(v)).

* * * * *

(ix) PIA OFFSETS. In the case of an offset plan, the plan provides that the offset applied to each employee's benefit is the lesser of a specified percentage of the employee's PIA and an offset that otherwise satisfies the requirements of this section (the "section 401(l) overlay"). The specified percentage of PIA must be the same for all employees with the same number of years of service. In the case of a plan that determines each employee's accrued benefit under the fractional accrual method of section 411(b)(1)(C), the specified percentage of PIA is deemed to be the same for all employees with the same number of years of service if the plan satisfies either of the deemed uniformity rules in paragraph (c)(2)(ii) or (iii) of this section, substituting "offset, expressed as a percentage of PIA, per year of service" for the term "offset percentage" (in addition to satisfying either of those rules with respect to the section 401(l) overlay).

* * * * *

(d) * * *

(8) * * *

(iii) NONDISCRIMINATION REQUIREMENT. The requirement of this paragraph (d)(8)(iii) is satisfied only if at least one of the following tests in paragraphs (d)(8)(iii)(A) through (D) of this section is satisfied.

* * * * *

(D) INDIVIDUAL DISPARITY REDUCTIONS. This test is satisfied only if the plan is an offset plan that uses an offset level of each employee's final average compensation and makes individual disparity reductions as permitted under paragraph (d)(9)(iii)(B) of this section.

* * * * *

(g) NO REDUCTIONS IN 0.75-PERCENT FACTOR FOR ANCILLARY BENEFITS. For purposes of applying the maximum excess allowance or the maximum offset allowance under paragraph (b)(2) or (3) of this section, no reduction is made to the 0.75-percent factor merely because the plan provides disparity in qualified disability benefits (within the meaning of section 411(a)(9)) or preretirement death benefits and the relevant benefits are payable before an employee's social security retirement age.

(h) BENEFITS ATTRIBUTABLE TO EMPLOYEE CONTRIBUTIONS NOT TAKEN INTO ACCOUNT. Benefits attributable to employee contributions to a defined benefit plan are not taken into account in determining whether the disparity provided under a defined benefit excess plan or an offset plan exceeds the maximum permitted disparity described in paragraph (b)of this section. See section 1.401(a)(4)-6(b) for methods of determining the employer-provided benefit under a plan that includes employee contributions not allocated to separate accounts (i.e., a contributory DB plan), including section 1.401(a)(4)-6(b)(2)(iii)(B) for adjustments to the base and excess benefit percentages or the gross benefit percentage under a section 401(l) plan. If, after adjustment, the employee's base benefit percentage or gross benefit percentage (whichever is applicable) is less than zero, such percentage is deemed to be zero for purposes of the maximum excess allowance or maximum offset allowance under paragraph (b)(2) or (3) of this section.

* * * * *

Par. 7. Section 1.401(l)-5 is amended as follows:

1. Paragraph (b)(5) is revised.

2. Paragraph (b)(8)(iii)(A) is revised by removing the words "of the employer" and adding "taken into account under paragraph (a)(3) of this section as" in their place.

3. Paragraph (b)(8)(v) is added.

4. Paragraphs (c)(1)(i) through (iii) are revised and new paragraphs (c)(1)(v) and (vi) are added.

5. Paragraph (c)(2) is amended by removing the reference "(b)(3)" and adding "(b)(2)" in its place.

6. Paragraph (c)(3) is revised.

7. Paragraph (c)(4) is redesignated as paragraph (c)(5) and a new paragraph (c)(4) is added.

8. Newly designated paragraph (c)(5) is amended by removing the language "paragraph (b)(2) or (b)(3) of this section" from the third sentence and adding "section 1.401(l)-3(b)(2) or (3)" in its place and by adding a new Example 5.

9. The added and revised provisions read as follows:

SECTION 1.401(l)-5 OVERALL PERMITTED DISPARITY LIMITS.

* * * * *

(b) * * *

(5) ANNUAL OFFSET PLAN DISPARITY FRACTION -- (i) IN GENERAL. For a plan year, the annual offset plan disparity fraction for an employee benefiting under an offset plan that is a section 401(l) plan is a fraction --

(A) The numerator of which is the disparity provided under the plan for the plan year; and

(B) The denominator of which is the maximum offset allowance under section 1.401(l)-3(b)(3) for the plan year.

(ii) PIA OFFSET PLANS. In the case of an offset plan that applies an offset of a specified percentage of the employee's PIA, as permitted under section 1.401(l)-3(c)(2)(ix), the numerator of the annual offset plan disparity fraction is the offset percentage used in the section 401(l) overlay under the plan.

* * * * *

(8) * * *

(v) FRACTIONAL ACCRUAL PLANS. If a section 401(l) plan determines each employee's accrued benefit under the fractional accrual method of section 411(b)(1)(C), the numerator of an employee's annual disparity fraction is based on the disparity provided in the benefit accrued for the employee for the plan year.

(c) CUMULATIVE PERMITTED DISPARITY LIMIT -- (1) IN GENERAL -- (i) EMPLOYEES WHO BENEFIT UNDER DEFINED BENEFIT PLANS. In the case of an employee who has benefited under one or more defined benefit plans for a plan year described in paragraph (c)(1)(v) of this section, the cumulative permitted disparity limit is satisfied if the employee's cumulative disparity fraction, as defined in paragraph (c)(2) of this section, does not exceed 35.

(ii) EMPLOYEES WHO DO NOT BENEFIT UNDER DEFINED BENEFIT PLANS. In the case of an employee who has not benefited under a defined benefit plan for any plan year described in paragraph (c)(1)(v) of this section, the cumulative permitted disparity limit is satisfied.

(iii) CERTAIN PLAN YEARS DISREGARDED. For purposes of this paragraph (c), an employee is not treated as benefiting under a defined benefit plan for a plan year described in paragraph (c)(1)(v) of this section if the employer can establish that for that plan year the defined benefit plan was not a section 401(l) plan and did not impute permitted disparity under section 1.401(a)(4)-7.

* * * * *

(v) APPLICABLE PLAN YEARS. In applying paragraphs (c)(1)(i), (ii), and (iii) of this section, for purposes of determining whether an employee benefits under a defined benefit plan, the applicable plan years are all plan years that begin on or after the regulatory effective date, as set forth in section 1.401(l)-6(b), or, in the case of governmental plans, as set forth in section 1.401(a)(4)- 13(b).

(vi) TRANSITION RULE FOR DEFINED CONTRIBUTION PLANS. A defined contribution plan is deemed to satisfy the cumulative permitted disparity limit for the first plan year to which these regulations apply, as set forth in section 1.401(l)-6(b), or, in the case of governmental plans, as set forth in section 1.401(a)(4)-13(b).

* * * * *

(3) DETERMINATION OF TOTAL ANNUAL DISPARITY FRACTIONS FOR PRIOR YEARS. For each of the employee's years of service credited as of the end of the last plan year beginning before January 1, 1989, not to exceed 35, under all plans as of that time that are taken into account under paragraph (a)(3) of this section (whether or not terminated), the employee's total annual disparity fraction is one. Therefore, if, before the first plan year beginning on or after January 1, 1989, an employee never participated in or benefited under any plan taken into account under paragraph (a)(3) of this section, the employee's total annual disparity fractions are determined without regard to this paragraph (c)(3). An employer may apply the rule in this paragraph (c)(3) with respect to all employees, using a year (including the current year) that is chosen by the employer and is later than 1989. Thus, for example, in lieu of calculating annual disparity fractions for all plan years, the employer may assume that the full disparity limit has been used in each prior plan year for which an employee has been credited with a year of service.

(4) SPECIAL RULES FOR GREATER OF FORMULAS AND OFFSET ARRANGEMENTS -- (i) GREATER OF FORMULAS -- (A) IN GENERAL. A defined benefit plan that is a section 401(l) plan and that provides a benefit equal to the greater of the benefits determined under two or more formulas is deemed to satisfy the cumulative permitted disparity limit with respect to an employee if each of the requirements in paragraphs (c)(4)(i)(B) and (C) of this section is satisfied. For this purpose, a plan that uses a fresh-start formula that determines the accrued benefit as the greater of two amounts under section 1.401 (a)(4)-13(c)(4)(ii) or (iii) provides a benefit equal to the greater of the benefits determined under two or more formulas.

(B) SEPARATE SATISFACTION BY FORMULAS. Each formula under the plan would satisfy the cumulative permitted disparity limit if it were the only formula under the plan. In the case of a current formula that applies to the employee's total years of service (as, for example, under section 1.401(a)(4)-13(c)(4)(ii)(B) or (iii)(B)), for purposes of determining whether that formula would satisfy the cumulative permitted disparity limit if it were the only formula under the plan, the special rule for prior years under paragraph (c)(3) of this section may be disregarded.

(C) SINGLE PLAN. The employee has never benefited under another plan taken into account under paragraph (a)(3) of this section that is a section 401(l) plan or that satisfies section 401(a)(4) by relying on section 1.401(a)(4)-7. For this purpose, if the benefit under the plan is offset in an offset arrangement described in paragraph (b)(8)(iii)(B) of this section, the other plan is disregarded. In addition, a plan does not fail the requirements of this paragraph (c)(4)(i)(C) merely because the employee benefits under another defined benefit plan, provided that --

(1) With respect to each benefit formula under the plan, no years of service taken into account under that benefit formula are taken into account under a benefit formula of the other plan; and

(2) Paragraph (c)(4)(i)(B) of this section would be satisfied if the plans were treated as a single plan that provided a benefit equal to the greater of the benefits provided under two or more formulas. For this purpose, a formula consists of the sum of a formula for the years of service taken into account under one plan and a formula for the years of service taken into account under the other plan. Thus, each possible combination of the formulas under the plans must satisfy paragraph (c)(4)(i)(B) of this section.

(ii) OFFSET ARRANGEMENTS -- (A) IN GENERAL. If a defined benefit plan is a section 401(l) plan and the benefit under the plan (the gross benefit plan) is offset by the benefit under another plan (the offsetting plan) in an offset arrangement described in paragraph (b)(8)(iii)(B) of this section, the gross benefit plan is deemed to satisfy the cumulative permitted disparity limit with respect to an employee if each of the requirements in paragraphs (c)(4)(ii)(B) and (C) of this section is satisfied.

(B) SEPARATE SATISFACTION BY PLANS. This requirement is satisfied if the gross benefit plan would satisfy the cumulative disparity limit if no offset applied, and the offsetting plan satisfies the cumulative permitted disparity limit, not taking into account the gross benefit plan.

(C) NO OTHER PLAN. Except for the plans in the offset arrangement, the employee has never benefited under another plan taken into account under paragraph (a)(3) of this section that is a section 401(l) plan or that satisfies section 401(a)(4) by relying on section 1.401(a)(4)-7. An offset arrangement does not fail the requirements of this paragraph (c)(4)(ii)(C) merely because the employee benefits under another defined benefit plan, provided no years of service taken into account under a benefit formula of any plan in the offset arrangement are also taken into account under a benefit formula of the other plan.

(5) * * *

EXAMPLE 5. (a) Plan O is a noncontributory defined benefit excess plan. Plan O provides an employee whose social security retirement age is 65 with the greater of the benefits determined under two formulas. The first formula provides a benefit of 1 percent of average annual compensation up to covered compensation, plus 1.75 percent of average annual compensation above covered compensation, for each year of service up to 35. The second formula provides a benefit of 1 percent of average annual compensation up to covered compensation, plus 1.6 percent of average annual compensation above covered compensation, for each year of service up to 40.

(b) Under paragraph (b)(4) of this section, an employee's annual defined benefit excess plan fraction for each of the 35 years under the first formula is 0.75/0.75 or one, and an employee's annual defined benefit excess plan fraction for each of the 40 years under the second formula is 0.6/0.75 or 0.8. Under paragraph (b)(8)(ii) of this section, an employee's annual defined benefit excess plan fraction (and total annual disparity fraction because the employee benefits only under Plan O) for the plan year is the larger fraction under the two formulas or one. Therefore, after 35 years, the employee has a cumulative disparity fraction of 35. The disparity provided under the second formula for years of service after 35 thus exceeds the cumulative permitted disparity limit unless the plan qualifies for the special rule in paragraph (c) (4) (i) of this section.

(c) Assume the condition in paragraph (c)(4)(i)(C) of this section is satisfied because no employee has benefited under another plan taken into account under paragraph (a)(3) of this section. In addition, the largest cumulative disparity fraction possible under the first formula is 35 times one or 35, and the largest cumulative disparity fraction possible under the second formula is 40 times 0.8 or 32. Thus, the requirement of paragraph (c)(4)(i)(B) of this section is also satisfied because each formula would satisfy the cumulative permitted disparity limit if it were the only formula under the plan. Under paragraph (c)(4)(i) of this section, the plan is deemed to satisfy the cumulative permitted disparity limit with respect to an employee whose social security retirement age is 65.

* * * * *

Par. 8. Section 1.401(l)-6 is revised to read as follows:

SECTION 1.401(l)-6 EFFECTIVE DATES AND TRANSITION RULES.

(a) STATUTORY EFFECTIVE DATE -- (1) IN GENERAL. Except as otherwise provided in paragraph (a)(2) of this section, section 401 (a)(5)(C) is effective for plan years beginning on or after January 1, 1989, and section 401(l) is effective with respect to plan years, and benefits attributable to plan years, beginning on or after January 1, 1989. The preceding sentence is applicable to a plan without regard to whether the plan was in existence as of a particular date.

(2) COLLECTIVELY BARGAINED PLANS. (i) In the case of a plan maintained pursuant to 1 or more collective bargaining agreements between employee representatives and 1 or more employers ratified before March 1, 1986, sections 401(a)(5) and 401(l) are applicable for plan years beginning on or after the later of --

(A) January 1, 1989; or

(B) The date on which the last of such collective bargaining agreements terminates (determined without regard to any extension of any such agreement occurring on or after March 1, 1986). However, notwithstanding the preceding sentence, sections 401(a)(5) and 401(l) apply to plans described in this paragraph (a)(2) no later than the first plan year beginning after January 1, 1991.

(ii) For purposes of paragraph (a)(2)(i)(B) of this section, a change made after October 22, 1986, in the terms or conditions of a collectively bargained plan, pursuant to a collective bargaining agreement ratified before March 1, 1986, is not treated as a change in the terms and conditions of the plan.

(iii) In the case of a collectively bargained plan described in paragraph (a)(2)(i) of this section, if the date in paragraph (a)(2)(i)(B) of this section precedes November 15, 1988, then the date in this paragraph (a)(2) is replaced with the date on which the last of any collective bargaining agreements m effect on November 15, 1988, terminates, provided that the plan complies during this period with a reasonable good faith interpretation of section 401(l).

(iv) Whether a plan is maintained pursuant to a collective bargaining agreement is determined under the principles applied under section 1017(c) of the Employee Retirement Income Security Act of 1974. See H.R. Rep. No. 1280, 93d Cong., 2d Sess. 266 (1974). In addition, a plan is not treated as maintained under a collective bargaining agreement unless the employee representatives satisfy section 7701(a)(46) of the Internal Revenue Code after March 31, 1984. See section 301.7701-17T of this chapter for other requirements for a plan to be considered to be collectively bargained.

(b) REGULATORY EFFECTIVE DATE -- (1) IN GENERAL. Except as otherwise provided in paragraph (b)(2) of this section, sections 1.401(l)-1 through 1.401(l)-6 apply to plan years beginning on or after January 1, 1994.

(2) PLANS OF TAX-EXEMPT ORGANIZATIONS. In the case of plans maintained by an organization exempt from income taxation under section 501(a), including plans subject to section 403(b)(12)(A)(i) (nonelective plans), sections 1.401(l)-1 through 1.401(l)-6 apply to plan years beginning on or after January 1, 1996.

(3) DEFINED CONTRIBUTION PLANS. A defined contribution plan satisfies section 401(l) with respect to a plan year beginning on or after the effective date of these regulations, as set forth in paragraphs (b)(1) and (b)(2) of this section, if it satisfies the applicable requirements of sections 1.401(l)-1 through 1.401(l)-5 for the plan year.

(4) DEFINED BENEFIT PLANS. A defined benefit excess plan or offset plan satisfies section 401(l) with respect to all plan years, and benefits attributable to all plan years, beginning on or after the effective date of these regulations, as set forth in paragraphs (b)(1) and (b)(2) of this section, by satisfying the applicable requirements of sections 1.401(l)-1 through 1.401(l)-5 and the requirements of section 1.401(a)(4)-13(c) (and section 1.401(a)(4)- 13(d), if applicable), using a fresh-start date that is on or after December 31, 1988, and before the effective date of these regulations. A defined benefit excess plan or offset plan that does not satisfy section 401(l) with respect to all plan years beginning on or after the effective date of these regulations may, under the rules of section 1.401(a)(4)-13(c) (and section 1.401(a)(4)-13(d), if applicable), satisfy section 401(l) for plan years beginning after a fresh-start date by satisfying the applicable requirements of sections 1.401(l)-1 through 1.401(l)-5 after the fresh-start date.

(c) COMPLIANCE DURING TRANSITION PERIOD. For plan years beginning on or after January 1, 1989, and before the effective date of these regulations, as set forth in paragraph (b) of this section, a plan must be operated in accordance with a reasonable, good faith interpretation of section 401(l). Whether a plan is operated in accordance with a reasonable, good faith interpretation of section 401(l) will generally be determined based on all of the relevant facts and circumstances, including the extent to which an employer has resolved unclear issues in its favor. A plan will be deemed to be operated in accordance with a reasonable, good faith interpretation of section 401(l) if it is operated in accordance with the terms of sections 1.401(l)-1 through 1.401(l)-5.