Proposed IRS Regulation Would Eliminate "One Bad Apple" Rule for Multiple Employer Defined Contribution Plans
On July 3, 2019, the IRS proposed a new regulation addressing one problem experienced by multiple employer defined contribution plans (DC MEPs) which are tax qualified as single plans under Section 413(c) of the Internal Revenue Code (the "Code"). Under 413(c), the failure by one contributing employer to meet the qualification rules would result in the disqualification of the entire plan. The proposed IRS regulation refers to this as the "unified plan rule," but is more generally referred to as the "one bad apple" rule, which provides that the qualification of a MEP is determined with respect to all employers maintaining the MEP. The regulation explicitly provides that "the failure by one employer maintaining the plan (or by the plan itself) to satisfy an applicable plan requirement will result in the disqualification of the MEP for all employers maintaining the plan." This unified plan rule applies without regard to whether the requirement tests participating employers on a unitary or individual basis (the employers in the MEP are treated as one employer for some 413(c) purposes, and as single employers for other purposes, such as minimum coverage under Code Section 410(b)).
The IRS proposal is needed because the DC MEPs do not have a clear mechanism to remove the "bad apple," the uncooperative employer, from the DC MEP to preserve the plan's qualification for the other participating employers. The preamble to the proposal explains that Section 413(c) was originally designed for 413(b) plans, which were mostly defined benefit plans, but that the 413(c) terms did not neatly apply to the administration of defined contribution MEPs. The IRS proposal is an attempt to provide some guidance in this area, including approving a process of spinning off and terminating from the MEP the non-cooperating employer's portion of the plan. The IRS notes that its proposal was drafted in consultation with the Department of Labor (the "Department" or "DOL") and asks for comments on how the DOL should take steps to facilitate the effectiveness of the IRS proposal, noting that the Department had informed the IRS that MEPs using the spin off guidance should be concerned about their fiduciary responsibilities and potential prohibited transaction issues.
At the heart of the issue is that Code Section 413(c) plans may not always be single plans under Title I of ERISA. The difficulty was highlighted in 2012 when the DOL issued an advisory opinion clarifying the very limited types of MEPs that could be single "multiple employer" Title I plans - noting that to be a single plan, the employers in the MEP had to have some cohesive commonality, and had to have control of the plan itself.1 The advisory opinion specifically noted that whether a MEP was a single plan under Code Section 413(c) was not determinative of whether the benefit arrangement was also a single Title I plan.
The proposed regulation is in response to an August 2018 Executive Order 13847, issued after several years of unsuccessful proposed legislation to correct the administrative difficulties in operating a MEP under Section 413(c). The Executive Order encourages the expansion of access to MEPs, directing the Secretary of the Treasury to "consider proposing amendments to regulations or other guidance, consistent with applicable law and the policy set forth in... this Order, regarding the circumstances under which a MEP may satisfy the tax qualification requirements... including the consequences if one or more employers that sponsored or adopted the plan fails to take one or more actions necessary to meet those requirements." A legislative solution is also currently before Congress, in the House-approved SECURE Act, which eliminates the unified plan rule under Section 413(c).
Under the proposed IRS regulation, a defined contribution MEP would not be disqualified on account of a participating employer (determined on a controlled group basis, including the affiliated service group rules), if certain conditions are satisfied. A participating employer failure is defined under the regulations as either a known qualification failure or a potential qualification failure. A known qualification failure is a failure to satisfy a qualification failure with respect to the MEP that is identified by the plan administrator and is attributable solely to an unresponsive participating employer. A potential qualification failure is a failure to satisfy a qualification requirement with respect to a MEP that the plan administrator reasonably believes might exist, but the plan administrator is unable to determine whether the qualification requirement is satisfied solely due to an unresponsive participating employer's failure to provide necessary data, documentation, and other information necessary to determine if the MEP is in compliance as it relates to the particular employer.
The conditions that must be satisfied to avoid application of the unified plan rule are as follows: First, the MEP must satisfy certain eligibility requirements, such as a requirement to have established practices and procedures to promote compliance and a requirement to adopt relevant plan language. Second, the plan administrator must provide notice and an opportunity for the unresponsive participating employer to take remedial action with respect to the participating failure. An unresponsive participating employer will receive three (3) notices, and its final deadline to take action is 90 days after the third notice is received. Third, if the unresponsive participating employer fails to take appropriate remedial action with respect to the participating employer failure, the plan administrator implements a spin-off. Fourth, the plan administrator complies with any information request that the IRS or a representative of the spun-off plan makes in connection with the IRS examination of the spun-off plan, including information relating to the participation of the MEP for years prior to the spinoff.
For these purposes, a spinoff can occur in one of two ways: it may be either a spin-off that is initiated by the unresponsive participating employer and implemented by the plan administrator, or a spin-off termination implemented unilaterally by the plan administrator pursuant to the terms of the plan. In general, distributions from a spun-off plan that is terminated in accordance with the proposed regulations would be eligible for the favorable tax treatment from tax qualified plans, including the ability to roll over the distribution. However, notwithstanding the general rule, the IRS reserves the right to pursue appropriate remedies against any party, such as the owner of the participating employer who is responsible for the participating employer failure that resulted in the spin-off termination, even if such person is a participant or beneficiary under the terminated plan. The IRS also requested comments on whether additional guidance should be provided with respect to the termination of the spun-off plan, such as adopting rules similar to those required in connection with converting single employer PEO plans into multiple employer plans.2
The spin-off approach is not without some historical antecedent. In the preamble to the 1979 regulations that included the unified plan rule, responding to comments made by participating employers in collectively-bargained plans, the great majority of which would have been defined benefits, the IRS indicated that "it is expected that the Service's administration of these provisions may shelter innocent and non-negligent employers from some of the harsh results of disqualification. Accordingly, in a proper case, the Commissioner could retain the Plan's qualified status for innocent employers by requiring collective and remedial action with respect to the plan such as allowing the withdrawal of an offending employer." However, that statement was contained in the preamble to a regulation, not the text of the regulation, as under the current proposal, and there is some question as to whether this regulatory proposal is consistent with the test of Code Section 413(c).
The IRS had considered expanding these proposed regulations to tax-qualified defined benefit plans as well, but, because of additional complexities that would be associated with applying these proposed regulations to defined benefit plans, elected not to do so. The IRS did, however, solicit comments regarding the possible extension of these rules to tax qualified defined benefit plans.
1 The IRS Preamble refers to the 2018 DOL proposed regulation, also issued pursuant to Executive Order 13847, which further defines which multiple employer retirement defined contribution benefit arrangements are single plans under Title I of ERISA. The Department retains its traditional test, but relaxes some of the outdated criteria, and proposes to conditionally offer single plan status to multiple employer plans sponsored by professional employer organizations ("PEOs"), and to multiple employer plans (other than those sponsored by PEOs) that include self-employed individuals. Some of the proposed elements, including the proposal to permit including self-employed individuals, were also included in a DOL final regulation for multiple employer group health plans ("AHPs"), which was vacated recently by a federal court and is now on appeal.
2 In 2002 IRS issued a revenue procedure, a pathway forward for leasing companies' DC MEPs, to convert from single employer plans to 413(c) multiple employer plans, including the ability to spin off and terminate the plans of noncontributing employers. As noted by many commentators since, the 2002 IRS guidance was inadequate because the revenue procedure purported to only apply to DC MEPs in existence at that time, and did not provide any assurance that 413(c) plans could satisfy the ERISA fiduciary standards in any spin off and termination.