The IRS has published final regulations (TD 9835) that modify the requirements for qualified matching contributions (QMACs) and qualified nonelective contributions (QNECs) for employer retirement plans.  These regulations are adopted essentially unchanged from the proposed versions issued in January 2017.

These payments are used to deal with issues that arise when an employer initially runs the ADP and/or ACP tests for a retirement plan and discovers the plan does not comply with one or both tests for the plan year.

Under the regulations, a plan will meet the ADP or ACP tests if the deferrals or contributions fall within the following ranges:

• If the non-highly compensated employee (NHCE) percentage is 2% of less, the highly-compensated employee percentage is no greater than twice the NHCE percentage
• If the NHCE percentage is between 2% and 8%, the HCE percentage is no more than the NHCE percentage plus 2%
• If the NHCE percentage is more than 8%, then the HCE percentage is no more than the NHCE percentage plus 1.25%.[1]

The IRS explains the ADP test and QMACs and QNECs in the preamble to the final regulations:

Under §1.401(k)-1(b)(1)(ii), a CODA satisfies the applicable nondiscrimination requirements if it satisfies the actual deferral percentage (ADP) test of section 401(k)(3), described in §1.401(k)-2.The ADP test limits the disparity permitted between the percentage of compensation made as employer contributions to the plan for a plan year on behalf of eligible highly compensated employees and the percentage of compensation made as employer contributions on behalf of eligible nonhighly compensated employees. If the ADP test limits are exceeded, the employer must take corrective action to ensure that the limits are met. In determining the amount of employer contributions made on behalf of an eligible employee, employers are allowed to take into account certain QMACs and QNECs made on behalf of the employee by the employer.

Similarly, the IRS goes on to discuss the ACP test in the preamble:

A defined contribution plan that provides for matching or employee aftertax contributions must satisfy the nondiscrimination requirements under section 401(m) with respect to those contributions for each plan year. Under §1.401(m)-1(b)(1), the matching contributions and employee contributions under a plan satisfy the nondiscrimination requirements for a plan year if the plan satisfies the actual contribution percentage (ACP) test of section 401(m)(2) described in §1.401(m)-2.

The ACP test limits the disparity permitted between the percentage of compensation made as matching contributions and after-tax employee contributions for or by eligible highly compensated employees under the plan and the percentage of compensation made as matching contributions and after-tax employee contributions for or by eligible nonhighly compensated employees under the plan. If the ACP test limits are exceeded, the employer must take corrective action to ensure that the limits are met. In determining the amount of employer contributions made on behalf of an eligible employee, employers are allowed to take into account certain QNECs made on behalf of the employee by the employer. Employers must also take into account QMACs made on behalf of the employee by the employer unless an exclusion applies (including an exclusion for QMACs that are taken into account under the ADP test)

Basically, the QMACs and QNECs can be used to solve some or all of the shortfall found when the ACP and ADP tests are performed by pushing up the NHCE percentage.  This can reduce or avoid the need for amounts to be returned to the NHCEs, reducing their ability to make use of the plan to the extent they prefer.

These contributions are subject to certain restrictions in order to qualify as either a QMAC or QNEC.  As the preamble notes:

As defined in §1.401(k)-6, QMACs and QNECs must satisfy the nonforfeitability requirements of §1.401(k)–1(c) and the distribution limitations1 of §1.401(k)–1(d) “when they are contributed to the plan.” Similarly, under the independent definitions in §1.401(m)-5, QMACs and QNECs must satisfy the nonforfeitability requirements of §1.401(k)–1(c) and the distribution limitations of §1.401(k)-1(d) “at the time the contribution is made.” In general, contributions satisfy the nonforfeitability requirements of §1.401(k)-1(c) if they are immediately nonforfeitable within the meaning of section 411, and contributions satisfy the distribution limitations of §1.401(k)-1(d) if they may not be distributed before the employee’s death, disability, severance from employment, attainment of age 59½, or hardship, or upon the termination of the plan. (emphasis added)

The new regulations are designed to solve a problem created by the fact that these contributions were required to meet the tests at the time the contribution was made.  The IRS had received comments noting that this prevented the use of forfeitures in the plan for such payments.

As the IRS described the comments in the preamble:

This is because the amounts would have been allocated to the forfeiture accounts only after a participant incurred a forfeiture of benefits and, thus, generally would have been subject to a vesting schedule when they were first contributed to the plan. Commenters requested that QMAC and QNEC requirements not be interpreted to prevent the use of plan forfeitures to fund QMACs and QNECs.

The IRS now agrees that there is no reason to bar the use of forfeitures for QMACs and QNECs, since the point is to provide nonforfeitable benefits for those that receive the QMAC and QNEC.  Thus, the new regulations require the payments meet the requirements at the time they are allocated to a participant’s account rather than when they were first contributed to the plan. [2]

The IRS had received some comments related to the proposed regulations raising a concern about whether a plan that was amended to apply the new rules applicable to QMACs and QNECs could run afoul of IRC §411(d)(6).  Generally, under IRC §411(d)(6) a plan cannot be amended in a way that would reduce the accrued benefit of a participant.  Commentators worried that, since the QMACs and QNECs coming out of forfeitures would reduce forfeitures that could be otherwise allocated under the plan, that an impermissible reduction of an accrued benefit would take place.

The IRS responds to this concern as follows in the preamble, giving two potential solutions.  First, it points out that if an amendment only applies to future years there is no problem

The application of section 411(d)(6) is generally outside the scope of these regulations. However, if a plan sponsor adopts a plan amendment to define QMACs and QNECs in a manner consistent with these final regulations and applies that amendment prospectively to future plan years, section 411(d)(6) would not be implicated.

However, there may be a way to take advantage of this change in the current plan year.  The IRS points out that if the plan provides that forfeitures first go to pay plan expenses, then all conditions have not yet been met by a participant to accrue a benefit.  Thus, the amendment could apply to the current plan year without running into §411(d)(6) issues.

Moreover, in the common case of a plan that provides that forfeitures will be used to pay plan expenses incurred during a plan year and that any remaining forfeitures in the plan at the end of the plan year will be allocated pursuant to a specified formula among active participants who have completed a specified number of hours of service during the plan year, section 411(d)(6) would not prohibit a plan amendment adopted before the end of the plan year that permits the use of forfeitures to fund QMACs and QNECs (even if, at the time of the amendment, one or more participants had already completed the specified number of hours of service). This is because all conditions for receiving an allocation will not have been satisfied at the time of the amendment, since one of the conditions for receiving an allocation is that plan expenses at the end of the plan year are less than the amount of forfeitures. See §1.411(d)-4, Q&A-1(d)(8) (features that are not section 411(d)(6) protected benefits include “[t]he allocation dates for contributions, forfeitures, and earnings, the time for making contributions (but not the conditions for receiving an allocation of contributions or forfeitures for a plan year after such conditions have been satisfied), and the valuation dates for account balances”).

The new regulations are effective for plan years beginning on or after July 20, 2018.  However, the regulations allow taxpayers to apply these regulations to earlier plan years.

Employer plans will generally need to be amended to allow for the use of forfeitures in this manner, as was noted above.  However, making such an amendment will make it easier and less expensive for employers to make these corrective contributions, so it seems likely that most employers who make use of these provisions (rather than using the safe harbor 401(k) provisions) will want to adopt such amendments.

[1] Regs. §1.401(k)-2(a)(1)(i) and §1.401(m)-2(a)(1)(i)

[2] Reg. §1.401(k)-6 as modified