Clarifying Amendments to Regs on CODAs and Matching Contributions

 [4830-01-u]

 ACTION: Final regulations.

 SUMMARY: This document amends final regulations governing certain cash or deferred arrangements and employee and matching contributions under employee plans. The amendments add cross-references to final regulations relating to nondiscrimination, minimum coverage, and related requirements, since the publication of the final regulations relating to cash or deferred arrangements and employee and matching contributions. The amendments also make various technical corrections to and clarifications of the final regulations governing cash or deferred arrangements and employee and matching contributions under employee plans, the final regulations relating to plan amendments reducing accrued benefits, and the final regulations relating to maximum contributions and benefits.

 EFFECTIVE DATE: August 15, 1991.

 FOR FURTHER INFORMATION CONTACT: Catherine Livingston Fernandez at 202-622-4606 (not a toll-free number).

 SUPPLEMENTARY INFORMATION:

BACKGROUND

Final regulations under sections 401(a)(30), 401(k), 401(m), 402(a)(8), 402(g), 411(d)(6), 415(c), 416, and 4979 of the Internal Revenue Code (Code) were published in the Federal Register on August 15, 1991 (56 FR 40507). Amendments to the final regulations were published in the Federal Register on December 4, 1991 (56 FR 63420). Minor corrections to the final regulations were published in the Federal Register on March 25, 1992 (57 FR 10289), on December 17, 1992 (57 FR 59915), and on March 16, 1993 (58 FR 14150). The final regulations published on August 15, 1991, as amended and corrected on or before March 16, 1993, are referred to herein as "the 1991 Final Regulations."

 Proposed amendments to the 1991 Final Regulations were published in the Federal Register on August 10, 1992 (57 FR 35536), and on January 4, 1993 (58 FR 43). A minor correction to the amendment proposed on January 4, 1993, was published in the Federal Register on March 22, 1993 (58 FR 15312). The amendments made by this document include these previously proposed amendments.

EXPLANATION OF PROVISIONS

1. COORDINATION WITH REGULATIONS UNDER SECTIONS 401(a)(4), 401(a)(17), 410(b), AND 414(s).

 Final regulations under section 401(a)(4) were published in the Federal Register on September 3, 1993 (58 FR 46773). Final regulations under section 401(a)(17) were published in the Federal Register on June 27, 1994 (59 FR 32903). Final regulations under section 410(b) were published in the Federal Register on September 19, 1991 (56 FR 47638). Amendments to the regulations under section 410(b) were published in the Federal Register on December 4, 1991 (56 FR 63420), September 3, 1993 (58 FR 46835), and June 27, 1994 (59 FR 32911). Final regulations under section 414(s) were published in the Federal Register on September 19, 1991 (56 FR 47659). Amendments to the regulations under section 414(s) were published in the Federal Register on September 7, 1993 (58 FR 47061).

 A number of provisions of the final regulations under sections 401(a)(4) and (17), 410(b), and 414(s) affect plans subject to the regulations governing cash or deferred arrangements and employee and matching contributions. The preamble to the 1991 Final Regulations states that "when final regulations are issued under section 410(b), these [section 410(k) and (m)] regulations will be revised to cross- refer to definitions of common applicability under sections 410(b), 401(k), and 401(m)." (56 FR 40507, 40511 (August 15, 1991)). Therefore, this document amends final regulations under sections 401(k) and (m), 402(g), and 4979 by inserting cross-references to the relevant provisions of the regulations under sections 401(a)(4) and (17), 410(b), and 414(s).

2. SCOPE OF THESE AMENDMENTS.

 Questions and comments received with respect to the 1991 Final Regulations have suggested that some technical corrections or clarifications would be helpful. Accordingly, in addition to inserting cross-references as described above, the amendments made by this document (referred to herein as the 1994 Amendments) make a number of technical corrections and clarifications. More significant changes are beyond the scope of this package, but may be considered at a later date. Treasury and the IRS continue to welcome comments concerning the regulations.

3. USE OF TERM "SECTION 401(k) PLAN" TO REFLECT SPECIAL NONDISCRIMINATION TESTING REQUIREMENTS FOR QNECS UNDER SECTIONS 401(a)(4) AND 410(b).

 Among the terms of common applicability under sections 410(b), 401(k), and 401(m) is the term "section 401(k) plan," which is defined in the regulations under sections 401(a)(4) and 410(b). Those regulations define a "section 401(k) plan" as consisting only of the elective contributions under a qualified cash or deferred arrangement (CODA). See section 1.410(b)-9. Qualified nonelective contributions (QNECs) that are used to pass the actual deferral percentage (ADP) test are not treated as part of a section 401(k) plan under those regulations and must be tested separately for nondiscrimination under sections 401(a)(4) and 410(b). See sections 1.401(a)(4)- 1(b)(2)(ii)(B) and 1.410(b)-7(c)(1). Thus, while QNECs may be used to pass the ADP test (and in fact are included in the definition of a CODA under the section 401(k) regulations at section 1.401(k)- 1(b)(4)), they are nonetheless part of a plan separate from the section 401(k) plan for purposes of section 401(a)(4) and 410(b) testing.

 These 1994 Amendments incorporate the term "section 401(k) plan" (defined as described above) into several provisions of the 1991 Final Regulations. This is to reflect the requirement (which is unchanged by the 1994 Amendments) for separate testing of QNECs under sections 401(a)(4) and 410(b). Except in the few places in these regulations where the term "section 401(k) plan" has been used, the regulations continue to use the existing term "cash or deferred arrangement" or "CODA" with its current meaning. Thus, incorporation of the term "section 401(k) plan" in selected provisions of the 1994 Amendments does not affect the testing requirements for qualified CODAs, including the two special nondiscrimination testing rules for QNECs in section 1.401(k)-1(b)(5)(i) and (ii).

 Under the first of these tests, the QNECs used in the ADP test are aggregated with other nonelective contributions as they would be if they had not been used in the ADP test. In accordance with the final regulations under section 410(b), permitted disparity under section 401(l) may be used to demonstrate that these plan contributions satisfy section 401(a)(4). Under the second test, only those QNECs that are not used in the ADP and actual contribution percentage (ACP) tests are taken into account, together with other nonelective contributions, in determining whether section 401(a)(4) is satisfied. Here too permitted disparity may be used.

 A similar term, "section 401(m) plan," has been added by the 1994 Amendments to reflect that QNECs used to pass the ACP test are part of a separate plan for purposes of the nondiscrimination testing required under sections 401(a)(4) and 410(b). Incorporation of the term "section 401(m) plan" does not affect the testing requirements governing employee and matching contributions, including the two special nondiscrimination testing rules in section 1.401(m)- 1(b)(5)(i) and (ii) for QNECs used in the ACP test. These testing rules are similar to the special testing rules which apply to QNECs that are used in the ADP test. Thus under the first test, the QNECs used in the ACP test must be tested under section 401(a)(4) by aggregating them with other nonelective contributions. Under the second test, only those QNECs that are not used in the ACP and ADP tests are taken into account, together with other nonelective contributions, for section 401(a)(4) testing purposes. Permitted disparity may also be used under both tests.

 As an additional matter, the 1994 Amendments specifically state the rule implicit in the 1991 Final Regulations that the same QNECs may not be used to satisfy both the ADP and the ACP tests. See section 1.401(m)-1(b)(4)(ii)(B).

4. PLANS BENEFITING OTHERWISE EXCLUDABLE EMPLOYEES.

 Final regulations under section 410(b) permit separate testing of the portion of a plan benefiting employees who have not satisfied the greatest minimum age and service requirements permitted under section 410(a). See section 1.410(b)-6(b)(3). The 1994 Amendments make clear that a plan may separately test these employees under section 401(k) or (m) without violating the 1991 Final Regulations' prohibition on restructuring, because this separate testing does not constitute restructuring within the meaning of the section 401(a)(4) regulations. Thus, an employer may treat a plan that benefits employees including otherwise excludable employees as two separate plans (one for the otherwise excludable employees and one for all other eligible employees) for purposes of sections 401(k) and (m) and 410(b). See sections 1.401(k)-1(b)(3)(ii) and 1.401(m)-1(b)(3)(ii).

5. RETROACTIVE CORRECTION OF CERTAIN DEFECTS.

 The 1994 Amendments add references to section 1.401(a)(4)- 11(g)(3)(vii), which allows retroactive correction of certain prohibited discrimination in section 401(k) and (m) plans. Section 1.401(a)(4)-11(g)(3)(vii)(A) permits the sponsor of a section 401(k) or 401(m) plan to amend the plan retroactively to satisfy the section 410(b) minimum coverage requirements by allocating QNECs to nonhighly compensated employees who were not eligible under the plan. Section 1.401(a)(4)-11(g)(3)(vii)(B) permits a plan to allocate QNECs to nonhighly compensated employees pursuant to a retroactive amendment in order to satisfy the nondiscriminatory current availability requirement of section 1.401(a)(4)-4(b) with respect to the right to a rate of matching contributions. Since the amount of the added QNECs is based on the ADP or ACP of the group of nonhighly compensated employees who were eligible before the correction, the addition of these QNECs does not change the calculation of the ADP or ACP or the plan's compliance with the ADP or ACP requirements.

 Consistent with the limitations contained in the retroactive correction provisions of section 1.401(a)(4)-11(g), the 1994 Amendments affirm that this section 401(a)(4) retroactive correction method cannot be used to correct excess contributions (amounts that exceed the limits under section 401(k)) or excess aggregate contributions (amounts that exceed the limits under section 401(m)). These contributions may be corrected only in accordance with section 1.401(k)-1(f)(1)(iii) or 1.401(m)-1(e)(1)(iii), respectively. Similarly, excess deferrals (amounts that exceed the limits under section 402(g)) may be corrected only in accordance with section 1.402(g)-1(e).

6. DISTRIBUTIONS UPON PLAN TERMINATION.

 Sections 401(k)(2)(B)(i)(II) and 401(k)(10)(A)(i) permit distributions from a qualified CODA after termination of the plan without the establishment or maintenance of a successor plan by the employer. Section 1.401(k)-1(d)(3) provides that if fewer than two percent of the employees who were eligible under the terminated defined contribution plan that included the CODA are eligible under another plan of the employer during a specified 24-month period, the other plan is not a successor plan. The 1994 Amendments clarify that the number of employees who were eligible under the terminated plan and the identity of the employer are determined as of the date of plan termination. See Rev. Rul. 89-87, 1989-2 C.B. 81, regarding the date of plan termination. Thus, for example, if a plan is terminated as of December 31, 1994, and the plan assets are timely distributed thereafter, then the number of employees who were eligible under the plan is determined as of December 31, 1994. The clarifications of the language relating to these successor plan rules, including the two percent test, are not intended to change the rules governing that test in any way.

7. OTHER BENEFITS NOT CONTINGENT UPON ELECTIVE CONTRIBUTIONS.

 Section 401(k)(4)(A) and section 1.401(k)-1(e)(6) of the 1991 Final Regulations provide that a CODA is a qualified CODA only if no other benefit (other than a matching contribution under section 401(m)) is conditioned (directly or indirectly) upon the employee's electing to make or not to make elective contributions. The 1994 Amendments add two examples to section 1.401(k)-1(e)(6) to respond to frequent questions concerning the application of the contingent benefit rule to two specific arrangements involving relationships between a nonqualified deferred compensation plan and a qualified CODA. These examples illustrate the existing rules, and are not intended to change those rules in any way.

8. COORDINATION OF EXCESS DEFERRALS WITH EXCESS CONTRIBUTIONS.

 The 1994 Amendments amend Example 2 in section 1.402(g)-1(e)(11) to reflect more accurately the rules that coordinate the correction of excess deferrals and excess contributions. Under these rules, excess deferrals that have been distributed to a highly compensated employee serve the purpose of reducing the amount to be distributed as an excess deferral and excess contribution. See sections 1.401(k)- 1(f)(5); 1.402(g)-1(e)(1)(ii). Conversely, excess contributions that have been distributed to a highly compensated employee reduce both the excess contribution and the amount to be distributed as an excess deferral. See sections 1.401(k)-1(f)(5); 1.402(g)-1(e)(6). The statement in Example 2 that further correction was required to pass the ADP test under the facts of the example was inaccurate and has been deleted.

9. DISTRIBUTION OF MATCHING CONTRIBUTIONS RELATED TO EXCESS DEFERRALS, EXCESS CONTRIBUTIONS, AND EXCESS AGGREGATE CONTRIBUTIONS.

 Questions have been raised about the extent to which a matching contribution may be distributed if it relates to an amount that is distributed as an excess contribution, excess deferral, or excess aggregate contribution. Distribution of excess deferrals, excess contributions, or excess aggregate contributions may cause matching contributions related to the distributed amounts to be discriminatory by producing an effective rate of match that discriminates in favor of highly compensated employees. See section 1.401(a)(4)-4(e)(3)(G).

 There are two circumstances under which a matching contribution may be distributed. First, it may be distributed if it is an excess aggregate contribution. In this case, the matching contribution will not be taken into account under section 401(a)(4). Thus, it will not be considered in determining whether there is a discriminatory rate of match. Second, the matching contribution may be distributed on some other permissible basis under the general plan qualification rules applicable to the type of plan under which the matching contribution was made, e.g., attainment of age 59-1/2 under a profit-sharing or stock bonus plan. However, in that case, the amount contributed would still be taken into account under section 401(a)(4), and therefore the distribution, even if timely made, would not correct any failure to satisfy a nondiscrimination requirement, including a discriminatory rate of match. Section 1.401(m)-1(e)(4) has been amended to make this explicit. The 1994 Amendments also explicitly state that a matching contribution may not be distributed simply because it relates to an excess deferral, an excess contribution, or an excess aggregate contribution that is distributed. See section 1.401(m)-1(e)(3)(vii).

 Where a matching contribution relates to an excess deferral, an excess contribution, or an excess aggregate contribution that is distributed, a discriminatory rate of match may result, unless the matching contribution is distributed as an excess aggregate contribution. If the matching contribution cannot be distributed as an excess aggregate contribution, so that the discriminatory rate of match cannot be corrected by distribution, a plan may provide that the matching contributions are forfeited, as permitted by sections 411(a)(3)(G) and 401(k)(8)(E). See sections 1.401(k)-1(f)(5)(iii); 1.401(m)-1(e)(4); 1.411(a)-4(b)(7). Alternatively, the discriminatory rate of match can be corrected by additional allocations to the accounts of nonhighly compensated employees, under section 1.401(a)(4)-11(g)(3)(vii)(B).

10. MULTIPLE USE TEST.

 The 1991 Final Regulations, as amended by the 1994 Amendments, continue to provide that if any highly compensated employee is eligible to participate in both a section 401(k) plan and a section 401(m) plan of an employer, the plans must satisfy the limitation on multiple use of the alternative methods of compliance with the ADP and ACP tests (the 200%/two-percentage-point method, as opposed to the 125% method) that are contained in sections 401(k)(3)(A)(ii)(II) and 401(m)(2)(A)(ii), respectively. Language has been added to section 1.401(m)-1(a)(1) to clarify that if the plans fail to satisfy the multiple use limitation in operation, and the failure is not corrected as permitted by section 1.401(m)-2(c), the section 401(m) plan fails to satisfy section 401(a)(4) and (m).

 An additional clarification in the multiple use rules has been added to section 1.401(m)-2(c)(1). The 1991 Final Regulations provide that multiple use may be corrected by reducing either the ADP or the ACP of the highly compensated employees. The 1994 Amendments clarify that multiple use may also be corrected by reducing a combination of the ADP and the ACP of the highly compensated employees.

11. SAFE HARBOR HARDSHIP WITHDRAWAL PROVISIONS.

 In response to suggestions, the 1994 Amendments expand the safe harbor hardship withdrawal provisions to provide that, in addition to tuition and related educational fees, amounts distributed for the payment of room and board expenses for the next 12 months of post- secondary education will be deemed to be on account of an immediate and heavy financial need. See section 1.401(k)-1(d)(2)(iv)(A)(3).

12. HARDSHIP DISTRIBUTIONS UNDER PROFIT-SHARING OR STOCK BONUS PLANS.

 The 1991 Final Regulations added section 1.411(d)-4, Q&A- 2(b)(2)(x) to make an exception to the protections of section 411(d)(6) and allow a qualified CODA that permits hardship distributions to be amended to specify or modify its standards for making such distributions, or to eliminate hardship distributions. In response to suggestions, the 1994 Amendments now amend this section to allow the same flexibility to any profit-sharing or stock bonus plan that permits hardship distributions. Under this amendment, a profit-sharing or stock bonus plan has this flexibility whether or not the plan limits hardship distributions (either before or after the plan amendment) to the types of hardship distributions that are permitted to be made from a qualified CODA. Hardship distributions under a portion of the plan that is a qualified CODA must be restricted in accordance with section 401(k) and the regulations.

13. EXCISE TAX TRANSITION RELIEF FOR COLLECTIVELY BARGAINED AND GOVERNMENTAL PLANS.

 In accordance with the applicable provisions of the Code, the 1991 Final Regulations provide that elective contributions under a CODA that is part of a collectively bargained plan and that fails the ADP test are includible in employees' gross incomes because the CODA is not qualified. The 1991 Final Regulations provided transition relief by not making this income inclusion effective for plan years beginning before January 1, 1993.

 The question has arisen whether this transition relief from income inclusion for collectively bargained plans would be expanded to cover the section 4979 excise tax on excess contributions. The 1994 Amendments respond by amending section 54.4979-1(d)(3) to provide that the excise tax does not apply to a collectively bargained plan for plan years beginning before January 1, 1993. Thus, for these plan years, a collectively bargained plan need not perform the ADP test for any purpose. Furthermore, the 1994 Amendments explicitly provide that the excise tax does not apply to employee and matching contributions under a collectively bargained plan.

 For governmental plans, the nondiscrimination rules, including the nondiscrimination requirements under sections 401(k) and 401(m), generally do not apply for plan years beginning before January 1, 1996. The proposed amendments to the 1991 Final Regulations reflected this extended effective date. The 1994 Amendments adopt the proposed amendments and also apply the same extended effective date to the section 4979 excise tax.

14. ONE-TIME IRREVOCABLE ELECTIONS.

 The 1991 Final Regulations provide that an employer may allow each of its employees to make a one-time irrevocable election, upon commencement of employment or initial eligibility under any plan of the employer, to have a specified amount or percentage of compensation (including no amount) contributed by the employer throughout the employee's employment. This type of election is not treated as a cash or deferred election. See section 1.401(k)- 1(a)(3)(iv).

 The question has occasionally been raised as to whether such an election could conceivably be made by an employee upon first becoming eligible under a plan even though the employee had previously become eligible under any other ongoing or terminated plan of the employer. The 1994 Amendments make clear that the answer to this question is in the negative. They confirm that the one-time irrevocable election provision was intended to preclude an election from constituting a non-cash-or-deferred election (and thus avoiding the rules governing qualified CODAs) in any case where the electing employee had previously become eligible under another plan of the employer, including a terminated plan, even if the employee is making an election with respect to a plan under which the employee is just then becoming eligible. Thus, an employee can make an election under section 1.401(k)-1(a)(3)(iv) only once during employment with a particular employer (even if, over time, the employee becomes eligible under more than one plan of the employer). This election can be made either (1) upon commencement of employment with the employer, or (2) upon becoming eligible under the plan of the employer under which the employee becomes eligible first.

 The 1991 Final Regulations reiterated a special, additional, one-time election transition rule for plans maintained by partnerships. See section 1.401(k)-1(a)(6)(ii)(C). This transition relief originally had been provided for under Notice 88-127, 1988-2 C.B. 538. See also Rev. Proc. 91-47, 1991-2 C.B. 757. As an alternative to compliance by a plan with the qualified CODA rules, the transition rule was intended to give existing partnership plans a limited period of time (until the later of the first day of the first plan year beginning after December 31, 1988, or March 31, 1989) for employees and partners to make one-time irrevocable elections, even after their commencement of employment or their initial eligibility under the plan or any other plan of the employer. However, occasional questions have been raised since 1989 as to whether this could nonetheless be interpreted as a continuing transition rule for partnerships that might permit such one-time irrevocable elections to be made in the future. The 1994 Amendments explicitly confirm that such elections under the special partnership transition rule may not be made in the future. A partnership may, of course, continue to allow partners and employees to make one-time irrevocable elections under the general rule of section 1.401(k)-1(a)(3)(iv) in the same limited circumstances as any other employer.

15. LIMIT ON ANNUAL ADDITIONS.

 a. CORRECTIVE DISTRIBUTION OF ELECTIVE DEFERRALS.

The 1991 Final Regulations amended section 1.415-6(b)(6) to allow plans to distribute elective deferrals to correct excess annual additions resulting from a reasonable error in determining the amount of elective deferrals that a participant may make under the limits of section 415. A question has arisen as to whether gains (investment gains and other income) attributable to the distributed elective deferrals are treated for section 415 purposes in a manner similar to gains attributable to employee contributions that are returned pursuant to section 1.415-6(b)(6) (which have been explicitly addressed in that regulation since before 1991). The 1994 Amendments make clear that similar treatment is intended, by providing that if gains attributable to the distributed elective deferrals are not also distributed to the employee, the gains will be considered as employer contributions for the limitation year in which the distributed elective deferrals were made. This provision of the 1994 Amendments is effective for limitation years beginning after December 31, 1995.

b. PLAN AMENDMENTS REDUCING ACCRUED BENEFITS TO COMPLY WITH TAX REFORM ACT OF 1986.

The Tax Reform Act of 1986 (TRA '86) generally reduced the amount of benefits that could be provided by a defined benefit plan under the section 415 benefit limitations. The changes generally were effective for limitation years beginning after December 31, 1986. However, section 1106(i)(3) of TRA '86 protected the "current accrued benefit" of an individual who was a participant in a defined benefit plan meeting certain requirements. The "current accrued benefit" was defined as the benefit that accrued before the effective date, not including any benefits under new plans or any benefits resulting from changes in existing plans after May 5, 1986. These additional accruals generally caused plan disqualification when the new limits applied. Notice 87-21, 1987-1 C.B. 458, Q&A-13, illustrated this effect and stated that future regulations would provide section 411(d)(6) relief allowing defined benefit plans to reduce accrued benefits that otherwise would violate the applicable limit. This relief would create an exception to the general section 411(d)(6) prohibition against plan amendments reducing accrued benefits.

 Q&A-17 of Notice 87-21 illustrated that these additional accruals could also result in a violation of the combined limit on contributions and benefits under section 415(e). The combined limit applies to participants covered by both a defined benefit plan and a defined contribution plan. Such a violation could occur even if the defined benefit plan was terminated before the effective date of the section 415 changes, and even if no contributions were made to the defined contribution plan after the effective date.

 The 1991 Final Regulations added section 1.411(d)-4, Q&A- 2(b)(2)(xi) to permit a defined benefit plan to reduce benefits that otherwise would violate the lower section 415(b) limit under TRA '86. These 1994 Amendments now expand this relief by allowing a reduction in benefits under either a defined benefit plan or a defined contribution plan to satisfy the combined limit under section 415(e), which also was reduced as a result of the changes made by TRA '86. This amendment to section 1.411(d)-4, Q&A-2(b)(2)(xi), will also allow a defined contribution plan to reduce a participant's account balance where the defined benefit plan has been terminated and thus can no longer be amended to reduce the participant's benefits. See also section 1.415-6(b)(6), providing methods for correcting excess annual additions to defined contribution plans in certain circumstances.

SPECIAL ANALYSES

 It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment 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)(3) of the Internal Revenue Code, these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Catherine Livingston Fernandez, Office of the Associate Chief Counsel (Employee Benefits and Exempt Organizations), IRS. However, personnel from other offices of the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS IN 26 CFR PART 1

 Income taxes, Reporting and recordkeeping requirements.

Treasury Decision 8581

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(k)-0 is amended as follows:

1. The entries for section 1.401(k)-1, paragraph (b)(3) and (b)(3)(i) and (ii) are revised.

2. The entries for section 1.401(k)-1, paragraph (b)(3)(ii)(A) and (B), and (b)(3)(iii) and (iv) are removed.

3. The entry for section 1.401(k)-1 paragraph (b)(4)(ii) is revised.

4. An entry for section 1.401(k)-1, paragraph (e)(6)(vi) is added.

5. The entries for section 1.401(k)-1, paragraph (g)(11)(i) and (ii) are revised.

6. Entries for section 1.401(k)-1, paragraphs (g)(11)(ii)(A) through (C) are added.

7. The entries for section 1.401(k)-1, paragraphs (g)(11)(iii), (g)(11)(iii)(A) through (D), (g)(11)(iii)(D)(1) and (2), and (g)(11)(iv) are removed.

8. Entries for section 1.401(k)-1, paragraph (g)(15) and (16) are added.

9. The entry for section 1.401(k)-1, paragraph (h)(4)(ii) is revised.

The added and revised entries read as follows:

SECTION 1.401(k)-0 CERTAIN CASH OR DEFERRED ARRANGEMENTS, TABLE OF CONTENTS. * * *

 * * * * *

Par. 3. Section 1.401(k)-1 is amended as follows:

1. Paragraph (a) is amended as follows:

i. Paragraph (a)(3)(iv) is amended by adding a sentence immediately before the last sentence.

ii. Paragraph (a)(3)(v) is revised.

iii. Paragraph (a)(3)(vi), Example 3, is added.

iv. Paragraphs (a)(4)(ii) and (iv), (a)(5)(iv), (a)(6)(ii)(C), and (a)(7)(i) are revised.

2. Paragraph (b) is amended as follows:

i. Paragraphs (b)(1)(i), (ii), and (b)(3) are revised.

ii. Paragraph (b)(4(ii) heading is revised and a sentence is added at the end of the paragraph.

iii. Paragraphs (b)(4)(iv), (b)(5)(i) and (ii) are amended by adding a sentence at the end of each paragraph.

iv. Paragraph (b)(5)(vi) is revised.

v. Paragraph (b)(6) is amended by:

a. Revising Example 2, paragraph (i).

b. Revising Example 3, paragraph (i).

c. Revising Example 4, paragraph (i).

3. Paragraph (d) is amended as follows:

i. Paragraphs (d)(2)(iv)(A)(3), (d)(3), and (d)(4)(i) are revised.

ii. The last sentence of paragraph (d)(5) is revised.

iii. A sentence is added at the end of paragraph (d)(6)(iv).

4. Paragraph (e) is amended as follows:

i. A sentence is added at the end of paragraph (e)(6)(ii).

ii. Paragraph (e)(6)(vi) is added.

iii. Paragraph (e)(7) is revised.

5. Paragraph (f) is amended as follows:

i. Paragraphs (f)(1)(iii), (f)(2), (f)3)(ii), and (f)(3)(iii)(C) are revised.

ii. In paragraph (f)(3)(v), paragraph (i) of the Example is revised.

iii. Paragraph (f)(4)(ii)(B) is revised.

iv. Paragraph (f)(7), paragraph (i) of Example 1, and Examples 2 and 3 are revised.

6. Paragraph (g) is amended as follows:

i. Paragraphs (g)(1)(ii)(B)(1) and (C)(1), and (g)(2)(i) are revised.

ii. A sentence is added at the end of paragraph (g)(4)(ii).

iii. Paragraphs (g)(5), (6) and (11) are revised.

iv. Paragraphs (g)(15) and (16) are added.

7. Paragraphs (h)(3)(iii)(A) and (B)(2), and (h)(4)(ii) are revised.

The added and revised provisions read as follows:

SECTION 1.401(k)-1 CERTAIN CASH OR DEFERRED ARRANGEMENTS.

(a) * * *

(3) * * *

(iv) * * * In no event is an election made after December 23, 1994 treated as a one-time irrevocable election under this paragraph if the election is made by an employee who previously became eligible under another plan (whether or not terminated) of the employer. * * *

(v) TAX TREATMENT OF EMPLOYEES. An amount generally is includible in an employee's gross income for the taxable year in which the employee actually or constructively receives the amount. But for section 402(e)(3) and section 401(k), an employee is treated as having received an amount that is contributed to a plan pursuant to the employee's cash or deferred election. This is the case even if the election to defer is made before the year in which the amount is earned, or before the amount is currently available. See section 1.402(a)-1(d).

(vi) * * *

* * * * *

EXAMPLE 3. (i) Employer A establishes a qualified money purchase pension plan in 1986. This is the first qualified plan established by Employer A. All salaried employees are eligible to participate under the plan. Hourly-paid employees are not eligible to participate under the plan. In 1996, Employer A establishes a profit-sharing plan under which all employees (both salaried and hourly) are eligible. Employer A permits all employees on the effective date of the profit-sharing plan to make a one-time irrevocable election to have Employer A contribute five percent of compensation on their behalf to the plan and to any other plan of Employer A (including plans not yet established) for the duration of the employee's employment with Employer A, and have their salaries reduced by five percent.

(ii) The election provided under the profit-sharing plan is not a one-time irrevocable election within the meaning of section 1.401(k)-1(a)(3)(iv) with respect to the salaried employees of Employer A who, at any time before becoming eligible to participate under the profit-sharing plan, became eligible to participate under the money purchase pension plan. The election under the profit-sharing plan is a one-time irrevocable election within the meaning of section 1.401(k)- 1(a)(3)(iv) with respect to the hourly employees, because they were not previously eligible to participate under another plan of the employer.

(4) * * *

(ii) TREATMENT OF ELECTIVE CONTRIBUTIONS AS EMPLOYER CONTRIBUTIONS. Except as provided in paragraph (f) of this section, elective contributions under a qualified cash or deferred arrangement are treated as employer contributions. Thus, for example, elective contributions are treated as employer contributions for purposes of sections 401(a) and 401(k), 402, 404, 409, 411, 412, 415, 416, and 417.

* * * * *

(iv) APPLICATION OF NONDISCRIMINATION REQUIREMENTS TO PLAN THAT INCLUDES A QUALIFIED CASH OR DEFERRED ARRANGEMENT. A plan that includes a qualified cash or deferred arrangement must satisfy the requirements of sections 401(a)(4) and 410(b). Thus, for example, the plan must satisfy section 401(a)(4) with respect to the amount of contributions or benefits and the availability of benefits, rights and features under the plan. See section 1.401(a)(4)-1(b)(3). The right to make each level of elective contributions under a cash or deferred arrangement is a benefit, right or feature subject to this requirement, and each of these rights must therefore generally be available to a group of employees that satisfies section 410(b). See section 1.401(a)(4)-4(e)(3)(i) and (iii)(D). Thus, for example, if all employees are eligible to make a stated level of elective contributions under a cash or deferred arrangement, but that level of contributions can only be made from compensation in excess of a stated amount, such as the Social Security taxable wage base, the arrangement will generally favor highly compensated employees with respect to the availability of elective contributions and thus will generally not satisfy the requirements of section 401(a)(4). For plan years beginning after December 31, 1984, the amount of elective contributions under a qualified cash or deferred arrangement satisfies the requirements of section 401(a)(4) only if the amount of elective contributions satisfies the special nondiscrimination test of section 401(k)(3) and paragraph (b)(2) of this section. See section 1.401(a)(4)-1(b)(2)(ii)(B). See also section 1.401(a)(4)- 11(g)(3)(vii)(A), relating to corrective amendments that may be made to satisfy the minimum coverage requirements of section 410(b).

(5) * * *

(iv) QUALIFICATION OF PLAN THAT INCLUDES A NONQUALIFIED CASH OR DEFERRED ARRANGEMENT. A profit-sharing, stock bonus, pre-ERISA money purchase pension, or rural cooperative plan does not fail to satisfy the requirements of section 401(a) merely because the plan includes a nonqualified cash or deferred arrangement. In determining whether the plan satisfies the requirements of section 401(a)(4), the special nondiscrimination tests of sections 401(k)(3) and 401(m)(2) may not be used. See sections 1.401(a)(4)-1(b)(2)(ii)(B) and 1.410(b)-9 (definition of section 401(k) plan).

(6) * * *

(ii) * * *

(C) TRANSITION RULE FOR PARTNERSHIP CASH OR DEFERRED ELECTIONS. A one-time irrevocable election to participate or not to participate in a plan in which partners may participate is not a cash or deferred election if the election was made on or before the later of the first day of the first plan year beginning after December 31, 1988, or March 31, 1989. This election may be made after the commencement of employment or after the employee's first becoming eligible under any plan of the employer. In no event, however, may the election be made after December 23, 1994. The election may be made even if the one- time irrevocable election in section 1.401(k)-1(a)(3)(iv) was previously made.

* * * * *

(7) * * * (i) IN GENERAL. The amount of employer contributions under a nonqualified cash or deferred arrangement is treated as satisfying section 401(a)(4) if the arrangement is part of a collectively bargained plan (including a plan adopted by a state or local government before May 6, 1986) that automatically satisfies the requirements of section 410(b). See sections 1.401(a)(4)-1(c)(5) and 1.410(b)-2(b)(7). Except as specifically provided otherwise, elective contributions under the arrangement are treated as employer contributions. See section 1.401(k)-1(a)(5)(ii). However, elective contributions under the nonqualified cash or deferred arrangement are treated as employee contributions for purposes of section 402(a) for plan years beginning after December 31, 1992, and are therefore not excludable from gross income under section 402(e)(3). See section 1.402(a)-1(d)(3)(iv).

* * * * *

(b) * * * (1) * * *

(i) The group of eligible employees under the section 401(k) plan and the group of employees benefiting under the plan to which the nonelective employer contributions are made separately satisfy the requirements of section 410(b) (including the average benefit percentage test, if applicable). For special rules governing the application of section 410(b) to a cash or deferred arrangement, see sections 1.410(b)-7(c)(1) and 1.410(b)-8(a)(1). See also section 1.401(a)(4)-11(g)(3)(vii)(A), relating to corrective amendments that may be made to satisfy the minimum coverage requirements of section 410(b).

(ii) The cash or deferred arrangement satisfies the actual deferral percentage test described in paragraph (b)(2) of this section. This is the exclusive nondiscrimination test applicable to the amount of elective contributions under a qualified cash or deferred arrangement. See section 1.401(a)(4)-1(b)(2)(ii)(B).

* * * * *

(3) AGGREGATION -- (i) AGGREGATION OF ARRANGEMENTS AND PLANS. Except as otherwise specifically provided in this paragraph (b)(3), all cash or deferred arrangements included in a plan are treated as a single cash or deferred arrangement. Thus, for example, if two groups of employees are eligible for separate cash or deferred arrangements under the same plan, the two cash or deferred arrangements are treated as a single cash or deferred arrangement, even if they have significantly different features, such as significantly different limits on elective contributions. See section 1.401(k)-1(g)(11) for the definition of plan used for purposes of this section. That definition contains the exclusive rules for aggregation and disaggregation of plans for purposes of this section. See also paragraph (g)(1)(ii) of this section for rules requiring the aggregation of elective contributions under two or more plans in computing the actual deferral ratios of certain employees.

(ii) RESTRUCTURING AND PERMISSIVE AGGREGATION. Effective for plan years beginning after December 31, 1991, restructuring under section 1.401(a)(4)-9(c) may not be used to demonstrate compliance with the requirements of section 401(k). See section 1.401(a)(4)- 9(c)(3)(ii). For plan years beginning before January 1, 1992, see section 1.401(k)-1(h)(3)(iii). An employer may, however, treat a plan benefiting otherwise excludable employees as two separate plans for purposes of sections 401(k) and 410(b) in accordance with sections 1.410(b)-6(b)(3) and 1.410(b)-7(c)(3).

(4) * * *

(ii) ELECTIVE CONTRIBUTIONS AND QUALIFIED NONELECTIVE CONTRIBUTIONS USED TO SATISFY ACTUAL CONTRIBUTION PERCENTAGE TEST. * * * A qualified nonelective contribution that is treated as a matching contribution is subject to the actual contribution percentage test of section 401(m)(2) and is not taken into account as an elective contribution under paragraph (b)(2) or (5) of this section.

* * * * *

(iv) * * * See sections 1.401(a)(4)-1(b)(2)(ii)(B); 1.410(b)- 7(c)(1).

(5) * * *

(i) * * * See section 1.401(a)(4)-1(b)(2).

(ii) * * * See section 1.401(a)(4)-1(b)(2).

* * * * *

(vi) For plan years beginning after December 31, 1988, or such later date provided in paragraph (h) of this section, the section 401(k) plan and the plan or plans to which the qualified nonelective contributions and qualified matching contributions are made, could be aggregated under section 1.410(b)-7(d) after application of the mandatory disaggregation rules of section 1.410(b)-7(c), as modified in section 1.401(k)-1(g)(11). If the plan year of the section 401(k) plan is changed to satisfy the requirement under section 1.410(b)- 7(d)(5) that aggregated plans have the same plan year, the qualified nonelective contributions and qualified matching contributions may be taken into account in the resulting short plan year only if the contributions satisfy the requirements of paragraph (b)(4)(i) of this section with respect to the short year as if the contributions were elective contributions and the aggregated plans could otherwise be aggregated for purposes of section 410(b).

(6) * * *

* * * * *

EXAMPLE 2. (i) The facts are the same as in Example 1, except that elective contributions are made pursuant to a salary reduction agreement and no bonuses are paid. Employer X includes elective contributions in compensation as permitted under section 1.414(s)-1(c)(4)(i). See section 1.401(k)-1(g)(2)(i). In addition, A defers $2,025. Thus, the compensation and elective contributions for A, B, and C are:

                                  Elective           Actual

EXAMPLE 3. (i) Employees D through L are eligible employees in Employer A's profit-sharing plan that contains a cash or deferred arrangement. Employer A includes elective contributions in compensation as permitted under section 1.414(s)-1(c)(4)(i). Each eligible employee may elect to defer up to six percent of compensation under the cash or deferred arrangement. Employees D and E are highly compensated. The compensation, elective contributions, and actual deferral ratios of these employees for the 1989 plan year are shown below:

                                  Elective           Actual

EXAMPLE 4. (i) Employer D maintains a profit-sharing plan that contains a cash or deferred arrangement. Employer D includes elective contributions in compensation as permitted under section 1.414(s)-1(c)(4)(i). The following amounts are contributed under the plan:

* * * * *

(d) * * *

(2) * * *

(iv) * * * (A) * * *

(3) Payment of tuition, related educational fees, and room and board expenses, for the next 12 months of post-secondary education for the employee, or the employee's spouse, children, or dependents (as defined in section 152); or

* * * * *

(3) RULES APPLICABLE TO DISTRIBUTIONS UPON PLAN TERMINATION. A distribution may not be made under paragraph (d)(1)(iii) of this section if the employer establishes or maintains a successor plan. For purposes of this rule, the definition of the term "employer" contained in paragraph (g)(6) of this section is applied as of the date of plan termination, and a successor plan is any other defined contribution plan maintained by the same employer. However, if at all times during the 24-month period beginning 12 months before the termination, fewer than two percent of the employees who were eligible under the defined contribution plan that includes the cash or deferred arrangement as of the date of plan termination are eligible under the other defined contribution plan, the other plan is not a successor plan. The term "defined contribution plan" means a plan that is a defined contribution plan as defined in section 414(i), but does not include an employee stock ownership plan as defined in section 4975(e) or 409(a) or a simplified employee pension as defined in section 408(k). A plan is a successor plan only if it exists at any time during the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan.

(4) * * * (i) SELLER MUST MAINTAIN THE PLAN. A distribution may be made under section 401(k)(10) and paragraph (d)(1)(iv) or (v) of this section only from a plan that the seller continues to maintain after the disposition. This requirement is satisfied if and only if the purchaser does not maintain the plan after the disposition. A purchaser maintains the plan of the seller if it adopts the plan or otherwise becomes an employer whose employees accrue benefits under the plan. A purchaser also maintains the plan if the plan is merged or consolidated with, or any assets or liabilities are transferred from the plan to, a plan maintained by the purchaser in a transaction subject to section 414(l)(1). A purchaser is not treated as maintaining the plan merely because a plan that it maintains accepts elective transfers described in sections 1.411(d)-4, Q&A-3(b)(1), or rollover contributions of amounts distributed by the plan (including distributions that the recipient elects, under section 401(a)(31), to have paid in a direct rollover to the plan of the purchaser).

* * * * *

(5) * * * The term LUMP SUM DISTRIBUTION has the meaning provided in section 402(d)(4), without regard to subparagraphs (A)(i) through (iv), (B), and (F) of that section.

(6) * * *

(iv) * * * The limitations of paragraph (d) of this section also do not apply to amounts distributed from another plan that the recipient elects under section 401(a)(31) to have paid in a direct rollover to the plan.

* * * * *

(e) * * *

(6) * * *

(ii) * * * Benefits under any other plan or arrangement (whether or not qualified) are not contingent upon an employee's electing to make or not to make elective contributions under a cash or deferred arrangement merely because the elective contributions are or are not taken into account as compensation under the other plan or arrangement for purposes of determining benefits.

* * * * *

(vi) EXAMPLES. The provisions of this paragraph (e)(6) are illustrated by the following examples.

EXAMPLE 1. Employer T maintains a cash or deferred arrangement for all of its employees. Employer T also maintains a nonqualified deferred compensation plan for two highly paid executives, Employees R and C. Under the terms of the nonqualified deferred compensation plan, R and C are eligible to participate only if they do not make elective contributions under the cash or deferred arrangement. Participation in the nonqualified plan is a contingent benefit for purposes of this paragraph (e)(6), because R's and C's participation is conditioned on their electing not to make elective contributions under the cash or deferred arrangement.

EXAMPLE 2. Employer T maintains a cash or deferred arrangement for all its employees. Employer T also maintains a nonqualified deferred compensation plan for two highly paid executives, Employees R and C. Under the terms of the arrangements, Employees R and C may defer a maximum of 10 percent of their compensation, and may allocate their deferral between the cash or deferred arrangement and the nonqualified deferred compensation plan in any way they choose (subject to the overall 10 percent maximum). Because the maximum deferral available under the nonqualified deferred compensation plan depends on the elective deferrals made under the cash or deferred arrangement, the right to participate in the nonqualified plan is a contingent benefit for purposes of paragraph (e)(6).

(7) COORDINATION WITH OTHER PLANS. For plan years beginning after December 31, 1988, or such later date provided in paragraph (h) of this section, a cash or deferred arrangement satisfies this paragraph (e) only if no elective contributions (or qualified matching contributions treated as elective contributions under paragraph (b)(5) of this section) under the arrangement are taken into account for purposes of determining whether any other contributions under any plan (including the plan to which the elective contributions are made) satisfy the requirements of section 401(a). Indeed, the portion of a plan that consists of elective contributions is treated as a separate plan for purposes of sections 401(a)(4) and 410(b). See section 1.410(b)-7(c)(1). Similarly, elective contributions under a cash or deferred arrangement generally may not be taken into account in determining whether a plan satisfies the minimum contribution or benefit requirements of section 416. See section 1.416-1, M-20. However, qualified nonelective contributions that are treated as elective contributions for purposes of section 401(k)(3) under paragraph (b)(5) of this section may be used to enable a plan to satisfy the minimum contribution or benefit requirements under section 416. See section 1.416-1, M-18. This paragraph (e) does not apply for purposes of determining whether a plan satisfies the average benefit percentage requirement of section 410(b)(2)(A)(ii). See also section 1.401(m)-1(b)(5) for circumstances under which elective contributions may be used to determine whether a plan satisfies the requirements of section 401(m).

* * * * *

(f) * * * (1) * * *

* * * * *

(iii) IMPERMISSIBLE CORRECTION METHODS. Excess contributions for a plan year may not remain unallocated or be allocated to a suspense account for allocation to one or more employees in any future year. In addition, excess contributions may not be corrected using the retroactive correction rules of section 1.401(a)(4)-11(g). See section 1.401(a)(4)-11(g)(3)(vii) and (5). See paragraph (f)(6) of this section for the effects of a failure to correct excess contributions.

(2) AMOUNT OF EXCESS CONTRIBUTIONS. The amount of excess contributions for a highly compensated employee for a plan year is the amount (if any) by which the employee's elective contributions must be reduced for the employee's actual deferral ratio to equal the highest permitted actual deferral ratio under the plan. To calculate the highest permitted actual deferral ratio under a plan, the actual deferral ratio of the highly compensated employee with the highest actual deferral ratio is reduced by the amount required to cause the employee's actual deferral ratio to equal the ratio of the highly compensated employee with the next highest actual deferral ratio. If a lesser reduction would enable the arrangement to satisfy the actual deferral percentage test, only this lesser reduction may be made. This process must be repeated until the cash or deferred arrangement satisfies the actual deferral percentage test. The highest actual deferral ratio remaining under the plan after leveling is the highest permitted actual deferral ratio. Thus, for each highly compensated employee, the amount of excess contributions for a plan year is equal to the employee's elective contributions, plus qualified nonelective contributions and qualified matching contributions taken into account in determining the employee's actual deferral ratio under paragraph (g)(1) of this section, minus the amount determined by multiplying the employee's actual deferral ratio (determined after application of this paragraph (f)(2)) by the compensation used in determining the ratio. In no case may the amount of excess contributions to be recharacterized or distributed for a plan year with respect to any highly compensated employee exceed the amount of elective contributions made on behalf of the highly compensated employee for the plan year.

(3) * * *

(ii) TREATMENT OF RECHARACTERIZED EXCESS CONTRIBUTIONS.

(A) Excess contributions recharacterized under this paragraph (f)(3) are includible in the employee's gross income on the earliest dates any elective contribution made on behalf of the employee during the plan year would have been received by the employee had the employee originally elected to receive the amounts in cash, or on such later date permitted in paragraph (f)(3)(iv) of this section. The recharacterized excess contributions must be treated as employee contributions for purposes of section 72, section 401(a)(4) and 401(m), and paragraphs (b) and (d) of this section. This requirement is not treated as satisfied unless:

(1) The payor or plan administrator reports the recharacterized excess contributions as employee contributions to the Internal Revenue Service and the employee by --

(i) Timely providing such forms as the Commissioner may designate to the employer and to employees whose excess contributions are recharacterized under this paragraph (f)(3); and

(ii) Timely taking such other action as the Commissioner may require; and

(2) The plan administrator accounts for the amounts as contributions by the employee for purposes of sections 72 and 6047.

(B) Recharacterized excess contributions continue to be treated as employer contributions that are elective contributions for all other purposes under the Internal Revenue Code, including sections 401(a) (other than 401(a)(4) and 401(m)), 404, 409, 411, 412, 415, 416, and 417. Thus, for example, recharacterized excess contributions remain subject to the requirements of paragraph (c) of this section; must be deducted under section 404; and are treated as employer contributions described in section 415(c)(2)(A) and section 1.415-6(b). In addition, these amounts are not treated as compensation for purposes of sections 404 and 415, and may be treated as compensation for purposes of sections 401(a)(4), 401(a)(5), 401(k), 401(l) and 414(s) only to the extent that elective contributions may be treated, and are treated under the plan, as compensation. See section 1.414(s)-1(c)(4)(i). Recharacterized excess contributions that relate to plan years ending on or before October 24, 1988, may be treated as either employer contributions or employee contributions for purposes of paragraph (d) of this section. The amount of excess contributions included in an employee's gross income is reduced as provided under paragraph (f)(5)(i)(B) of this section.

(iii) * * *

(C) PLANS UNDER WHICH EXCESS CONTRIBUTIONS MAY BE RECHARACTERIZED. For plan years beginning after December 31, 1991, elective contributions may be recharacterized under this paragraph (f)(3) only under the plan under which they are made or under a plan with which that plan could be aggregated under section 1.410(b)-7(d) after application of the mandatory disaggregation rules of section 410(b)-7(c), as modified in section 1.401(k)-1(g)(11). For plan years beginning before that date and after December 31, 1988, or such later date provided under paragraph (h) of this section, elective contributions may be recharacterized under this paragraph (f)(3) only under the plan under which they are made or under a plan with the same plan year as that plan.

* * * * *

(v) * * *

EXAMPLE. (i) Employer X maintains Plan Y, a calendar year profit-sharing plan that includes a qualified cash or deferred arrangement. Under Plan Y, each eligible employee may elect to defer up to 10 percent of compensation under a salary reduction agreement. An eligible employee may also make employee contributions of up to 10 percent of compensation. X pays the amounts deferred to the trust on the last day of each month. Employer X includes elective contributions in compensation as permitted under section 1.414(s)-1(c)(4)(i). See section 1.401(k)-1(g)(2)(i). Salaries are paid on the same date.

* * * * *

(4) * * *

(ii) * * *

(B) METHOD OF ALLOCATING INCOME. A plan may use any reasonable method for computing the income allocable to excess contributions, provided that the method does not violate section 401(a)(4), is used consistently for all participants and for all corrective distributions under the plan for the plan year, and is used by the plan for allocating income to participants' accounts. See section 1.401(a)(4)-1(c)(8).

* * * * *

(7) * * *

EXAMPLE 1. (i) The Y corporation maintains a cash or deferred arrangement. The plan year is the calendar year. For plan year 1989, all 10 of Y's employees are eligible to participate in the cash or deferred arrangement. The Y corporation includes elective contributions in compensation as permitted under section 1.414(s)-1(c)(4)(i). See section 1.401(k)-1(g)(2)(i). The employees' compensation, elective contributions, and actual deferral ratios are shown in the following table:

                             Elective           Actual

EXAMPLE 2. A, B, and C are highly compensated employees of Employer R. Employer R maintains a cash or deferred arrangement. Employer R includes elective contributions in compensation as permitted under section 1.414(s)-1(c)(4)(i). For the plan year 1990, A, B, and C each earns compensation of $100,000 and contributes $7,000 to the plan during the period January through June. B retires in November of 1990 and makes a withdrawal of B's entire account balance of $200,000. In January of 1991, R computes the ADP test for its employees and learns that the highly compensated employees should have contributed only five percent of compensation. Since B made a contribution of $7,000 for 1990, B's contribution and compensation are used in determining the ADP despite the subsequent $200,000 withdrawal. A, B, and C must each receive a corrective distribution of $2,000 in order to meet the ADP test. Since B has already withdrawn B's total account balance under the plan, only A and C must receive a distribution of $2,000 each in order for the plan to meet the ADP test of section 401(k)(3)(A)(ii). Pursuant to the 1990 Form 1099-R Instructions, the plan must issue two Forms 1099-R to B, one reporting the portion of the distribution that was necessary to correct the excess contribution (including income), and one reporting the balance of the distribution. If B had withdrawn less than the total account balance, B would have to withdraw the lesser of $2,000 or the remaining account balance.

EXAMPLE 3. Individual A has a child, B. Both participate in a cash or deferred arrangement maintained by Employer X. A is one of the 10 most highly compensated employees and B is a nonhighly compensated employee. Employer X includes elective contributions in compensation as permitted under section 1.414(s)-1(c)(4)(i). A has compensation of $100,000 and defers $7,000 under the cash or deferred arrangement; B has compensation of $40,000 and defers $4,000 under the arrangement. The actual deferral ratio of the family unit is 7.86 percent, calculated by aggregating the contributions and compensation of A and B ($7,000 + $4,000)/($100,000 + $40,000). For the plan, it is determined that under section 1.401(k)-1(f)(2), the actual deferral ratio of the aggregate family unit must be reduced to 7.20 percent. This reduction is applied in proportion to A's and B's contributions. The excess contributions are $920 ($11,000 total contributions minus $10,080 (7.20% x $140,000)). A's share of the excess contributions is $585.45 ($7,000/$11,000 x $920); B's share is $334.55 ($4,000/$11,000 x $920).

* * * * *

(g) * * *

(1) * * *

(ii) * * *

(B) * * * (1) HIGHLY COMPENSATED EMPLOYEES. For plan years beginning after December 31, 1984, the actual deferral ratio of a highly compensated employee who is eligible to participate in more than one cash or deferred arrangement of the same employer is generally calculated by treating all the cash or deferred arrangements in which the employee is eligible to participate as one arrangement. However, plans that are not permitted to be aggregated under section 1.410(b)-7(c), as modified in paragraph (g)(11) of this section, are not aggregated for this purpose. For example, if a highly compensated employee with compensation of $80,000 could make elective contributions under two separate cash or deferred arrangements, the actual deferral ratio for the employee under each arrangement would generally be calculated by dividing the total elective contributions by the employee under both arrangements by $80,000. If one of the cash or deferred arrangements were part of an ESOP, however, while the other was not, the actual deferral percentage of the employee under each arrangement would be calculated by dividing the employee's elective contributions under each arrangement by $80,000 because the ESOP portion is mandatorily disaggregated from the non-ESOP portion.

* * * * *

(C) * * * (1) AGGREGATION OF ELECTIVE CONTRIBUTIONS AND OTHER AMOUNTS. For plan years beginning after December 31, 1986, or any later date provided in paragraph (h) of this section, if a highly compensated employee is subject to the family aggregation rules of section 414(q)(6) because that employee is either a five-percent owner or one of the 10 most highly compensated employees, the combined actual deferral ratio for the family group (which is treated as one highly compensated employee) must be determined by combining the elective contributions, compensation, and amounts treated as elective contributions of all family members.

* * * * *

(2) * * * (i) YEARS BEGINNING AFTER DECEMBER 31, 1986. For plan years beginning after December 31, 1986, or such later date provided in paragraph (h) of this section, the term COMPENSATION means compensation as defined in section 414(s) and section 1.414(s)-1. The period used to determine an employee's compensation for a plan year must be either the plan year or the calendar year ending within the plan year. Whichever period is selected must be applied uniformly to determine the compensation of every eligible employee under the plan for that plan year for purposes of this section. An employer may, however, limit the period taken into account under either method to that portion of the plan year or calendar year in which the employee was an eligible employee, provided that this limit is applied uniformly to all eligible employees under the plan for the plan year for purposes of this section. See also section 401(a)(17) and section 1.401(a)(17)-1(c)(1).

* * * * *

(4) * * *

(ii) * * * In no event is an election made after December 23, 1994 treated as a one-time irrevocable election under this paragraph if the election is made by an employee who previously became eligible under another plan (whether or not terminated) of the employer.

(5) EMPLOYEE. The term employee means an employee within the meaning of section 1.410(b)-9.

(6) EMPLOYER. The term employer means the employer within the meaning of section 1.410(b)-9.

* * * * *

(11) PLAN -- (i) APPLICATION OF SECTION 410(b) RULES. The term plan means a plan within the meaning of section 1.410(b)-7(a) and (b), after application of the mandatory disaggregation rules of section 1.410(b)-7(c) and the permissive aggregation rules of section 1.410(b)-7(d), with the modifications provided in paragraph (g)(11)(ii) of this section. Thus, for example, two plans (within the meaning of section 1.410(b)-7(b)) that are treated as a single plan pursuant to the permissive aggregation rules of section 1.410(b)-7(d) are treated as a single plan for purposes of section 401(k). See also section 1.401(k)-1(b)(3)(ii).

(ii) MODIFICATIONS TO SECTION 410(b) RULES -- (A) IN GENERAL. For purposes of this paragraph (g)(11), section 1.410(b)-7(c) and (d) are applied without regard to section 1.410(b)-7(c)(1), relating to section 401(k) and 401(m) plans.

(B) PLANS BENEFITING COLLECTIVE BARGAINING UNIT EMPLOYEES. A plan that benefits employees who are included in a unit of employees covered by a collective bargaining agreement and employees who are not included in such a collective bargaining unit is treated as comprising separate plans. This paragraph (g)(11)(ii)(B) is generally applied separately with respect to each collective bargaining unit. At the option of the employer, however, two or more separate collective bargaining units can be treated as a single collective bargaining unit, provided that the combinations of units are determined on a basis that is reasonable and reasonably consistent from year to year. Thus, for example, if a plan benefits employees in three categories--employees included in collective bargaining unit A, employees included in collective bargaining unit B, and employees who are not included in any collective bargaining unit--the plan can be treated as comprising three separate plans, each of which benefits only one category of employees. However, if collective bargaining units A and B are treated as a single collective bargaining unit, the plan will be treated as comprising only two separate plans, one benefiting all employees who are included in a collective bargaining unit and another benefiting all other employees. Similarly, if a plan benefits only employees who are included in collective bargaining unit A and employees who are included in collective bargaining unit B, the plan can be treated as comprising two separate plans. However, if collective bargaining units A and B are treated as a single collective bargaining unit, the plan will be treated as a single plan. An employee is treated as included in a unit of employees covered by a collective bargaining agreement if and only if the employee is a collectively bargained employee within the meaning of section 1.410(b)-6(d)(2).

(C) MULTIEMPLOYER PLANS. Consistent with section 413(b), the portion of the plan that is maintained pursuant to a collective bargaining agreement (within the meaning of section 1.413-1(a)(2)) is treated as a single plan maintained by a single employer that employs all the employees benefiting under the same benefit computation formula and covered pursuant to that collective bargaining agreement. The rules of paragraph (g)(11)(ii)(B) of this section (including the optional aggregation of collective bargaining units) apply to the resulting deemed single plan in the same manner as they would to a single employer plan, except that the plan administrator is substituted for the employer where appropriate and appropriate fiduciary obligations are taken into account. The noncollectively bargained portion of the plan is treated as maintained by one or more employers, depending on whether the noncollective bargaining unit employees who benefit under the plan are employed by one or more employers.

* * * * *

(15) SECTION 401(k) PLAN. The term SECTION 401(k) PLAN means a section 401(k) plan within the meaning of section 1.410(b)-9.

(16) SECTION 401(m) PLAN. The term SECTION 401(m) PLAN means a section 401(m) plan within the meaning of section 1.410(b)-9.

(h) * * *

(3) * * *

(iii) * * * (A) GENERAL RULE. In determining whether the requirements of section 401(k) are satisfied for plan years beginning before January 1, 1992, a plan may be treated as consisting of two or more component plans, each consisting of all of the allocations and other benefits, rights, and features provided to a group of employees under the plan. See section 1.401(a)(4)-9(c). An employee may not be included in more than one component plan of the same plan for a plan year under this method. If this method is used for a plan year, the requirements of section 401(k) are applied separately with respect to each component plan for the plan year. Thus, for example, the actual deferral ratio and the amount of excess contributions, if any, of each eligible employee under each component plan must be determined as if the component plan were a separate plan. This method applies solely for purposes of section 401(k). Thus, for example, the requirements of section 410(b) must still be satisfied by the entire plan.

(B) * * *

(2) COMMONALITY REQUIREMENT. The group of employees used to identify a component plan must share some common attribute or attributes, other than similar actual deferral ratios. Permissible common attributes include, for example, employment at the same work site, in the same job category, for the same division or subsidiary, or for a unit acquired in a specific merger or acquisition, employment for the same number of years, compensation under the same method, e.g., salaried or hourly, coverage under the same contribution formula, and attributes that could be used as the basis of a classification that would be treated as reasonable under section 1.410(b)-4(b). Employees whose only common attribute is the same or similar actual deferral ratios, or another attribute having substantially the same effect as the same or similar actual deferral ratios, are not considered as sharing a common attribute for this purpose. This rule applies regardless of whether the component plan or the plan of which it is a part satisfies the ratio or percentage test of section 410(b).

(4) * * *

(ii) PLAN YEARS BEGINNING BEFORE JANUARY 1, 1996. The following rules apply to a governmental plan described in section 414(d) that is not a collectively bargained plan and includes a nonqualified cash or deferred arrangement. These rules apply for plan years beginning before the later of January 1, 1996, or 90 days after the opening of the first legislative session beginning on or after January 1, 1996, of the governing body with authority to amend the plan, if that body does not meet continuously. For purposes of this paragraph (b)(1), the term GOVERNING BODY WITH AUTHORITY TO AMEND THE PLAN means the legislature, board, commission, council, or other governing body with authority to amend the plan.

* * * * *

Par. 4. Section 1.401(m)-0 is amended as follows:

1. The entry for section 1.401(m)-1, paragraph (b)(3)(ii) is removed.

2. The entry for section 1.401(m)-1, paragraph (b)(3)(iii) is revised and redesignated (b)(3)(ii).

3. The entry for section 1.401(m)-1, paragraph (b)(4)(ii)(B) is revised.

4. An entry for section 1.401(m)-1, paragraph (e)(3)(vii) is added.

5. Entries for section 1.401(m)-1, paragraph (f)(16) and (17) are added.

The added and revised entries read as follows:

SECTION 1.401(m)-0 EMPLOYEE AND MATCHING CONTRIBUTIONS, TABLE OF CONTENTS. * * * * *

 SECTION 1.401(m)-1 * * *

Par. 5. Section 1.401(m)-1 is amended as follows:

1. Paragraph (a) is revised.

2. Paragraph (b) is amended as follows:

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

ii. Paragraphs (b)(3)(i) and (b)(3)(ii) are revised.

iii. Paragraph (b)(3)(iii) is removed.

iv. A sentence is added at the end of paragraph (b)(4)(ii)(A).

v. Paragraph (b)(4)(ii)(B) is revised.

vi. Paragraph (b)(5)(i) and (ii) are amended by adding a sentence at the end.

vii. Paragraph (b)(5)(v) is revised.

3. Paragraph (c)(1) is revised.

4. Paragraph (d) is amended as follows:

i. Paragraph (i) of Example 3 is revised.

ii. Paragraph (i) of Example 4 is revised.

5. Paragraph (e) is amended as follows:

i. Paragraph (e)(1)(iii) is revised.

ii. A sentence is added at the end of paragraph (e)(3)(ii)(B).

iii. Paragraph (e)(3)(vii) is added.

iv. Paragraph (e)(4) is revised.

v. Paragraph (e)(6) is amended as follows:

a. Examples 2 through 6 are revised.

b. Example 8 is added.

6. Paragraph (f) is amended as follows:

i. Paragraphs (f)(1)(ii)(B) and (C)(1), and (f)(2) are revised.

ii. A sentence is added at the end of paragraph (f)(4)(ii).

iii. Paragraph (f)(12)(i)(B) is revised.

iv. Paragraphs (f)(16) and (17) are added.

7. Paragraph (g)(4), (g)(5)(ii)(A) and (B)(2) are revised.

The added and revised provisions read as follows:

SECTION 1.401(m)-1 EMPLOYEE AND MATCHING CONTRIBUTIONS.

(a) GENERAL RULES -- (1) NONDISCRIMINATORY AMOUNT OF CONTRIBUTIONS. A defined contribution plan does not satisfy section 401(a)(4) for a plan year unless the amount of employee and matching contributions to the plan for the plan year satisfies section 401(a)(4). See section 1.401(a)(4)-1(b)(2)(ii). Except as specifically provided otherwise, for plan years beginning after December 31, 1986 (or such later date provided in paragraph (g) of this section) the amount of employee and matching contributions under a plan satisfies the requirements of section 401(a)(4) only if the employee and matching contributions under the plan satisfy the actual contribution percentage test of section 401(m)(2) and paragraph (b) of this section. See section 1.401(a)(4)-1(b)(2)(ii)(B). Also, except as specifically provided otherwise, for plan years beginning after December 31, 1988 (or such later date provided in section 1.401(m)- 2(d)), the amount of employee and matching contributions under a plan satisfies the requirements of sections 401(m) and 401(a)(4) only if any multiple use of the alternative methods of compliance with sections 401(k) and (m) (contained in sections 401(k)(3)(A)(ii)(II) and 401(m)(2)(A)(ii), respectively) is corrected under section 1.401(m)-2(c). See section 401(m)(9) and section 1.401(m)-2. For these purposes, the employee and matching contributions are combined with the elective and qualified nonelective contributions, if any, that are treated as matching contributions, and the recharacterized elective contributions, if any, that are treated as employee contributions for purposes of section 401(m).

(2) OTHER NONDISCRIMINATION RULES. Nondiscrimination requirements in addition to those described in paragraph (a)(1) of this section apply to employee and matching contributions under sections 401(a)(4) and 410(b). For example, under section 401(a)(4) a plan may not discriminate with respect to the availability of benefits, rights, and features under the plan. See section 1.401(a)(4)-1(b)(3). The right to make each level of employee contributions, and the right to each level of matching contributions, are benefits, rights, or features subject to this requirement, and each level must therefore generally be available to a group of employees that satisfies section 410(b). See section 1.401(a)(4)- 4(e)(3)(i) and (iii)(F) through (G). Thus, for example, a plan does not satisfy section 401(a)(4) if it provides a higher rate of matching contributions for highly compensated employees than for nonhighly compensated employees. See paragraph (e)(4) of this section for rules relating to the application of section 401(a)(4) to the correction of excess aggregate contributions. See section 1.401(a)(4)-11(g)(3)(vii) for special rules relating to correction of violations of the minimum coverage requirements or discriminatory rates of match in a section 401(m) plan. For special rules governing the application of section 410(b) to employee and matching contributions, see sections 1.410(b)-7(c)(1) and 1.410(b)-8(a)(1).

(3) RULES APPLICABLE TO COLLECTIVELY BARGAINED PLANS. The requirements of this section are treated as satisfied by employee and matching contributions under a collectively bargained plan (or the portion of a plan) that automatically satisfies section 410(b). See sections 1.401(a)(4)-1(c)(5) and 1.410(b)-2(b)(7). There are no excess aggregate contributions under a plan (or a portion of a plan) that is treated under this paragraph (a)(3) as satisfying the requirements of this section. Thus, the provisions of section 4979 and section 54.4979-1 of this chapter do not apply to contributions described in the first sentence of this paragraph (a)(3).

(b) ACTUAL CONTRIBUTION PERCENTAGE TEST -- (1) GENERAL RULE. (i) For plan years beginning after December 31, 1986, or such later date provided in paragraph (g) of this section, the actual contribution percentage test is satisfied if --

(A) The actual contribution percentage for the group of eligible highly compensated employees is not more than the actual contribution percentage for the group of all other eligible employees multiplied by 1.25; or

(B) The excess of the actual contribution percentage for the group of eligible highly compensated employees over the actual contribution percentage for the group of all other eligible employees is not more than two percentage points, and the actual contribution percentage for the group of eligible highly compensated employees is not more than the actual contribution percentage for the group of all other eligible employees multiplied by two.

(ii) A plan does not fail to satisfy the requirements of this paragraph (b)(1) merely because all of the eligible employees under the plan for a year are highly compensated employees.

* * * * *

(3) * * * (i) GENERAL RULE. See section 1.401(m)-1(f)(14) for the definition of a plan used for purposes of this section and section 1.401(m)-2. That definition contains the exclusive rules for aggregation and disaggregation of plans for purposes of this section and section 1.401(m)-2.

(ii) RESTRUCTURING AND PERMISSIVE DISAGGREGATION. Effective for plan years beginning after December 31, 1991, restructuring under section 1.401(a)(4)-9(c) may not be used to demonstrate compliance with the requirements of section 401(m). See section 1.401(a)(4)- 9(c)(3)(ii). For plan years beginning before January 1, 1992, see section 1.401(m)-1(g)(5)(ii). An employer may, however, treat a plan benefiting otherwise excludable employees as two separate plans for purposes of sections 401(m) and 410(b) in accordance with sections 1.410(b)-6(b)(3) and 1.410(b)-7(c)(3).

(4) * * *

(ii) * * * (A) * * * See sections 1.401(a)(4)-1(b)(2)(ii)(B); 1.410(b)-7(c)(1).

(B) MATCHING CONTRIBUTIONS AND QUALIFIED NONELECTIVE CONTRIBUTIONS USED TO SATISFY ACTUAL DEFERRAL PERCENTAGE TEST. A matching contribution that is treated as an elective contribution is subject to the actual deferral percentage test of section 401(k)(3) and is not taken into account under paragraph (b)(1) of this section. See section 1.401(k)-1(b)(5)(iii) for the rule relating to years before January 1, 1987. A qualified nonelective contribution that is treated as an elective contribution is subject to the actual deferral percentage test of section 401(k)(3) and is not taken into account as a matching contribution under paragraph (b)(1) or (5) of this section.

* * * * *

(5) * * *

(i) * * * See section 1.401(a)(4)-1(b)(2).

(ii) * * * See section 1.401(a)(4)-1(b)(2).

* * * * *

(v) For plan years beginning after December 31, 1988, or such later date provided in paragraph (g) of this section, the plan that takes qualified nonelective contributions and elective contributions into account in determining whether employee and matching contributions satisfy the requirements of section 401(m)(2)(A), and the plans to which the qualified nonelective contributions and elective contributions are made, could be aggregated under section 1.410(b)-7(d) after application of the mandatory disaggregation rules of section 1.410(b)-7(c), as modified in section 1.401(k)-1(g)(11). If the plan year of the section 401(m) plan is changed to satisfy the requirement under section 1.410(b)-7(d)(5) that the aggregated plans have the same plan year, the elective contributions may be taken into account in the resulting short plan year only if these contributions satisfy the requirements of section 1.401(k)-1(b)(4) with respect to the short year, and the qualified nonelective contributions may be taken into account in the resulting short plan year only if these contributions satisfy the requirements of section 1.401(k)- 1(b)(4)(i)(A) with respect to the short year as if they were elective contributions.

(c) * * * (1) COORDINATION WITH OTHER PLANS. Except as expressly permitted under section 401(k) or 401(m), for plan years beginning after December 31, 1988, or such later date provided in paragraph (g) of this section, employee or matching contributions (or elective contributions treated as matching contributions under paragraph (b)(5) of this section) may not be taken into account for purposes of determining whether any other contributions under any plan (including the plan to which the employee or matching contributions are made) satisfy the requirements of section 401(a). Indeed, the portion of a plan that consists of employee and matching contributions is treated as a separate plan for purposes of sections 401(a)(4) and 410(b). See section 1.410(b)-7(c)(1). Similarly, although matching contributions and qualified nonelective contributions may be used to enable a plan to satisfy the minimum contribution or benefit requirements under section 416, matching contributions that are used in this way are not treated as matching contributions, and must therefore satisfy the nondiscrimination requirements of section 401(a)(4) without regard to section 401(k) or 401(m). See section 1.416-1, M-18 & M-19 and paragraph (f)(12)(iii) of this section. See also section 1.401(k)-1(b)(5) for circumstances under which matching contributions may be used to determine whether a plan satisfies the requirements of section 401(k). This paragraph does not apply for purposes of determining whether a plan satisfies the average benefit percentage test of section 410(b)(2)(A)(ii).

* * * * *

(d) * * *

EXAMPLE 3. (i) Employer N maintains a plan that contains a cash or deferred arrangement and permits employee contributions. Employer N includes elective contributions in compensation as permitted under section 1.414(s)-1(c)(4)(i). See section 1.401(k)-1(g)(2)(i). For the 1988 plan year, the average percentages of compensation contributed to the plan by the highly compensated and nonhighly compensated employees as elective contributions and employee contributions are shown in the chart below. Elective contributions meet the requirements of paragraph (b)(5) of this section.

                             Elective            Employee

EXAMPLE 4. (i) Employer P maintains a plan that includes a cash or deferred arrangement. Elective contributions, qualified nonelective contributions (QNCs), employee contributions, and matching contributions are made to the plan. Employer P includes elective contributions in compensation as permitted under section 1.414(s)-1(c)(4)(i). The elective contributions and QNCs meet the requirements of paragraph (b)(5) of this section. For the 1989 plan year, the QNCs, elective contributions, and employee and matching contributions, expressed as a percentage of compensation, are shown in the following table:

                                 Elective         Employee/Matching

(e) * * * (1) * * *

(iii) IMPERMISSIBLE CORRECTION METHODS. Excess aggregate contributions may not be corrected by forfeiting vested matching contributions, recharacterizing matching contributions, or not making matching contributions required under the terms of the plan. Excess aggregate contributions for a plan year may not remain unallocated or be allocated to a suspense account for allocation to one or more employees in any future year. In addition, excess aggregate contributions may not be corrected using the retroactive correction rules of section 1.401(a)(4)-11(g). See section 1.401(a)(4)- 11(g)(3)(vii) and (5). See paragraph (e)(5) of this section for the effects of a failure to correct excess aggregate contributions. See section 1.411(a)-4(b)(7) regarding permissible forfeitures of matching contributions.

* * * * *

(3) * * *

(ii) * * *

(B) * * * See section 1.401(a)(4)-1(c)(8).

* * * * *

(vii) NO CORRECTIVE DISTRIBUTION OF MATCHING CONTRIBUTIONS OTHER THAN EXCESS AGGREGATE CONTRIBUTIONS. A matching contribution that is an excess aggregate contribution may be distributed as provided in section 401(m)(6) and section 1.401(m)-1(e)(3). A matching contribution may not be distributed merely because the contribution to which it relates is treated as an excess contribution, excess deferral, or excess aggregate contribution. See sections 1.401(k)- 1(f)(5)(iii) and 1.411(a)-4(b)(7) regarding permissible forfeitures of matching contributions that relate to excess contributions, excess deferrals, or excess aggregate contributions.

(4) COORDINATION WITH SECTION 401(a)(4). A matching contribution is taken into account under section 401(a)(4) even if it is distributed, unless the distributed contribution is an excess aggregate contribution. However, the method of distributing excess aggregate contributions provided in the plan must satisfy the requirements of section 401(a)(4). This requires that after correction each level of matching contributions be currently and effectively available to a group of employees that satisfies section 410(b). See section 1.401(a)(4)-4(e)(3)(iii)(G). Thus, a plan that provides the same rate of matching contributions to all employees will not meet the requirements of section 401(a)(4) if employee contributions are distributed under this paragraph (e) to highly compensated employees to the extent needed to meet the requirements of section 401(m)(2), while matching contributions attributable to employee contributions remain allocated to the highly compensated employees' accounts. See section 1.411(a)-4(b)(7) for a rule that allows forfeiture of these matching contributions to avoid a violation of section 401(a)(4). See also section 1.401(a)(4)- 11(g)(3)(vii)(B) regarding the use of additional allocations to the accounts of nonhighly compensated employees for the purpose of correcting a discriminatory rate of matching contributions. A method of distributing excess aggregate contributions will not be considered discriminatory solely because, in accordance with the terms of the plan, unmatched employee contributions that exceed the highest rate at which employee contributions are matched are distributed before matched employee contributions, or matching contributions are distributed (or forfeited) prior to employee contributions. See Example 6 in paragraph (e)(6) of this section.

* * * * *

(6) * * *

* * * * *

EXAMPLE 2. (i) Employee A is the sole highly compensated participant in a cash or deferred arrangement maintained by Employer X. The plan that includes the arrangement, Plan X, provides a fully vested matching contribution equal to 50 percent of elective contributions. Plan X is a calendar year plan. Employer X includes elective contributions in compensation as permitted under section 1.414(s)-1(c)(4)(i). See section 1.401(k)-1(g)(2)(i). Plan X corrects excess contributions by recharacterization. For the 1988 plan year, A's compensation is $58,333, and A's elective contributions are $7,000. The actual deferral percentages and actual contribution percentages of A and other employees under Plan X are shown below:

                      Actual          Actual

EXAMPLE 3. Same as Example 2, except that in 1988 A also had elective contributions of $1,313 under Plan Y, maintained by an employer unrelated to X. In January 1989, A requests and receives a distribution of $1,000 in excess deferrals from Plan X. Pursuant to the terms of Plan X, A forfeits the $500 match on the excess deferrals to correct a discriminatory rate of match (see Example 8). The $1,167 that would otherwise have been recharacterized for Plan X to satisfy the actual deferral percentage test is reduced by the $1,000 already distributed as an excess deferral, leaving $167 to be recharacterized. See section 1.401(k)-1(f)(5)(i). Pursuant to the terms of Plan X, A forfeits the $83.50 match on the recharacterized $167 to correct a discriminatory rate of match. A's actual contribution ratio is now 5.29 percent ($2,916.50 ($3,500 - $500 - $83.50))in matching contributions plus $167 in employee contributions, divided by $58,333 in compensation). Since Plan X satisfies the actual contribution percentage test, no further distribution is required or permitted.

EXAMPLE 4. Same as Example 3, except that A does not request a distribution of excess deferrals until March 1989. Employer X has already recharacterized $1,167 as employee contributions. Under section 1.402(g)-1(e)(6), the amount of excess deferrals is reduced by the amount of excess contributions that are recharacterized. Because the amount recharacterized is greater than the excess deferrals, Plan X is neither required nor permitted to make a distribution of excess deferrals, and the recharacterization has corrected the excess deferrals.

EXAMPLE 5. For the 1987 plan year, Employee B defers $7,000 under Plan C and $1,000 under plan D. Plans C and D are maintained by unrelated Employers C and D; both Plans C and D have calendar plan years. Plan C provides a fully vested, 100 percent matching contribution and does not take elective contributions into account under section 401(m) or take matching contributions into account under section 401(k). Employer C determines that B has excess contributions of $600 and excess aggregate contributions of $1,600. B timely requests and receives a distribution of the $1,000 excess deferral from Plan C, and pursuant to the terms of Plan C, forfeits the corresponding $1,000 matching contribution to correct a discriminatory rate of match (see Example 8). Plan C provides that excess contributions and excess aggregate contributions are corrected by distribution. No distribution is required or permitted to correct the excess contributions because $1,000 has been distributed from this plan as excess deferrals. The distribution required to correct the excess aggregate contributions (after forfeiting the matching contribution) is $600 ($1,600 in excess aggregate contributions minus $1,000 in forfeited matching contributions). If B had corrected the excess deferrals of $1,000 by withdrawing $1,000 from Plan D, Plan C would have had to correct the $600 excess contributions in Plan C by distributing $600. Since B then would have forfeited $600 (instead of $1,000) in matching contributions, B would have had $1,000 ($1,600 in excess aggregate contributions minus $600 in forfeited matching contributions) remaining of excess aggregate contributions in Plan C. These would have been corrected by distributing an additional $1,000 from Plan C.

EXAMPLE 6. Employee B is the sole highly compensated employee in a thrift plan under which the employer matches 100 percent of employee contributions up to two percent of compensation, and 50 percent of employee contributions up to the next four percent of compensation. For the 1988 plan year, B has compensation of $100,000. B makes an employee contribution of $7,000, or seven percent, and receives a four percent matching contribution of $4,000. Thus, B's actual contribution ratio (ACR) is 11 percent. The actual contribution percentage for the nonhighly compensated employees is five percent, and the employer determines that B's ACR must be reduced to seven percent to comply with the rules of section 401(m). In this case, the plan satisfies the requirements of this paragraph if it distributes the unmatched employee contributions of $1,000, and $2,000 of matched employee contributions with their related matches of $1,000. This would leave B with four percent employee contributions, and three percent matching contributions, for an ACR of seven percent. The plan could instead distribute all matching contributions. The plan would fail to meet the requirements of this paragraph if it distributed $4,000 (four percent) of B's employee contributions and none of B's matching contributions because this would result in a discriminatory rate of matching contributions. See section 1.401(m)-1(e)(2) and (4). See also Example 8.

* * * * *

EXAMPLE 8. (i) Employer B maintains a calendar year profit sharing plan that includes a cash or deferred arrangement. Elective contributions are matched at the rate of 100 percent. After-tax employee contributions are permitted under the plan only for nonhighly compensated employees and are matched at the same rate. No employees make excess deferrals. Employee A, a highly compensated employee, makes an $8,000 elective contribution and receives an $8,000 matching contribution.

(ii) Employer B performs the actual deferral percentage (ADP), the actual contribution percentage (ACP), and the multiple use tests. To correct failures of the ADP and ACP tests, the plan distributes to A $1,000 of excess contributions and $500 of excess aggregate contributions. After the distributions, A's contributions for the year are $7,000 of elective contributions and $7,500 of matching contributions. As a result, A has received a higher effective rate of matching contributions than nonhighly compensated employees ($7,000 of elective contributions matched by $7,500 is an effective matching rate of 107 percent). If this amount remains in A's account without correction, it will cause the plan to fail to satisfy section 401(a)(4), because only a highly compensated employee receives the higher matching contribution rate. The remaining $500 matching contribution may be forfeited (but not distributed) under section 411(a)(3)(G), if the plan so provides. The plan could instead correct the discriminatory rate of matching contributions by making additional allocations to the accounts of nonhighly compensated employees. See section 1.401(a)(4)-11(g)(3)(vii)(B) and (6), Example 7.

(f) * * *

(1) * * *

(ii) * * *

(B) HIGHLY COMPENSATED EMPLOYEE ELIGIBLE UNDER MORE THAN ONE PLAN. The actual contribution ratio of a highly compensated employee who is eligible to participate in more than one plan of an employer to which employee or matching contributions are made is calculated by treating all the plans in which the employee is eligible to participate as one plan. However, plans that are not permitted to be aggregated under section 1.410(b)-7(c), as modified in section 1.401(k)-1(g)(11), are not aggregated for this purpose. For example, if a highly compensated employee with compensation of $80,000 may receive matching contributions under two plans of an employer, the employee's actual contribution ratio under each plan is calculated by dividing the employee's total matching contributions under both plans by $80,000, unless the plans are required to be disaggregated. In that case, the actual contribution ratio of the employee under each plan is to be calculated by dividing the employee's matching contributions under that plan by $80,000. See paragraph (b)(3) of this section for the treatment of certain multiple plans. For plan years beginning after December 31, 1988, or such later date provided in paragraph (g) of this section, if a highly compensated employee participates in two or more plans that have different plan years, this paragraph (f)(1)(ii) is applied by treating all plans whose plan years end with or within the same calendar year as a single plan.

(C) EMPLOYEES SUBJECT TO FAMILY AGGREGATION RULES -- (1) AGGREGATION OF EMPLOYEE CONTRIBUTIONS AND OTHER AMOUNTS. For plan years beginning after December 31, 1986, or such later date provided in paragraph (g) of this section, if a highly compensated employee is subject to the family aggregation rules of section 414(q)(6) because that employee is either a five-percent owner or one of the 10 most highly compensated employees, the combined actual contribution ratio for the family group (treated as one highly compensated employee) must be determined by combining the employee contributions, matching contributions, amounts treated as matching contributions, and compensation of all family members.

* * * * *

(2) COMPENSATION. The term COMPENSATION means compensation as defined in section 1.401(k)-1(g)(2)(i).

* * * * *

(4) * * *

(ii) * * * In no event is an election made after December 23, 1994 treated as a one-time irrevocable election under this paragraph if the election is made by an employee who previously became eligible under another plan (whether or not terminated) of the employer.

* * * * *

(12) * * * (i) * * *

(B) Any employer contribution (including a contribution made at the employer's discretion) to a defined contribution plan on account of an elective deferral (as defined in section 1.402(g)-1(b)); and

* * * * *

(16) SECTION 401(k) PLAN. The term SECTION 401(k) PLAN means a section 401(k) plan within the meaning of section 1.410(b)-9.

(17) SECTION 401(m) PLAN. The term SECTION 401(m) PLAN means a section 401(m) plan within the meaning of section 1.410(b)-9.

(g) * * *

(4) STATE AND LOCAL GOVERNMENT PLANS. A governmental plan described in section 414(d), including a plan subject to section 403(b)(12)(A)(i) (nonelective plan) is treated as satisfying section 401(m) for plan years beginning before the later of January 1, 1996, or 90 days after the opening of the first legislative session beginning on or after January 1, 1996, of the governing body with authority to amend the plan, if that body does not meet continuously. For purposes of this paragraph (g)(4), the term governing body with authority to amend the plan means the legislature, board, commission, council, or other governing body with authority to amend the plan.

(5) * * *

(ii) * * * (A) GENERAL RULE. In determining whether the requirements of section 401(m) are satisfied for plan years beginning before January 1, 1992, a plan may be treated as consisting of two or more component plans, each consisting of all of the allocations and other benefits, rights, and features provided to a group of employees under the plan. See section 1.401(a)(4)-9(c). An employee may not be included in more than one component plan of the same plan for a plan year under this method. If this method is used for a plan year, the requirements of section 401(m) are applied separately with respect to each component plan for the plan year. Thus, for example, the actual contribution ratio and the amount of excess aggregate contributions, if any, of each eligible employee under each component plan must be determined as if the component plan were a separate plan. This method applies solely for purposes of section 401(m). Thus, for example, the requirements of section 410(b) must still be satisfied by the entire plan.

(B) * * *

(2) COMMONALITY REQUIREMENT. The group of employees used to identify a component plan must share some common attribute or attributes, other than similar actual contribution ratios. Permissible common attributes include, for example, employment at the same work site, in the same job category, for the same division or subsidiary, or for a unit acquired in a specific merger or acquisition, employment for the same number of years, compensation under the same method (e.g., salaried or hourly), coverage under the same contribution formula, and attributes that could be used as the basis of a classification that would be treated as reasonable under section 1.410(b)-4(b). Employees whose only common attribute is the same or similar actual contribution ratios, or another attribute having substantially the same effect as the same or similar actual contribution ratios, are not considered as sharing a common attribute for this purpose. This rule applies regardless of whether the component plan or the plan of which it is a part satisfies the ratio or percentage test of section 410(b).

Par. 6. Section 1.401(m)-2 is amended as follows:

1. A sentence is added at the end of paragraph (a).

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

3. Paragraph (c)(1) and (c)(4), Example 1 (i), is revised.

4. The added and revised provisions read as follows:

SECTION 1.401(m)-2 MULTIPLE USE OF ALTERNATIVE LIMITATION.

(a) * * * The consequences of multiple use of the alternative methods of compliance are described in section 1.401(m)-1(a)(1).

(b) GENERAL RULE FOR DETERMINATION OF MULTIPLE USE -- (1) IN GENERAL. (i) Multiple use of the alternative limitation occurs if all of the conditions of this paragraph (b)(1) are satisfied:

(A) One or more highly compensated employees of the employer are eligible employees in both a cash or deferred arrangement subject to section 401(k) and a plan maintained by the employer subject to section 401(m).

(B) The sum of the actual deferral percentage of the entire group of eligible highly compensated employees under the arrangement subject to section 401(k) and the actual contribution percentage of the entire group of eligible highly compensated employees under the plan subject to section 401(m) exceeds the aggregate limit of paragraph (b)(3) of this section.

(C) The actual deferral percentage of the entire group of eligible highly compensated employees under the arrangement subject to section 401(k) exceeds the amount described in section 401(k)(3)(A)(ii)(I).

(D) The actual contribution percentage of the entire group of eligible highly compensated employees under the arrangement subject to section 401(m) exceeds the amount described in section 401(m)(2)(A)(i).

(ii) The actual deferral percentage and actual contribution percentage of the group of eligible highly compensated employees are determined after use of qualified nonelective contributions and qualified matching contributions to meet the requirements of section 401(k)(3)(A)(ii) and after use of qualified nonelective contributions and elective contributions to meet the requirements of section 401(m)(2)(A). The actual deferral percentage and actual contribution percentage of the group of eligible highly compensated employees are determined after any corrective distribution or forfeiture of excess deferrals, excess contributions, or excess aggregate contributions and after any recharacterization of excess contributions required without regard to this section. Only plans and arrangements maintained by the same employer are taken into account under this paragraph (b)(1). If the employer maintains two or more plans after application of the rules under section 1.401(k)-1(g)(11), multiple use is tested separately with respect to each plan. Thus, for example, if an employer maintains a cash or deferred arrangement with matching contributions, under which elective contributions may be made under either an ESOP or a non-ESOP, multiple use is tested separately with respect to elective contributions and matching contributions under the ESOP, and with respect to elective contributions and matching contributions under the non-ESOP.

* * * * *

(c) * * * (1) IN GENERAL. If multiple use of the alternative limitation occurs with respect to two or more plans or arrangements maintained by an employer, it must be corrected by reducing the actual deferral percentage, the actual contribution percentage of highly compensated employees, or a combination of the two, in the manner described in paragraph (c)(3) of this section. Instead of making this reduction, the employer may eliminate the multiple use of the alternative limitation by making qualified nonelective contributions in accordance with section 1.401(k)-1(b)(5) and (f)(1) or section 1.401(m)-1(b)(5) and (e)(1).

* * * * *

(4) * * *

EXAMPLE 1. (i) All employees of Employer Q are eligible in both an arrangement subject to section 401(k) and a plan subject to section 401(m). Both plans have a calendar plan year. The plans provide that multiple use of the alternative limitation will be corrected in the plan subject to section 401(m) and that any required reduction in actual contribution ratios will apply only to employees eligible to participate in both arrangements. Employer Q includes elective contributions in compensation as permitted under section 1.414(s)-1(c)(4)(i). See section 1.401(k)-1(g)(2)(i). Employees X and Y are highly compensated. Each received compensation of $100,000, deferred $6,000, received a $3,000 matching contribution, and made employee contributions of $3,000. Actual deferral and contribution percentages under the arrangement and plan for the 1989 plan year are shown below. No excess deferrals, excess contributions, or excess aggregate contributions have yet been required to be distributed, forfeited, or recharacterized under the plan.

                                     Actual        Actual

Par. 7. Section 1.402(a)-1 is amended as follows:

1. Paragraph (d)(3)(iv) is revised.

2. Paragraph (d)(3)(v) is added.

3. The added and revised provisions read as follows:

SECTION 1.402(a)-1 TAXABILITY OF BENEFICIARY UNDER A TRUST WHICH MEETS THE REQUIREMENTS OF SECTION 401(a).

* * * * *

(d) * * *

(3) * * *

(iv) SPECIAL RULE FOR COLLECTIVELY BARGAINED PLANS. For plan years beginning before January 1, 1993, a nonqualified cash or deferred arrangement will be treated as satisfying section 401(k)(3) solely for purposes of paragraph (d)(2)(i) of this section if it is part of a plan (or portion of a plan) that automatically satisfies section 401(a)(4) under section 1.401(k)-1(a)(7), relating to certain collectively bargained plans.

(v) SPECIAL RULE FOR GOVERNMENTAL PLANS. For plan years beginning before the later of January 1, 1996, or 90 days after the opening of the first legislative session beginning on or after January 1, 1996, of the governing body with authority to amend the plan, if that body does not meet continuously, in the case of governmental plans described in section 414(d), a nonqualified cash or deferred arrangement will be treated as satisfying section 401(k)(3) solely for purposes of paragraph (d)(2)(i) of this section if it is part of a plan adopted by a state or local government before May 6, 1986. For purposes of this paragraph (d)(3)(v), the term governing body with authority to amend the plan means the legislature, board, commission, council, or other governing body with authority to amend the plan.

Par. 8. Section 1.402(g)-1 is amended as follows:

1. Paragraph (e)(5)(ii) is revised.

2. In paragraph (e)(11), paragraph (iv) of Example 2, is revised and paragraph (v) is removed.

3. The added and revised provisions read as follows:

SECTION 1.402(g)-1 LIMITATION ON EXCLUSION FOR ELECTIVE DEFERRALS.

(e) * * *

(5) * * *

(ii) METHOD OF ALLOCATING INCOME. A plan may use any reasonable method for computing the income allocable to excess deferrals, provided that the method does not violate section 401(a)(4), is used consistently for all participants and for all corrective distributions under a plan for the plan year, and is used by the plan for allocating income to participants' accounts. See section 1.401(a)(4)-1(c)(8).

* * * * *

(11) * * *

EXAMPLE 2. * * *

(iv) In February 1990, B notifies X that B made elective deferrals of $2,000 under a qualified cash or deferred arrangement maintained by an unrelated employer in 1989, and requests distribution of $2,000 from X's plan. However, since B has already received a distribution of $2,002 to meet the ADP test, no additional amounts are required or are permitted to be distributed as excess deferrals by this plan, and the prior distribution of excess contributions has corrected the excess deferrals. But X must report $2,000 as a distribution of an excess deferral and $2 as a distribution of an excess contribution.

* * * * *

Par. 9. In section 1.411(d)-4, A-2 is amended by revising paragraph (b)(2)(x) and (xi) to read as follows:

SECTION 1.411(D)-4 SECTION 411(d)(6) PROTECTED BENEFITS.

* * * * * A-2: * * *

(b) * * *

(2) * * *

(x) AMENDMENT OF HARDSHIP DISTRIBUTION STANDARDS. A qualified cash or deferred arrangement that permits hardship distributions under section 1.401(k)-1(d)(2) may be amended to specify or modify nondiscriminatory and objective standards for determining the existence of an immediate and heavy financial need, the amount necessary to meet the need, or other conditions relating to eligibility to receive a hardship distribution. For example, a plan will not be treated as violating section 411(d)(6) merely because it is amended to specify or modify the resources an employee must exhaust to qualify for a hardship distribution or to require employees to provide additional statements or representations to establish the existence of a hardship. A qualified cash or deferred arrangement may also be amended to eliminate hardship distributions. The provisions of this paragraph also apply to profit-sharing or stock bonus plans that permit hardship distributions, whether or not the hardship distributions are limited to those described in section 1.401(k)-1(d)(2).

(xi) SECTION 415 BENEFIT LIMITATIONS. Accrued benefits under a plan as of the first day of the first limitation year beginning after December 31, 1986, that exceed the benefit limitations under section 415(b) or (e), effective on the first day of the plan's first limitation year beginning after December 31, 1986, because of a change in the terms and conditions of the plan made after May 5, 1986, or the establishment of a plan after that date, may be reduced to the level permitted under section 415(b) or (e).

* * * * *

Par. 10. Section 1.415-6 is amended by revising paragraph (b)(6)(iv) to read as follows:

SECTION 1.415-6 LIMITATION FOR DEFINED CONTRIBUTION PLANS.

* * * * *

(b) * * *

(6) * * *

(iv) Notwithstanding paragraph (b)(6)(i), (ii), or (iii) of this section, the plan may provide for the distribution of elective deferrals (within the meaning of section 402(g)(3)) or the return of employee contributions (whether voluntary or mandatory), and for the distribution of gains attributable to those elective deferrals and employee contributions, to the extent that the distribution or return would reduce the excess amounts in the participant's account. These distributed or returned amounts are disregarded for purposes of section 402(g), the actual deferral percentage test of section 401(k)(3), and the actual contribution percentage test of section 401(m)(2). However, the return of mandatory employee contributions may result in discrimination in favor of highly compensated employees. If the plan does not provide for the return of gains attributable to the returned employee contributions, such earnings will be considered as an employee contribution for the limitation year in which the returned contribution was made. For limitation years beginning after December 31, 1995, if a plan does not provide for the distribution of gains attributable to the distributed elective deferrals, such earnings will be considered as an employer contribution for the limitation year in which the distributed elective deferral was made. If a suspense account is in existence at any time during the limitation year in accordance with this subparagraph, investment gains and losses and other income may, but need not, be allocated to the suspense account. To the extent that investment gains or other income or investment losses are allocated to the suspense account, the entire amount allocated to participants from the suspense account, including any such gains or other income or less any such losses, is considered as the annual addition. See section 1.401(a)-2(b) for provisions relating to the disposition of a suspense account in existence upon termination of a plan.

* * * * *

PART 54 -- PENSION EXCISE TAXES

Par. 11. The authority citation for part 54 continues to read in part as follows:

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

Par. 12. Section 54.4979-0 is amended as follows:

1. The entry for section 54.4979-1, paragraph (d)(4) is revised.

2. The entry for section 54.4979-1, paragraph (d)(5) is removed.

The revised entry reads as follows:

SECTION 54.4979-0. EXCISE TAX ON CERTAIN EXCESS CONTRIBUTIONS AND EXCESS AGGREGATE CONTRIBUTIONS, TABLE OF CONTENTS. * * *

* * * * *

Section 1.54-4979-1 * * *

(d) * * *

(4) Plan years beginning before January 1, 1992.

Par. 13. Section 54.4979-1 is amended as follows:

1. Paragraph (d)(1) is revised.

2. Paragraph (d)(3) is revised.

3. Paragraph (d)(4) is removed.

4. Paragraph (d)(5) is redesignated as paragraph (b)(4).

5. The paragraph heading for newly designated paragraph (d)(4) is revised.

The revised provisions read as follows:

SECTION 54.4979-1 EXCISE TAX ON CERTAIN EXCESS CONTRIBUTIONS AND EXCESS AGGREGATE CONTRIBUTIONS.

(d) EFFECTIVE DATE -- (1) GENERAL RULE. Except as provided in paragraphs (d)(2) through (4), this section is effective for plan years beginning after December 31, 1986.

* * * * *

(3) COLLECTIVELY BARGAINED PLANS AND PLANS OF STATE OR LOCAL GOVERNMENTS. For plan years beginning before January 1, 1993, the provisions of this section do not apply to a collectively bargained plan that automatically satisfies the requirements of section 410(b). See sections 1.401(a)(4)-1(c)(5) and 1.410(b)-2(b)(7) of this chapter. In the case of a plan (including a collectively bargained plan) maintained by a state or local government, the provisions of this section do not apply for plan years beginning before the later of January 1, 1996, or 90 days after the opening of the first legislative session beginning on or after January 1, 1996, of the governing body with authority to amend the plan, if that body does not meet continuously. For purposes of this paragraph (d)(3), the term GOVERNING BODY WITH AUTHORITY TO AMEND THE PLAN means the legislature, board, commission, council, or other governing body with authority to amend the plan.

(4) Plan years beginning before January 1, 1992. * * *