For many years, the Internal Revenue Code has had in place a set of rules, in Code Section 413(c), which govern tax-qualified retirement plans that cover the employees of unaffiliated employers. These plans, which go by the name “multiple employer plans,” are required under Section 413(c) to satisfy a number of tax qualification operational requirements on a per-employer, rather than plan-wide basis. However, the Section 413(c) regulations have historically provided that the failure of any one employer to comply with these requirements can result in the plan losing its tax qualification. This plan-level imposed sanction is often called the “one bad apple” rule.

On July 3, the Internal Revenue Service issued proposed changes to the regulations under Section 413(c) to provide a mechanism by which a multiple employer plan can prevent a single employer's compliance failure from infecting the entire plan.

Employee Leasing Meets Section 401(k)

Employee leasing companies — also known as professional employer organizations, or PEOs — provide smaller businesses an escape from having to comply with the paperwork and related administrative burdens associated with payroll taxes by treating the businesses’ workers as the PEO’s employees under a shared or co-employer structure.

By aggregating the employees of a number of businesses, PEOs are able to offer the businesses access to health and other welfare benefits, as well as a 401(k) plan, on more favorable terms and at a lesser administrative cost, than if the businesses obtained such benefits or a 401(k) plan on their own.

The shifting of the payroll and benefit arrangements to the PEO from the PEO’s clients does not typically result in the clients’ workers becoming subject to the control of the PEO in the performance of the workers’ services, and as a result, the workers remain common law employees of the clients.

In Revenue Procedure 2002-21, the IRS announced that under a standard PEO arrangement, the PEO’s clients are to be treated as separate employers for purposes of the Section 413(c) multiple employer plan rules. Because of the requirement that each separate employer must satisfy tax-qualification operational requirements, and the attendant consequence that the failure to do so disqualifies the multiple employer plan, this characterization created potentially burdensome outcomes.

Consider, for example, the following two scenarios:

1. As a condition of maintaining its tax qualification, a 401(k) plan must undergo annual testing, which among other things compares the elective contributions and matching contributions of highly compensated employees — as defined in Section 414(q) of the Internal Revenue Code — for a plan year, with the elective contributions and matching contributions for the plan year of employees who are not highly compensated employees.

These nondiscrimination tests limit the extent to which the average annual elective contributions and the average annual matching contributions of highly compensated employees can exceed the average annual elective contributions and the average annual matching contributions of nonhighly compensated employees.

A PEO that is administering a 401(k) plan is required to collect demographic information each year — including dates of hire, amounts of contributions and compensation — from each of its clients, and under Section 413(c), run the contribution nondiscrimination tests separately for each client.

Keeping in mind that the clientele of PEOs are small businesses, it is easy to envision a PEO having difficulties accumulating the necessary data from all of its clients in order to be able to timely run the tests for a plan year. Under the one bad apple rule, a PEO with hundreds, or for that matter thousands, of clients that cannot run the tests for any one of those clients is potentially faced with having its 401(k) plan lose its tax qualification.

2. Under the IRS’s interpretation of the tax qualification rules, a 401(k) plan must be operated in accordance with the written documents that embody the plan. A common 401(k) plan format used by PEOs is a basic document, which sets forth the provisions that the IRS requires be included in a plan, and a separate adoption agreement that is filled out and signed by the PEO’s clients, which allows each client to select among choices related to optional features — such as eligibility waiting period, vesting requirements for employer contributions, and timing and forms of distribution.

Given the complexity of the plan documents, it would not be uncommon for a PEO client to fail to comprehend the import of the choices the client made in a 401(k) plan adoption agreement. For example, a PEO’s client might not realize that the adoption agreement completed by the client to participate in the PEO’s 401(k) plan provided for the inclusion of all employees, without regard to their period of service, believing mistakenly that employees who are part-time or who do not complete 90 days of service are excluded from participation.

Although the PEO’s oversight of the client’s payroll function would in many instances discover this error relatively quickly, there could well be some period where, as to this client, the 401(k) plan was not operated in accordance with its terms. In that event, the plan administrator would be required to correct the error under the IRS employee plans compliance resolution system's voluntary correction program, currently set forth in Revenue Procedure 2019-19. If the client refuses to cooperate with the plan administrator’s correction effort, the PEO would be faced with a qualification problem that would negatively impact the whole 401(k) plan.

The IRS Provides Assistance

The IRS’ proposed changes to the regulations under Section 413(c) provide a road map which, if followed, will avoid the potentially onerous impact of the one bad apple rule.

Although the discussion below references PEOs and 401(k) plans, the proposed changes apply to others that maintain a multiple employer plan and to defined contribution plans other than 401(k) plans.

The proposed changes are inapplicable to multiple employer defined benefit plans. Also, the relief granted by the changes is not available to a multiple employer plan that is under IRS examination.

The proposed regulations discuss how to address a “potential qualification failure,” an example of which would be the first scenario described above — that is, a situation in which the PEO needs information from a client to be able to properly administer a plan, but the client is either unwilling or unable to provide the information.

The proposed regulations also provide guidance regarding a “known qualification failure,” which would be second scenario described above — that is, a situation in which a qualification failure has been identified by the PEO.

The proposed regulations lay out a notice procedure which a PEO with a 401(k) plan that has a potential qualification failure or a known qualification failure must follow. This procedure is a three-notice process, with specified deadlines and information that must be included in the notices.

The first two notices are sent to the client that is the subject of the qualification failure. The third notice is sent to the client, the U.S. Department of Labor and to the client’s employees who are participants in the PEO’s 401(k) plan and their beneficiaries.

Spinoff and Termination — “You’re Fired”

If, after the third notice, a PEO client has failed to take appropriate remedial action — either by providing the information with respect to a potential qualification failure or by taking action that enables the plan administrator to correct a known operational failure — the PEO can move forward with a plan spin off and termination.

A plan spinoff can be likened to a form of quarantine, in which the assets of the PEO’s 401(k) plan that are attributable to the employees of the errant client are transferred to a new 401(k) plan. The spun-off plan is then terminated and the assets of the spun-off plan are distributed to the employees or beneficiaries whose plan benefits were transferred to that plan.

If a PEO acts in accordance with the notice and spinoff/termination process, a client’s potential or known qualification failure will not disqualify the PEO’s 401(k) plan.

Tax Treatment of the Spun-Off Plan Distribution

The proposed regulations include significant relief for plan participants who receive distributions from the spun-off plan. Even though the assets of the spun-off plan can be viewed as tainted for tax qualification purposes, the proposed regulations state that “distributions made from a spun-off plan … will not solely, because of the participating employer failure, fail to be eligible for favorable tax treatment accorded to distributions from qualified plans ... .”

The proposed regulations specifically confirm that distributions from the spun-off plan may be rolled over tax-free to an IRA or other eligible retirement plan. The IRS, however, reserves the right to deny such favorable treatment to a party who is responsible for the participating employer failure and includes, as an example of a responsible party, the owner of the participating employer.

In light of the increasing prevalence of PEOs and other employee leasing arrangements, this proposed guidance makes a great deal of practical sense by eliminating what to date has been a tax-qualification Catch-22.

"How the IRS Would Replace the 1 Bad Apple Rule," by Dan Morgan was published in Law360 on July 9, 2019. Reprinted with permission.