Bulletin No. 2003-35September 2, 2003

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

REG–133791–02, page 493.Taxpayers may receive a tax credit for certain expenses in-curred in conducting qualified research. Proposed regulationsunder section 41 of the Code provide guidance on the propermethod for computing and allocating the research credit formembers of a controlled group of corporations or a group oftrades or businesses under common control. A public hearingis scheduled for November 13, 2003. REG–105606–99 with-drawn.

REG–162625–02, page 500.Proposed regulations under section 446 of the Code set outrules relating to the proper timing and source of income of feesreceived to induce the acquisition of noneconomic residual in-terests in REMICs. A public hearing is scheduled for November18, 2003.

EMPLOYEE PLANS

T.D. 9081, page 420.REG–129709–03, page 506.Temporary and proposed regulations under section 409(p) ofthe Code provide guidance concerning the requirements foremployee stock ownership plans (ESOPs) holding stock of Sub-chapter S corporations. A public hearing on the proposed reg-ulations is scheduled for November 20, 2003.

REG–108639–99, page 431.Proposed regulations under sections 401(k) and 401(m) of theCode provide guidance on the requirements for certain retire-ment plans containing cash or deferred arrangements and pro-viding for matching contributions or employee after-tax contri-butions. These regulations affect certain plans or contracts

providing for elective deferrals under section 401(k), match-ing contributions or employee after-tax contributions under sec-tion 401(m), and participants eligible under these plans or con-tracts. A public hearing is scheduled for November 12, 2003.

REG–112039–03, page 504.Proposed regulations under section 411 of the Code amendsection 1.411(d)–4, of the regulations to reflect the additionof section 411(d)(6)(E) by the Economic Growth and Tax Re-lief Reconciliation Act of 2001. The proposed regulations re-tain rules under which a defined contribution plan could beamended, but remove the 90-day notice condition.

Notice 2003–58, page 429.Weighted average interest rate update. The weighted averageinterest rate for August 2003 and the resulting permissiblerange of interest rates used to calculate current liability forpurposes of the full funding limitation of section 412(c)(7) ofthe Code are set forth.

ADMINISTRATIVE

Notice 2003–59, page 429.Uniform capitalization; methods of accounting. This noticemodifies Notice 2003–36 to permit certain taxpayers to usethe automatic approval procedures of Rev. Proc. 2002–9 tochange their method of accounting to the simplified servicecost or simplified production method for self-constructed as-sets for their most recent taxable year ending on or beforeMay 8, 2003. This notice also informs taxpayers that, in thefuture, the Service and Treasury Department may provide guid-ance under which the automatic approval procedures will nolonger apply to a method of accounting, effective for applica-tions filed after such change is announced. Notice 2003–36modified.

Finding Lists begin on page ii.Index for July through August begins on page viii.

The IRS MissionProvide AmericaÊs taxpayers top quality service by helpingthem understand and meet their tax responsibilities and byapplying the tax law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument ofthe Commissioner of Internal Revenue for announcing officialrulings and procedures of the Internal Revenue Service and forpublishing Treasury Decisions, Executive Orders, Tax Conven-tions, legislation, court decisions, and other items of generalinterest. It is published weekly and may be obtained from theSuperintendent of Documents on a subscription basis. Bul-letin contents are consolidated semiannually into CumulativeBulletins, which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin all sub-stantive rulings necessary to promote a uniform application ofthe tax laws, including all rulings that supersede, revoke, mod-ify, or amend any of those previously published in the Bulletin.All published rulings apply retroactively unless otherwise indi-cated. Procedures relating solely to matters of internal man-agement are not published; however, statements of internalpractices and procedures that affect the rights and duties oftaxpayers are published.

Revenue rulings represent the conclusions of the Service on theapplication of the law to the pivotal facts stated in the revenueruling. In those based on positions taken in rulings to taxpayersor technical advice to Service field offices, identifying detailsand information of a confidential nature are deleted to preventunwarranted invasions of privacy and to comply with statutoryrequirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not berelied on, used, or cited as precedents by Service personnel inthe disposition of other cases. In applying published rulings andprocedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be considered,and Service personnel and others concerned are cautionedagainst reaching the same conclusions in other cases unlessthe facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A,Tax Conventions and Other Related Items, and Subpart B, Leg-islation and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references to thesesubjects are contained in the other Parts and Subparts. Alsoincluded in this part are Bank Secrecy Act Administrative Rul-ings. Bank Secrecy Act Administrative Rulings are issued bythe Department of the TreasuryÊs Office of the Assistant Sec-retary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The first Bulletin for each month includes a cumulative indexfor the matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, andare published in the first Bulletin of the succeeding semiannualperiod, respectively.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

September 2, 2003 2003-35 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Code of 1986Section 263A.—Capital-ization and Inclusion inInventory of Certain Expenses

Taxpayers are informed that, in the future, the Ser-vice and Treasury Department may provide guidanceunder which the automatic approval procedures willno longer apply to a particular method of accounting,effective for applications filed after such change is an-nounced. See Notice 2003-59, page 429.

Section 409(p).—Qualifica-tions for Tax Credit EmployeeStock Ownership Plans —Prohibited Allocations ofSecurities in an S-Corporation

T.D. 9081

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Part 1

Prohibited Allocations ofSecurities in an S Corporation

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document containstemporary regulations concerning re-quirements for employee stock ownershipplans (ESOPs) holding stock of Sub-chapter S corporations. The temporaryregulations provide guidance on identify-ing disqualified persons and determiningwhether a plan year is a nonallocationyear under section 409(p) and on the def-inition of synthetic equity under section409(p)(5). These temporary regulationswould generally affect plan sponsors of,and participants in, ESOPs holding stockof Subchapter S corporations. The textof the temporary regulations also servesas the text of the proposed regulations(REG–129709–03) set forth in the noticeof proposed rulemaking on this subject onpage 506 of this issue of the Bulletin.

DATES: Effective Date: These regulationsare effective July 21, 2003.

Applicability Date: These temporaryregulations are applicable with respect toplan years ending after October 20, 2003.

FOR FURTHER INFORMATIONCONTACT: John T. Ricotta at (202)622–6060 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Section 4975(e)(7) provides that anESOP is a defined contribution plan that isdesigned to invest primarily in qualifyingemployer securities and that is either astock bonus plan which is qualified, ora stock bonus plan and money purchasepension plan both of which are qualified,under section 401(a). Section 4975(e)(7)authorizes the Secretary to issue regula-tions imposing additional requirementsfor ESOPs (see §54.4975–11 of the Ex-cise Tax Regulations). A plan is nottreated as an ESOP under the Code un-less it meets the following requirements,to the extent applicable: section 409(h)(relating to participants' right to receiveemployer securities; put options); section409(o) (relating to participants' distribu-tion rights and payment requirements);section 409(n) (relating to securities re-ceived in transactions to which section1042 applies); section 409(p) (relating toprohibited allocations of securities in anS corporation); section 664(g) (relating toqualified gratuitous transfers of qualifiedemployer securities); and section 409(e)(relating to participants' voting rights ifthe employer has a registration-type classof securities). As authorized by section4975(e)(7), additional requirements areimposed under §54.4975–11.

Section 1361(b)(1)(D) provides that aSubchapter S corporation (S corporation)may not have more than one class of stock.Section 1361(b)(1)(B) provides that an Scorporation may not have as a shareholdera person that is not an estate, a trust de-scribed in section 1361(c)(2), an organi-zation described in section 1361(c)(6), oran individual. In 1996, section 1361(c)(6)was amended to permit a qualified plan un-der section 401(a) to be a shareholder inan S corporation. Section 1316(a) of theSmall Business Job Protection Act of 1996(SBJPA) (110 Stat. 1755) (1996).

Section 511(a)(1) imposes a tax onthe unrelated business taxable income(as defined in section 512(a)) of organi-zations described in section 511(a)(2),

which include plans that qualify undersection 401(a). Section 512(e)(1) pro-vides that if an organization described insection 1361(c)(6) holds stock in an Scorporation, the interest is treated as aninterest in an unrelated trade or businessand, notwithstanding the organization'sgeneral tax-exempt status, all items ofincome, loss, or deduction taken into ac-count under section 1366(a) and any gainor loss on the disposition of the stock inthe S corporation are taken into account incomputing the unrelated business taxableincome of the organization. In 1997, sec-tion 512(e) was amended to provide thatsection 512(e) does not apply to employersecurities (within the meaning of section409(l)) held by an ESOP described insection 4975(e)(7). Section 1523 of theTaxpayer Relief Act of 1997 (TRA ’97)(111 Stat. 788) (1997). Accordingly,S corporation income allocable to stockheld by an ESOP is not subject to regularincome or unrelated business income tax,but S corporation income allocable tostock held by any other qualified plan ortax-exempt entity under section 501(c)(3)is subject to the unrelated business incometax under section 511.

Congress became aware that the taxexemption for earnings on S corporationstock held by an ESOP may lead to inap-propriate tax deferral or avoidance in somecases. In order to address these concerns,Congress enacted section 409(p) as partof the Economic Growth and Tax ReliefReconciliation Act of 2001 (EGTRRA)(115 Stat. 38) (2001). Section 409(p) isintended to limit the tax benefits of ESOPsmaintained by S corporations unless theESOP provides meaningful benefits torank-and-file employees. As explained inthe legislative history:

The Committee continues to believethat S corporations should be able to en-courage employee ownership throughan ESOP. The Committee does not be-lieve, however, that ESOPs should beused by S corporation owners to obtaininappropriate tax deferral or avoidance.

Specifically, the Committee believesthat the tax deferral opportunities pro-vided by an S corporation ESOP shouldbe limited to those situations in whichthere is broad-based employee coverage

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under the ESOP and the ESOP bene-fits rank-and-file employees as well ashighly compensated employees and his-torical owners.

H. R. Rep. No. 107–51, part 1, at 100(2001).

Section 409(p)(1) requires an ESOPholding employer securities consistingof stock in an S corporation to providethat no portion of the assets of the planattributable to (or allocable in lieu of)such employer securities may, during anonallocation year, accrue (or be allocateddirectly or indirectly under any plan ofthe employer meeting the requirementsof section 401(a)) for the benefit of anydisqualified person, as defined in section409(p).1

Section 409(p)(3)(A) provides that a“nonallocation year” includes any planyear during which the ownership of the Scorporation is so concentrated among dis-qualified persons that they own at least 50percent of its shares. Section 409(p)(3)(B)provides that, in determining the sharesowned by an individual for purposes ofsection 409(p)(3)(A), the attribution rulesof section 318(a) apply, with certain ex-ceptions, and the individual is treated asowning his or her deemed-owned ESOPshares.

Under section 409(p)(4)(C)(i), the termdeemed-owned shares includes, with re-spect to any person, the stock in the Scorporation constituting employer securi-ties of an ESOP which is allocated to thatperson under the ESOP, and that person'sshare of the stock in the S corporationwhich is held by the ESOP but which is notallocated to participants under the ESOP.Suspense account stock is deemed to be al-located to participants in the same propor-tion as the most recent plan allocation.

Section 409(p)(4) provides, in general,that whether someone is a “disqualifiedperson” depends on a person's ownershipof deemed-owned shares of S corporationstock held by an ESOP (deemed-ownedESOP shares). Section 409(p)(4) provides,in general, that a “disqualified person”means any person whose deemed-ownedESOP shares are at least 10 percent ofthe number of deemed-owned ESOPor for whom the aggregate number ofdeemed-owned ESOP shares of such per-son and the members of such person's

family is at least 20 percent of the numberof deemed-owned ESOP shares.

The determination of whether someoneis a disqualified person and whether a planyear is a nonallocation year is made with-out regard to “synthetic equity” attribut-able to that person and is also made sep-arately taking into account synthetic eq-uity. Synthetic equity is a general clas-sification unique to section 409(p). Theprovisions relating to synthetic equity donot modify the rules relating to S corpora-tions, e.g., the circumstances in which op-tions or similar interests are treated as cre-ating a second class of stock. H.R. Conf.Rep. No. 107–84, at 102 n.52. Under sec-tion 409(p)(6)(C), synthetic equity is de-fined as:

any stock option, warrant, restrictedstock, deferred issuance stock right, orsimilar interest or right that gives theholder the right to acquire or receivestock of the S corporation in the future.Except to the extent provided in regu-lations, synthetic equity also includes astock appreciation right, phantom stockunit, or similar right to a future cashpayment based on the value of suchstock or appreciation in such value.

Under the rules for the treatment of syn-thetic equity at section 409(p)(5), if a per-son owns synthetic equity in an S corpo-ration, then the shares of stock in suchcorporation on which such synthetic eq-uity is based are generally treated as out-standing stock in such corporation, and asdeemed-owned shares of such person, ifsuch treatment of synthetic equity resultseither in the treatment of any person asa disqualified person or the treatment ofany year as a nonallocation year. Accord-ingly, if a person is treated as a disquali-fied person or a year is treated as a non-allocation year without regard to syntheticequity, then the inclusion of synthetic eq-uity as outstanding stock does not causethe person to fail to be treated as a disqual-ified person or the year to fail to be treatedas a nonallocation year.

Section 409(p)(7)(A) authorizes theSecretary to prescribe such regulations asmay be necessary to carry out the purposesof section 409(p). As indicated by the leg-islative history above, section 409(p) isintended to limit the tax benefits of ESOPsmaintained by S corporations unless the

ESOP provides meaningful benefits torank-and-file employees. See H.R. Rep.No. 107–51, part 1, at 100 (2001). Section409(p)(7)(B) provides that the Secretarymay, by regulation or other guidance ofgeneral applicability, provide that a nonal-location year occurs in any case in whichthe principal purpose of the ownershipstructure of an S corporation constitutesan avoidance or evasion of section 409(p).“For example, this might apply if morethan 10 independent businesses are com-bined in an S corporation owned by anESOP in order to take advantage of theincome tax treatment of S corporationsowned by an ESOP.” H.R. Conf. Rep. No.107–84, at 277 (2001).

Under section 656 of EGTRRA, sec-tion 409(p) is effective for plan years end-ing after March 14, 2001, except for thoseESOPs eligible for a delayed effective dateapplicable to certain ESOPs that were es-tablished on or before March 14, 2001. SeeRev. Rul. 2003–6, 2003–3 I.R.B. 286.

Section 4979A imposes a 50 percent ex-cise tax in certain cases, including an allo-cation of employer securities that is pro-hibited by section 409(p), the ownershipof any synthetic equity by a disqualifiedperson during a nonallocation year, andthe occurrence of the first nonallocationyear of an ESOP, as described in section4979A(e)(2)(C).

Explanation of Provisions

Overview

Section 409(p) was enacted to addressconcerns about ownership structures in-volving S corporations and ESOPs thatconcentrate the benefits of the ESOP in asmall number of persons. Under the statuteas amended, an ESOP is still permitted tohold S corporation stock, provided that theESOP benefits a sufficiently broad-basedgroup of employees.

These temporary regulations reflect thestatutory language under section 409(p)(1)prohibiting an accrual or allocation in anonallocation year, but do not provide ad-ditional guidance on what constitutes aprohibited accrual or allocation. It is ex-pected that this issue will be addressed inadditional regulations.

An ESOP has a nonallocation yearfor any plan year during which, at any

1 This definition is different from the definition of disqualified person for purposes of section 4975.

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time, disqualified persons hold at least 50percent of the outstanding shares of stockin the S corporation or 50 percent of theoutstanding shares of stock and syntheticequity in the S corporation. These tem-porary regulations provide guidance onthe rules applicable for this purpose. Inaddition, pursuant to section 409(p)(7)(B),these temporary regulations authorize theCommissioner to provide that a nonallo-cation year exists in any year in whichthe principal purpose of the ownershipstructure is avoidance or evasion of sec-tion 409(p). These temporary regulationsalso provide guidance on identification ofdisqualified persons.

Synthetic Equity

As discussed above, disqualified per-sons and nonallocation years are identi-fied both with and without synthetic eq-uity. Section 409(p) defines synthetic eq-uity very broadly. Synthetic equity in-cludes restricted stock, rights to acquirestock in the corporation, such as stock op-tions or warrants, and other similar inter-ests. It also includes payments denomi-nated in share value, including a phantomstock unit, stock appreciation right, or sim-ilar interest.

In addition, under these temporaryregulations, synthetic equity includes twoother categories of interests or payments:nonqualified deferred compensation (eventhough it is neither payable in, nor cal-culated by reference to, stock in the Scorporation) and rights to acquire interestsin certain related entities. In each case,treatment of these interests as syntheticequity is necessary to carry out the Con-gressional purpose of section 409(p) oflimiting the tax deferral opportunities pro-vided by an S corporation ESOP to thosesituations in which the benefits of theESOP ownership are available, at a min-imum, to a broad group of rank-and-fileemployees who have the opportunity tobe the primary beneficiaries of the growthof the business through the ESOP. Unlessthese interests are treated as syntheticequity, the benefits associated with owner-ship of an interest in an S Corporation bymeans of the ESOP could be concentratedin a small group, and diverted away fromthe rank-and-file employees, through useof these interests. In this respect, theseinterests have the same effect as stock

appreciation rights payable in cash, whichare explicitly included in synthetic equityby statute.

Nonqualified Deferred Compensation asSynthetic Equity

Since the addition of section 409(p),arrangements have been promoted to tax-payers in which an S corporation that iseither entirely or substantially owned byan ESOP is used to shelter the incomeof an active business while the profits ofthe business are primarily provided forcertain management employees of thebusiness through various obligations tomake future payments to the employees.Typically in these arrangements, the obli-gation to make future payments to themanagement employees suppresses thevalue of the company's stock that is allo-cated to rank-and-file employees throughthe ESOP, depriving them of the opportu-nity to be the primary beneficiaries of thegrowth of the business through the ESOP.

For example, under some of these ar-rangements, the owners of the operatingcompany establish a management com-pany and the operating company agreesto pay management fees equal to sub-stantially all (or most) of the profits ofthe operating company. The managementcompany agrees to provide future com-pensation to certain executives or otheremployees of the operating company orthe management company in an amountequal to substantially all of the profits ofthe management company. Finally, themanagement company elects to be treatedas an S corporation and transfers all, or asubstantial portion, of its stock to an ESOPestablished to cover rank-and-file employ-ees. Under this arrangement, the operatingcompany claims a deduction for the feespaid to the management corporation. Themanagement corporation in turn retainsthese fees to satisfy its obligations to payfuture compensation. Although the stockof the management corporation is ownedby the ESOP, the ownership interest heldfor rank-and-file employees through theESOP has a substantially reduced value.Rather than being a mechanism for thetransfer of not only ownership, but alsothe rights associated with ownership, tothe employees of the S corporation, theESOP is used as part of a structure de-signed to shelter profits that will be paid

as future compensation for a small groupof executives or management employees.

These temporary regulations treat non-qualified deferred compensation providedby the S corporation or certain related enti-ties as synthetic equity, including deferredcompensation that is neither payable instock of the S corporation nor calculatedby reference to stock of the S corpora-tion. S Corporations that do not maintainESOPs typically do not provide nonquali-fied deferred compensation to owners. Bytreating nonqualified deferred compen-sation provided by the S corporation (orcertain related entities) as synthetic equity,these temporary regulations address own-ership structures that are designed to avoidor evade section 409(p) and provide guid-ance allowing individuals to determinewhen these interests result in a failure tocomply with section 409(p). Nonqualifieddeferred compensation is appropriatelycharacterized as synthetic equity becauseit functions similarly to other forms of syn-thetic equity by diverting value away fromshareholders, thereby reducing the valueof the S corporation and diminishing theESOP's interest in the value that, absentthe nonqualified deferred compensation,would be reflected in the shares of the Scorporation held by the ESOP. This effectoccurs even if the nonqualified deferredcompensation is a fixed dollar amount,and even if such deferred compensation isnot payable in stock of the S corporationor measured by reference to that stock (di-rectly, such as a stock appreciation rightpayable in cash, or less directly, such aspercentage of the future profits of the Scorporation).

Right to Acquire Assets as SyntheticEquity

Under these temporary regulations,rights to acquire stock or other similarinterests in a related entity are treated assynthetic equity if the ownership of suchinterests in the related entity is the onlysignificant asset of the S corporation andthe S corporation is the only significantholder of stock (or other similar interests)of the related entity. For this purpose,related entities are entities in which theS corporation holds an interest and withrespect to which income is passed throughto the S corporation. These rights are

2003-35 I.R.B. 422 September 2, 2003

properly treated as synthetic equity be-cause they provide the holders of theserights with an opportunity to benefit fromthe S corporation ESOP structure that iscomparable to the opportunity providedthrough synthetic equity issued directly bythe S corporation. Taking rights to acquirestock or other similar interests in a relatedentity into account as synthetic equity pro-vides a method for identifying situationsin which the interests in the S corporation(and its assets) have, directly or indirectly,become concentrated in a manner thatshould result in a nonallocation year undersection 409(p).

These temporary regulations providethat synthetic equity does not includerights to acquire goods or services at fairmarket value in the ordinary course ofbusiness. The temporary regulations donot address, at this time, rights to ac-quire other assets of the S Corporationor assets of the related entity or otherrelated entities. This absence should notbe interpreted as a conclusion that a rightto acquire these other assets cannot besynthetic equity. It may be appropriateto treat the right to acquire assets of theS Corporation, other than its interest in arelated entity (such as its ownership of amanufacturing plant), as synthetic equity.It may also be appropriate to treat rights toacquire assets held by the related entity assynthetic equity.

The temporary regulations also do notaddress rights to acquire interests in relatedentities if the ownership of such interests inthe related entity is not the only significantasset of the S corporation or the S corpo-ration is not the only significant holder ofstock (or other similar interests) of the re-lated entity. Rights to acquire interests inother related entities is reserved because,for example, it may be appropriate in casesin which a related entity is not the only sig-nificant asset of the S Corporation to treatas synthetic equity only a portion of thevalue of the rights to acquire stock or othersimilar interests in the related entity.

The IRS and Treasury intend to issueadditional regulations providing guidanceon the definition of synthetic equity on anumber of issues, including issues identi-fied as reserved in these temporary regula-tions. For example, the IRS and Treasuryintend to issue additional guidance relatingto rights to acquire interests in other relatedentities and rights to acquire assets of an

S corporation or related entity. The addi-tional regulations are expected to addressthe treatment of these interests, includinghow any such interests treated as syntheticequity should be converted into shares ofsynthetic equity in the S corporation andwhether such conversion should take intoaccount the extent to which income of therelated entity is allocated to a shareholderthat is subject to regular income tax or un-related trade or business income tax. Theseitems are reserved in order to allow for ad-ditional consideration of these issues, in-cluding consideration of comments on theproposed regulations accompanying theseregulations. The additional regulations areexpected to be issued in conjunction withguidance on prohibited accruals or alloca-tions to disqualified persons in a nonallo-cation year, which is also identified as re-served in these temporary regulations.

In the meantime, these temporary reg-ulations provide an anti-abuse provisiontreating acquisition rights as synthetic eq-uity in certain situations. Specifically, thistreatment applies to an option or right toacquire assets of the S corporation, or a re-lated person, that is part of a structure thatprovides rights to the holder comparable tothe rights provided by arrangements iden-tified as synthetic equity under these tem-porary regulations and in which the prin-cipal purpose of the structure is the avoid-ance or evasion of section 409(p). In ad-dition, the temporary regulations delegateauthority to the Commissioner to provide,through revenue rulings, notices and otherguidance published in the Internal Rev-enue Bulletin (see §601.601(d)(2)(ii)(b) ofthis chapter), that synthetic equity includesa right to acquire stock or other similar in-terests in a related entity in cases in whichthe S corporation's interest in the relatedentity is not the only significant asset ofthe S corporation or the S corporation isnot the only significant owner of the re-lated entity.

Rights to Acquire Shares of Stock That areIssued and Outstanding

The definition of synthetic equity pro-vides that rights to acquire shares in an Scorporation with respect to shares that are,at all times during the period when suchrights are effective, both issued and out-standing and held by persons other than theESOP, S corporation, or a related entity are

not synthetic equity. These arrangementsinclude, for example, rights of first refusalheld by one shareholder in the S corpora-tion with respect to the shares of anothertaxable shareholder (i.e., shares held out-side the tax-exempt structure created bythe ESOP). However, in certain limitedcases, a disqualified person who has theright to acquire such issued and outstand-ing stock is treated as owning the stock ifsuch treatment results in a nonallocationyear.

Conversion of Synthetic Equity

Synthetic equity that is determined byreference to shares of S corporation stockis treated as the corresponding number ofshares of stock. Synthetic equity that is de-termined by reference to shares of stock(or similar interests) in a related entity isconverted into an equivalent number ofshares of stock of the S corporation withthe same aggregate value as the numberof shares of stock (or similar interests) ofthe related entity (with such value deter-mined without regard to any lapse restric-tion as defined at §1.83–3(i)). The valueof any other synthetic equity interest, suchas fixed dollar nonqualified deferred com-pensation, is converted into an equivalentnumber of shares of stock in the S corpo-ration based on the present value of theinterest or right to nonqualified deferredcompensation (with such value determinedwithout regard to any lapse restriction asdefined at §1.83–3(i)) and the fair marketvalue of the S corporation shares on the de-termination date (with both values deter-mined as of any reasonable date during theplan year).

Identification of Disqualified Persons

Under these temporary regulations,a person is a disqualified person basedeither on deemed-owned ESOP shares ordeemed-owned ESOP shares combinedwith synthetic equity. Whether there isa nonallocation year is then determinedby taking into account the holdings of alldisqualified persons, first based only onoutstanding shares of stock of the cor-poration and then based on outstandingshares of stock and synthetic equity of thecorporation. In accordance with the lastsentence of section 409(p)(5), syntheticequity cannot result in a person who is

September 2, 2003 423 2003-35 I.R.B.

treated as a disqualified person for a year,or a year that is treated as a nonallocationyear, not being so treated. In addition,these temporary regulations provide that,in any year in which the Commissionerprovides that a nonallocation year occursbecause the principal purpose of the own-ership structure of the S corporation is anavoidance or evasion of section 409(p),the Commissioner may also treat any indi-vidual as a disqualified person.

As a result of the provisions of thesetemporary regulations relating to syntheticequity, employees who benefit from non-qualified deferred compensation arrange-ments or who hold rights to acquire in-terests in certain related entities will betreated as owning synthetic equity and maybe treated as disqualified persons. As a re-sult, certain plan years of the ESOP may betreated as nonallocation years. This resultwill not occur unless the aggregate inter-est held by disqualified persons — throughsynthetic equity, direct share ownership,and deemed-owned ESOP shares — con-stitutes at least half of the value of the out-standing stock and synthetic equity of theS corporation.

Effective Date

In the case of an ESOP holding stockin an S corporation that is eligible forthe delayed effective date under sec-tion 656(d)(2) of EGTRRA applicableto certain ESOPs established on or be-fore March 14, 2001, these temporaryregulations do not apply until plan yearsbeginning on or after January 1, 2005. Foran ESOP to which the delayed effectivedate is not applicable, these temporaryregulations are applicable with respectto plan years ending after October 20,2003. The temporary regulations permit Scorporations to avoid having nonqualifieddeferred compensation treated as syntheticequity under paragraph (f)(2)(iv) of thesetemporary regulations by distributing thedeferred compensation by July 21, 2004.

Request for Comments in ProposedRegulations and Future Guidance

See the preamble of the cross-referencenotice of proposed rulemaking publishedelsewhere in this issue of the Bulletinwhich asks for comments with respect toissues raised by S corporation ESOPs.

Special Analysis

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessmentis not required. It also has been deter-mined that section 553(b) of the Admin-istrative Procedure Act (5 U.S.C. chapter5) does not apply to these regulations. Forthe applicability of the Regulatory Flexi-bility Act (5 U.S.C. chapter 6) refer to theSpecial Analyses section of the preambleto the cross-referencing notice of proposedrulemaking published in this issue of theBulletin. Pursuant to section 7805(f) ofthe Internal Revenue Code, these tempo-rary regulations will be submitted to theChief Counsel for Advocacy of the SmallBusiness Administration for comment ontheir impact.

Drafting Information

The principal author of these regula-tions is John T. Ricotta of theOffice of theDivision Counsel/Associate Chief Coun-sel (Tax Exempt and Government Enti-ties). However, other personnel from theIRS and Treasury participated in their de-velopment.

* * * * *

Amendments to the Regulations

Accordingly, 26 CFR part 1 is amendedas follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * *Section 1.409(p)–1T is also issued un-

der 26 U.S.C. 409(p)(7). * * *Par. 2. Section 1.409(p)–1T is added to

read as follows:

§1.409(p)–1T Prohibited allocation ofsecurities in an S corporation (temporary).

(a) Organization of this section. Sec-tions 409(p) and 4979A apply if a non-allocation year occurs in an employeestock ownership plan (ESOP), as definedin section 4975(e)(7), that holds sharesof stock of a Subchapter S corporation (Scorporation) that are employer securities

as defined in section 409(l). Paragraph (b)of this section sets forth the general ruleunder section 409(p)(1) and (2) prohibit-ing an allocation to a disqualified personin a nonallocation year. Paragraph (c) ofthis section sets forth rules under section409(p)(3), (5), and (7) for determiningwhether a year is a nonallocation year,generally based on whether disqualifiedpersons own at least 50 percent of theshares of the S corporation, either tak-ing into account only the outstandingshares of the S corporation (includingshares held by the ESOP) or taking intoaccount both the outstanding shares andsynthetic equity of the S corporation.Paragraphs (d), (e), and (f) of this sec-tion contain definitions of a disqualifiedperson under section 409(p)(4) and (5),deemed-owned ESOP shares under sec-tion 409(p)(4)(C), and synthetic equityunder section 409(p)(6)(C).

(b) Prohibited accruals in a nonalloca-tion year—(1) General rule. An ESOPholding employer securities consisting ofstock in an S corporation must provide thatno portion of the assets of the plan attrib-utable to (or allocable in lieu of ) such em-ployer securities may, during a nonalloca-tion year, accrue (or be allocated directlyor indirectly under any plan of the em-ployer meeting the requirements of section401(a)) for the benefit of any disqualifiedperson.

(2) Additional rules. [Reserved](c) Nonallocation year — (1) Definition

generally. A nonallocation year means aplan year of an ESOP during which, at anytime, the ESOP holds any employer securi-ties that are shares of an S corporation andeither —

(i) Disqualified persons own at least50 percent of the number of outstandingshares of stock in the S corporation (in-cluding deemed-owned ESOP shares), or

(ii) Disqualified persons own at least50 percent of the aggregate number ofoutstanding shares of stock (includingdeemed-owned ESOP shares) and syn-thetic equity in the S corporation.

(2) Attribution rules. For purposes ofthis paragraph (c), the rules of section318(a) apply to determine ownership ofshares in the S corporation (includingdeemed-owned ESOP shares) and syn-thetic equity. However, for this purpose,section 318(a)(4) (relating to options to

2003-35 I.R.B. 424 September 2, 2003

acquire stock) is disregarded and, in apply-ing section 318(a)(1), the members of anindividual's family include members of theindividual's family under paragraph (d)(2)of this section. In addition, an individualis treated as owning deemed-owned ESOPshares of that individual notwithstandingthe employee trust exception in section318(a)(2)(B)(i). If the attribution rulesin paragraph (f)(1) of this section apply,then the rules of paragraph (f)(1) of thissection are applied before the rules of thisparagraph (c)(2).

(3) Special rule for avoidance orevasion. Under section 409(p)(7)(B),the Commissioner, in revenue rulings,notices, and other guidance publishedin the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(B) of this chapter),may provide that a nonallocation yearoccurs in any case in which the principalpurpose of the ownership structure of anS corporation constitutes an avoidance orevasion of section 409(p). For any yearthat is a nonallocation year under thisparagraph (c)(3), the Commissioner maytreat any person as a disqualified person.

(4) Special rule for certain stock rights.(i) For purposes of paragraph (c)(1) of thissection, a person is treated as owning stockthat the person has a right to acquire if,at all times during the period when suchrights are effective, the stock that the per-son has the right to acquire is both issuedand outstanding and is held by personsother than the ESOP, the S corporation, ora related entity (as defined in paragraph(f)(2)(iii)(A)(4) of this section).

(ii) This paragraph (c)(4) applies onlyif treating persons as owning the sharesdescribed in paragraph (c)(4)(i) resultsin a nonallocation year. This paragraph(c)(4) does not apply to a right that, un-der §1.1361–1(l)(2)(iii) or (l)(4)(iii)(C),would not be taken into account in deter-mining if an S corporation has a secondclass of stock, and does not apply forpurposes of determining ownership ofdeemed-owned ESOP shares or whetheran interest constitutes synthetic equity (seethe last sentence of paragraph (f)(2)(i)).

(d) Disqualified persons — (1) Generalrule. A disqualified person is any personfor whom —

(i) The number of such person'sdeemed-owned ESOP shares is at least 10percent of the number of deemed-ownedESOP shares of the S corporation;

(ii) The aggregate number of suchperson's deemed-owned ESOP sharesand synthetic equity shares is at least10 percent of the aggregate number ofdeemed-owned ESOP and synthetic eq-uity shares of the S corporation;

(iii) The aggregate number of deemed-owned ESOP shares of such person and ofthe members of such person's family is atleast 20 percent of the number of deemed-owned ESOP shares of the S corporation;or

(iv) The aggregate number of deemed-owned ESOP shares and synthetic equityshares of such person and of the membersof such person's family is at least 20 per-cent of the aggregate number of deemed-owned ESOP and synthetic equity sharesof the S corporation.

(2) Treatment of family members; def-inition. (i) Each member of the family ofany person who is a disqualified person un-der paragraph (d)(1)(iii) or (iv) of this sec-tion is a disqualified person. Member ofthe family means, with respect to an indi-vidual —

(A) the spouse of the individual;(B) an ancestor or lineal descendant of

the individual or the individual's spouse;(C) a brother or sister of the individual

or of the individual's spouse and any linealdescendant of the brother or sister; and

(D) the spouse of any individual de-scribed in paragraph (d)(2)(ii) or (iii) ofthis section.

(ii) A spouse of an individual who islegally separated from such individualunder a decree of divorce or separatemaintenance is not treated as such individ-ual's spouse for purposes of this paragraph(d)(2).

(3) Special rule for certain nonalloca-tion years. See paragraph (c)(3) of thissection (relating to avoidance or evasion ofsection 409(p)) for a special rule permit-ting any person to be treated as a disquali-fied person in certain nonallocation years.

(e) Deemed-owned ESOP shares.A person is treated as owning hisor her deemed-owned ESOP shares.Deemed-owned ESOP shares mean, withrespect to any person —

(1) Any shares of stock in the S corpo-ration constituting employer securities thatare allocated to such person's account un-der the ESOP; and

(2) Such person's share of the stock inthe S corporation that is held by the ESOP

but is not allocated to the account of anyparticipant or beneficiary (with such per-son's share to be determined in the sameproportion as the most recent stock alloca-tion under the ESOP).

(f) Synthetic equity — (1) Ownershipof synthetic equity. For purposes of sec-tion 409(p) and this section, synthetic eq-uity is treated as owned by a person in thesame manner as stock is treated as ownedby a person, directly or under the rules ofsection 318(a)(2) and (3). Synthetic equitymeans the rights described in paragraph(f)(2) of this section.

(2) Synthetic equity— (i) Rights to ac-quire stock of the S corporation. Syntheticequity includes any stock option, warrant,restricted stock, deferred issuance stockright, stock appreciation right payable instock, or similar interest or right that givesthe holder the right to acquire or receivestock of the S corporation in the future.Rights to acquire stock in an S corporationwith respect to stock that is, at all timesduring the period when such rights are ef-fective, both issued and outstanding andheld by persons other than the ESOP, theS corporation, or a related entity, are notsynthetic equity (but see paragraph (c)(4)of this section).

(ii) Special rule for certain stock rights.Synthetic equity also includes a right toa future payment (payable in cash or anyother form other than stock of the S corpo-ration) from an S corporation that is basedon the value of the stock of the S corpora-tion or appreciation in such value, such asa stock appreciation right with respect tostock of an S corporation that is payable incash or a phantom stock unit with respectto stock of an S corporation that is payablein cash.

(iii) Rights to acquire assets of an Scorporation or related entity—(A) Rightsto acquire interests in a related entity —(1) Treatment as synthetic equity. Syn-thetic equity includes a right to acquirestock or other similar interests in a relatedentity that is described in this paragraph(f)(2)(iii)(A).

(2) Significant interests. Synthetic eq-uity includes a right to acquire stock orother similar interests in a related entity ifsuch interests in the related entity are theonly significant asset of the S corporationand the S corporation is the only signifi-cant owner of the related entity. Whetheran asset is the only significant asset of the

September 2, 2003 425 2003-35 I.R.B.

S corporation or the S corporation is theonly significant owner of the related entitydepends on the relevant facts and circum-stances.

(3) Rights to acquire interests in otherrelated entities. [Reserved]

(4) Related entity. For purposes of thissection, related entity means any entity inwhich the S corporation holds an interestand which is a partnership, a trust, an el-igible entity that is disregarded as an en-tity that is separate from its owner under§301.7701–3 of this chapter or a Quali-fied Subchapter S Subsidiary under section1361(b)(3).

(B) Rights to acquire assets of an S cor-poration or related entity other than rightsto acquire stock or similar interests in a re-lated entity—(1) General rule. [Reserved]

(2) Exception for rights to acquiregoods or services in ordinary course ofbusiness. Synthetic equity does not includerights to acquire goods or services at fairmarket value in the ordinary course ofbusiness.

(C) Authority to provide guidance.The Commissioner, in revenue rulings,notices, and other guidance publishedin the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(B) of this chapter),may provide that synthetic equity includesa right to acquire stock or other similarinterests in a related entity in cases inwhich such interests in the related entityare not the only significant asset of the Scorporation or the S corporation is not theonly significant owner of the related entityif necessary to carry out the purposes ofsection 409(p).

(D) Synthetic equity includes compara-ble rights. An option or right to acquireassets of the S corporation or another per-son is treated as synthetic equity if suchoption or right is part of a structure thatprovides rights to the holder comparable tothe rights provided by arrangements iden-tified as synthetic equity under this para-graph (f)(2)(iii) and the principal purposeof the structure is the avoidance or evasionof section 409(p).

(iv) Special rule for nonqualified de-ferred compensation. Synthetic equity

also includes any remuneration for ser-vices rendered to the S corporation, or arelated entity, to which section 404(a)(5)applies (including remuneration for whicha deduction would be permitted under sec-tion 404(a)(5) if separate accounts weremaintained), any right to receive property(to which section 83 applies) in a futureyear for the performance of services toan S corporation, or related entity, andany transfer of property (to which sec-tion 83 applies) in connection with theperformance of services to an S corpora-tion, or a related entity, to the extent thatthe property is not substantially vestedwithin the meaning of §1.83–3(i) by theend of the plan year in which transferred.Synthetic equity also includes any otherremuneration for services rendered to theS corporation, or a related entity, under aplan, or method or arrangement, deferringthe receipt of compensation to a date thatis after the 15th day of the 3rd calendarmonth after the end of the entity's taxableyear in which the related services are ren-dered, other than a plan that is an eligibleretirement plan within the meaning ofsection 402(c)(7)(B).

(3) No overlap among shares ofdeemed-owned ESOP shares or syn-thetic equity. Synthetic equity under thisparagraph (f) does not include shares thatare deemed-owned ESOP shares. In ad-dition, synthetic equity under a specificsubparagraph of this paragraph (f) doesnot include anything that is synthetic eq-uity under a preceding subparagraph ofthis paragraph (f).

(4) Number of synthetic shares— (i)Synthetic equity determined by reference toS corporation shares. In the case of syn-thetic equity that is determined by refer-ence to shares of stock of the S corporation,the person who is entitled to the syntheticequity is treated as owning the correspond-ing number of shares of stock. For exam-ple, if a corporation grants an employee ofan S corporation an option to purchase 100shares of the corporation's stock, the em-ployee is the deemed owner of 100 syn-thetic equity shares of the stock of the cor-poration.

(ii) Synthetic equity determined by ref-erence to shares in a related entity. In thecase of synthetic equity that is determinedby reference to shares of stock (or similarinterests) in a related entity, the person whois entitled to the synthetic equity is treatedas owning shares of stock of the S corpo-ration with the same aggregate value as thenumber of shares of stock (or similar inter-ests) of the related entity (with such valuedetermined without regard to any lapse re-striction as defined at §1.83–3(i)).

(iii) Other synthetic equity. In the caseof any other synthetic equity, the personwho is entitled to the synthetic equityis treated as owning a number of sharesof stock in the S corporation equal tothe present value of the synthetic equity(with such value determined without re-gard to any lapse restriction as definedat §1.83–3(i)) divided by the fair marketvalue of a share of the S corporation'sstock as of the same date. For purposesof this paragraph (f)(4)(iii), the numberof shares of S corporation is permitted tobe determined as of the first day of theESOP's plan year, or any other reasonabledetermination date or dates during a planyear that is consistently used by the cor-poration for this purpose for all persons.The number of shares of synthetic equitytreated as owned for any period from adetermination date through the date im-mediately preceding the next followingdetermination date is the number of sharestreated as owned on the first day of thatperiod.

(g) Examples. The rules of this sectionare illustrated by the following examples:

Example 1. (i) Facts. Corporation X is a calen-dar year S corporation that maintains an ESOP. X hasa single class of common stock, of which there are atotal of 1,200 shares outstanding. X has no syntheticequity. In 2006, individual A, who is not an employeeof X (and is not related to any employee of X), owns100 shares directly, individual B owns 100 shares di-rectly, and the remaining 1,000 shares are owned byan ESOP maintained by X for its employees. TheESOP's 1,000 shares are allocated to the accounts ofindividuals who are employees of X (none of whomare related), as set forth in columns 1 and 2 in the fol-lowing table:

2003-35 I.R.B. 426 September 2, 2003

1Shareholders

2Deemed-Owned ESOP Shares

(total of 1,000)

3Percentage Deemed-Owned

ESOP Shares

4Disqualified Person

B 330 33% Yes

C 145 14.5% Yes

D 75 7.5% No

E 30 3% No

F 20 2% No

Other participants 400 (none exceed 10 shares) 1% or less No

(ii) Conclusion with respect to disqualified per-sons. As shown in column 4 in the table above,individuals B and C are disqualified persons for2006 under paragraph (d)(1) of this section becauseeach owns at least 10% of X's deemed-owned ESOPshares.

(iii) Conclusion with respect to nonallocationyear. However, 2006 is not a nonallocation yearunder section 409(p) because disqualified per-sons do not own at least 50% of X's outstandingshares (the 100 shares owned directly by B, B's330 deemed-owned ESOP shares, plus C's 145

deemed-owned ESOP shares equal only 47.9% ofthe 1,200 outstanding shares of X).

Example 2. (i) Facts. The facts are the same as inExample 1, except that, as shown in column 4 of thetable below, individual E has an option to acquire 500shares of the common stock of X from X:

1Shareholders

2Deemed-OwnedESOP Shares

(total of 1,000)

3Percentage

Deemed-OwnedESOP Shares

4Synthetic Equity

(500)

5Percentage

Deemed-OwnedESOP plus

Synthetic EquityShares (total of

1,500)

6Disqualified Person

B 330 33% 22% Yes (cols. 3 and 5)

C 145 14.5% 9.7% Yes (col. 3)

D 75 7.5% 5% No

E 30 3% 500 35.3% Yes (col. 5)

F 20 2% 1.3% No

Other participants 400 (none exceed10 shares)

1% or less under 1% No

(ii) Conclusion with respect to disqualified per-sons. E's option constitutes 500 shares of syntheticequity. Accordingly, as shown in column 6 in thetable above, individuals B, C, and E are disqualifiedpersons for 2006 because each owns at least 10% ofX's deemed-owned ESOP shares or X's total deemed-owned ESOP and synthetic equity shares.

(iii) Conclusion with respect to nonallocationyear. The 100 shares owned directly by B, B's 330deemed-owned ESOP shares, C's 145 deemed-ownedESOP shares, E's 30 deemed-owned ESOP shares,plus E's 500 synthetic equity shares equals 65% ofthe 1,700 outstanding and synthetic equity shares ofX. Thus, 2006 is a nonallocation year for X's ESOPunder section 409(p) because disqualified personsown at least 50% of X's total shares of outstandingstock and synthetic equity. In addition, independentof the preceding conclusion, 2006 would be a non-allocation year because disqualified persons own atleast 50% of X's outstanding shares because the 100shares owned directly by B, B's 330 deemed-ownedESOP shares, C's 145 deemed-owned ESOP shares,

plus E's 30 deemed-owned ESOP shares equals50.4% of the 1,200 outstanding shares of X.

(h) Effective date —(1) General effec-tive dates. Except as provided in para-graph (h)(2) of this section, section 409(p)applies for plan years ending after March14, 2001, and this section applies for planyears ending after October 20, 2003, ex-cept that paragraph (f)(2)(iv) of this sectionis disregarded with respect to nonqualifieddeferred compensation that is distributedon or before July 21, 2004.

(2) Certain ESOPs established on orbefore March 14, 2001. If an ESOP hold-ing stock in an S corporation was estab-lished on or before March 14, 2001, andthe election under section 1362(a) with re-spect to that S Corporation was in effect

on March 14, 2001, section 409(p) and thissection apply for plan years beginning onor after January 1, 2005.

Robert E. Wenzel,Deputy Commissioner for Ser-

vices and Enforcement.

Approved July 9, 2003.

Pamela F. Olson,Assistant Secretary of Treasury

(Tax Policy).

(Filed by the Office of the Federal Register on July 18, 2003,8:45 a.m., and published in the issue of the Federal Registerfor July 21, 2003, 68 F.R. 42970)

September 2, 2003 427 2003-35 I.R.B.

Section 446.—General Rulefor Methods of Accounting

26 CFR 1.446-1: General rule for methods of ac-counting.

Taxpayers are informed that, in the future, the Ser-vice and Treasury Department may provide guidanceunder which the automatic approval procedures willno longer apply to a particular method of accounting,effective for applications filed after such change is an-nounced. See Notice 2003-59, page 429.

Section 860.—Taxation ofResidual Interests

For rules on the proper accounting for incomefrom inducement fees, see section 1.446-6. SeeREG-162625-02, page 500.

Section 863.—Special Rulesfor Determining Source

Sourcing rule for inducement fees defined in sec-tion 1.446-6. See REG-162625-02, page 500.

2003-35 I.R.B. 428 September 2, 2003

Part III. Administrative, Procedural, and Miscellaneous

Weighted Average Interest RateUpdate

Notice 2003–58

Sections 412(b)(5)(B) and 412(l)(7)(C)(i) of the Internal Revenue Codeprovide that the interest rates used tocalculate current liability for purposes ofdetermining the full funding limitationunder § 412(c)(7) and the required con-tribution under § 412(l) must be withina permissible range around the weightedaverage of the rates of interest on 30-yearTreasury securities during the four-yearperiod ending on the last day before thebeginning of the plan year.

Notice 88–73, 1988–2 C.B. 383, pro-vides guidelines for determining the

weighted average interest rate and the re-sulting permissible range of interest ratesused to calculate current liability for thepurpose of the full funding limitation of§ 412(c)(7) of the Code.

Section 417(e)(3)(A)(ii)(II) of the Codedefines the applicable interest rate, whichmust be used for purposes of determiningthe minimum present value of a partici-pant’s benefit under § 417(e)(1) and (2),as the annual rate of interest on 30-yearTreasury securities for the month beforethe date of distribution or such other timeas the Secretary may by regulations pre-scribe. Section 1.417(e)–1(d)(3) of the In-come Tax Regulations provides that the ap-plicable interest rate for a month is the an-nual interest rate on 30-year Treasury se-curities as specified by the Commissioner

for that month in revenue rulings, noticesor other guidance published in the InternalRevenue Bulletin.

The rate of interest on 30-year TreasurySecurities for July 2003 is 4.93 percent.Pursuant to Notice 2002–26, 2002–1 C.B.743, the Service has determined this rateas the monthly average of the daily deter-mination of yield on the 30-year Treasurybond maturing in February 2031.

Section 405 of the Job Creation andWorker Assistance Act of 2002 amended§ 412(l)(7)(C) of the Code to provide thatfor plan years beginning in 2002 and 2003the permissible range is extended to 120percent.

The following rates were determinedfor the plan years beginning in the monthshown below.

Month YearWeightedAverage

90% to 110%Permissible

Range

90% to 120%Permissible

Range

August 2003 5.31 4.78 to 5.85 4.78 to 6.38

Drafting Information

The principal authors of this noticeare Paul Stern and Tony Montanaro ofthe Employee Plans, Tax Exempt andGovernment Entities Division. For fur-ther information regarding this notice,please contact the Employee Plans’ tax-payer assistance telephone service at1–877–829–5500 (a toll-free number),between the hours of 8:00 a.m. and6:30 p.m. Eastern time, Monday throughFriday. Mr. Stern may be reached at1–202–283–9703. Mr. Montanaro maybe reached at 1–202–283–9714. The tele-phone numbers in two preceding sentencesare not toll-free.

Simplified Service Cost Method;Simplified Production Method

Notice 2003–59

Notice 2003–36, 2003–23 I.R.B. 992,provides that after May 8, 2003, the In-ternal Revenue Service will not acceptForms 3115, Application for Change in

Accounting Method, filed under the auto-matic consent procedures of Rev. Proc.2002–9, 2002–1 C.B. 327, that requestconsent to change to either the simpli-fied service cost method or the simplifiedproduction method for self-constructedassets under §§ 1.263A–1(h)(2)(i)(D)and 1.263A–2(b)(2)(i)(D) of the IncomeTax Regulations. This notice informstaxpayers that the Service and TreasuryDepartment have decided that a taxpayerwill be permitted, after May 8, 2003, totimely file Forms 3115 to make thesechanges under Rev. Proc. 2002–9 forits most recent taxable year ending onor before May 8, 2003. To qualify un-der this notice, a taxpayer that wishesto file a Form 3115 on or after August13, 2003, must do so under Rev. Proc.2002–9 requesting to make a change forits most recent taxable year ending on orbefore May 8, 2003, and in addition tocomplying with the requirements of Rev.Proc. 2002–9, must include the followingstatement on top of the form: “AutomaticChange Filed Under Notice 2003–59.”

A taxpayer that has timely filed its orig-inal federal income tax return after May 8,2003, but on or before September 12, 2003,

for a taxable year ending on or before May8, 2003, also may request automatic con-sent to make such a change by comply-ing with Rev. Proc. 2002–9 and this no-tice. However, such a taxpayer is not sub-ject to the filing requirements in section6.02(3)(a) of Rev. Proc. 2002–9, providedthat the taxpayer complies with the follow-ing filing requirements. The taxpayer mustcomplete and file a Form 3115 in dupli-cate. The original must be attached to thetaxpayer's amended federal income tax re-turn for its most recent taxable year endingon or before May 8, 2003. This amendedreturn must be filed no later than February13, 2004. A copy of the Form 3115 mustbe filed with the national office (see section6.02(6)(a) of Rev. Proc. 2002–9 for theaddress) no later than when the taxpayer'samended return is filed.

For taxable years ending after May 8,2003, Forms 3115 to make these changesmust be filed with the national office underRev. Proc. 97–27, 97–1 C.B. 680.

In the future, if the Service and Trea-sury Department provide that the auto-matic consent procedures no longer applyfor one or more methods of accountingfor which taxpayers had been permitted

September 2, 2003 429 2003-35 I.R.B.

to use the automatic consent procedures,such change may be effective for Forms3115 filed after such change is announced.In such case, a taxpayer that has not fileda copy of Form 3115 with the nationaloffice by the time the change is announced

would not be permitted to use the auto-matic consent procedures.

EFFECT ON OTHER DOCUMENTS

Notice 2003–36 is modified.

DRAFTING INFORMATION

The principal author of this notice isScott H. Rabinowitz of the Office of As-sociate Chief Counsel (Income Tax & Ac-counting). For further information regard-ing this notice, contact Mr. Rabinowitz at(202) 622–4970 (not a toll-free call).

2003-35 I.R.B. 430 September 2, 2003

Part IV. Items of General InterestNotice of Proposed Rulemakingand Notice of Public Hearing

Retirement Plans; Cash orDeferred Arrangements UnderSection 401(k) and MatchingContributions or EmployeeContributions Under Section401(m) Regulations

REG–108639–99

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemakingand notice of public hearing.

SUMMARY: This document contains pro-posed regulations that would provide guid-ance for certain retirement plans contain-ing cash or deferred arrangements undersection 401(k) and providing for match-ing contributions or employee contribu-tions under section 401(m). These regu-lations affect sponsors of plans that con-tain cash or deferred arrangements or pro-vide for employee or matching contribu-tions, and participants in these plans. Thisdocument also contains a notice of publichearing on these proposed regulations.

DATES: Written and electronic commentsand requests to speak (with outlines of oralcomments) at a public hearing scheduledfor November 12, 2003, must be receivedby October 22, 2003.

ADDRESSES: Send submissions to:CC:PA:RU (REG–108639–99), room5226, Internal Revenue Service, POB7604, Ben Franklin Station, Washington,DC 20044. Submissions may be handdelivered Monday through Friday be-tween the hours of 8 a.m. and 4 p.m. to:CC:PA:RU (REG–108639–99), Courier'sDesk, Internal Revenue Service, 1111Constitution Avenue, NW, Washington,DC. Alternatively, taxpayers may submitcomments electronically via the Inter-net directly to the IRS Internet site at:www.irs.gov/regs. The public hearing willbe held in the IRS Auditorium (7th Floor),Internal Revenue Building, 1111 Consti-tution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATIONCONTACT: Concerning the regulations,R. Lisa Mojiri-Azad or John T. Ricotta at(202) 622–6060 (not a toll-free number);concerning submissions and the hear-ing, and/or to be placed on the buildingaccess list to attend the hearing, LaNitaVan Dyke, (202) 622–7180 (not a toll-freenumber).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information con-tained in this notice of proposed rulemak-ing have been submitted to the Office ofManagement and Budget for review inaccordance with the Paperwork Reduc-tion Act of 1995 (44 U.S.C. 3507(d)).Comments on the collections of infor-mation should be sent to the Office ofManagement and Budget, Attn: Desk Of-ficer for the Department of the Treasury,Office of Information and RegulatoryAffairs, Washington, DC 20503, withcopies to the Internal Revenue Service,Attn: IRS Reports Clearance Officer,W:CAR:MP:T:T:SP, Washington, DC20224. Comments on the collections ofinformation should be received by Septem-ber 15, 2003. Comments are specificallyrequested concerning:

Whether the proposed collections of in-formation are necessary for the proper per-formance of the functions of the IRS, in-cluding whether the information will havepractical utility;

The accuracy of the estimated burdenassociated with the proposed collection ofinformation (see below);

How the quality, utility, and clarity ofthe information to be collected may be en-hanced;

How the burden of complying with theproposed collection of information may beminimized, including through the appli-cation of automated collection techniquesor other forms of information technology;and

Estimates of capital or start-up costsand costs of operation, maintenance, andpurchase of services to provide informa-tion.

The collections of information inthese proposed regulations are con-tained in §§1.401(k)–1(d)(3)(iii)(C),1.401(k)–2(b)(3), 1.401(k)–3(d), 1.401(k)–3(f), 1.401(k)–3(g), 1.401(k)–4(d)(3),1.401(m)–3(e), 1.401(m)–3(g) and 1.401(m)–3(h). The information requiredby §§1.401(k)–3(d), 1.401(k)–3(f), 1.401(k)–3(g), 1.401(m)–3(e), 1.401(m)–3(g)and 1.401(m)–3(h) is required by the IRSto comply with the requirements of sec-tions 401(k)(12)(D) and 401(m)(11)(A)(ii)regarding notices that must be providedto eligible participants to apprize them oftheir rights and obligations under certainplans. This information will be used byparticipants to determine whether to par-ticipate in the plan, and by the IRS to con-firm that the plan complies with applicablequalification requirements to avoid ad-verse tax consequences. The informationrequired by §1.401(k)–4(d)(3) is requiredby the IRS to comply with the require-ments of section 401(k)(11)(B)(iii)(II)regarding notices that must be providedto eligible participants to apprize themof their rights and obligations under cer-tain plans. This information will be usedby participants to determine whether toparticipate in the plan, and by the IRS toconfirm that the plan complies with appli-cable qualification requirements to avoidadverse tax consequences. The informa-tion required by §1.401(k)–2(b)(3) willbe used by employees to file their incometax returns and by the IRS to assess thecorrect amount of tax. The informationprovided under §1.40(k)–1(d)(3)(iii)(C)will be used by employers in determiningwhether to make hardship distributions toparticipants. The collections of informa-tion are mandatory. The respondents arebusinesses or other for-profit institutions,and nonprofit institutions.

Estimated total annual reporting bur-den: 26,500 hours.

The estimated annual burden per re-spondent is 1 hour, 10 minutes.

Estimated number of respondents:22,500.

The estimated annual frequency of re-sponses: On occasion.

An agency may not conduct or sponsor,and a person is not required to respond to, acollection of information unless it displays

September 2, 2003 431 2003-35 I.R.B.

a valid control number assigned by the Of-fice of Management and Budget.

Books or records relating to a collectionof information must be retained as longas their contents may become material inthe administration of any internal revenuelaw. Generally, tax returns and tax returninformation are confidential, as requiredby 26 U.S.C. 6103.

Background

This document contains proposed newcomprehensive regulations setting forththe requirements (including the nondis-crimination requirements) for cash or de-ferred arrangements under section 401(k)and for matching contributions and em-ployee contributions under section 401(m)of the Internal Revenue Code (Code).

Comprehensive final regulations un-der sections 401(k) and 401(m) of theCode were last published in the FederalRegister in T.D. 8357, 1991–2 C.B. 181,(published August 9, 1991) and T.D. 8376,1991–2 C.B. 245, (published December 2,1991) and amended by T.D. 8581, 1995–1C.B. 54, published on December 22, 1994.Since 1994, many significant changes havebeen made to sections 401(k) and 401(m)by the Small Business Job ProtectionAct of 1996, Public Law 104–188 (110Stat. 1755) (SBJPA), the Taxpayer ReliefAct of 1997, Public Law 105–34 (111Stat. 788) (TRA ’97), and the EconomicGrowth and Tax Relief Reconciliation Actof 2001, Public Law 107–16 (115 Stat.38) (EGTRRA).

The most substantial changes to the sec-tion 401(k) and section 401(m) provisionswere made to the methodology for test-ing the amount of elective contributions,matching contributions, and employeecontributions for nondiscrimination. Sec-tion 401(a)(4) prohibits discrimination incontribution or benefits in favor of highlycompensated employees (within the mean-ing of section 414(q)) (HCEs). Section401(k) provides a special nondiscrimina-tion test for elective contributions under acash or deferred arrangement that is partof a profit-sharing plan, stock bonus plan,pre-ERISA money purchase plan, or ruralcooperative plan, called the actual deferralpercentage (ADP) test. Section 401(m)provides a parallel test for matching con-tributions and employee contributionsunder a defined contribution plan, called

the actual contribution percentage (ACP)test. These special nondiscriminationstandards are provided in recognition ofthe fact that the amount of elective contri-butions and employee contributions (andcorresponding matching contributions) isdetermined by the employee's utilizationof the contribution opportunity offeredunder the plan. This is in contrast to thesituation in other defined contributionplans where the amount of contributionsis determined by the amount the employerdecides to contribute.

Sections 401(k) and 401(m) providealternative methods for satisfying theapplicable nondiscrimination rules: amathematical comparison and a numberof design-based methods. The inherentvariation in the amount of contributionsamong employees noted above, and thefact that the economic situation of HCEsmay make them more likely to make elec-tive or employee contributions, means thatthe usual nondiscrimination test undersection 401(a)(4) — under which for eachHCE with a contribution level there mustbe a specified number of nonhighly com-pensated employees (NHCEs) with equalor greater contributions — is not appropri-ate. Instead, average rates of contributionare used in the ADP and ACP tests (witha built-in differential permitted for HCEs)and minimum standards for nonelective ormatching contributions are provided in thedesign-based alternatives.

Prior to the enactment of SBJPA, sec-tions 401(k) and 401(m) provided only formathematical comparison. Specifically,the ADP and ACP tests compare the av-erage of the rates of contributions of theHCEs to the average of the rates of contri-butions of the NHCEs. For this purpose,the rate of contributions for an employeeis the amount of contributions for anemployee divided by the employee’s com-pensation for the plan year. These testsare satisfied if the average rate of HCEcontributions does not exceed 1.25 timesthe average rate of contributions of theNHCEs. Alternatively, these tests aresatisfied if the average rate of HCE contri-butions does not exceed the average rate ofcontributions of the NHCEs by more than2 percentage points and is no more than 2times the average rate of contributions ofthe NHCEs. To the extent that these testsare not satisfied, the statute provides forcorrection through distribution to HCEs

(or forfeiture of nonvested matching con-tributions) or, to the extent provided inregulations, recharacterization of electivecontributions as after-tax contributions. Inaddition, to the extent provided in regu-lations, nonelective contributions can bemade to NHCEs and elective contributionsand certain matching contributions can bemoved between the ADP and ACP tests, inorder the reduce the discrepancy betweenthe average rates of contribution for theHCEs and the NHCEs.

SBJPA added design-based alternativemethods of satisfying the ADP and ACPtests. Under these methods, if a plan meetscertain contribution and notice require-ments, the plan is deemed to satisfy thenondiscrimination rules without regardto actual utilization of the contributionopportunity offered under the plan. Theseregulations reflect this change and theother changes that were made to sections401(k) and 401(m) under SBJPA, TRA’97 and EGTRRA since the issuance offinal regulations under those sections.

SBJPA made the following significantchanges affecting section 401(k) and sec-tion 401(m) plans:

• The ADP test and ACP test wereamended to allow the use of prior yeardata for NHCEs.

• The method of distributing to correctfailures of the ADP test or ACP testwas changed to require distribution tothe HCEs with the highest contribu-tions.

• Tax-exempt organizations and Indiantribal governments are permitted tomaintain section 401(k) plans.

• A safe harbor alternative to the ADPtest and ACP test was introduced in or-der to provide a design-based methodto satisfy the nondiscrimination tests.

• The SIMPLE 401(k) plan (an alter-native design-based method to satisfythe nondiscrimination tests for smallemployers that corresponds to the pro-visions of section 408(p) for SIMPLEIRA plans by providing for smallercontributions) was added.

• A special testing option was providedfor plans that permit participation be-fore employees meet the minimum age

2003-35 I.R.B. 432 September 2, 2003

and service requirements, in order toencourage employers to permit em-ployees to start participating sooner.TRA '97 made the following significant

changes affecting section 401(k) and sec-tion 401(m) plans:

• State and local governmental plans aretreated as automatically satisfying theADP and ACP tests.

• Matching contributions for self-em-ployed individuals are no longertreated as elective contributions.EGTRRA made the following signifi-

cant changes affecting section 401(k) andsection 401(m) plans:

• Catch-up contributions were added toprovide for additional elective contri-butions for participants age 50 or older.

• The Secretary was directed to changethe section 401(k) regulations toshorten the period of time that anemployee is stopped from makingelective contributions under the safeharbor rules for hardship distributions.

• Beginning in 2006, section 401(k)plans will be permitted to allow em-ployees to designate their electivecontributions as “Roth contributions”that will be subject to taxation underthe rules applicable to Roth IRAs un-der section 408A.

• Section 401(k) plans using the design-based safe harbor and providing no ad-ditional contributions in a year are ex-empted from the top-heavy rules ofsection 416.

• Distributions from section 401(k)plans are permitted upon “severancefrom employment” rather than “sepa-ration from service.”

• The multiple use test specified in sec-tion 401(m)(9) is repealed.

• Faster vesting is required for matchingcontributions

• Matching contributions are taken intoaccount in satisfying the top-heavy re-quirements of section 416.In addition, since publication of the fi-

nal regulations, a number of items of guid-ance affecting section 401(k) and section

401(m) plans addressing these statutorychanges and other items have been issuedby the IRS, including:

• Notice 97–2, 1997–1 C.B. 348, pro-vided initial guidance on prior yearADP and ACP testing and guidance oncorrection of excess contributions andexcess aggregate contributions, includ-ing distribution to the HCEs with thehighest contributions.

• Rev. Proc. 97–9, 1997–1 C.B. 624,provided model amendments for SIM-PLE 401(k) plans.

• Notice 98–1, 1998–1 C.B. 327, pro-vided additional guidance on prior yeartesting issues.

• Notice 98–52, 1998–2 C.B. 632, andNotice 2000–3, 2000–1 C.B. 413, pro-vided guidance on safe harbor section401(k) plans.

• Rev. Rul. 2000–8, 2000–1 C.B. 617,addressed the use of automatic enroll-ment features in section 401(k) plans.

• Notice 2001–56, 2001–2 C.B. 277,and Notice 2002–4, 2002–2 I.R.B.298, provided initial guidance relatedto the changes made by EGTRRA.

These items of guidance are incorporatedinto these proposed regulations with somemodifications and the proposed regula-tions have been reorganized as indicatedin the tables of contents at proposed§§1.401(k)–0 and 1.401(m)–0. Treasuryand the IRS believe that a single restate-ment of the section 401(k) and section401(m) rules serves the interests of plansponsors, third-party administrators, planparticipants, and plan beneficiaries.

The process of reviewing and integrat-ing all existing administrative guidanceunder sections 401(k) and 401(m) has ledTreasury and the IRS to reconsider certainrules and to propose certain changes inthose rules. To the extent practicable,this preamble identifies the substantivechanges and explains the underlying anal-ysis. In many cases, the changes willclarify or simplify existing guidance andwill reduce plan administrative burdens.

Treasury and the IRS appreciate thefact that plan sponsors and third-partyadministrators have developed systemsand practices in the application of existing

administrative guidance to the design andoperation of section 401(k) and section401(m) plans. In many cases, the detailsof these systems and practices have beendetermined through a plan sponsor's oradministrator's interpretation of specificterms in existing guidance or, where noguidance has been provided, through aplan sponsor's or administrator's best legaland practical judgment. As a result, thesesystems and practices may differ from ad-ministrator to administrator, from sponsorto sponsor, or from plan to plan.

Treasury and the IRS also recognizethat certain of the substantive changes inthese proposed regulations will requirechanges in plan design or plan operation.However, the proposed regulations are nototherwise intended to require significantchanges in plan systems and practices thatwere developed under existing guidanceand that conform to the requirements ofsections 401(k) and 401(m). Therefore,Treasury and the IRS specifically requestthat plan sponsors and third-party admin-istrators comment on points where theproposed regulations might have the unin-tended effect of requiring a change to plansystems or practices so that Treasury andthe IRS can further evaluate whether sucha change is in fact appropriate or whetherTreasury and the IRS should instead makean adjustment in the final regulations.

Explanation of Provisions

1. Rules Applicable to All Cash orDeferred Arrangements

Section 401(k)(1) provides that a profit-sharing, stock bonus, pre-ERISA moneypurchase or rural cooperative plan will notfail to qualify under section 401(a) merelybecause it contains a qualified cash or de-ferred arrangement. Section 1.401(k)–1would set forth the general definition of acash or deferred arrangement (CODA), theadditional requirements that a CODA mustsatisfy in order to be a qualified CODA,and the treatment of contributions madeunder a qualified or nonqualified CODA.

As under the existing final regulations,a CODA is defined as an arrangement un-der which employees can make a cash ordeferred election with respect to contribu-tions to, or accruals or benefits under, aplan intended to satisfy the requirements

September 2, 2003 433 2003-35 I.R.B.

of section 401(a). A cash or deferred elec-tion is any direct or indirect election byan employee (or modification of an earlierelection) to have the employer either: 1)provide an amount to the employee in theform of cash or some other taxable benefitthat is not currently available; or 2) con-tribute an amount to a trust, or provide anaccrual or other benefit, under a plan defer-ring the receipt of compensation. A cash ordeferred election can include a salary re-duction agreement, but the specific refer-ence to a salary reduction agreement hasbeen eliminated as unnecessary. In addi-tion, the proposed regulations would in-corporate prior guidance on automatic en-rollment, and thus would reflect the factthat a CODA can specify that the defaultthat applies in the absence of an affirmativeelection by an employee can be a contribu-tion to a trust, as described in Rev. Rul.2000–8.1

The proposed regulations would con-tinue to provide that the definition of aCODA excludes contributions that aretreated as after-tax employee contribu-tions at the time of the contribution andcontributions made pursuant to certainone-time irrevocable elections, but wouldalso specify that a CODA does not includean arrangement under which dividendspaid to an ESOP are either distributed toa participant or reinvested in employersecurities in the ESOP pursuant to anelection by the participant or beneficiaryunder section 404(k)(2)(A)(iii) as addedby EGTRRA.

The proposed regulations would alsospecify that a contribution is made pur-suant to a cash or deferred election only ifthe contribution is made after the electionis made. Thus, a contribution made in an-ticipation of an employee's election is nottreated as an elective contribution. Simi-larly, the regulations would provide that acontribution is made pursuant to a cash ordeferred election only if the contribution ismade after the employee's performance ofservices which relate to the compensationthat, but for the election, would be paid

to the employee. (If the payment of com-pensation would have preceded the per-formance of services, a contribution madeno earlier than the date the compensationwould have been paid, but for the election,is also treated as made pursuant to a cash ordeferred election). Accordingly, amountscontributed in anticipation of future perfor-mance of services generally would not betreated as elective contributions under sec-tion 401(k). These restrictions on the tim-ing of contributions are consistent with thefundamental premise of elective contribu-tions, that these are contributions that arepaid to the plan as a result of an employeeelection not to receive those amounts incash. Moreover, ensuring that contribu-tions are made after the employee's elec-tion furthers plan administrability.

The deductibility of these prefundedelective contributions (as well as pre-funded matching contributions) for thetaxable year in which the contribution wasmade was addressed in Notice 2002–48,2002–29 I.R.B.139. In that notice, the IRSindicated that it was reviewing issues otherthan the deductibility of prefunded contri-butions but, pending additional guidance,would not challenge the deductibility ofthe contributions provided actual paymentis made during the taxable year for whichthe deduction is claimed and the amountdeducted does not exceed the applicablelimit under section 404(a)(3)(A)(i). Afterconsidering this issue, the IRS and Trea-sury have concluded that the prefundingof elective contributions and matchingcontributions is inconsistent with sections401(k) and 401(m). Thus, under these pro-posed regulations, an employer would notbe able to prefund elective contributionsto accelerate the deduction for electivecontributions. Once these regulations arefinalized, employer contributions madeunder the facts in Notice 2002–48 wouldno longer be permitted to be taken into ac-count under the ADP test or the ACP testand would not satisfy any plan require-ment to provide elective contributions ormatching contributions.

2. Qualified CODAs

A. General rules relating to qualifiedCODAs

Elective contributions under a qualifiedCODA are treated as employer contribu-tions and generally are not included in theemployee's gross income at the time thecash would have been received (but for thecash or deferred election), or at the timecontributed to the plan. Elective contribu-tions under a qualified CODA are includedin the employee's gross income however, ifthe contributions are in excess of the sec-tion 402(g) limit for a year, are designatedRoth contributions (under section 402A,effective for tax years beginning after De-cember 31, 2005) or are recharacterized asafter-tax contributions as part of a correc-tion of an ADP test failure.

A CODA is not qualified unless it ispart of a profit sharing plan, stock bonusplan, pre-ERISA money purchase plan,or rural cooperative plan and providesfor an election between contributions tothe plan or payments directly in cash. Inaddition, a CODA is not qualified unless itmeets the following requirements: 1) theelective contributions under the CODAsatisfy either the ADP test set forth in sec-tion 401(k)(3) or one of the design-basedalternatives in section 401(k)(11) or (12);2) elective contributions under the CODAare nonforfeitable at all times; 3) electivecontributions are distributable only on theoccurrence of certain events, includingattainment of age 591/2, hardship, death,disability, severance from employment,or termination of the plan; 4) the groupof employees eligible to participate in theCODA satisfies the coverage requirementsof section 410(b)(1); 5) no other bene-fit (other than matching contributions oranother specified benefit) is conditioned,directly or indirectly, upon the employee'smaking or not making elective contribu-tions under the CODA; and 6) no morethan 1 year of service is required for eli-gibility to elect to make a cash or deferredelection.

Subject to certain exceptions, state andlocal governmental plans are not allowed

1 The Department of Labor has advised Treasury and the IRS that, under Title I of the Employee Retirement Income Security Act of 1974 (ERISA), fiduciaries of a plan must ensure thatthe plan is administered prudently and solely in the interest of plan participants and beneficiaries. While ERISA section 404(c) may serve to relieve certain fiduciaries from liability whenparticipants or beneficiaries exercise control over the assets in their individual accounts, the Department of Labor has taken the position that a participant or beneficiary will not be consideredto have exercised control when the participant or beneficiary is merely apprised of investments that will be made on his or her behalf in the absence of instructions to the contrary. See 29 CFR2550.404c–1 and 57 FR 46924.

2003-35 I.R.B. 434 September 2, 2003

to include a qualified CODA. Plans spon-sored by Indian tribal governments and ru-ral cooperatives are allowed to include aqualified CODA.

B. Nondiscrimination rules applicable toCODAs

As under the existing regulations, theproposed regulations would provide thatthe special nondiscrimination standardsset forth in section 401(k) are the exclusivemeans by which a qualified CODA cansatisfy the nondiscrimination in amountof contribution requirement of section401(a)(4). These special nondiscrimi-nation standards now include: the ADPtest, the ADP safe harbor and the SIM-PLE 401(k) plan. Pursuant to section401(k)(3)(G), a state or local governmen-tal plan is deemed to satisfy the ADP test.

In addition, as under existing regula-tions, the plan must satisfy the require-ments of §1.401(a)(4)–4 with respectto the nondiscriminatory availability ofbenefits, rights and features, includingthe availability of each level of electivecontributions, matching contributions, andafter-tax employee contributions. Theprovisions of the existing regulations re-lated to compliance with sections 410(b)and 401(a)(4) would be revised to clarifythe relationship of the rules under sections410(b) and 401(a)(4) to the requirementsfor a qualified CODA and to remove re-dundant provisions. Except as providedbelow, however, these rules are substan-tively unchanged.

These proposed regulations are de-signed to provide simple, practicalrules that accommodate legitimate planchanges. At the same time, the rulesare intended to be applied by employersin a manner that does not make use ofchanges in plan testing procedures orother plan provisions to inflate inappro-priately the ADP for NHCEs (which isused as a benchmark for testing the ADPfor HCEs) or to otherwise manipulate thenondiscrimination testing requirements ofsection 401(k). Further, these nondiscrim-ination requirements are part of the overallrequirement that benefits or contributionsnot discriminate in favor of HCEs. There-fore, a plan will not be treated as satisfyingthe requirements of section 401(k) if thereare repeated changes to plan testing pro-cedures or plan provisions that have the

effect of distorting the ADP so as to in-crease significantly the permitted ADPfor HCEs, or otherwise manipulate thenondiscrimination rules of section 401(k),if a principal purpose of the changes wasto achieve such a result.

C. Aggregation and disaggregation ofplans

The proposed regulations would con-solidate the rules in the existing regula-tions regarding identification of CODAsand plans for purposes of demonstrat-ing compliance with the requirements ofsection 401(k). As under the existingregulations, all CODAs included in a planare treated as a single CODA for pur-poses of applying the nondiscriminationtests. For this purpose, a plan is generallydefined by reference to §1.410(b)–7(a)and (b) after application of the mandatorydisaggregation rules of §1.410(b)–7(c)(other than the mandatory disaggregationof section 401(k) and section 401(m)plans) and permissive aggregation rulesof §1.410(b)–7(d), as modified underthese regulations. For example, if a plancovers collectively bargained employeesand noncollectively bargained employees,the elective contributions for the separategroups of employees must be subject toseparate nondiscrimination tests undersection 401(k). The proposed regula-tions would also retain the special rulesin the existing regulations that permitthe aggregation of certain employees indifferent collective bargaining units andthe prohibition on restructuring under§1.401(a)(4)–9(c).

The proposed regulations wouldchange the treatment of a CODA undera plan which includes an ESOP. Section1.410(b)–7(c)(2) provides that the portionof a plan that is an ESOP and the portionthat is not an ESOP are treated as sepa-rate plans for purposes of section 410(b)(except as provided in §54.4975–11(e)).Accordingly, under the existing regula-tions, such a plan must apply two separatenondiscrimination tests: one for electivecontributions going into the ESOP portion(and invested in employer stock) and onefor elective contributions going in thenon-ESOP portion of the plan. The addi-tional testing results in increased expenseand administrative difficulty for the planand creates the possibility that the ESOP

portion or the non-ESOP portion may failthe ADP test or ACP test because HCEsmay be more or less likely to invest inemployer securities than NHCEs.

Since the issuance of the existing regu-lations, the use of an ESOP as the employerstock fund in a section 401(k) plan hasbecome much more widespread. In lightof this development, the proposed regu-lations would eliminate disaggregation ofthe ESOP and non-ESOP portions of asingle section 414(l) plan for purposes ofADP testing. The same rule would applyfor ACP testing under section 401(m). Inaddition, the proposed regulations wouldprovide that, for purposes of applying theADP test or the ACP test, an employercould permissively aggregate two section414(l) plans, one that is an ESOP and onethat is not.

However, the exception to mandatorydisaggregation of ESOPs from non-ESOPsset forth in these proposed regulationswould not apply for purposes of satisfyingsection 410(b). Accordingly, the groupof eligible employees under the ESOPand non-ESOP portions of the plan muststill separately satisfy the requirements ofsections 401(a)(4) and 410(b).

The proposed regulations would alsoprovide that a single testing method mustapply to all CODAs under a plan. Thishas the effect of restricting an employer'sability to aggregate section 414(l) plans forpurposes of section 410(b), if those plansapply inconsistent testing methods. Forexample, a plan that applies the ADP testof section 401(k)(3) may not be aggregatedwith a plan that uses the ADP safe harborof section 401(k)(12) for purposes of sec-tion 410(b).

D. Restrictions on withdrawals

As discussed above, a qualified CODAmust provide that elective contributionsmay only be distributed after certainevents, including hardship and severancefrom employment. EGTRRA amendedsection 401(k)(2)(B)(i)(I) by replacing“separation from service” with “severancefrom employment.” This change elimi-nated the “same desk rule” as a standardfor distributions under section 401(k)plans.

In addition, EGTRRA amended Codesection 401(k)(10) by deleting dispositionby a corporation of substantially all of the

September 2, 2003 435 2003-35 I.R.B.

assets of a trade or business and disposi-tion of a corporation's interest in a sub-sidiary, leaving termination of the plan asthe only distributable event described insection 401(k)(10). Finally, EGTRRA di-rects the Secretary of the Treasury to re-vise the regulations relating to distribu-tions under section 401(k)(2)(B)(i)(IV) toprovide that the period during which anemployee is prohibited from making elec-tive and employee contributions follow-ing a hardship distribution is 6 months(instead of 12 months as required under§1.401(k)–1(d)(2)(iv)(B)(4) of the existingregulations).2

Notice 2001–56 and Notice 2002–4provided guidance on these EGTRRAchanges to the distribution rules for elec-tive contributions. That guidance is in-corporated in these proposed regulations.In connection with the change to sever-ance from employment, comments arerequested on whether a change in statusfrom employee to leased employee de-scribed in section 414(n) should be treatedas a severance from employment thatwould permit a distribution to be made.In addition, the proposed regulations donot include reference to “retirement” (in-cluded in the existing regulation) as anevent allowing distribution because re-tirement is not listed in the statute, and issubsumed by severance from employment.

In addition to the statutory changes,the rules relating to hardship distributionshave been reorganized in order to clarifycertain ambiguities, including the rela-tionship between the generally applicablerules, employee representations, and thesafe harbors provided under the existingregulations. The existing regulations setforth two basic requirements (i.e., theemployee has an immediate and heavyfinancial need and the distribution is nec-essary to satisfy that need) followed bysafe harbor provisions. The proposedregulations would retain those basic re-quirements, but would clarify that eachsafe harbor is separately applicable toeach basic requirement. In addition, theproposed regulations would provide thatan employee representation used for pur-poses of determining that a distributionis necessary to satisfy an immediate andheavy financial need must provide that the

need cannot reasonably be relieved by anyavailable distribution or nontaxable planloan (even if the distribution or loan wouldnot be sufficient to satisfy the financialneed), but need not provide that a loanfrom a commercial source will be takenif no such loan in an amount sufficient tosatisfy the need is available on reasonablecommercial terms.

The proposed regulations would alsomodify the existing regulations to addother types of defined contribution plansto the list of plans that an employer maymaintain after the termination of the planthat contains the qualified CODA whilestill providing for distribution of electivecontributions upon plan termination. Thelist of such plans has been expanded toinclude not only an ESOP and a SEP,but also a SIMPLE IRA plan, a plan orcontract that satisfies section 403(b) and asection 457 plan.

Finally, under the existing regulations,a plan that receives a plan-to-plan trans-fer that includes elective contributions,QNECs, or QMACs, must provide that therestrictions on withdrawals continue afterthe transfer. These proposed regulationswould also make explicit a requirementthat the transferor plan will fail to complywith the restrictions on withdrawals if ittransfers elective contributions, QNECs,or QMACs to a plan that does not providefor these restrictions. However, a trans-feror plan will not fail to comply with thisrequirement if it reasonably concludes thatthe transferee plan provides for restric-tions on withdrawals. What constitutes abasis for a reasonable conclusion wouldbe comparable to the rules related to ac-ceptance of rollover distributions. See§1.401(a)(31)–1, A–14.

E. Other rules for qualified CODAs

The proposed regulations would gen-erally retain the additional requirementsset forth in the existing regulations that aCODA must satisfy in order to be quali-fied, with some modifications. First, in or-der to be a qualified CODA the arrange-ment must provide an employee with aneffective opportunity to elect to receive theamount in cash no less than once during theplan year. Under the proposed regulations,

whether an employee has an effective op-portunity is determined based on all therelevant facts and circumstances, includ-ing notice of the availability of the election,the period of time before the cash is cur-rently available during which an electionmay be made, and any other conditions onelections.

The proposed regulations would alsoprovide that a plan must provide for sat-isfaction of one of the specific nondis-crimination alternatives described in sec-tion 401(k). As with the existing regula-tions, the plan may accomplish this by in-corporating by reference the ADP test ofsection 401(k)(3) and the regulations underproposed §1.401(k)–2, if that is the nondis-crimination alternative being used. If, withrespect to the nondiscrimination alterna-tive being used there are optional choices,the plan must provide which of the optionalchoices will apply. For example, a planthat uses the ADP test of section 401(k)(3)must specify whether it is using the cur-rent year testing method or prior year test-ing method. Additionally, a plan that usesthe prior year testing method must specifywhether the ADP for eligible NHCEs forthe first plan year is 3% or the ADP forthe eligible NHCEs for the first plan year.Similarly, a plan that uses the safe har-bor method must specify whether the safeharbor contribution will be the nonelec-tive safe harbor contribution or the match-ing safe harbor contribution and is not per-mitted to provide that ADP testing will beused if the requirements for the safe har-bor are not satisfied. The safe harbors areintended to provide employees with a min-imum threshold in benefits in exchange foreasier compliance for the plan sponsor. Itwould be inconsistent with this approachto providing benefits to allow an employerto deliver smaller benefits to NHCEs andrevert to testing.

The proposed regulations would retainthe existing rules relating to the section401(k)(4)(A) prohibition on having ben-efits (other than a match) contingent onmaking or not making an elective contri-bution. However, the proposed regulationswould specify that, in the case of a ben-efit that requires an amount to be with-held from an employee's pay, an employeris not violating the section 401(k)(4)(A)

2 Under section 402(c), as amended by the IRS Restructuring and Reform Act of 1998, Public Law 105–206 (112 Stat. 685), and EGTRRA, a hardship distribution is not an eligible rolloverdistribution. While the change affects distributions from a section 401(k) plan, there is no specific reference to the change in these proposed regulations because these regulations are undersections 401(k) and 401(m).

2003-35 I.R.B. 436 September 2, 2003

contingent benefit rule merely because theCODA restricts elective contributions toamounts available after such withholdingfrom the employee's pay (after deductionof all applicable income and employmenttaxes). In addition, these proposed regu-lations also reflect the amendment to sec-tion 416(c)(2)(A) under which matchingcontributions can be taken into account forpurposes of satisfying the top-heavy mini-mum contribution requirement without vi-olating the prohibition on making benefitscontingent on making or not making elec-tive contributions.

To reflect the amendment of section401(k)(4)(B) by SBJPA to allow tax ex-empt organizations to maintain section401(k) plans, the proposed regulationswould also eliminate the provision pro-hibiting a tax-exempt employer fromadopting a section 401(k) plan.

As under the existing final regulations,these proposed regulations would providethat a partnership is permitted to main-tain a CODA, and individual partners arepermitted to make cash or deferred elec-tions with respect to compensation attrib-utable to services rendered to the entity,under the same rules that apply to com-mon-law employees. This rule has beenextended to sole proprietors. The provi-sions of these regulations also reflect theenactment of section 402(g)(8) (initiallysection 402(g)(9) as enacted by TRA '97)providing that matching contributions withrespect to partners and sole proprietors areno longer treated as elective contributions.

3. Nonqualified CODAs

The proposed regulations would gener-ally retain the rules in the existing regula-tions applicable to a nonqualified CODA(i.e., a CODA that fails one or more ofthe applicable requirements to be a qual-ified CODA). Because elective contribu-tions under such an arrangement are notentitled to the constructive receipt reliefset forth in section 402(e)(3), the contribu-tions are currently taxable to the employee.In addition, the plan to which such contri-butions are made must satisfy any nondis-crimination requirements that would oth-erwise apply under section 401(a)(4).

4. The Actual Deferral Percentage (ADP)Test

A. General rules relating to the ADP test

Section 1.401(k)–2 sets forth the rulesfor a CODA that is applying the ADP testcontained in section 401(k)(3). Under theADP test, the percentage of compensationdeferred for the eligible HCEs is comparedannually to the percentage of compensa-tion deferred for eligible NHCEs, and ifcertain limits are exceeded by the HCEs,corrective action must be taken by the plan.Correction can be made through the distri-bution of excess contributions, the rechar-acterization of excess contributions, or thecontribution of additional employer contri-butions.

Section 401(k)(3)(A), as amended bySBJPA, generally provides for the use ofprior year data in determining the ADP ofNHCEs, while current year data is used forHCEs. This testing option is referred toas the prior year testing method. Alter-natively, a plan may provide for the useof current year data for determining theADPs for both NHCEs and HCEs, which isknown as the current year testing method.The proposed regulations would use theterm applicable year to describe the yearfor which the ADP is determined for theNHCEs.

Section 401(k)(3)(F), as added bySBJPA, provides that a plan benefittingotherwise excludable employees and that,pursuant to section 410(b)(4)(B), is beingtreated as two separate plans for purposesof section 410(b), is permitted to disregardNHCEs who have not met the minimumage and service requirements of section410(a)(1)(A). Thus, the proposed regula-tions would permit such a plan to performthe ADP test by comparing the ADP forall eligible HCEs for the plan year and theADP of eligible NHCEs for the applicableyear, disregarding all NHCEs who havenot met the minimum age and servicerequirements of section 410(a)(1)(A). Theproposed regulations treat this rule as per-missive. Accordingly, the new statutoryprovision does not eliminate the exist-ing testing option under which a planbenefitting otherwise excludable employ-ees is disaggregated into separate planswhere the ADP test is performed sepa-rately for all eligible employees who havecompleted the minimum age and service

requirements of section 410(a)(1)(A) andfor all eligible employees who have notcompleted the minimum age and servicerequirements of section 410(a)(1)(A).

B. Elective contributions used in the ADPtest

The proposed regulations would gen-erally follow the existing regulations indefining which elective contributions arereflected in the ADP test and which onesare not. The proposed regulations wouldreflect the rule contained in the regula-tions under section 414(v), under whichcatch-up contributions that are in excessof a statutory limit or an employer-pro-vided limit are not taken into account un-der the ADP test. See §1.414(v). In ad-dition, the proposed regulations would in-corporate the rule in §1.402(g)–1 that pro-vides excess deferrals that are distributedare still taken into account under the ADPtest (with the exception of deferrals madeby NHCEs that were in violation of sec-tion 401(a)(30)). The proposed regulationsretain the rule that elective contributionsmust be paid to the trust within 12 monthsafter the end of the plan year. However, forplans subject to Title I of ERISA, contribu-tions must be paid to the trust much soonerin order to satisfy the Department of La-bor's regulations relating to when electivecontributions become plan assets.

Section 401(k)(3) provides that the ac-tual deferral ratio (ADR) of an HCE who iseligible to participate in 2 or more CODAsof the same employer is calculated by treat-ing all CODAs in which the employee iseligible to participate as one CODA. Theexisting regulations implement this ruleby aggregating the elective contributionsof such an HCE for all plan years thatend with or within a single calendar year.This can yield an inappropriate result ifthe plan years are different, because morethan 12 months of elective contributionscould be included in an employee's ADR.These proposed regulations would modifythis rule to provide that the ADR for eachHCE participating in more than one CODAis determined by aggregating the HCE'selective contributions that are within theplan year of the CODA being tested. Inaddition, the definition of period of partic-ipation for purposes of determining com-pensation would be modified to take into

September 2, 2003 437 2003-35 I.R.B.

account periods of participation under an-other plan where the elective contributionsmust be aggregated for an HCE. As a re-sult, even in the case of plans with dif-ferent plan years, each of the employer'sCODAs will use 12 months of elective con-tributions and 12 months of compensationin determining the ADR for an HCE whoparticipates in multiple arrangements.

The proposed regulations would retainthe rule in the existing regulations thatprovides that the HCE aggregation ofelective contributions under CODAs doesnot apply where the CODAs are withinplans that cannot be aggregated under§1.410(b)–7(d), but only after applyingthe modifications to the section 410(b)aggregation and disaggregation rules forsection 401(k) plans provided in the pro-posed regulations. The non-applicationof the HCE aggregation rule would haveless significance in light of the changedescribed above relating to the eliminationof the required disaggregation of ESOPand non-ESOP plans. In addition, theproposed regulations would clarify that,in determining whether two plans couldbe aggregated for this purpose, the prohi-bition on aggregating plans with CODAsthat apply inconsistent testing methods setforth under these proposed regulations andthe section 410(b) prohibition on aggre-gating plans that have different plan yearswould not apply.

C. Additional employer contributions usedin the ADP test

The proposed regulations would gen-erally retain the rules in the existing reg-ulations permitting a plan to take quali-fied nonelective contributions or qualifiedmatching contributions (i.e., nonelectiveor matching contributions that satisfy thevesting and distribution limitations of sec-tion 401(k)(2)(B) and (C)) into account un-der the ADP test, except as described be-low. Thus, an employer whose CODA hasfailed the ADP test can correct this failureby making additional qualified nonelec-tive contributions (QNECs) or qualifiedmatching contributions (QMACs) for itsNHCEs. The proposed regulations wouldno longer describe such contributions as

being treated as elective contributions un-der the arrangement, but would nonethe-less permit such contributions to be takeninto account under the ADP test.

As under the existing regulations, theseproposed regulations would provide thatQNECs must satisfy four requirementsin addition to the vesting and distributionrules described above before they can betaken into account under the ADP test: 1)The amount of nonelective contributions,including the QNECs that are used underthe ADP test or the ACP test, must satisfysection 401(a)(4); 2) the nonelective con-tributions, excluding the QNECs that areused under the ADP test or the ACP test,must satisfy section 401(a)(4); 3) the planto which the QNEC or QMAC is mademust be a plan that can be aggregated withthe plan maintaining the CODA; and 4) theQNECs or QMACs must not be contingenton the performance of services after theallocation date and must be contributedwithin 12 months after the end of the planyear within which the contribution is tobe allocated.3 Thus, in the case of a planusing prior year ADP testing, any QNECsthat are to be allocated to the NHCEs forthe prior plan year must be contributedbefore the last day of the current plan yearin order to be taken into account.

Some plans provide a correction mech-anism for a failed ADP test that targetsQNECs to certain NHCEs in order to re-duce the total contributions to NHCEs un-der the correction. Under the method thatminimizes the total QNECs allocated toNHCEs under the correction, the employermakes a QNEC to the extent permitted bythe section 415 limits to the NHCE withthe lowest compensation during the yearin order to raise that NHCE's ADR. If theplan still fails to pass the ADP test, the em-ployer continues expanding the group ofNHCEs who receive QNECs to the nextlowest-paid NHCE until the ADP test issatisfied. By using this bottom-up level-ing technique, the employer can pass theADP test by contributing small amounts ofmoney to NHCEs who have very low com-pensation for the plan year (for example,an employee who terminated employmentin early January with $300 of compensa-tion). This is because of the fact that the

ADP test is based on an unweighted aver-age of ADRs and a small dollar (but highpercentage of compensation) contributionto a terminated or other partial-year em-ployee has a larger impact on the ADP testthan a more significant contribution to afull-year employee.

The IRS and Treasury have beenconcerned that, by using these types oftechniques, employers may pass the ADPtest by making high percentage QNECsto a small number of employees with lowcompensation rather than providing con-tributions to a broader group of NHCEs.In addition, the legislative history toEGTRRA expresses Congressional intentthat the Secretary of the Treasury will usehis existing authority to address situationswhere qualified nonelective contributionsare targeted to certain participants withlower compensation in order to increasethe ADP of the NHCEs. (See EGTRRAConference Report, H.R. Conf. Rep.107–84, 240).

Accordingly, the proposed regulationswould add a new requirement that a QNECmust satisfy in order to be taken into ac-count under the ADP test. This require-ment, designed to limit the use of targetedQNECs, would generally treat a plan asproviding impermissibly targeted QNECsif less than half of all NHCEs are receiv-ing QNECs and would also treat a QNECas impermissibly targeted if the contribu-tion is more than double the QNECs othernonhighly compensated employees are re-ceiving, when expressed as a percentage ofcompensation. However, QNECs that donot exceed 5% of compensation are nevertreated as targeted and would always sat-isfy the new requirement.

This restriction on targeting QNECswould be implemented in the proposedregulations by providing that a QNECthat exceeds 5% of compensation couldbe taken into account for the ADP testonly to the extent the contribution, whenexpressed as a percentage of compen-sation, does not exceed two times theplan's representative contribution rate.The plan's representative contribution ratewould be defined as the lowest contribu-tion rate among a group of NHCEs that ishalf of all the eligible NHCEs under thearrangement (or the lowest contribution

3 With respect to this timing requirement, it should be noted that in order to be taken into account for purposes of section 415(c) for a limitation year, the contributions will need to be madeno later than 30 days after the end of the section 404(a)(6) period applicable to the taxable year with or within which the limitation year ends.

2003-35 I.R.B. 438 September 2, 2003

rate among all eligible NHCEs under thearrangement who are employed on the lastday of the year, if greater). For purposesof determining an NHCE's contributionrate, the employee's qualified nonelectivecontributions and the qualified matchingcontributions taken into account underthe ADP test for the plan year are addedtogether and the sum is divided by theemployee's compensation for the sameperiod. The proposed regulations undersection 401(m) would provide parallel re-strictions on QNECs taken into account inACP testing, and a QNEC cannot be takeninto account under both the ADP and ACPtest (including for purposes of determiningthe representative contribution rate). Asdiscussed more fully below, the proposedregulations would also have a limitation ontargeting matching contributions, whichwould limit the extent to which QMACscan be targeted as a means of avoiding therestrictions on targeted QNECs.

The proposed regulations would alsoimplement a prohibition against doublecounting of QNECs that was set forth inNotice 98–1. Generally, QNECs used inan ADP or ACP test, used to satisfy thesafe harbor under section 401(k), or undera SIMPLE 401(k) plan can not be usedagain to demonstrate compliance withanother test under section 401(k)(3) or401(m)(2). For example, double count-ing could arise when QNECs on behalf ofNHCEs are used to determine the ADP un-der current year testing in year 1 and then,if the employer elected prior year testing,are used again in year 2 to determine theADP of NHCEs. However, unlike Notice98–1, these proposed regulations wouldnot contain the additional limitations ondouble counting elective contributions ormatching contributions that were movedbetween the ADP and ACP tests.

D. Correction

Section 401(k)(8)(C), as amended bythe SBJPA, provides that, for purposesof correcting a plan's failure to meet thenondiscrimination requirements of section401(k)(3), distribution of excess contribu-tions is made on the basis of the amount ofthe contributions by, or on behalf of, eachHCE. The proposed regulations wouldimplement this correction procedure in thesame manner as set forth in Notice 97–2.

Thus, the total amount of excess contribu-tions is determined using the rules underthe existing final regulations (i.e., basedon high percentages). Then that totalamount is apportioned among the HCEsby assigning the excess to be distributedfirst to those HCEs who have the greatestdollar amount of contributions taken intoaccount under the ADP test (as opposed tothe highest deferral percentage). If theseamounts are distributed or recharacterizedin accordance with these regulations, theplan complies with the ADP test for theplan year with no obligation to recalculatethe ADP test.

The proposed regulations would pro-vide a special rule for correcting throughdistribution of excess contributions in thecase of an HCE who participates in mul-tiple plans with CODAs. In that case,the proposed regulations would providethat, for purposes of determining whichHCE will be apportioned a share of the to-tal excess contributions to be distributedfrom a plan, all contributions in CODAs inwhich such an HCE participates are aggre-gated and the HCE with the highest dol-lar amount of contributions will be appor-tioned excess contributions first. How-ever, only actual contributions under theplan undergoing correction — rather thanall contributions taken into account in cal-culating the employee's ADR — may bedistributed from a plan. If the high dollarHCE's actual contributions under the planare insufficient to allow full correction,then the HCE with the next highest dol-lar amount of contributions is apportionedthe remaining excess contributions. If ad-ditional correction is needed, this processis repeated until the excess contributionsare completely apportioned. This correc-tion mechanism is applied independentlyto each CODA in which the HCE partici-pates. If correction is needed in more thanone CODA, the ADRs of HCEs who havereceived corrective distributions under theother arrangements are not recalculated af-ter correction in the first plan.

The proposed regulations would gener-ally follow the rules in the existing regula-tions on the determination of net incomeattributable to excess contributions. Theexisting regulations provide for a reason-able determination of net income attrib-utable to an excess contribution, but donot specify which contribution within theplan year is to be treated as the excess

contribution to be distributed. This pro-vision would be retained in the proposedregulations along with the existing alterna-tive method of determining the net income,which approximates the result that wouldapply if the excess contribution is madeon the first day of the plan year. How-ever, to the extent the employee is or willbe credited with allocable gain or loss onthose excess contributions for the periodafter the end of the plan year (the gap pe-riod), the proposed regulations would nowrequire that income be determined for thatperiod. As under the existing regulations,the determination of the income for the gapperiod could be based on the income de-termined using the alternative method forthe aggregate of the plan year and the gapperiod or using 10% of the income for theplan year (determined under the alternativemethod) for each month in the gap period.

The proposed regulations would permitthe recharacterization of excess contribu-tions in a manner that generally followsthe existing regulations. However, the yearthe employee must include the recharac-terized contribution in current income hasbeen changed to match the year that theemployee would have had to include theexcess contribution in income, had it beendistributed. Thus, if the recharacterizedamount is less than $100, it is included ingross income in the year that it is recharac-terized, rather than the year of the earliestelective contributions for the employee.

The proposed regulations would retainthe rules in the existing regulations regard-ing the timing and tax treatment of distri-butions of excess contributions, coordina-tion with the distribution of excess defer-rals and the treatment of matches attribut-able to excess contributions.

E. Special rules relating to prior yeartesting

The proposed regulations would gen-erally follow the rules set forth in No-tice 98–1 regarding prior year testing, in-cluding the limitations on switching fromcurrent year testing to prior year testing.However, the proposed regulations wouldprovide that a plan is permitted to be in-consistent between the choice of currentyear testing method and prior year testingmethod, as applied for ADP purposes andACP purposes. In such a case, any move-ment of elective contributions or QMACs

September 2, 2003 439 2003-35 I.R.B.

between the ADP and ACP tests (includingrecharacterization) would be prohibited.

The proposed regulations would gen-erally incorporate the rules set forth inNotice 98–1 relating to plan coveragechanges in the case of a plan using prioryear testing. Thus, in the case of a planthat uses prior year testing and experi-ences a plan coverage change affectingmore than 10% of the NHCEs, the ADPof the NHCEs would generally be de-termined as the weighted average of theADP of the NHCEs of the plans in whichthe NHCEs participated in the prior year.The definition of plan coverage changeincludes changes in the group of eligibleemployees under a plan resulting from theestablishment or amendment of a plan,a plan merger or spin-off or a change inthe way plans are combined or separatedunder the section 410(b) rules. The defini-tion under the proposed regulations wouldalso include a reclassification of a sub-stantial group of employees that has thesame effect as amending the plan. Theseproposed regulations retain the rule thata plan that experiences coverage changesaffecting 10% or less of the NHCEs dis-regards those changes in calculating theADP for the NHCEs. Similarly, a planthat merely experiences a spin-off is notrequired to recalculate the ADP for theNHCEs.

5. Safe Harbor Section 401(k) Plans

Section 401(k)(12) provides a de-sign-based safe harbor method underwhich a CODA is treated as satisfying theADP test if the arrangement meets cer-tain contribution and notice requirements.Section 1.401(k)–3 of these proposed reg-ulations, which sets forth the requirementsfor these arrangements, generally followsthe rules set forth in Notice 98–52 andNotice 2000–3. Thus, a plan satisfiesthe section 401(k) safe harbor if it makesspecified QMACs for all eligible NHCEs.The matching contributions can be undera basic matching formula that providesfor QMACs equal to 100% of the first3% of elective contributions and 50% ofthe next 2% or an enhanced matchingformula that is at least as generous in theaggregate, provided the rate of match-ing contributions under the enhancedmatching formula does not increase as theemployee's rate of elective contributions

increases. In lieu of QMACs, the plan ispermitted to provide QNECs equal to 3%of compensation for all eligible NHCEs.In addition, notice must be provided toeach eligible employee, within a reason-able time before the beginning of the year,of their right to defer under the plan.

A plan using the safe harbor methodmust also comply with certain other re-quirements. Among these is the require-ment in section 401(k)(12)(B)(ii) that pro-vides that the rate of matching contribu-tion for any elective contribution on thepart of any HCE cannot exceed the rateof matching contribution that would applyto any NHCE with the same rate of elec-tive contribution. Notice 98–52 advisedthat the general rules on aggregating con-tributions for HCEs eligible under morethan one CODA would apply for this pur-pose. The IRS and Treasury have deter-mined that such aggregation is not appli-cable under the ADP safe harbor. Accord-ingly, these proposed regulations wouldnot require that elective or matching con-tributions on behalf of an HCE who iseligible to participate in more than oneplan of the same employer be aggregatedfor purposes of the requirement of section401(k)(12)(B)(ii). Thus, the rate of matchfor purposes of determining whether anHCE has a higher matching rate is basedonly on matching contributions with re-spect to elective contributions under thesafe harbor plan. However, for an em-ployer that uses the safe harbor method ofsatisfying the ACP test, the rule in No-tice 98–52 is retained for applying the ACPsafe harbor, with an exception for nonsi-multaneous participation (as discussed inconnection with the ACP safe harbor be-low).

These proposed regulations do notprovide any rules relating to suspensionof employee contributions under a planthat provides that safe harbor matchingcontributions are made with respect tothe sum of elective contributions and em-ployee contributions. Although Notice2000–3 specifically permitted suspensionof employee contributions in certain cir-cumstances, the IRS and Treasury havedetermined that there are no limits on sus-pending employee contributions, providedthat safe harbor matching contributionsare made with respect to elective contribu-tions. This is because the restrictions onsuspension of elective contributions are

sufficient to ensure an eligible NHCE canget the full matching contribution.

The proposed regulations do not in-clude any exception to the requirementsfor safe harbor matching contributionswith respect to catch-up contributions.Treasury and the IRS are aware that thereare questions concerning the extent towhich catch up contributions are requiredto be matched under a plan that providesfor safe harbor matching contributions.Treasury and the IRS are interested incomments on the specific circumstancesunder which elective contributions by aNHCE to a safe harbor plan would be lessthan the amount required to be matched,e.g., less than 5% of safe harbor compen-sation, but would be treated by the plan ascatch-up contributions, and on the extentto which a safe harbor plan should berequired to match catch-up contributionsunder such circumstances.

Section 401(k)(12)(D) contains a re-quirement that each eligible employee beprovided with a notice of the employee'srights and obligations under the plan.These proposed regulations do not ad-dress the extent to which the notice canbe provided through electronic media. Asnoted in the preamble to other regulations,the IRS and the Treasury Department areconsidering the extent to which the noticedescribed in section 401(k)(12)(D), as wellas other notices under the various InternalRevenue Code requirements relating toqualified retirement plans, can be pro-vided electronically, taking into accountthe effect of the Electronic Signaturesin Global and National Commerce Act(E-SIGN), Public Law 106–229 (114 Stat.464 (2000)). The IRS and the TreasuryDepartment anticipate issuing proposedregulations regarding these issues, and in-vite comments on these issues. Until thoseproposed regulations are issued, plan ad-ministrators and employers may continueto rely on the interim guidance in Q&A–7of Notice 2000–3 on use of electronicmedia to satisfy the notice requirement insection 401(k)(12)(D).

These proposed regulations would clar-ify that a section 401(k) safe harbor planmust generally be adopted before the be-ginning of the plan year and be maintainedthroughout a full 12-month plan year. Thisrequirement is consistent with the notionthat the statute specifies a certain contri-bution level for nonhighly compensated

2003-35 I.R.B. 440 September 2, 2003

employees in order to be deemed to passthe nondiscrimination requirements. If thecontribution level is not maintained fora full 12-month year, the employer con-tributions made on behalf of nonhighlycompensated employees should not sup-port what could be a full year's contribu-tion by the highly compensated employ-ees.

The proposed regulations would adoptthe exception to the requirement that a sec-tion 401(k) safe harbor plan be in place be-fore the beginning of the plan year that wasprovided in Notice 2000–3. Under that op-tion, an employer could adopt a section401(k) safe harbor plan which has contin-gent non-elective contributions, providedthe employer notifies employees of thiscontingent arrangement before the start ofthe year, amends the plan to provide thenonelective contributions no less than 30days before the end of the year, and pro-vides employees with a follow-up notice ifthe contribution will be made. Similarly,the proposed regulations would adopt theexception for a section 401(k) safe har-bor plan that uses the matching contribu-tion alternative. Under that exception, anemployer can amend the plan to eliminatematching contributions with respect to fu-ture elective deferrals, provided that thematching contributions are made with re-spect to pre-amendment elective deferrals,employees are provided with notice of thechange and the opportunity to change theirelections, and the plan satisfies the ADP orACP test for the plan year using the currentyear testing method.

The proposed regulations would recog-nize the practical difficulty in a 12-monthrequirement by following the rule in No-tice 98–52 that allowed a short plan year inthe first plan year and would allow a shortplan year in certain other circumstances.Specifically, a section 401(k) safe harborplan could have a short plan year in theyear the plan terminates, if the plan ter-mination is in connection with a mergeror acquisition involving the employer, orthe employer incurs a substantial businesshardship comparable to a substantial busi-ness hardship described in section 412(d).In addition, a section 401(k) safe harborplan could have a short plan year if the planterminates, the employer makes the safeharbor contributions for the short year, em-ployees are provided notice of the change,

and the plan passes the ADP test. Fi-nally, a safe harbor plan could have a shortplan year if it is preceded and followed by12-month plan years as a section 401(k)safe harbor plan.

Under section 401(k)(12)(F), safe har-bor contributions are permitted to be madeto a plan other than the plan that containsthe CODA. These proposed regulations re-flect that rule and provide that the planto which the safe harbor contributions aremade need not be a plan that can be aggre-gated with the plan that contains the cashor deferred arrangement.

Whether a contribution is taken into ac-count for purposes of the safe harbor isdetermined in accordance with the rulesregarding inclusion in ADP testing underproposed §1.401(k)–2(a). Thus, for exam-ple, a plan that provides for safe harbormatching contributions in 2006 need notprovide for a matching contribution withrespect to an elective contribution madeduring the first 21/2 months of 2007 andattributable to service during 2006, unlessthat elective contribution is taken into ac-count for 2006.

6. SIMPLE 401(k) Plans

Pursuant to section 401(k)(11), a SIM-PLE 401(k) plan is treated as satisfying therequirements of section 401(k)(3)(A)(ii)if the contribution, vesting, notice andexclusive plan requirements of sec-tion 401(k)(11) are satisfied. Section1.401(k)–4 of these proposed regula-tions reflects the provisions of section401(k)(11) in a manner that follows thepositions reflected in the model amend-ments set forth in Rev. Proc. 97–9.

7. Matching Contributions and EmployeeContributions.

Section 401(m)(2) sets forth a nondis-crimination test, the ACP test, with re-spect to matching contributions and em-ployee contributions that is parallel to thenondiscrimination test for elective contri-butions set forth in section 401(k). Section1.401(m)–1 of the proposed regulationswould set forth this test in a manner thatis consistent with the nondiscriminationtest set forth in proposed §1.401(k)–1(b).Thus, satisfaction of the ACP test, the ACPsafe harbor or the SIMPLE 401(k) pro-visions of the proposed regulations under

section 401(k) are the exclusive means thatmatching contributions and employee con-tributions can use to satisfy the nondis-crimination in amount of contribution re-quirements of section 401(a)(4). An anti-abuse provision comparable to that pro-vided in connection with the proposed reg-ulations under section 401(k) limits theability of an employer to make repeatedchanges in plan provisions or testing pro-cedures that have the effect of distortingthe ACP so as to increase significantlythe permitted ACP for HCEs, or otherwisemanipulate the nondiscrimination rules ofsection 401(m), if a principal purpose ofthe changes was to achieve such a result.

These proposed regulations also in-clude provisions regarding plan aggrega-tion and disaggregation that are similar tothose proposed for CODAs under section401(k). For example, matching contri-butions made under the portion of a planthat is an ESOP and the portion of thesame plan that is not an ESOP would notbe disaggregated under these proposedregulations.

The definitions of matching contri-bution and employee contribution under§1.401(m)–1 of the proposed regulationswould generally follow the definitions inthe existing regulations. Thus, whether anemployer contribution is on account of anelective deferral or employee contribution— and thus is a matching contribution— is determined based on all the relevantfacts and circumstances. However, theproposed regulations would provide thata contribution would not be treated as amatching contribution on account of anelective deferral if it is contributed beforethe employee's performance of serviceswith respect to which the elective deferralis made (or when the cash that is subjectto the cash or deferred election wouldbe currently available, if earlier) and anemployer contribution is not a matchingcontribution made on account of an em-ployee contribution if it is contributedbefore the employee contribution. Thus,under these regulations, an employerwould not be able to prefund matchingcontributions to accelerate the deductionfor those contributions and, as noted abovewith respect to the timing of elective con-tributions, employer contributions madeunder the facts in Notice 2002–48 wouldnot be taken into account under the ACP

September 2, 2003 441 2003-35 I.R.B.

test and would not satisfy any plan require-ment to provide matching contributions.

8. ACP Test for Matching Contributionsand Employee Contributions

Section 1.401(m)–2 of the proposedregulations would provide rules for theACP test that generally parallel the rulesapplicable to the ADP test in proposed§1.401(k)–2. Thus, for example, the ACPtest may be run by comparing the ACP foreligible HCEs for the current year withthe ACP for eligible NHCEs for eitherthe current plan year or the prior planyear. Similarly, the proposed regulationsreflect the special ACP testing rule insection 401(m)(5)(C) for a plan that pro-vides for early participation, comparableto the special ADP testing rule in section401(k)(3)(F), as set forth in proposed§1.401(k)–2(a)(1)(iii).

The determination of the actual con-tribution ratio (ACR) for an eligible em-ployee, and the contributions that are takeninto account in determining that ACR, un-der these proposed regulations are compa-rable to the rules under the proposed sec-tion 401(k) regulations. Thus, for exam-ple, the ACR for an HCE who has match-ing contributions or employee contribu-tions under two or more plans is deter-mined by adding together matching contri-butions and employee contributions underall plans of the employer during the planyear of the plan being tested, in a man-ner comparable to that for determining theADR of an HCE who participates in two ormore CODAs.

The proposed regulations would re-tain the rule from the existing regulationsunder which a QMAC that is taken into ac-count in the ADP test is excluded from theACP test. In addition, the proposed reg-ulations would continue to allow QNECsto be taken into account for ACP testing,but would provide essentially the samerestrictions on targeting QNECs to a smallnumber of NHCEs as is provided in pro-posed §1.401(k)–2. The only differencein the rules would be that the contribu-tion percentages used to determine thelowest contribution percentage would bebased on the sum of the QNECs and thosematching contributions taken into accountin the ACP test, rather than the sum ofthe QNECs and the QMACs taken intoaccount under the ADP test. Because

QNECs that do not exceed 5% are notsubject to the limits on targeted QNECsunder either the ADP test or the ACP test,an employer is permitted to take into ac-count up to 10% in QNECs for an eligibleNHCE, 5% in ADP testing and 5% inACP testing, without regard to how manyNHCEs receive QNECs.

In addition, to prevent an employerfrom using targeted matching contri-butions to circumvent the limitation ontargeted QNECs, the proposed regulationswould provide that matching contributionsare not taken into account in the ACP testto the extent the matching rate for thecontribution exceeds the greater of 100%and 2 times the representative matchingrate. Paralleling the rule to limit targetedQNECs, the representative plan matchingrate is the lowest matching rate for anyeligible employee in a group of NHCEsthat consists of half of all eligible NHCEsin the plan for the plan year (or the lowestmatching rate for all eligible NHCEs in theplan who are employed by the employeron the last day of the plan year, if greater).For this purpose, the matching rate is theratio of the matching contributions to thecontributions that are being matched, andonly NHCEs who make elective deferralsor employee contributions for the planyear are taken into account.

The proposed regulations would setlimits on the use of elective contributionsin the ACP test that are in addition tothe rules in the existing regulations underwhich elective contributions may be takeninto account for the ACP test only to theextent the plan satisfies the ADP test,determined by including such electivecontributions in the ADP test. Under thenew rule, the proposed regulations wouldprovide that elective contributions undera plan that is not subject to the ADP test,such as a plan that uses the safe harbormethod of section 401(k)(12) or a contractor arrangement subject to the requirementsof section 403(b)(12)(A)(ii), may not betaken into account for the ACP test. In theabsence of this prohibition, contributionsthat are not properly considered “excess”could be taken into account under the ACPtest.

The provisions of these proposed reg-ulations regarding correction of excessaggregate contributions, including allo-cation of excess aggregate contributions

and determination of allocable income,would generally be consistent with theprovisions of the proposed regulationsunder section 401(k). These proposedregulations continue the provisions of thecurrent regulations regarding correctionthrough distribution of vested matchingcontributions and forfeiture of unvestedmatching contributions. Similarly, theproposed regulations reflect the provisionsof section 411(a)(3)(G) which permit theforfeiture of a matching contribution madewith respect to an excess deferral, excesscontribution, or excess aggregate contribu-tion. This provision is necessary to allowforfeiture of matching contributions thatwould otherwise violate section 401(a)(4).

9. Safe Harbor Section 401(m) Plans

Section 401(m)(11) provides a design-based safe harbor method of satisfying theACP test contained in section 401(m)(2).Under section 401(m)(11), a defined con-tribution plan is treated as satisfying theACP test with respect to matching contri-butions if the plan satisfies the ADP safeharbor of section 401(k)(12) and matchingcontributions are not made with respect toemployee contributions or elective contri-butions in excess of 6% of an employee'scompensation. For a plan that satisfies theADP safe harbor using a 3% nonelectivecontribution, two additional requirementsthat apply to a plan that satisfies the ADPsafe harbor using matching contributionsalso apply: 1) the rate of an employer'smatching contribution does not increase asthe rate of employee contributions or elec-tive deferrals increase; and 2) the match-ing contribution with respect to any HCE atany rate of employee contribution or elec-tive deferral is not greater than with re-spect to any NHCE. In addition, the ra-tio of matching contributions on behalf ofan HCE to that HCE's elective deferralsand employee contributions for a plan yearcannot be greater than the ratio of match-ing contributions to elective deferrals oremployee contributions that would applywith respect to any NHCE who contributes(as an elective deferral or employee contri-bution) the same percentage of safe harborcompensation for that plan year.

Section 1.401(m)–3 of these proposedregulations, which sets forth the require-ments for these plans, would generallyfollow the rules set forth in Notice 98–52

2003-35 I.R.B. 442 September 2, 2003

and Notice 2000–3. These proposed reg-ulations would clarify that, for purposesof determining whether an HCE has ahigher rate of matching contributionsthan any NHCE, any NHCE who is aneligible employee under the safe harborCODA must be taken into account, evenif the NHCE is not eligible for a match-ing contribution. This means that a planwith a provision which limits matchingcontributions to employees who are em-ployed on the last day of the plan yearwill not be able to satisfy the ACP safeharbor, since a NHCE who is not eligibleto receive a matching contribution onaccount of the last day requirement willnonetheless be taken into considerationin determining whether the plan satisfiessection 401(m)(11)(B)(iii). The proposedregulations also include the requirementthat matching contributions made at theemployer's discretion with respect to anyemployee cannot exceed a dollar amountequal to 4% of the employee's compen-sation and that a safe harbor plan mustpermit all eligible NHCEs to make suffi-cient elective contributions (or employeecontributions, if applicable) to receive themaximum matching contribution providedunder the plan.

The proposed regulations would pro-vide a special rule for satisfying section401(m)(11)(B)(iii) in the case of an HCEwho participates in two or more plans thatprovide for matching contributions. Underthis rule, a plan will not fail to satisfy therequirements of section 401(m)(11)(B)(iii)merely because an HCE participates dur-ing the plan year in more than one plan thatprovides for matching contributions, pro-vided that the HCE is not simultaneouslyan eligible employee under two plans thatprovide for matching contributions main-tained by an employer for a plan year; andthe period used to determine compensa-tion for purposes of determining match-ing contributions under each such plan islimited to periods when the HCE partici-pated in the plan. In such a case, an HCEcan transfer from a plan with a more gen-erous matching schedule to an otherwisesafe harbor section 401(m) plan (for exam-ple, as a result of switching jobs within thecontrolled group) without causing the safeharbor plan to violate section 401(m)(11).However, the plan which is not the safeharbor plan will still have to aggregate

matching contributions for the HCE underthe rule set forth in section 401(m)(2)(B).

The safe harbor in section 401(m)(11)does not apply to employee contributions.Consequently, a plan that provides for em-ployee contributions and matching con-tributions must satisfy the ACP test eventhough the matching contributions satisfythe safe harbor requirements for section401(m)(11). However, the proposed reg-ulations would also adopt the position inNotice 98–52 that the ACP test is permittedto be applied by disregarding all matchingcontributions with respect to all eligibleemployees. If the ADP safe harbor usingmatching contributions is satisfied but theACP safe harbor is not satisfied, the pro-posed regulations would adopt the positionin Notice 98–52 that the ACP test is per-mitted to be applied disregarding matchingcontributions for any employee that do notexceed 4% of compensation.

Proposed Effective Date

The regulations are proposed to applyfor plan years beginning no sooner than12 months after publication of final regu-lations in the Federal Register. However,it is anticipated that the preamble for thefinal regulations will permit plan sponsorsto implement the final regulations for thefirst plan year beginning after publicationof final regulations in the Federal Regis-ter.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a significantregulatory action as defined in ExecutiveOrder 12866. Therefore, a regulatoryassessment is not required. It is herebycertified that the collection of informa-tion in these regulations will not have asignificant economic impact on a sub-stantial number of small entities. Thiscertification is based upon the conclu-sion that few plans containing qualifiedCODAs will correct excess contributionsthrough the recharacterization of theseamounts as employee contributions un-der §1.401(k)–2(b)(3) of these proposedregulations. The collections of informa-tion contained in §§1.401(k)–3(d), (f) and1.401(m)–3(e) are required by statutoryprovisions. However, the IRS has con-sidered alternatives that would lessen the

impact of these statutory requirements onsmall entities and has requested commentson the use of electronic media to satisfythese notice requirements. Thus, the col-lection of information in these regulationswill not have a significant economic im-pact on a substantial number of smallentities. Therefore, an analysis under theRegulatory Flexibility Act (5 U.S.C. chap-ter 6) is not required. Pursuant to section7805(f) of the Code, this notice of pro-posed rulemaking will be submitted to theChief Counsel for Advocacy of the SmallBusiness Administration for comment onits impact on small business.

Comments and Public Hearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any electronic or writ-ten comments (preferably a signed origi-nal and eight (8) copies) that are submittedtimely to the IRS. In addition to the otherrequests for comments set forth in this doc-ument, the IRS and Treasury also requestcomments on the clarity of the proposedrule and how it may be made easier to un-derstand. All comments will be availablefor public inspection and copying.

A public hearing has been scheduled forNovember 12, 2003, at 10 a.m. in the IRSAuditorium (7th Floor), Internal RevenueBuilding, 1111 Constitution Avenue, NW,Washington, DC. Due to building securityprocedures, visitors must enter at the Con-stitution Avenue, NW, entrance, locatedbetween 10th and 12th Streets, NW. In ad-dition, all visitors must present photo iden-tification to enter the building. Becauseof access restrictions, visitors will not beadmitted beyond the immediate entrancearea more than 30 minutes before the hear-ing starts. For information about havingyour name placed on the building accesslist to attend the hearing, see the “FORFURTHER INFORMATION CONTACT”section of this preamble.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing.

Persons who wish to present oral com-ments at the hearing must submit writtencomments and an outline of the topics tobe discussed and the time to be devotedto each topic (signed original and eight (8)copies) by October 22, 2003.

A period of 10 minutes will be allottedto each person for making comments.

September 2, 2003 443 2003-35 I.R.B.

An agenda showing the scheduling ofthe speakers will be prepared after thedeadline for receiving outlines has passed.Copies of the agenda will be available freeof charge at the hearing.

Drafting Information

The principal authors of these regula-tions are R. Lisa Mojiri-Azad and John T.Ricotta of the Office of the Division Coun-sel/Associate Chief Counsel (Tax Exemptand Government Entities). However, otherpersonnel from the IRS and Treasury par-ticipated in their development.

* * * * *

Proposed Amendments to TheRegulations

Accordingly, 26 CFR part 1 is proposedto be amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 780526 U.S.C. 401(m)(9) * * *Par. 2. Sections 1.401(k)–0 and

1.401(k)–1 are revised and §§1.401(k)–2through 1.401(k)–6 are added to read asfollows:

§1.401(k)–0 Table of contents.

This section contains first a list of sec-tion headings and then a list of the para-graphs in each section in §§1.401(k)–1through 1.401(k)–6.

LIST OF SECTIONS

§1.401(k)–1 Certain cash or deferred ar-rangements.§1.401(k)–2 ADP test.§1.401(k)–3 Safe harbor requirements.§1.401(k)–4 SIMPLE 401(k) plan require-ments.§1.401(k)–5 Special rules for mergers, ac-quisitions and similar events. [Reserved].§1.401(k)–6 Definitions.

LIST OF PARAGRAPHS

§1.401(k)–1 Certain cash or deferredarrangements.

(a) General rules.(1) Certain plans permitted to include cashor deferred arrangements.

(2) Rules applicable to cash or deferredarrangements generally.(i) Definition of cash or deferred arrange-ment.(ii) Treatment of after-tax employee con-tributions.(iii) Treatment of ESOP dividend election.(iv) Treatment of elective contributions asplan assets.(3) Rules applicable to cash or deferredelections generally.(i) Definition of cash or deferred election.(ii) Automatic enrollment.(iii) Rules related to timing.(A) Requirement that amounts not be cur-rently available.(B) Contribution may not precede election.(iv) Current availability defined.(v) Certain one-time elections not treatedas cash or deferred elections.(vi) Tax treatment of employees.(vii) Examples.(4) Rules applicable to qualified cash ordeferred arrangements.(i) Definition of qualified cash or deferredarrangement.(ii) Treatment of elective contributions asemployer contributions.(iii) Tax treatment of employees.(iv) Application of nondiscrimination re-quirements to plan that includes a qualifiedcash or deferred arrangement.(A) Exclusive means of amounts testing.(B) Testing benefits, rights and features.(C) Minimum coverage requirement.(5) Rules applicable to nonqualified cashor deferred arrangements.(i) Definition of nonqualified cash or de-ferred arrangement.(ii) Treatment of elective contributions asnonelective contributions.(iii) Tax treatment of employees.(iv) Qualification of plan that includesa nonqualified cash or deferred arrange-ment.(A) In general.(B) Application of section 401(a)(4) to cer-tain plans.(v) Example.(6) Rules applicable to cash or deferred ar-rangements of self-employed individuals.(i) Application of general rules.(ii) Treatment of matching contributionsmade on behalf of self-employed individ-uals.(iii) Timing of self-employed individual'scash or deferred election.

(b) Coverage and nondiscrimination re-quirements.(1) In general.(2) Automatic satisfaction by certain plans.(3) Anti-abuse provisions.(4) Aggregation and restructuring.(i) In general.(ii) Aggregation of cash or deferred ar-rangements within a plan.(iii) Aggregation of plans.(A) In general.(B) Plans with inconsistent ADP testingmethods.(iv) Disaggregation of plans and separatetesting.(A) In general.(B) Restructuring prohibited.(v) Modifications to section 410(b) rules.(A) Certain disaggregation rules not appli-cable.(B) Permissive aggregation of collectivebargaining units.(C) Multiemployer plans.(vi) Examples.(c) Nonforfeitability requirements.(1) General rule.(2) Definition of immediately nonfor-feitable.(3) Example.(d) Distribution limitation.(1) General rule.(2) Rules applicable to distributions uponseverance from employment.(3) Rules applicable to hardship distribu-tions.(i) Distribution must be on account of hard-ship.(ii) Limit on maximum distributableamount.(A) General rule.(B) Grandfathered amounts.(iii) Immediate and heavy financial need.(A) In general.(B) Deemed immediate and heavy finan-cial need.(iv) Distribution necessary to satisfy finan-cial need.(A) Distribution may not exceed amount ofneed.(B) No alternative means available.(C) Employer reliance on employee repre-sentation.(D) Employee need not take counterpro-ductive actions.(E) Distribution deemed necessary to sat-isfy immediate and heavy financial need.(F) Definition of other plans.(v) Commissioner may expand standards.

2003-35 I.R.B. 444 September 2, 2003

(4) Rules applicable to distributions uponplan termination.(i) No alternative defined contributionplan.(ii) Lump sum requirement for certain dis-tributions.(5) Rules applicable to all distributions.(i) Exclusive distribution rules.(ii) Deemed distributions.(iii) ESOP dividend distributions.(iv) Limitations apply after transfer.(6) Examples.(e) Additional requirements for qualifiedcash or deferred arrangements.(1) Qualified plan requirement.(2) Election requirements.(i) Cash must be available.(ii) Frequency of elections.(3) Separate accounting requirement.(i) General rule.(ii) Satisfaction of separate accounting re-quirement.(4) Limitations on cash or deferred ar-rangements of state and local govern-ments.(i) General rule.(ii) Rural cooperative plans and Indiantribal governments.(iii) Adoption after May 6, 1986.(iv) Adoption before May 7, 1986.(5) One-year eligibility requirement.(6) Other benefits not contingent uponelective contributions.(i) General rule.(ii) Definition of other benefits.(iii) Effect of certain statutory limits.(iv) Nonqualified deferred compensation.(v) Plan loans and distributions.(vi) Examples.(7) Plan provision requirement.(f) Effective dates.(1) General rule.(2) Collectively bargained plans.

§1.401(k)–2 ADP test.

(a) Actual deferral percentage (ADP) test.(1) In general.(i) ADP test formula.(ii) HCEs as sole eligible employees.(iii) Special rule for early participation.(2) Determination of ADP.(i) General rule.(ii) Determination of applicable year undercurrent year and prior year testing method.(3) Determination of ADR.(i) General rule.

(ii) ADR of HCEs eligible under more thanone arrangement.(A) General rule.(B) Plans not permitted to be aggregated.(iii) Examples.(4) Elective contributions taken into ac-count under the ADP test.(i) General rule.(ii) Elective contributions for partners andself-employed individuals.(iii) Elective contributions for HCEs.(5) Elective contributions not taken intoaccount under the ADP test.(i) General rule.(ii) Elective contributions for NHCEs.(iii) Elective contributions treated ascatch-up contributions.(iv) Elective contributions used to satisfythe ACP test.(6) Qualified nonelective contributions andqualified matching contributions that maybe taken into account under the ADP test.(i) Timing of allocation.(ii) Requirement that amount satisfy sec-tion 401(a)(4).(iii) Aggregation must be permitted.(iv) Disproportionate contributions nottaken into account.(A) General rule.(B) Definition of representative contribu-tion rate.(C) Definition of applicable contributionrate.(v) Qualified matching contributions.(vi) Contributions only used once.(7) Examples.(b) Correction of excess contributions.(1) Permissible correction methods.(i) In general.(A) Qualified nonelective contributions orqualified matching contributions.(B) Excess contributions distributed.(C) Excess contributions recharacterized.(ii) Combination of correction methods.(iii) Exclusive means of correction.(2) Corrections through distribution.(i) General rule.(ii) Calculation of total amount to be dis-tributed.(A) Calculate the dollar amount of excesscontributions for each HCE.(B) Determination of the total amount ofexcess contributions.(C) Satisfaction of ADP.(iii) Apportionment of total amount of ex-cess contributions among the HCEs.(A) Calculate the dollar amount of excesscontributions for each HCE.

(B) Limit on amount apportioned to anyindividual.(C) Apportionment to additional HCEs.(iv) Income allocable to excess contribu-tions.(A) General rule.(B) Method of allocating income.(C) Alternative method of allocating planyear income.(D) Safe harbor method of allocating gapperiod income.(E) Alternative method for allocating planyear and gap period income.(v) Distribution.(vi) Tax treatment of corrective distribu-tions.(A) General rule.(B) Rule for de minimis distributions.(vii) Other rules.(A) No employee or spousal consent re-quired.(B) Treatment of corrective distributions aselective contributions.(C) No reduction of required minimumdistribution.(D) Partial distributions.(viii) Examples.(3) Recharacterization of excess contribu-tions.(i) General rule.(ii) Treatment of recharacterized excesscontributions.(iii) Additional rules.(A) Time of recharacterization.(B) Employee contributions must be per-mitted under plan.(C) Treatment of recharacterized excesscontributions.(4) Rules applicable to all corrections.(i) Coordination with distribution of excessdeferrals.(A) Treatment of excess deferrals that re-duce excess contributions.(B) Treatment of excess contributions thatreduce excess deferrals.(ii) Forfeiture of match on distributed ex-cess contributions.(iii) Permitted forfeiture of QMAC.(iv) No requirement for recalculation.(v) Treatment of excess contributions thatare catch-up contributions.(5) Failure to timely correct.(i) Failure to correct within 21/2 monthsafter end of plan year.(ii) Failure to correct within 12 months af-ter end of plan year.(c) Additional rules for prior year testingmethod.

September 2, 2003 445 2003-35 I.R.B.

(1) Rules for change in testing method.(i) General rule.(ii) Situations permitting a change to theprior year testing method.(2) Calculation of ADP under the prioryear testing method for the first plan year.(i) Plans that are not successor plans.(ii) First plan year defined.(iii) Successor plans.(3) Plans using different testing methodsfor the ADP and ACP test.(4) Rules for plan coverage changes.(i) In general.(ii) Optional rule for minor plan coveragechanges.(iii) Definitions.(A) Plan coverage change.(B) Prior year subgroup.(C) Weighted average of the ADPs for theprior year subgroups.(iv) Examples.

§1.401(k)–3 Safe harbor requirements.

(a) ADP test safe harbor.(b) Safe harbor nonelective contributionrequirement.(1) General rule.(2) Safe harbor compensation defined.(c) Safe harbor matching contribution re-quirement.(1) In general.(2) Basic matching formula.(3) Enhanced matching formula.(4) Limitation on HCE matching contribu-tions.(5) Use of safe harbor match not precludedby certain plan provisions.(i) Safe harbor matching contributions onemployee contributions.(ii) Periodic matching contributions.(6) Permissible restrictions on electivecontributions by NHCEs.(i) General rule.(ii) Restrictions on election periods.(iii) Restrictions on amount of electivecontributions.(iv) Restrictions on types of compensationthat may be deferred.(v) Restrictions due to limitations underthe Internal Revenue Code.(7) Examples.(d) Notice requirement.(1) General rule.(2) Content requirement.(i) General rule.(ii) Minimum content requirement.

(iii) References to SPD.(3) Timing requirement.(i) General rule.(ii) Deemed satisfaction of timing require-ment.(e) Plan year requirement.(1) General rule.(2) Initial plan year.(3) Change of plan year.(4) Final plan year.(f) Plan amendments adopting safe harbornonelective contributions.(1) General rule.(2) Contingent notice provided.(3) Follow-up notice requirement.(g) Permissible reduction or suspension ofsafe harbor matching contributions.(1) General rule.(2) Notice of suspension requirement.(h) Additional rules.(1) Contributions taken into account.(2) Use of safe harbor nonelective contri-butions to satisfy other nondiscriminationtests.(3) Early participation rules.(4) Satisfying safe harbor contribution re-quirement under another defined contribu-tion plan.(5) Contributions used only once.

§1.401(k)–4 SIMPLE 401(k) planrequirements.

(a) General rule.(b) Eligible employer.(1) General rule.(2) Special rule.(c) Exclusive plan.(1) General rule.(2) Special rule.(d) Election and notice.(1) General rule.(2) Employee elections.(i) Initial plan year of participation.(ii) Subsequent plan years.(iii) Election to terminate.(3) Employee notices.(e) Contributions.(1) General rule.(2) Elective contributions.(3) Matching contributions.(4) Nonelective contributions.(5) SIMPLE compensation.(f) Vesting.(g) Plan year.(h) Other rules.

§1.401(k)–5 Special rules for mergers,acquisitions and similar events.[Reserved]

§1.401(k)–6 Definitions.

§1.401(k)–1 Certain cash or deferredarrangements.

(a) General rules—(1) Certain planspermitted to include cash or deferredarrangements. A plan, other than aprofit-sharing, stock bonus, pre-ERISAmoney purchase pension, or rural coopera-tive plan, does not satisfy the requirementsof section 401(a) if the plan includes a cashor deferred arrangement. A profit-sharing,stock bonus, pre-ERISA money purchasepension, or rural cooperative plan doesnot fail to satisfy the requirements ofsection 401(a) merely because the planincludes a cash or deferred arrangement.A cash or deferred arrangement is part ofa plan for purposes of this section if anycontributions to the plan, or accruals orother benefits under the plan, are made orprovided pursuant to the cash or deferredarrangement.

(2) Rules applicable to cash or deferredarrangements generally—(i) Definition ofcash or deferred arrangement. Except asprovided in paragraphs (a)(2)(ii) and (iii)of this section, a cash or deferred arrange-ment is an arrangement under which an el-igible employee may make a cash or de-ferred election with respect to contribu-tions to, or accruals or other benefits un-der, a plan that is intended to satisfy therequirements of section 401(a) (includinga contract that is intended to satisfy the re-quirements of section 403(a)).

(ii) Treatment of after-tax employeecontributions. A cash or deferred arrange-ment does not include an arrangementunder which amounts contributed under aplan at an employee's election are desig-nated or treated at the time of contributionas after-tax employee contributions (e.g.,by treating the contributions as taxableincome subject to applicable withholdingrequirements). See also section 414(h)(1).This is the case even if the employee'selection to make after-tax employee con-tributions is made before the amountssubject to the election are currently avail-able to the employee.

(iii) Treatment of ESOP dividend elec-tion. A cash or deferred arrangement

2003-35 I.R.B. 446 September 2, 2003

does not include an arrangement underan ESOP under which dividends are ei-ther distributed or invested pursuant toan election made by participants or theirbeneficiaries in accordance with section404(k)(2)(A)(iii).

(iv) Treatment of elective contributionsas plan assets. The extent to which elec-tive contributions constitute plan assetsfor purposes of the prohibited transactionprovisions of section 4975 and Title I ofthe Employee Retirement Income SecurityAct of 1974 is determined in accordancewith regulations and rulings issued bythe Department of Labor. See 29 CFR2510.3–102.

(3) Rules applicable to cash or deferredelections generally—(i) Definition of cashor deferred election. A cash or deferredelection is any direct or indirect election(or modification of an earlier election) byan employee to have the employer either—

(A) Provide an amount to the employeein the form of cash (or some other taxablebenefit) that is not currently available; or

(B) Contribute an amount to a trust, orprovide an accrual or other benefit, under aplan deferring the receipt of compensation.

(ii) Automatic enrollment. For pur-poses of determining whether an electionis a cash or deferred election, it is irrel-evant whether the default that applies inthe absence of an affirmative election isdescribed in paragraph (a)(3)(i)(A) ofthis section (i.e., the employee receivesan amount in cash or some other taxablebenefit) or in paragraph (a)(3)(i)(B) of thissection (i.e., the employer contributes anamount to a trust or provides an accrualor other benefit under a plan deferring thereceipt of compensation).

(iii) Rules related to timing—(A) Re-quirement that amounts not be currentlyavailable. A cash or deferred election canonly be made with respect to an amountthat is not currently available to the em-ployee on the date of the election. Fur-ther, a cash or deferred election can only bemade with respect to amounts that would(but for the cash or deferred election) be-come currently available after the later ofthe date on which the employer adopts thecash or deferred arrangement or the dateon which the arrangement first becomes ef-fective.

(B) Contribution may not precede elec-tion. A contribution is made pursuant to a

cash or deferred election only if the contri-bution is made after the election is made.In addition, a contribution is made pur-suant to a cash or deferred election onlyif the contribution is made after the em-ployee's performance of services with re-spect to which the contribution is made(or when the cash or other taxable benefitwould be currently available, if earlier).

(iv) Current availability defined. Cashor another taxable benefit is currentlyavailable to the employee if it has beenpaid to the employee or if the employee isable currently to receive the cash or othertaxable benefit at the employee's discre-tion. An amount is not currently availableto an employee if there is a significantlimitation or restriction on the employee'sright to receive the amount currently. Sim-ilarly, an amount is not currently availableas of a date if the employee may under nocircumstances receive the amount before aparticular time in the future. The determi-nation of whether an amount is currentlyavailable to an employee does not dependon whether it has been constructively re-ceived by the employee for purposes ofsection 451.

(v) Certain one-time elections nottreated as cash or deferred elections. Acash or deferred election does not include aone-time irrevocable election upon an em-ployee's commencement of employmentwith the employer, or upon the employee'sfirst becoming eligible under the plan orany other plan of the employer (whetheror not such other plan has terminated),to have contributions equal to a specifiedamount or percentage of the employee'scompensation (including no amount ofcompensation) made by the employer onthe employee's behalf to the plan and aspecified amount or percentage of theemployee's compensation (including noamount of compensation) divided amongall other plans of the employer (includingplans not yet established) for the durationof the employee's employment with theemployer, or in the case of a defined bene-fit plan to receive accruals or other benefits(including no benefits) under such plans.Thus, for example, employer contributionsmade pursuant to a one-time irrevocableelection described in this paragraph arenot treated as having been made pursuantto a cash or deferred election and are notincludible in an employee's gross incomeby reason of §1.402(a)–1(d). In the case of

an irrevocable election made on or beforeDecember 23, 1994—

(A) The election does not fail to betreated as a one-time irrevocable electionunder this paragraph (a)(3)(v) merely be-cause an employee was previously eligi-ble under another plan of the employer(whether or not such other plan has termi-nated); and

(B) In the case of a plan in which part-ners may participate, the election does notfail to be treated as a one-time irrevoca-ble election under this paragraph (a)(3)(v)merely because the election was made aftercommencement of employment or after theemployee's first becoming eligible underany plan of the employer, provided that theelection was made before the first day ofthe first plan year beginning after Decem-ber 31,1988, or, if later, March 31,1989.

(vi) Tax treatment of employees. Anamount generally is includible in an em-ployee's gross income for the taxableyear in which the employee actually orconstructively receives the amount. Butfor sections 402(e)(3) and 401(k), anemployee is treated as having receivedan amount that is contributed to a planpursuant to the employee's cash or de-ferred election. This is the case even if theelection to defer is made before the yearin which the amount is earned, or beforethe amount is currently available. See§1.402(a)–1(d).

(vii) Examples. The following exam-ples illustrate the application of paragraph(a)(3) of this section:

Example 1. (i) An employer maintains a profit-sharing plan under which each eligible employee hasan election to defer an annual bonus payable on Jan-uary 30 each year. The bonus equals 10% of com-pensation during the previous calendar year. Deferredamounts are not treated as after-tax employee contri-butions. The bonus is currently available on January30.

(ii) An election made prior to January 30 to deferall or part of the bonus is a cash or deferred election,and the bonus deferral arrangement is a cash or de-ferred arrangement.

Example 2. (i) An employer maintains a profit-sharing plan which provides for discretionary profitsharing contributions and under which each eligibleemployee may elect to reduce his compensation byup to 10% and to have the employer contribute suchamount to the plan. The employer pays each em-ployee every two weeks for services during the imme-diately preceding two weeks. The employee's elec-tion to defer compensation for a payroll period mustbe made prior to the date the amount would other-wise be paid. The employer contributes to the plan theamount of compensation that each employee electedto defer, at the time it would otherwise be paid to the

September 2, 2003 447 2003-35 I.R.B.

employee, and does not treat the contribution as anafter-tax employee contribution.

(ii) The election is a cash or deferred election andthe contributions are elective contributions.

Example 3. (i) The facts are the same as in Exam-ple 2, except that the employer makes a $10,000 con-tribution on January 31 of the plan year that is in ad-dition to the contributions that satisfy the employer'sobligation to make contributions with respect to cashor deferred elections for prior payroll periods. Em-ployee A makes an election on February 15 to defer$2,000 from compensation that is not currently avail-able and the employer reduces the employee's com-pensation to reflect the election.

(ii) None of the additional $10,000 contributedJanuary 31 is a contribution made pursuant to Em-ployee A's cash or deferred election, because the con-tribution was made before the election was made. Ac-cordingly, the employer must make an additional con-tribution of $2,000 in order to satisfy its obligationto contribute an amount to the plan pursuant to Em-ployee A's election. The $10,000 contribution can beallocated under the plan terms providing for discre-tionary profit sharing contributions.

Example 4. (i) The facts are the same as in Ex-ample 3, except that Employee A had an outstand-ing election to defer $500 from each payroll period'scompensation.

(ii) None of the additional $10,000 contributedJanuary 31 is a contribution made pursuant to Em-ployee A's cash or deferred election for future pay-roll periods, because the contribution was made be-fore the earlier of Employee A's performance of ser-vices to which the contribution is attributable or whenthe compensation would be currently available. Ac-cordingly, the employer must make an additional con-tribution of $500 per payroll period in order to satisfyits obligation to contribute an amount to the plan pur-suant to Employee A's election. The $10,000 contri-bution can be allocated under the plan terms provid-ing for discretionary profit sharing contributions.

Example 5. (i) Employer B establishes a moneypurchase pension plan in 1986. This is the first qual-ified plan established by Employer B. All salariedemployees are eligible to participate under the plan.Hourly-paid employees are not eligible to participateunder the plan. In 2000, Employer B establishes aprofit-sharing plan under which all employees (bothsalaried and hourly) are eligible. Employer B permitsall employees on the effective date of the profit-shar-ing plan to make a one-time irrevocable election tohave Employer B contribute 5% of compensation ontheir behalf to the plan and make no other contribu-tion to any other plan of Employer B (including plansnot yet established) for the duration of the employee'semployment with Employer B, and have their salariesreduced by 5%.

(ii) The election provided under the profit-shar-ing plan is not a one-time irrevocable election withinthe meaning of paragraph (a)(3)(v) of this sectionwith respect to the salaried employees of EmployerB who, before becoming eligible to participate underthe profit-sharing plan, became eligible to participateunder the money purchase pension plan. The electionunder the profit-sharing plan is a one-time irrevocableelection within the meaning of paragraph (a)(3)(v) ofthis section with respect to the hourly employees, be-cause they were not previously eligible to participateunder another plan of the employer.

(4) Rules applicable to qualified cashor deferred arrangements—(i) Definitionof qualified cash or deferred arrangement.A qualified cash or deferred arrangementis a cash or deferred arrangement that sat-isfies the requirements of paragraphs (b),(c), (d), and (e) of this section.

(ii) Treatment of elective contributionsas employer contributions. Except asotherwise provided in §1.401(k)–2(b)(3),elective contributions under a qualifiedcash or deferred arrangement are treatedas employer contributions. Thus, for ex-ample, elective contributions are treatedas employer contributions for purposes ofsections 401(a) and 401(k), 402, 404, 409,411, 412, 415, 416, and 417.

(iii) Tax treatment of employees. Exceptas provided in section 402(g), 402A (ef-fective for years beginning after Decem-ber 31, 2005), or 1.401(k)–2(b)(3), elec-tive contributions under a qualified cash ordeferred arrangement are neither includi-ble in an employee's gross income at thetime the cash would have been includiblein the employee's gross income (but for thecash or deferred election), nor at the timethe elective contributions are contributedto the plan. See §1.402(a)–1(d)(2)(i).

(iv) Application of nondiscriminationrequirements to plan that includes a qual-ified cash or deferred arrangement—(A)Exclusive means of amounts testing. Elec-tive contributions under a qualified cash ordeferred arrangement satisfy the require-ments of section 401(a)(4) with respectto amounts if and only if the amount ofelective contributions satisfies the nondis-crimination test of section 401(k) underparagraph (b)(1) of this section. See§1.401(a)(4)–1(b)(2)(ii)(B).

(B) Testing benefits, rights and fea-tures. A plan that includes a qualifiedcash or deferred arrangement must sat-isfy the requirements of section 401(a)(4)with respect to benefits, rights and fea-tures in addition to the requirementsregarding amounts described in paragraph(a)(4)(iv)(A) of this section. For example,the right to make each level of electivecontributions under a cash or deferredarrangement is a benefit, right or featuresubject to the requirements of section401(a)(4). See §1.401(a)(4)–4(e)(3)(i)and (iii)(D). Thus, for example, if all em-ployees are eligible to make a stated levelof elective contributions under a cash ordeferred arrangement, but that level of

contributions can only be made from com-pensation in excess of a stated amount,such as the Social Security taxable wagebase, the arrangement will generally favorHCEs with respect to the availability ofelective contributions and thus will gener-ally not satisfy the requirements of section401(a)(4).

(C) Minimum coverage requirement.A qualified cash or deferred arrangementis treated as a separate plan that mustsatisfy the requirements of section 410(b).See §1.410(b)–7(c)(1) for special rules.The determination of whether a cash ordeferred arrangement satisfies the require-ments of section 410(b) must be madewithout regard to the modifications tothe disaggregation rules set forth in para-graph (b)(4)(v) of this section. See also§1.401(a)(4)–11(g)(3)(vii)(A), relating tocorrective amendments that may be madeto satisfy the minimum coverage require-ments of section 410(b).

(5) Rules applicable to nonqualifiedcash or deferred arrangements—(i) Def-inition of nonqualified cash or deferredarrangement. A nonqualified cash or de-ferred arrangement is a cash or deferredarrangement that fails to satisfy one ormore of the requirements in paragraph (b),(c), (d) or (e) of this section.

(ii) Treatment of elective contributionsas nonelective contributions. Except asspecifically provided otherwise, electivecontributions under a nonqualified cashor deferred arrangement are treated asnonelective employer contributions. Thus,for example, the elective contributionsare treated as nonelective employer con-tributions for purposes of sections 401(a)(including section 401(a)(4)) and 401(k),404, 409, 411, 412, 415, 416, and 417and are not subject to the requirements ofsection 401(m).

(iii) Tax treatment of employees. Elec-tive contributions under a nonqualifiedcash or deferred arrangement are includi-ble in an employee's gross income at thetime the cash or other taxable amount thatthe employee would have received (but forthe cash or deferred election) would havebeen includible in the employee's grossincome. See §1.402(a)–1(d)(1).

(iv) Qualification of plan that includesa nonqualified cash or deferred arrange-ment—(A) In general. A profit-sharing,stock bonus, pre-ERISA money purchasepension, or rural cooperative plan does

2003-35 I.R.B. 448 September 2, 2003

not fail to satisfy the requirements ofsection 401(a) merely because the planincludes a nonqualified cash or deferredarrangement. In determining whetherthe plan satisfies the requirements ofsection 401(a)(4), the nondiscrimina-tion tests of sections 401(k), paragraph(b)(1) of this section, section 401(m)(2)and §1.401(m)–1(b) may not be used.See §§1.401(a)(4)–1(b)(2)(ii)(B) and1.410(b)–9 (definition of section 401(k)plan).

(B) Application of section 401(a)(4) tocertain plans. The amount of employercontributions under a nonqualified cash ordeferred arrangement is treated as satisfy-ing section 401(a)(4) if the arrangement ispart of a collectively bargained plan thatautomatically satisfies the requirements ofsection 410(b). See §§1.401(a)(4)–1(c)(5)and 1.410(b)–2(b)(7). Additionally, therequirements of sections 401(a)(4) and410(b) do not apply to a governmen-tal plan (within the meaning of section414(d)) maintained by a state or local gov-ernment or political subdivision thereof(or agency or instrumentality thereof). Seesections 401(a)(5) and 410(c)(1)(A).

(v) Example. The following exampleillustrates the application of this paragraph(a)(5):

Example. (i) For the 2006 plan year, Employer Amaintains a collectively bargained plan that includesa cash or deferred arrangement. Employer contribu-tions under the cash or deferred arrangement do notsatisfy the nondiscrimination test of section 401(k)and paragraph (b) of this section.

(ii) The arrangement is a nonqualified cash or de-ferred arrangement. The employer contributions un-der the cash or deferred arrangement are consideredto be nondiscriminatory under section 401(a)(4), andthe elective contributions are generally treated as em-ployer contributions under paragraph (a)(5)(ii) of thissection. Under paragraph (a)(5)(iii) of this sectionand under §1.402(a)–1(d)(1), however, the electivecontributions are includible in each employee's grossincome.

(6) Rules applicable to cash or deferredarrangements of self-employed individuals—(i) Application of general rules. Gener-ally, a partnership or sole proprietorship ispermitted to maintain a cash or deferredarrangement, and individual partners orowners are permitted to make cash or de-ferred elections with respect to compensa-tion attributable to services rendered to theentity, under the same rules that apply toother cash or deferred arrangements. For

example, any contributions made on be-half of an individual partner or owner pur-suant to a cash or deferred arrangementof a partnership or sole proprietorship areelective contributions unless they are des-ignated or treated as after-tax employeecontributions. In the case of a partner-ship, a cash or deferred arrangement in-cludes any arrangement that directly or in-directly permits individual partners to varythe amount of contributions made on theirbehalf. Consistent with §1.402(a)–1(d),the elective contributions under such an ar-rangement are includible in income and arenot deductible under section 404(a) unlessthe arrangement is a qualified cash or de-ferred arrangement (i.e., the requirementsof section 401(k) and this section are sat-isfied). Also, even if the arrangement isa qualified cash or deferred arrangement,the elective contributions are includible ingross income and are not deductible undersection 404(a) to the extent they exceed theapplicable limit under section 402(g). Seealso §1.401(a)–30.

(ii) Treatment of matching contribu-tions made on behalf of self-employedindividuals. Under section 402(g)(8),matching contributions made on behalf ofa self-employed individual are not treatedas elective contributions made pursuant toa cash or deferred election, without regardto whether such matching contributionsindirectly permit individual partners tovary the amount of contributions made ontheir behalf.

(iii) Timing of self-employed individ-ual's cash or deferred election. For pur-poses of paragraph (a)(3)(iv) of this sec-tion, a partner's compensation is deemedcurrently available on the last day of thepartnership taxable year and a sole pro-prietor's compensation is deemed currentlyavailable on the last day of the individ-ual's taxable year. Accordingly, a self-em-ployed individual may not make a cashor deferred election with respect to com-pensation for a partnership or sole propri-etorship taxable year after the last day ofthat year. See §1.401(k)–2(a)(4)(ii) for therules regarding when these contributionsare treated as allocated.

(b) Coverage and nondiscrimination re-quirements—(1) In general. A cash or de-ferred arrangement satisfies this paragraph(b) for a plan year only if—

(i) The group of eligible employees un-der the cash or deferred arrangement (in-cluding any employee taken into accountfor purposes of section 410(b) pursuantto §1.401(a)(4)–11(g)(3)(vii)(A)) satisfiesthe requirements of section 410(b) (includ-ing the average benefit percentage test, ifapplicable); and

(ii) The cash or deferred arrangementsatisfies—

(A) The ADP test of section 401(k)(3)described in §1.401(k)–2;

(B) The ADP safe harbor provi-sions of section 401(k)(12) describedin §1.401(k)–3; or

(C) The SIMPLE 401(k) provi-sions of section 401(k)(11) describedin §1.401(k)–4.

(2) Automatic satisfaction by cer-tain plans. Notwithstanding paragraph(b)(1) of this section, a governmental plan(within the meaning of section 414(d))maintained by a state or local governmentor political subdivision thereof (or agencyor instrumentality thereof) shall be treatedas meeting the requirements of this para-graph (b).

(3) Anti-abuse provisions. Sections1.401(k)–1 through 1.401(k)–6 aredesigned to provide simple, practicalrules that accommodate legitimate planchanges. At the same time, the rules areintended to be applied by employers in amanner that does not make use of changesin plan testing procedures or other planprovisions to inflate inappropriately theADP for NHCEs (which is used as abenchmark for testing the ADP for HCEs)or to otherwise manipulate the nondis-crimination testing requirements of thisparagraph (b). Further, this paragraph (b)is part of the overall requirement that ben-efits or contributions not discriminate infavor of HCEs. Therefore, a plan will notbe treated as satisfying the requirementsof this paragraph (b) if there are repeatedchanges to plan testing procedures or planprovisions that have the effect of distortingthe ADP so as to increase significantly thepermitted ADP for HCEs, or otherwisemanipulate the nondiscrimination rules ofthis paragraph, if a principal purpose ofthe changes was to achieve such a result.

(4) Aggregation and restructuring—(i)In general. This paragraph (b)(4) contains

September 2, 2003 449 2003-35 I.R.B.

the exclusive rules for aggregating and dis-aggregating plans and cash or deferred ar-rangements for purposes of this section,and §§1.401(k)–2 through 1.401(k)–6.

(ii) Aggregation of cash or deferred ar-rangements within a plan. Except as oth-erwise specifically provided in this para-graph (b)(4), all cash or deferred arrange-ments included in a plan are treated as asingle cash or deferred arrangement and aplan must apply a single test under para-graph (b)(1)(ii) of this section with re-spect to all such arrangements within theplan. Thus, for example, if two groupsof employees are eligible for separate cashor deferred arrangements under the sameplan, all contributions under both cash ordeferred arrangements must be treated asmade under a single cash or deferred ar-rangement subject to a single test, even ifthey have significantly different features,such as different limits on elective contri-butions.

(iii) Aggregation of plans—(A) Ingeneral. For purposes of this sectionand §§1.401(k)–2 through 1.401(k)–6, theterm plan means a plan within the meaningof §1.410(b)–7(a) and (b), after applica-tion of the mandatory disaggregation rulesof §1.410(b)–7(c), and the permissiveaggregation rules of §1.410(b)–7(d), asmodified by paragraph (b)(4)(v) of thissection. Thus, for example, two plans(within the meaning of §1.410(b)–7(b))that are treated as a single plan pursuantto the permissive aggregation rules of§1.410(b)–7(d) are treated as a single planfor purposes of section 401(k) and section401(m).

(B) Plans with inconsistent ADP test-ing methods. Pursuant to paragraph(b)(4)(ii) of this section, a single testingmethod must apply with respect to allcash or deferred arrangements under aplan. Thus, in applying the permissiveaggregation rules of §1.410(b)–7(d), anemployer may not aggregate plans (withinthe meaning of §1.410(b)–7(b)) that ap-ply inconsistent testing methods. Forexample, a plan (within the meaning of§1.410(b)–7(b)) that applies the currentyear testing method may not be aggre-gated with another plan that applies theprior year testing method. Similarly, anemployer may not aggregate a plan (withinthe meaning of §1.410(b)–7(b)) using theADP safe harbor provisions of section

401(k)(12) and another plan that is usingthe ADP test of section 401(k)(3).

(iv) Disaggregation of plans and sepa-rate testing—(A) In general. If a cash ordeferred arrangement is included in a plan(within the meaning of §1.410(b)–7(b))that is mandatorily disaggregated underthe rules of section 410(b) (as modi-fied by this paragraph (b)(4)), the cashor deferred arrangement must be dis-aggregated in a consistent manner. Forexample, in the case of an employer thatis treated as operating qualified separatelines of business under section 414(r), ifthe eligible employees under a cash ordeferred arrangement are in more thanone qualified separate line of business,only those employees within each qual-ified separate line of business may betaken into account in determining whethereach disaggregated portion of the plancomplies with the requirements of section401(k), unless the employer is applyingthe special rule for employer-wide plansin §1.414(r)–1(c)(2)(ii) with respect tothe plan. Similarly, if a cash or deferredarrangement under which employees arepermitted to participate before they havecompleted the minimum age and servicerequirements of section 410(a)(1) ap-plies section 410(b)(4)(B) for determiningwhether the plan complies with section410(b)(1), then the arrangement must betreated as two separate arrangements, onecomprising all eligible employees whohave met the age and service requirementsof section 410(a)(1) and one comprisingall eligible employees who have not metthe age and service requirements undersection 410(a)(1), unless the plan is usingthe rule in §1.401(k)–2(a)(1)(iii)(A).

(B) Restructuring prohibited. Restruc-turing under §1.401(a)(4)–9(c) may notbe used to demonstrate compliance withthe requirements of section 401(k). See§1.401(a)(4)–9(c)(3)(ii).

(v) Modifications to section 410(b)rules—(A) Certain disaggregation rulesnot applicable. The mandatory disag-gregation rules relating to section 401(k)plans and section 401(m) plans set forthin §1.410(b)–7(c)(1) and ESOP andnon-ESOP portions of a plan set forth in§1.410(b)–7(c)(2) shall not apply for pur-poses of this section and §§1.401(k)–2through 1.401(k)–6. Accordingly,notwithstanding §1.410(b)–7(d)(2), an

ESOP and a non-ESOP which are dif-ferent plans (within the meaning of§1.410(b)–7(b)) are permitted to be aggre-gated for these purposes.

(B) Permissive aggregation of collec-tive bargaining units. Notwithstandingthe general rule under section 410(b) and§1.410(b)–7(c) that a plan that benefitsemployees who are included in a unit ofemployees covered by a collective bar-gaining agreement and employees whoare not included in the collective bargain-ing unit is treated as comprising separateplans, an employer can treat two or moreseparate collective bargaining units asa single collective bargaining unit forpurposes of this section and §1.401(k)–2through §1.401(k)–6, provided that thecombinations of units are determined ona basis that is reasonable and reasonablyconsistent from year to year. Thus, forexample, if a plan benefits employees inthree categories (e.g., employees includedin collective bargaining unit A, employeesincluded in collective bargaining unit B,and employees who are not included inany collective bargaining unit), the plancan be treated as comprising three sep-arate plans, each of which benefits onlyone category of employees. However, ifcollective bargaining units A and B aretreated as a single collective bargainingunit, the plan will be treated as comprisingonly two separate plans, one benefit-ting all employees who are included ina collective bargaining unit and anotherbenefitting all other employees. Similarly,if a plan benefits only employees who areincluded in collective bargaining unit Aand employees who are included in col-lective bargaining unit B, the plan can betreated as comprising two separate plans.However, if collective bargaining units Aand B are treated as a single collectivebargaining unit, the plan will be treated asa single plan. An employee is treated asincluded in a unit of employees coveredby a collective bargaining agreement ifand only if the employee is a collectivelybargained employee within the meaningof §1.410(b)–6(d)(2).

(C) Multiemployer plans. Notwith-standing §1.410(b)–7(c)(4)(ii)(C), theportion of the plan that is maintained pur-suant to a collective bargaining agreement(within the meaning of §1.413–1(a)(2)) istreated as a single plan maintained by a

2003-35 I.R.B. 450 September 2, 2003

single employer that employs all the em-ployees benefitting under the same benefitcomputation formula and covered pursuantto that collective bargaining agreement.The rules of paragraph (b)(4)(v)(B) ofthis section (including the permissive ag-gregation of collective bargaining units)apply to the resulting deemed single planin the same manner as they would toa single employer plan, except that theplan administrator is substituted for theemployer where appropriate and appro-priate fiduciary obligations are taken intoaccount. The noncollectively bargainedportion of the plan is treated as maintainedby one or more employers, depending onwhether the noncollectively bargainingunit employees who benefit under the planare employed by one or more employers.

(vi) Examples. The following examplesillustrate the application of this paragraph(b)(4):

Example 1. (i) Employer A maintains Plan V, aprofit-sharing plan that includes a cash or deferredarrangement in which all of the employees of Em-ployer A are eligible to participate. For purposes ofapplying section 410(b), Employer A is treated as op-erating qualified separate lines of business under sec-tion 414(r) in accordance with §1.414(r)–1(b). How-ever, Employer A applies the special rule for em-ployer-wide plans in §1.414(r)–1(c)(2)(ii) to the por-tion of its profit-sharing plan that consists of electivecontributions under the cash or deferred arrangement(and to no other plans or portions of plans).

(ii) Under these facts, the requirements of this sec-tion and §§1.401(k)–2 through 1.401(k)–6 must beapplied on an employer-wide rather than a qualifiedseparate line of business basis.

Example 2. (i) Employer B maintains Plan W, aprofit-sharing plan that includes a cash or deferred ar-rangement in which all of the employees of EmployerB are eligible to participate. For purposes of apply-ing section 410(b), the plan treats the cash or deferredarrangement as two separate plans, one for the em-ployees who have completed the minimum age andservice eligibility conditions under section 410(a)(1)and the other for employees who have not completedthe conditions. The plan provides that it will sat-isfy the section 401(k) safe harbor requirement of§1.401(k)–3 with respect to the employees who havemet the minimum age and service conditions and thatit will meet the ADP test requirements of §1.401(k)–2with respect to the employees who have not met theminimum age and service conditions.

(ii) Under these facts, the cash or deferred ar-rangement must be disaggregated on a consistent ba-sis with the disaggregation of Plan W. Thus, the re-quirements of §1.401(k)–2 must be applied by com-paring the ADP for eligible HCEs who have not com-pleted the minimum age and service conditions withthe ADP for eligible NHCEs for the applicable yearwho have not completed the minimum age and ser-vice conditions.

Example 3. (i) Employer C maintains Plan X, astock-bonus plan including an ESOP. The plan also

includes a cash or deferred arrangement for partici-pants in the ESOP and non-ESOP portions of the plan.

(ii) Pursuant to paragraph (b)(4)(v)(A) of thissection the ESOP and non-ESOP portions of thestock-bonus plan are a single cash or deferredarrangement for purposes of this section and§§1.401(k)–2 through 1.401(k)–6. However, asprovided in paragraph (a)(4)(iv)(C) of this section,the ESOP and non-ESOP portions of the plan are stilltreated as separate plans for purposes of satisfyingthe requirements of section 410(b).

(c) Nonforfeitability requirements—(1)General rule. A cash or deferred arrange-ment satisfies this paragraph (c) only ifthe amount attributable to an employee'selective contributions are immediatelynonforfeitable, within the meaning ofparagraph (c)(2) of this section, are dis-regarded for purposes of applying section411(a) to other contributions or benefits,and the contributions remain nonfor-feitable even if the employee makes noadditional elective contributions under acash or deferred arrangement.

(2) Definition of immediately non-forfeitable. An amount is immediatelynonforfeitable if it is immediately non-forfeitable within the meaning of section411, and would be nonforfeitable underthe plan regardless of the age and serviceof the employee or whether the employeeis employed on a specific date. An amountthat is subject to forfeitures or suspensionspermitted by section 411(a)(3) does notsatisfy the requirements of this paragraph(c).

(3) Example. The following exampleillustrates the application of this paragraph(c):

Example. (i) Employees B and C are covered byEmployer Y's stock bonus plan, which includes a cashor deferred arrangement. All employees participatingin the plan have a nonforfeitable right to a percent-age of their account balance derived from all contri-butions (including elective contributions) as shown inthe following table:

Years of service Nonforfeitablepercentage

Less than 1 0%

1 20%

2 40%

3 60%

4 80%

5 or more 100%

(ii) The cash or deferred arrangement does notsatisfy paragraph (c) of this section because electivecontributions are not immediately nonforfeitable.

Thus, the cash or deferred arrangement is a nonqual-ified cash or deferred arrangement.

(d) Distribution limitation—(1) Gen-eral rule. A cash or deferred arrangementsatisfies this paragraph (d) only if amountsattributable to elective contributions maynot be distributed before one of the fol-lowing events, and any distributions sopermitted also satisfy the additional re-quirements of paragraphs (d)(2) through(5) of this section (to the extent applica-ble)—

(i) The employee's death, disability, orseverance from employment;

(ii) In the case of a profit-sharing, stockbonus or rural cooperative plan, the em-ployee's attainment of age 591/2, or the em-ployee's hardship; or

(iii) The termination of the plan.(2) Rules applicable to distributions

upon severance from employment. Anemployee has a severance from employ-ment when the employee ceases to be anemployee of the employer maintainingthe plan. An employee does not have aseverance from employment if, in con-nection with a change of employment, theemployee's new employer maintains suchplan with respect to the employee. Forexample, a new employer maintains a planwith respect to an employee by continuingor assuming sponsorship of the plan orby accepting a transfer of plan assets andliabilities (within the meaning of section414(l)) with respect to the employee).

(3) Rules applicable to hardship distri-butions—(i) Distribution must be on ac-count of hardship. A distribution is treatedas made after an employee's hardship forpurposes of paragraph (d)(1)(ii) of this sec-tion if and only if it is made on accountof the hardship. For purposes of this rule,a distribution is made on account of hard-ship only if the distribution both is madeon account of an immediate and heavy fi-nancial need of the employee and is neces-sary to satisfy the financial need. The de-termination of the existence of an imme-diate and heavy financial need and of theamount necessary to meet the need mustbe made in accordance with nondiscrimi-natory and objective standards set forth inthe plan.

(ii) Limit on maximum distributableamount—(A) General rule. A distributionon account of hardship must be limitedto the maximum distributable amount.The maximum distributable amount is

September 2, 2003 451 2003-35 I.R.B.

equal to the employee's total elective con-tributions as of the date of distribution,reduced by the amount of previous distri-butions of elective contributions. Thus,the maximum distributable amount doesnot include earnings, QNECs or QMACs,unless grandfathered under paragraph(d)(3)(ii)(B) of this section.

(B) Grandfathered amounts. If theplan provides, the maximum distributableamount may be increased for amountscredited to the employee's account as of adate specified in the plan that is no laterthan December 31, 1988, or if later, theend of the last plan year ending before July1, 1989 (or in the case of a collectivelybargained plan, the earlier of—

(1) the later of January 1, 1989, or thedate on which the last of the collective bar-gaining agreements in effect on March 1,1986, terminates (determined without re-gard to any extension thereof after Febru-ary 28, 1986); or

(2) January 1, 1991, and consisting of—(i) Income allocable to elective contri-

butions;(ii) Qualified nonelective contributions

and allocable income; and(iii) Qualified matching contributions

and allocable income.(iii) Immediate and heavy financial

need—(A) In general. Whether an em-ployee has an immediate and heavyfinancial need is to be determined basedon all the relevant facts and circumstances.Generally, for example, the need to paythe funeral expenses of a family memberwould constitute an immediate and heavyfinancial need. A distribution made toan employee for the purchase of a boator television would generally not consti-tute a distribution made on account of animmediate and heavy financial need. A fi-nancial need may be immediate and heavyeven if it was reasonably foreseeable orvoluntarily incurred by the employee.

(B) Deemed immediate and heavy fi-nancial need. A distribution is deemed tobe on account of an immediate and heavyfinancial need of the employee if the dis-tribution is for—

(1) Expenses for medical care describedin section 213(d) previously incurred bythe employee, the employee's spouse, orany dependents of the employee (as de-fined in section 152) or necessary for thesepersons to obtain medical care described insection 213(d);

(2) Costs directly related to the pur-chase of a principal residence for the em-ployee (excluding mortgage payments);

(3) Payment of tuition, related educa-tional fees, and room and board expenses,for up to the next 12 months of post-sec-ondary education for the employee, or theemployee's spouse, children, or depen-dents (as defined in section 152); or

(4) Payments necessary to prevent theeviction of the employee from the em-ployee's principal residence or foreclosureon the mortgage on that residence.

(iv) Distribution necessary to satisfy fi-nancial need—(A) Distribution may notexceed amount of need. A distributionis treated as necessary to satisfy an im-mediate and heavy financial need of anemployee only to the extent the amountof the distribution is not in excess of theamount required to satisfy the financialneed. For this purpose, the amount re-quired to satisfy the financial need may in-clude any amounts necessary to pay anyfederal, state, or local income taxes orpenalties reasonably anticipated to resultfrom the distribution.

(B) No alternative means available. Adistribution is not treated as necessary tosatisfy an immediate and heavy financialneed of an employee to the extent theneed may be relieved from other resourcesthat are reasonably available to the em-ployee. This determination generally is tobe made on the basis of all the relevantfacts and circumstances. For purposes ofthis paragraph (d)(3)(iv), the employee'sresources are deemed to include thoseassets of the employee's spouse and mi-nor children that are reasonably availableto the employee. Thus, for example, avacation home owned by the employeeand the employee's spouse, whether ascommunity property, joint tenants, tenantsby the entirety, or tenants in common,generally will be deemed a resource of theemployee. However, property held for theemployee's child under an irrevocable trustor under the Uniform Gifts to Minors Act(or comparable State law) is not treated asa resource of the employee.

(C) Employer reliance on employeerepresentation. For purposes of paragraph(d)(3)(iv)(B) of this section, an immediateand heavy financial need generally maybe treated as not capable of being relievedfrom other resources that are reasonablyavailable to the employee, if the employer

relies upon the employee's written repre-sentation, unless the employer has actualknowledge to the contrary, that the needcannot reasonably be relieved—

(1) Through reimbursement or compen-sation by insurance or otherwise;

(2) By liquidation of the employee's as-sets;

(3) By cessation of elective contribu-tions or employee contributions under theplan;

(4) By other distributions or nontax-able (at the time of the loan) loans fromplans maintained by the employer or byany other employer; or

(5) By borrowing from commercialsources on reasonable commercial termsin an amount sufficient to satisfy the need.

(D) Employee need not take counter-productive actions. For purposes of thisparagraph (d)(3)(iv), a need cannot reason-ably be relieved by one of the actions de-scribed in paragraph (d)(3)(iv)(C) of thissection if the effect would be to increasethe amount of the need. For example, theneed for funds to purchase a principal res-idence cannot reasonably be relieved by aplan loan if the loan would disqualify theemployee from obtaining other necessaryfinancing.

(E) Distribution deemed necessary tosatisfy immediate and heavy financialneed. A distribution is deemed necessaryto satisfy an immediate and heavy finan-cial need of an employee if each of thefollowing requirements are satisfied—

(1) The employee has obtained alldistributions, other than hardship distribu-tions, and all nontaxable (at the time ofthe loan) loans currently available underthe plan and all other plans maintained bythe employer; and

(2) The employee is prohibited, un-der the terms of the plan or an otherwiselegally enforceable agreement, from mak-ing elective contributions and employeecontributions to the plan and all otherplans maintained by the employer for atleast 6 months after receipt of the hardshipdistribution.

(F) Definition of other plans. For pur-poses of paragraph (d)(3)(iv)(C)(4) and(E)(1) of this section, the phrase “plansmaintained by the employer” means allqualified and nonqualified plans of de-ferred compensation maintained by theemployer, including a cash or deferredarrangement that is part of a cafeteria

2003-35 I.R.B. 452 September 2, 2003

plan within the meaning of section 125.However, it does not include the manda-tory employee contribution portion of adefined benefit plan or a health or welfarebenefit plan (including one that is part ofa cafeteria plan). In addition, for purposesof paragraph (d)(3)(iv)(E)(2) of this sec-tion, the phrase “plans maintained by theemployer” also includes a stock option,stock purchase, or similar plan maintainedby the employer. See §1.401(k)–6 for thecontinued treatment of suspended employ-ees as eligible employees.

(v) Commissioner may expand stan-dards. The Commissioner may prescribeadditional guidance of general applicabil-ity, published in the Internal Revenue Bul-letin (see 601.601(d)(2) of this chapter),expanding the list of deemed immediateand heavy financial needs and prescribingadditional methods for distributions to bedeemed necessary to satisfy an immediateand heavy financial need.

(4) Rules applicable to distributionsupon plan termination—(i) No alternativedefined contribution plan. A distribu-tion may not be made under paragraph(d)(1)(iii) of this section if the employerestablishes or maintains an alternativedefined contribution plan. For purposesof the preceding sentence, the defini-tion of the term “employer” contained in§1.401(k)–6 is applied as of the date ofplan termination, and a plan is an alterna-tive defined contribution plan only if it isa defined contribution plan that exists atany time during the period beginning onthe date of plan termination and ending12 months after distribution of all assetsfrom the terminated plan. However, if atall times during the 24-month period be-ginning 12 months before the termination,fewer than 2% of the employees who wereeligible under the defined contributionplan that includes the cash or deferredarrangement as of the date of plan termi-nation are eligible under the other definedcontribution plan, the other plan is notan alternative defined contribution plan.In addition, a defined contribution planis not treated as an alternative definedcontribution plan if it is an employeestock ownership plan as defined in sec-tion 4975(e)(7) or 409(a), a simplifiedemployee pension as defined in section408(k), a SIMPLE IRA plan as defined insection 408(p), a plan or contract that sat-isfies the requirements of section 403(b),

or a plan that satisfies the requirements ofsection 457.

(ii) Lump sum requirement for cer-tain distributions. A distribution may bemade under paragraph (d)(1)(iii) of thissection only if it is a lump sum distri-bution. The term lump sum distributionhas the meaning provided in section402(e)(4)(D) (without regard to section402(e)(4)(D)(i)(I), (II), (III) and (IV)). Inaddition, a lump sum distribution includesa distribution of an annuity contract froma trust that is part of a plan described insection 401(a) and which is exempt fromtax under section 501(a) or an annuity plandescribed in 403(a).

(5) Rules applicable to all distribu-tions—(i) Exclusive distribution rules.Amounts attributable to elective contribu-tions may not be distributed on account ofany event not described in this paragraph(d), such as completion of a stated periodof plan participation or the lapse of a fixednumber of years. For example, if excessdeferrals (and income) for an employee'staxable year are not distributed withinthe time prescribed in §1.402(g)–1(e)(2)or (3), the amounts may be distributedonly on account of an event described inthis paragraph (d). Pursuant to section401(k)(8), the prohibition on distributionsset forth in this section does not applyto a distribution of excess contributionsunder §1.401(k)–2(b). In addition, theprohibition on distributions set forth inthis paragraph (d) does not apply to adistribution of excess annual additionspursuant to §1.415–6(b)(6)(iv).

(ii) Deemed distributions. The cost oflife insurance (determined under section72) is not treated as a distribution for pur-poses of section 401(k)(2) and this para-graph (d). The making of a loan is nottreated as a distribution, even if the loanis secured by the employee's accrued ben-efit attributable to elective contributions oris includible in the employee's income un-der section 72(p). However, the reduction,by reason of default on a loan, of an em-ployee's accrued benefit derived from elec-tive contributions is treated as a distribu-tion.

(iii) ESOP dividend distributions. Aplan does not fail to satisfy the require-ments of this paragraph (d) merely by rea-son of a dividend distribution described insection 404(k)(2).

(iv) Limitations apply after transfer.The limitations of this paragraph (d)generally continue to apply to amountsattributable to elective contributions (in-cluding QNECs and qualified matchingcontributions taken into account for theADP test under §1.401(k)–2(a)(6)) thatare transferred to another qualified plan ofthe same or another employer. Thus, thetransferee plan will generally fail to sat-isfy the requirements of section 401(a) andthis section if transferred amounts maybe distributed before the times specifiedin this paragraph (d). In addition, a cashor deferred arrangement fails to satisfythe limitations of this paragraph (d) if ittransfers amounts to a plan that does notprovide that the transferred amounts maynot be distributed before the times speci-fied in this paragraph (d). The transferorplan does not fail to comply with the pre-ceding sentence if it reasonably concludesthat the transferee plan provides thatthe transferred amounts may not be dis-tributed before the times specified in thisparagraph (d). What constitutes a basis fora reasonable conclusion is comparable tothe rules related to acceptance of rolloverdistributions. See §1.401(a)(31)–1, A–14.The limitations of this paragraph (d) ceaseto apply after the transfer, however, ifthe amounts could have been distributedat the time of the transfer (other thanon account of hardship), and the trans-fer is an elective transfer described in§1.411(d)–4, Q&A–3(b)(1). The limi-tations of this paragraph (d) also do notapply to amounts that have been paid ina direct rollover to the plan after beingdistributed by another plan.

(6) Examples. The following examplesillustrate the application of this paragraph(d):

Example 1. Employer M maintains Plan V, aprofit-sharing plan that includes a cash or deferredarrangement. Elective contributions under the ar-rangement may be withdrawn for any reason aftertwo years following the end of the plan year in whichthe contributions were made. Because the planpermits distributions of elective contributions beforethe occurrence of one of the events specified insection 401(k)(2)(B) and this paragraph (d), the cashor deferred arrangement is a nonqualified cash ordeferred arrangement and the elective contributionsare currently includible in income under section 402.

Example 2. (i) Employer N maintains Plan W, aprofit-sharing plan that includes a cash or deferredarrangement. Plan W provides for distributions upona participant's severance from employment, deathor disability. All employees of Employer N and itswholly owned subsidiary, Employer O, are eligible to

September 2, 2003 453 2003-35 I.R.B.

participate in Plan W. Employer N agrees to sell allissued and outstanding shares of Employer O to anunrelated entity, Employer T, effective on December31, 2006. Following the transaction, Employer Owill be a wholly owned subsidiary of EmployerT. Additionally, individuals who are employed byEmployer O on the effective date of the sale con-tinue to be employed by Employer O following thesale. Following the transaction, all employees ofEmployer O will cease to participate in Plan W andwill become eligible to participate in the cash ordeferred arrangement maintained by Employer T,Plan X. No assets will be transferred from Plan W toPlan X, except in the case of a direct rollover withinthe meaning of section 401(a)(31).

(ii) Employer O ceases to be a member of Em-ployer N's controlled group as a result of the sale.Therefore, employees of Employer O who partici-pated in Plan W will have a severance from employ-ment and are eligible to receive a distribution fromPlan W.

Example 3. (i) Employer Q maintains Plan Y, aprofit-sharing plan that includes a cash or deferred ar-rangement. Plan Y, the only plan maintained by Em-ployer Q, does not provide for loans. However, PlanY provides that elective contributions under the ar-rangement may be distributed to an eligible employeeon account of hardship using the deemed immedi-ate and heavy financial need provisions of paragraph(d)(3)(iii)(B) of this section and provisions regard-ing distributions necessary to satisfy financial need ofparagraphs (d)(3)(iv)(A) through (D) of this section.Employee A is an eligible employee in Plan Y withan account balance of $50,000 attributable to electivecontributions made by Employee A. The total amountof elective contributions made by Employee A, whohas not previously received a distribution from PlanY, is $20,000. Employee A requests a $15,000 hard-ship distribution of his elective contributions to pay6 months of college tuition and room and board ex-penses for his dependent child. At the time of the dis-tribution request, the sole asset of Employee A (that isreasonably available to Employee A within the mean-ing of paragraph (d)(3)(iv)(B) of this section) is a sav-ings account with an available balance of $10,000.

(ii) A distribution is made on account of hardshiponly if the distribution both is made on account of animmediate and heavy financial need of the employeeand is necessary to satisfy the financial need. Underparagraph (d)(3)(iii)(B) of this section, a distributionfor payment of up to the next 12 months of post-sec-ondary education and room and board expenses forEmployee A's dependant child is deemed to be on ac-count of an immediate and heavy financial need ofEmployee A.

(iii) A distribution is treated as necessary tosatisfy Employee A's immediate and heavy financialneed to the extent the need may not be relieved fromother resources reasonably available to EmployeeA. Under paragraph (d)(3)(iv)(B) of this section,Employee A's $10,000 savings account is a resourcethat is reasonably available to the employee and mustbe taken into account in determining the amountnecessary to satisfy Employee A's immediate andheavy financial need. Thus, Employee A may re-ceive a distribution of only $5,000 of his electivecontributions on account of this hardship, plus anamount necessary to pay any federal, state, or local

income taxes or penalties reasonably anticipated toresult from the distribution.

Example 4. (i) The facts are the same as in Ex-ample 3. Employee B, another employee of Em-ployer Q has an account balance of $25,000, attrib-utable to Employee B's elective contributions. Thetotal amount of elective contributions made by Em-ployee B, who has not previously received a distribu-tion from Plan Y, is $15,000. Employee B requestsa $10,000 distribution of his elective contributions topay 6 months of college tuition and room and boardexpenses for his dependent child. Employee B makesa written representation (with respect to which Em-ployer Q has no actual knowledge to the contrary) thatthe need cannot reasonably be relieved: 1) through re-imbursement or compensation by insurance or other-wise; 2) by liquidation of the employee's assets; 3) bycessation of elective contributions or employee con-tributions under the plan; 4) by other distributionsor nontaxable (at the time of the loan) loans fromplans maintained by the employer or by any other em-ployer; or 5) by borrowing from commercial sourceson reasonable commercial terms in an amount suffi-cient to satisfy the need.

(ii) Under paragraph (d)(3)(iii)(B) of this section,a distribution for payment of up to the next 12 monthsof post-secondary education and room and board ex-penses for Employee B's dependant child is deemedto be on account of an Employee B's immediate andheavy financial need. In addition, because EmployerQ can rely on Employee B's written representation,the distribution is considered necessary to satisfyEmployee B's immediate and heavy financial need.Therefore, Employee B may receive a $10,000distribution of his elective contributions on accountof hardship plus an amount necessary to pay anyfederal, state, or local income taxes or penaltiesreasonably anticipated to result from the distribution.

Example 5. (i) The facts are the same as inExample 3, except Plan Y provides for hardshipdistributions using the safe harbor rule of paragraph(d)(3)(iv)(E) of this section. Accordingly, Plan Yprovides for a 6 month suspension of an eligibleemployee's elective contributions and employee con-tributions to the plan after the receipt of a hardshipdistribution by such eligible employee.

(ii) Under paragraph (d)(3)(iii)(B) of this section,a distribution for payment of up to the next 12 monthsof post-secondary education and room and board ex-penses for Employee A's dependant child is deemedto be on account of an Employee A's immediate andheavy financial need. In addition, because EmployeeA is not eligible for any other distribution or loan fromPlan Y and Plan Y suspends Employee A's electivecontributions and employee contributions followingreceipt of the hardship distribution, the distributionwill be deemed necessary to satisfy Employee A's im-mediate and heavy financial need (and Employee Ais not required to first liquidate his savings account).Therefore, Employee A may receive a $15,000 dis-tribution of his elective contributions on account ofhardship plus an amount necessary to pay any fed-eral, state, or local income taxes or penalties reason-ably anticipated to result from the distribution.

Example 6. Employer R maintains a pre-ERISAmoney purchase pension plan that includes a cashor deferred arrangement that is not a rural coopera-tive plan. Elective contributions under the arrange-ment may be distributed to an employee on account

of hardship. Under paragraph (d)(1) of this section,hardship is a permissible distribution event only in aprofit-sharing, stock bonus or rural cooperative plan.Since elective contributions under the arrangementmay be distributed before a permissible distributionevent occurs, the cash or deferred arrangement doesnot satisfy this paragraph (d), and is not a qualifiedcash or deferred arrangement. Moreover, the plan isnot a qualified plan because a money purchase pen-sion plan may not provide for payment of benefitsupon hardship. See §1.401–1(b)(1)(i).

(e) Additional requirements for quali-fied cash or deferred arrangements—(1)Qualified plan requirement. A cash or de-ferred arrangement satisfies this paragraph(e) only if the plan of which it is a part isa profit-sharing, stock bonus, pre-ERISAmoney purchase or rural cooperative planthat otherwise satisfies the requirementsof section 401(a) (taking into account thecash or deferred arrangement). A plan thatincludes a cash or deferred arrangementmay provide for other contributions, in-cluding employer contributions (other thanelective contributions), employee contri-butions, or both. However, except as ex-pressly permitted under section 401(m),410(b)(2)(A)(ii) or 416(c)(2)(A), electivecontributions and matching contributionstaken into account under §1.401(k)–2(a)may not be taken into account for purposesof determining whether any other contribu-tions under any plan (including the plan towhich the contributions are made) satisfythe requirements of section 401(a).

(2) Election requirements—(i) Cashmust be available. A cash or deferredarrangement satisfies this paragraph (e)only if the arrangement provides thatthe amount that each eligible employeemay defer as an elective contribution isavailable to the employee in cash. Thus,for example, if an eligible employee isprovided the option to receive a taxablebenefit (other than cash) or to have theemployer contribute on the employee'sbehalf to a profit-sharing plan an amountequal to the value of the taxable benefit,the arrangement is not a qualified cash ordeferred arrangement. Similarly, if an em-ployee has the option to receive a specifiedamount in cash or to have the employercontribute an amount in excess of the spec-ified cash amount to a profit-sharing planon the employee's behalf, any contributionmade by the employer on the employee'sbehalf in excess of the specified cashamount is not treated as made pursuant toa qualified cash or deferred arrangement.

2003-35 I.R.B. 454 September 2, 2003

This cash availability requirement applieseven if the cash or deferred arrangement ispart of a cafeteria plan within the meaningof section 125.

(ii) Frequency of elections. A cash ordeferred arrangement satisfies this para-graph (e) only if the arrangement providesan employee with an effective opportunityto make (or change) a cash or deferredelection at least once during each plan year.Whether an employee has an effective op-portunity is determined based on all therelevant facts and circumstances, includ-ing notice of the availability of the election,the period of time during which an electionmay be made, and any other conditions onelections.

(3) Separate accounting require-ment—(i) General rule. A cash or deferredarrangement satisfies this paragraph (e)only if the portion of an employee's benefitsubject to the requirements of paragraphs(c) and (d) of this section is determinedby an acceptable separate accounting be-tween that portion and any other benefits.Separate accounting is not acceptable un-less gains, losses, withdrawals, and othercredits or charges are separately allocatedon a reasonable and consistent basis tothe accounts subject to the requirementsof paragraphs (c) and (d) of this sectionand to other accounts. Subject to section401(a)(4), forfeitures are not required tobe allocated to the accounts in which ben-efits are subject to paragraphs (c) and (d)of this section.

(ii) Satisfaction of separate accountingrequirement. The requirements of para-graph (e)(3)(i) of this section are treatedas satisfied if all amounts held under aplan that includes a cash or deferred ar-rangement (and, if applicable, under an-other plan to which QNECs and QMACsare made) are subject to the requirementsof paragraphs (c) and (d) of this section.

(4) Limitations on cash or deferredarrangements of state and local gov-ernments—(i) General rule. A cash ordeferred arrangement does not satisfy therequirements of this paragraph (e) if thearrangement is adopted after May 6, 1986,by a state or local government or politi-cal subdivision thereof, or any agency orinstrumentality thereof (a governmentalunit). For purposes of this paragraph(e)(4), an employer that has made a legallybinding commitment to adopt a cash or

deferred arrangement is treated as havingadopted the arrangement on that date.

(ii) Rural cooperative plans and Indiantribal governments. This paragraph (e)(4)does not apply to a rural cooperative planor to a plan of an employer which is an In-dian tribal government (as defined in sec-tion 7701(a)(40)), a subdivision of an In-dian tribal government (determined in ac-cordance with section 7871(d)), an agencyor instrumentality of an Indian tribal gov-ernment or subdivision thereof, or a cor-poration chartered under federal, state ortribal law which is owned in whole or inpart by any of the entities in this paragraph(e)(4)(ii).

(iii) Adoption after May 6, 1986. Acash or deferred arrangement is treated asadopted after May 6, 1986, with respect toall employees of any employer that adoptsthe arrangement after such date.

(iv) Adoption before May 7, 1986. Ifa governmental unit adopted a cash ordeferred arrangement before May 7, 1986,then any cash or deferred arrangementadopted by the unit at any time is treatedas adopted before that date. If an em-ployer adopted an arrangement prior tosuch date, all employees of the employermay participate in the arrangement.

(5) One-year eligibility requirement. Acash or deferred arrangement satisfies thisparagraph (e) only if no employee is re-quired to complete a period of service withthe employer maintaining the plan extend-ing beyond the period permitted under sec-tion 410(a)(1) (determined without regardto section 410(a)(1)(B)(i)) to be eligible tomake a cash or deferred election under thearrangement.

(6) Other benefits not contingent uponelective contributions—(i) General rule.A cash or deferred arrangement satisfiesthis paragraph (e) only if no other benefitis conditioned (directly or indirectly) uponthe employee's electing to make or not tomake elective contributions under the ar-rangement. The preceding sentence doesnot apply to —

(A) Any matching contribution (as de-fined in §1.401(m)–1(a)(2)) made by rea-son of such an election;

(B) Any benefit, right or feature (suchas a plan loan) that requires, or resultsin, an amount to be withheld from anemployee's pay (e.g. to pay for the benefitor to repay the loan), to the extent the cashor deferred arrangement restricts elective

contributions to amounts available aftersuch withholding from the employee's pay(after deduction of all applicable incomeand employment taxes);

(C) Any reduction in the employer'stop-heavy contributions under section416(c)(2) because of matching contri-butions that resulted from the electivecontributions; or

(D) Any benefit that is provided at theemployee's election under a plan describedin section 125(d) in lieu of an elective con-tribution under a qualified cash or deferredarrangement.

(ii) Definition of other benefits. Forpurposes of this paragraph (e)(6), otherbenefits include, but are not limited to,benefits under a defined benefit plan;nonelective contributions under a definedcontribution plan; the availability, cost,or amount of health benefits; vacationsor vacation pay; life insurance; dentalplans; legal services plans; loans (in-cluding plan loans); financial planningservices; subsidized retirement benefits;stock options; property subject to section83; and dependent care assistance. Also,increases in salary and bonuses (other thanthose actually subject to the cash or de-ferred election) are benefits for purposesof this paragraph (e)(6). The ability tomake after-tax employee contributionsis a benefit, but that benefit is not con-tingent upon an employee's electing tomake or not make elective contributionsunder the arrangement merely because theamount of elective contributions reducesdollar-for-dollar the amount of after-taxemployee contributions that may be made.Additionally, benefits under any other planor arrangement (whether or not qualified)are not contingent upon an employee'selecting to make or not to make electivecontributions under a cash or deferredarrangement merely because the electivecontributions are or are not taken intoaccount as compensation under the otherplan or arrangement for purposes of deter-mining benefits.

(iii) Effect of certain statutory limits.Any benefit under an excess benefit plandescribed in section 3(36) of the EmployeeRetirement Income Security Act of 1974that is dependent on the employee's elect-ing to make or not to make elective contri-butions is not treated as contingent.

(iv) Nonqualified deferred compen-sation. Participation in a nonqualified

September 2, 2003 455 2003-35 I.R.B.

deferred compensation plan is treated ascontingent for purposes of this paragraph(e)(6) only to the extent that an employeemay receive additional deferred compen-sation under the nonqualified plan to theextent the employee makes or does notmake elective contributions. Deferredcompensation under a nonqualified planof deferred compensation that is depen-dent on an employee's having made themaximum elective deferrals under section402(g) or the maximum elective contribu-tions permitted under the terms of the planalso is not treated as contingent.

(v) Plan loans and distributions. A loanor distribution of elective contributions isnot a benefit conditioned on an employee'selecting to make or not make elective con-tributions under the arrangement merelybecause the amount of the loan or distri-bution is based on the amount of the em-ployee's account balance.

(vi) Examples. The following examplesillustrate the application of this paragraph(e)(6):

Example 1. Employer T maintains a cash or de-ferred arrangement for all of its employees. EmployerT also maintains a nonqualified deferred compensa-tion plan for two highly paid executives, EmployeesR and C. Under the terms of the nonqualified deferredcompensation plan, R and C are eligible to participateonly if they do not make elective contributions underthe cash or deferred arrangement. Participation in thenonqualified plan is a contingent benefit for purposesof this paragraph (e)(6), because R's and C's partic-ipation is conditioned on their electing not to makeelective contributions under the cash or deferred ar-rangement.

Example 2. Employer T maintains a cash or de-ferred arrangement for all its employees. EmployerT also maintains a nonqualified deferred compensa-tion plan for two highly paid executives, EmployeesR and C. Under the terms of the arrangements, Em-ployees R and C may defer a maximum of 10% oftheir compensation, and may allocate their deferralbetween the cash or deferred arrangement and thenonqualified deferred compensation plan in any waythey choose (subject to the overall 10% maximum).Because the maximum deferral available under thenonqualified deferred compensation plan depends onthe elective deferrals made under the cash or deferredarrangement, the right to participate in the nonquali-fied plan is a contingent benefit for purposes of para-graph (e)(6).

(7) Plan provision requirement. A planthat includes a cash or deferred arrange-ment satisfies this paragraph (e) only ifit provides that the nondiscrimination re-quirements of section 401(k) will be met.

Thus, the plan must provide for satisfac-tion of one of the specific alternatives de-scribed in paragraph (b)(1)(ii) of this sec-tion and, if with respect to that alterna-tive there are optional choices, which ofthe optional choices will apply. For exam-ple, a plan that uses the ADP test of sec-tion 401(k)(3), as described in paragraph(b)(1)(ii)(A) of this section, must specifywhether it is using the current year testingmethod or prior year testing method. Ad-ditionally, a plan that uses the prior yeartesting method must specify whether theADP for eligible NHCEs for the first planyear is 3% or the ADP for the eligibleNHCEs for the first plan year. Similarly,a plan that uses the safe harbor method ofsection 401(k)(12), as described in para-graph (b)(1)(ii)(B) of this section, mustspecify whether the safe harbor contribu-tion will be the nonelective safe harborcontribution or the matching safe harborcontribution and is not permitted to pro-vide that ADP testing will be used if therequirements for the safe harbor are notsatisfied. For purposes of this paragraph(e)(7), a plan may incorporate by refer-ence the provisions of section 401(k)(3)and §1.401(k)–2 if that is the nondiscrimi-nation test being applied.

(f) Effective dates—(1) General rule.This section and §§1.401(k)–2 through1.401(k)–6 apply to plan years that beginon or after the date that is 12 months afterthe issuance of these regulations in finalform, except as otherwise provided in thisparagraph (f).

(2) Collectively bargained plans. Inthe case of a plan maintained pursuant toone or more collective bargaining agree-ments between employee representativesand one or more employers in effect on thedate described in paragraph (f)(1) of thissection, the provisions of this section and§§1.401(k)–2 through 1.401(k)–6 apply tothe later of the first plan year beginning af-ter the termination of the last such agree-ment or the plan year described in para-graph (f)(1) of this section.

§1.401(k)–2 ADP test.

(a) Actual deferral percentage (ADP)test—(1) In general—(i) ADP test for-mula. A cash or deferred arrangementsatisfies the ADP test for a plan year onlyif—

(A) The ADP for the eligible HCEs forthe plan year is not more than the ADP forthe eligible NHCEs for the applicable yearmultiplied by 1.25; or

(B) The excess of the ADP for the eli-gible HCEs for the plan year over the ADPfor the eligible NHCEs for the applicableyear is not more than 2 percentage points,and the ADP for the eligible HCEs for theplan year is not more than the ADP forthe eligible NHCEs for the applicable yearmultiplied by 2.

(ii) HCEs as sole eligible employees.If, for the applicable year for determiningthe ADP of the NHCEs for a plan year,there are no eligible NHCEs (i.e., all of theeligible employees under the cash or de-ferred arrangement for the applicable yearare HCEs), the arrangement is deemed tosatisfy the ADP test for the plan year.

(iii) Special rule for early participation.If a cash or deferred arrangement providesthat employees are eligible to participatebefore they have completed the minimumage and service requirements of section410(a)(1)(A), and if the plan applies sec-tion 410(b)(4)(B) in determining whetherthe cash or deferred arrangement meetsthe requirements of section 410(b)(1), thenin determining whether the arrangementmeets the requirements under paragraph(a)(1) of this section, either—

(A) Pursuant to section 401(k)(3)(F),the ADP test is performed under the plan(determined without regard to disaggrega-tion under §1.410(b)–7(c)(3)), using theADP for all eligible HCEs for the plan yearand the ADP of eligible NHCEs for the ap-plicable year, disregarding all NHCEs whohave not met the minimum age and servicerequirements of section 410(a)(1)(A); or

(B) Pursuant to §1.401(k)–1(b)(4), theplan is disaggregated into separate plansand the ADP test is performed separatelyfor all eligible employees who have com-pleted the minimum age and service re-quirements of section 410(a)(1)(A) and forall eligible employees who have not com-pleted the minimum age and service re-quirements of section 410(a)(1)(A).

(2) Determination of ADP—(i) Generalrule. The ADP for a group of eligible em-ployees (either eligible HCEs or eligibleNHCEs) for a plan year or applicable yearis the average of the ADRs of the eligi-ble employees in that group for that year.

2003-35 I.R.B. 456 September 2, 2003

The ADP for a group of eligible employ-ees is calculated to the nearest hundredthof a percentage point.

(ii) Determination of applicable yearunder current year and prior year testingmethod. The ADP test is applied usingthe prior year testing method or the currentyear testing method. Under the prior yeartesting method, the applicable year for de-termining the ADP for the eligible NHCEsis the plan year immediately preceding theplan year for which the ADP test is beingperformed. Under the prior year testingmethod, the ADP for the eligible NHCEsis determined using the ADRs for the eli-gible employees who were NHCEs in thatpreceding plan year, regardless of whetherthose NHCEs are eligible employees orNHCEs in the plan year for which the ADPtest is being calculated. Under the cur-rent year testing method, the applicableyear for determining the ADP for the eli-gible NHCEs is the same plan year as theplan year for which the ADP test is be-ing performed. Under either method, theADP for eligible HCEs is the average ofthe ADRs of the eligible HCEs for the planyear for which the ADP test is being per-formed. See paragraph (c) of this sectionfor additional rules for the prior year test-ing method.

(3) Determination of ADR—(i) Generalrule. The ADR of an eligible employee fora plan year or applicable year is the sum ofthe employee's elective contributions takeninto account with respect to such employeefor the year, determined under the rules ofparagraphs (a)(4) and (5) of this section,and the qualified nonelective contributionsand qualified matching contributions takeninto account with respect to such employeeunder paragraph (a)(6) of this section forthe year, divided by the employee's com-pensation taken into account for the year.

The ADR is calculated to the nearest hun-dredth of a percentage point. If no electivecontributions, qualified nonelective con-tributions, or qualified matching contribu-tions are taken into account under this sec-tion with respect to an eligible employeefor the year, the ADR of the employee iszero.

(ii) ADR of HCEs eligible under morethan one arrangement—(A) General rule.Pursuant to section 401(k)(3)(A), the ADRof an HCE who is an eligible employee inmore than one cash or deferred arrange-ment of the same employer is calculatedby treating all contributions with respectto such HCE under any such arrangementas being made under the cash or deferredarrangement being tested. Thus, the ADRfor such an HCE is calculated by accu-mulating all contributions under any cashor deferred arrangement (other than acash or deferred arrangement describedin paragraph (a)(3)(ii)(B) of this section)that would be taken into account underthis section for the plan year, if the cashor deferred arrangement under which thecontribution was made applied this sectionand had the same plan year. For example,in the case of a plan with a 12-monthplan year, the ADR for the plan year ofthat plan for an HCE who participates inmultiple cash or deferred arrangements ofthe same employer is the sum of all contri-butions during such 12-month period thatwould be taken into account with respectto the HCE under all such arrangements inwhich the HCE is an eligible employee, di-vided by the HCE's compensation for that12-month period (determined using thecompensation definition for the plan beingtested), without regard to the plan year ofthe other plans and whether those plansare satisfying this section or §1.401(k)–3.

(B) Plans not permitted to be aggre-gated. Cash or deferred arrangements

under plans that are not permitted tobe aggregated under §1.401(k)–1(b)(4)(determined without regard to the pro-hibition on aggregating plans with in-consistent testing methods set forth in§1.401(k)–1(b)(4)(iii)(B) and the prohi-bition on aggregating plans with differentplan years set forth in §1.410(b)–7(d)(5))are not aggregated under this paragraph(a)(3)(ii).

(iii) Examples. The following examplesillustrate the application of this paragraph(a)(3):

Example 1. (i) Employee A, an HCE with com-pensation of $120,000, is eligible to make electivecontributions under Plan S and Plan T, two profit-sharing plans maintained by Employer H with calen-dar year plan years, each of which includes a cash ordeferred arrangement. During the current plan year,Employee A makes elective contributions of $6,000to Plan S and $4,000 to Plan T.

(ii) Under each plan, the ADR for Employee A isdetermined by dividing Employee A's total electivecontributions under both arrangements by EmployeeA's compensation taken into account under the planfor the year. Therefore, Employee A's ADR undereach plan is 8.33% ($10,000/$120,000).

Example 2. (i) The facts are the same as in Exam-ple 1, except that Plan T defines compensation (fordeferral and testing purposes) to exclude all bonusespaid to an employee. Plan S defines compensation(for deferral and testing purposes) to include bonusespaid to an employee. During the current year, Em-ployee A's compensation included a $10,000 bonus.Therefore, Employee A's compensation under Plan Tis $110,000 and Employee A's compensation underPlan S is $120,000.

(ii) Employee A's ADR under Plan T is 9.09%($10,000/$110,000) and under Plan S, Employee A'sADR is 8.33% ($10,000/$120,000).

Example 3. (i) Employer J sponsors two profit-sharing plans, Plan U and Plan V, each of which in-cludes a cash or deferred arrangement. Plan U's planyear begins on July 1 and ends on June 30. Plan Vhas a calendar year plan year. Compensation underboth plans is limited to the participant's compensa-tion during the period of participation. Employee Bis an HCE who participates in both plans. EmployeeB's monthly compensation and elective contributionsto each plan for the 2005 and 2006 calendar years areas follows:

Calendar year Monthly Compensation Monthly Elective Contributionto Plan U

Monthly Elective Contributionto Plan V

2005 $10,000 $500 $400

2006 $11,500 $700 $550

(ii) Under Plan U, Employee B's ADR for the planyear ended June 30, 2006, is equal to Employee B'stotal elective contributions under Plan U and Plan Vfor the plan year ending June 30, 2006, divided byEmployee B's compensation for that period. There-fore, Employee B's ADR under Plan U for the plan

year ending June 30, 2006, is (($900 x 6) + ($1,250 x6)) / (($10,000 x 6) + ($11,500 x 6)), or 10%.

(iii) Under Plan V, Employee B's ADR for theplan year ended December 31, 2005, is equal to to-tal elective contributions under Plan U and V for the

plan year ending December 31, 2005, divided by Em-ployee B's compensation for that period. Therefore,Employee B's ADR under Plan V for the plan yearending December 31, 2005, is ($10,800/$120,000),or 9%.

September 2, 2003 457 2003-35 I.R.B.

Example 4. (i) The facts are the same as Example3, except that Employee B first becomes eligible toparticipate in Plan U on January 1, 2006.

(ii) Under Plan U, Employee B's ADR for the planyear ended June 30, 2006, is equal to Employee B'stotal elective contributions under Plan U and V forthe plan year ending June 30, 2006, divided by Em-ployee B's compensation for that period. Therefore,Employee B's ADR under Plan U for the plan yearending June 30, 2006, is (($400 x 6)+ ($1,250 x 6)) /(($10,000 x 6) + ($11,500 x 6)), or 7.67%.

(4) Elective contributions taken intoaccount under the ADP test—(i) Generalrule. An elective contribution is taken intoaccount in determining the ADR for aneligible employee for a plan year or ap-plicable year only if each of the followingrequirements is satisfied:

(A) The elective contribution is allo-cated to the eligible employee's accountunder the plan as of a date within that year.For purposes of this rule, an elective contri-bution is considered allocated as of a datewithin a year only if—

(1) The allocation is not contingent onthe employee's participation in the plan orperformance of services on any date sub-sequent to that date; and

(2) The elective contribution is actuallypaid to the trust no later than the end ofthe 12-month period immediately follow-ing the year to which the contribution re-lates.

(B) The elective contribution relates tocompensation that either—

(1) Would have been received by theemployee in the year but for the employee'selection to defer under the arrangement; or

(2) Is attributable to services performedby the employee in the year and, but for theemployee's election to defer, would havebeen received by the employee within 21/2months after the close of the year, but onlyif the plan so provides for elective con-tributions that relate to compensation thatwould have been received after the closeof a year to be allocated to such prior yearrather than the year in which the compen-sation would have been received.

(ii) Elective contributions for partnersand self-employed individuals. For pur-poses of this paragraph (a)(4), a partner'sdistributive share of partnership income istreated as received on the last day of thepartnership taxable year and a sole propri-etor's compensation is treated as receivedon the last day of the individual's taxableyear. Thus, an elective contribution madeon behalf of a partner or sole proprietor is

treated as allocated to the partner's accountfor the plan year that includes the last dayof the partnership taxable year, providedthe requirements of paragraph (a)(4)(i) ofthis section are met.

(iii) Elective contributions for HCEs.Elective contributions of an HCE mustinclude any excess deferrals, as describedin §1.402(g)–1(a), even if those excessdeferrals are distributed, pursuant to§1.402(g)–1(e).

(5) Elective contributions not taken intoaccount under the ADP test—(i) Generalrule. Elective contributions that do not sat-isfy the requirements of paragraph (a)(4)(i)of this section may not be taken into ac-count in determining the ADR of an el-igible employee for the plan year or ap-plicable year with respect to which thecontributions were made, or for any otherplan year. Instead, the amount of the elec-tive contributions must satisfy the require-ments of section 401(a)(4) (without regardto the ADP test) for the plan year for whichthey are allocated under the plan as if theywere nonelective contributions and werethe only nonelective contributions for thatyear. See §§1.401(a)(4)–1(b)(2)(ii)(B) and1.410(b)–7(c)(1).

(ii) Elective contributions for NHCEs.Elective contributions of an NHCE shallnot include any excess deferrals, as de-scribed in §1.402(g)–1(a), to the extent theexcess deferrals are prohibited under sec-tion 401(a)(30). However, to the extentthat the excess deferrals are not prohibitedunder section 401(a)(30), they are includedin elective contributions even if distributedpursuant to §1.402(g)–1(e).

(iii) Elective contributions treated ascatch-up contributions. Elective con-tributions that are treated as catch-upcontributions under section 414(v) be-cause they exceed a statutory limit or em-ployer-provided limit (within the meaningof §1.414(v)–1(b)(1)) are not taken intoaccount under paragraph (a)(4) of thissection for the plan year for which thecontributions were made, or for any otherplan year.

(iv) Elective contributions used to sat-isfy the ACP test. Except to the extentnecessary to demonstrate satisfaction ofthe requirement of §1.401(m)–2(a)(6)(ii),elective contributions taken into accountfor the ACP test under §1.401(m)–2(a)(6)are not taken into account under paragraph(a)(4) of this section.

(6) Qualified nonelective contributionsand qualified matching contributions thatmay be taken into account under the ADPtest. Qualified nonelective contributionsand qualified matching contributions maybe taken into account in determining theADR for an eligible employee for a planyear or applicable year but only to the ex-tent the contributions satisfy the followingrequirements.

(i) Timing of allocation. The quali-fied nonelective contribution or qualifiedmatching contribution is allocated to theemployee's account as of a date withinthat year within the meaning of paragraph(a)(4)(i)(A) of this section. Consequently,under the prior year testing method, in or-der to be taken into account in calculat-ing the ADP for the eligible NHCEs forthe applicable year, a qualified nonelectivecontribution or qualified matching contri-bution must be contributed no later thanthe end of the 12-month period immedi-ately following the applicable year eventhough the applicable year is different thanthe plan year being tested.

(ii) Requirement that amount satisfysection 401(a)(4). The amount of nonelec-tive contributions, including those quali-fied nonelective contributions taken intoaccount under this paragraph (a)(6) andthose qualified nonelective contributionstaken into account for the ACP test of sec-tion 401(m)(2) under §1.401(m)–2(a)(6),satisfies the requirements of section401(a)(4). See §1.401(a)(4)–1(b)(2).The amount of nonelective contributions,excluding those qualified nonelective con-tributions taken into account under thisparagraph (a)(6) and those qualified non-elective contributions taken into accountfor the ACP test of section 401(m)(2)under §1.401(m)–2(a)(6), satisfies therequirements of section 401(a)(4). See§1.401(a)(4)–1(b)(2). In the case ofan employer that is applying the spe-cial rule for employer-wide plans in§1.414(r)–1(c)(2)(ii) with respect to thecash or deferred arrangement, the determi-nation of whether the qualified nonelectivecontributions satisfy the requirements ofthis paragraph (a)(6)(ii) must be madeon an employer-wide basis regardless ofwhether the plans to which the qualifiednonelective contributions are made aresatisfying the requirements of section410(b) on an employer-wide basis. Con-versely, in the case of an employer that

2003-35 I.R.B. 458 September 2, 2003

is treated as operating qualified separatelines of business, and does not apply thespecial rule for employer-wide plans in§1.414(r)–1(c)(2)(ii) with respect to thecash or deferred arrangement, then thedetermination of whether the qualifiednonelective contributions satisfy the re-quirements of this paragraph (a)(6)(ii)is not permitted to be made on an em-ployer-wide basis regardless of whetherthe plans to which the qualified nonelec-tive contributions are made are satisfyingthe requirements of section 410(b) on thatbasis.

(iii) Aggregation must be permitted.The plan that contains the cash or deferredarrangement and the plan or plans to whichthe qualified nonelective contributions orqualified matching contributions aremade, are plans that would be permittedto be aggregated under §1.401(k)–1(b)(4).If the plan year of the plan that con-tains the cash or deferred arrangement ischanged to satisfy the requirement under§1.410(b)–7(d)(5) that aggregated planshave the same plan year, qualified nonelec-tive contributions and qualified matchingcontributions may be taken into account inthe resulting short plan year only if suchqualified nonelective contributions andqualified matching contributions couldhave been taken into account under anADP test for a plan with the same shortplan year.

(iv) Disproportionate contributions nottaken into account—(A) General rule.Qualified nonelective contributions cannotbe taken into account for a plan year foran NHCE to the extent such contribu-tions exceed the product of that NHCE'scompensation and the greater of 5% ortwo times the plan's representative con-tribution rate. Any qualified nonelective

contribution taken into account underan ACP test under §1.401(m)–2(a)(6)(including the determination of the repre-sentative contribution rate for purposes of§1.401(m)–2(a)(6)(v)(B)), is not permit-ted to be taken into account for purposesof this paragraph (a)(6) (including thedetermination of the representative contri-bution rate under paragraph (a)(6)(iv)(B)of this section).

(B) Definition of representative contri-bution rate. For purposes of this paragraph(a)(6)(iv), the plan's representative contri-bution rate is the lowest applicable contri-bution rate of any eligible NHCE amonga group of eligible NHCEs that consists ofhalf of all eligible NHCEs for the plan year(or, if greater, the lowest applicable con-tribution rate of any eligible NHCE in thegroup of all eligible NHCEs for the planyear and who is employed by the employeron the last day of the plan year).

(C) Definition of applicable contribu-tion rate. For purposes of this paragraph(a)(6)(iv), the applicable contribution ratefor an eligible NHCE is the sum of thequalified matching contributions takeninto account under this paragraph (a)(6)for the eligible NHCE for the plan yearand the qualified nonelective contributionsmade for that eligible NHCE for the planyear, divided by that eligible NHCE'scompensation for the same period.

(v) Qualified matching contributions.Qualified matching contributions satisfythis paragraph (a)(6) only to the extent thatsuch qualified matching contributions arematching contributions that are not pre-cluded from being taken into account un-der the ACP test for the plan year under therules of §1.401(m)–2(a)(5)(ii).

(vi) Contributions only used once.Qualified nonelective contributions and

qualified matching contributions can notbe taken into account under this paragraph(a)(6) to the extent such contributionsare taken into account for purposes ofsatisfying any other ADP test, any ACPtest, or the requirements of §1.401(k)–3,1.401(m)–3 or 1.401(k)–4. Thus, for ex-ample, matching contributions that aremade pursuant to §1.401(k)–3(c) cannotbe taken into account under the ADP test.Similarly, if a plan switches from the cur-rent year testing method to the prior yeartesting method pursuant to §1.401(k)–2(c),qualified nonelective contributions that aretaken into account under the current yeartesting method for a year may not be takeninto account under the prior year testingmethod for the next year.

(7) Examples. The following examplesillustrate the application of this paragraph(a):

Example 1. (i) Employer X has three employees,A, B, and C. Employer X sponsors a profit-sharingplan (Plan Z) that includes a cash or deferred arrange-ment. Each year, Employer X determines a bonus at-tributable to the prior year. Under the cash or deferredarrangement, each eligible employee may elect to re-ceive none, all or any part of the bonus in cash. Xcontributes the remainder to Plan Z. The portion ofthe bonus paid in cash, if any, is paid 2 months af-ter the end of the plan year and thus is included incompensation for the following plan year. EmployeeA is an HCE, while Employees B and C are NHCEs.The plan uses the current year testing method and de-fines compensation to include elective contributionsand bonuses paid during each plan year. In Febru-ary of 2005, Employer X determined that no bonuseswill be paid for 2004. In February of 2006, EmployerX provided a bonus for each employee equal to 10%of regular compensation for 2005. For the 2005 planyear, A, B, and C have the following compensationand make the following elections:

Employee Compensation Elective Contribution

A $100,000 $4,340

B 60,000 2,860

C 45,000 1,250

September 2, 2003 459 2003-35 I.R.B.

(ii) For each employee, the ratio of elective contributions to the employee's compensation for the plan year is:

Employee Ratio of Elective Contribution to Compensation ADR

A $4,340/$100,000 4.34%

B 2,860/60,000 4.77

C 1,250/45,000 2.78

(iii) The ADP for the HCEs (Employee A) is4.34%. The ADP for the NHCEs is 3.78% ((4.77%+ 2.78%)/2). Because 4.34% is less than 4.73%(3.78% multiplied by 1.25), the plan satisfies theADP test under paragraph (a)(1)(i) of this section.

Example 2. (i) The facts are the same as in Exam-ple 1, except that elective contributions are made pur-suant to a salary reduction agreement throughout theplan year, and no bonuses are paid. As provided by

section 414(s)(2), Employer X includes elective con-tributions in compensation. During the year, B and Cdefer the same amount as in Example 1, but A defers$5,770. Thus, the compensation and elective contri-butions for A, B, and C are:

Employee Gross Compensation Elective Contributions ADR

A $100,000 $5,770 5.77%

B 60,000 2,860 4.77

C 45,000 1,250 2.78

(ii) The ADP for the HCEs (Employee A) is5.77%. The ADP for the NHCEs is 3.78% ((4.77%+ 2.78%)/2). Because 5.77% exceeds 4.73% (3.78%x 1.25), the plan does not satisfy the ADP test underparagraph (a)(1)(i) of this section. However, becausethe ADP for the HCEs does not exceed the ADP forthe NHCEs by more than 2 percentage points and theADP for the HCEs does not exceed the ADP for the

NHCEs multiplied by 2 (3.78% x 2 = 7.56%), theplan satisfies the ADP test under paragraph (a)(1)(ii)of this section.

Example 3. (i) Employees D through L are eli-gible employees in Plan T, a profit-sharing plan thatcontains a cash or deferred arrangement. The plan isa calendar year plan that uses the prior year testingmethod. Plan T provides that elective contributions

are included in compensation (as provided under sec-tion 414(s)(2)). Each eligible employee may elect todefer up to 6% of compensation under the cash or de-ferred arrangement. Employees D and E are HCEs.The compensation, elective contributions, and ADRsof Employees D and E for the 2006 plan year areshown below:

Employee Compensation for2006 Plan Year

Elective Contributions for2006 Plan

Year

ADR for 2006 Plan Year

D $100,000 $10,000 10%

E $95,000 $4,750 5%

(ii) During the 2005 plan year, Employees Fthrough L were eligible NHCEs. The compensation,elective contributions and ADRs of Employees F

through L for the 2005 plan year are shown in thefollowing table:

Employee Compensation for 2005 Plan Year Elective Contributions for2005 Plan Year

ADR for 2005 Plan Year

F $60,000 $3,600 6%

G $40,000 $1,600 4%

H $30,000 $1,200 4%

I $20,000 $600 3%

J $20,000 $600 3%

K $10,000 $300 3%

L $5,000 $150 3%

(iii) The ADP for 2006 for the HCEs is 7.5%. Be-cause Plan T is using the prior year testing method,

the applicable year for determining the NHCE ADPis the prior plan year (i.e., 2005). The NHCE ADP is

determined using the ADRs for NHCEs eligible dur-ing the prior plan year (without regard to whether they

2003-35 I.R.B. 460 September 2, 2003

are eligible under the plan during the plan year). TheADP for the NHCEs is 3.71% (the sum of the individ-ual ADRs, 26%, divided by 7 employees). Because7.5% exceeds 4.64% (3.71% x 1.25), Plan T does notsatisfy the ADP test under paragraph (a)(1)(i) of thissection. In addition, because the ADP for the HCEsexceeds the ADP for the NHCEs by more than 2 per-centage points, Plan T does not satisfy the ADP testunder paragraph (a)(1)(ii) of this section. Therefore,the cash or deferred arrangement fails to be a qualified

cash or deferred arrangement unless the ADP failureis corrected under paragraph (b) of this section.

Example 4. (i) Plan U is a calendar year profit-sharing plan that contains a cash or deferred arrange-ment and uses the current year testing method. PlanU provides that elective contributions are included incompensation (as provided under section 414(s)(2)).The following amounts are contributed under PlanU for the 2006 plan year: (A) QNECs equal to 2%of each employee's compensation; (B) Contributionsequal to 6% of each employee's compensation that arenot immediately vested under the terms of the plan;

(C) 3% of each employee's compensation that the em-ployee may elect to receive as cash or to defer un-der the plan. Both types of nonelective contributionsare made for the HCEs (employees M and N) and theNHCEs (employees O through S) for the plan yearand are contributed after the end of the plan year andbefore the end of the following plan year. In addi-tion, neither type of nonelective contributions is usedfor any other ADP or ACP test.

(ii) For the 2006 plan year, the compensation,elective contributions, and actual deferral ratios ofemployees M through S are shown in the followingtable:

Employee Compensation Elective Contributions Actual Deferral Ratio

M $100,000 $3,000 3%

N $100,000 $2,000 2%

O $60,000 $1,800 3%

P $40,000 0 0

Q $30,000 0 0

R $5,000 0 0

S $20,000 0 0

(iii) The elective contributions alone do not sat-isfy the ADP test of section 401(k)(3) and paragraph(a)(1) of this section because the ADP for the HCEs,consisting of employees M and N, is 2.5% and theADP for the NHCEs is 0.6%.

(iv) The 2% QNECs satisfies the timing require-ment of paragraph (a)(6)(i) of this section because it ispaid within 12-month after the plan year for which al-located. All nonelective contributions also satisfy therequirements relating to section 401(a)(4) set forth inparagraph (a)(6)(ii) of this section (because all em-ployees receive an 8% nonelective contribution andthe nonelective contributions excluding the QNECsis 6% for all employees). In addition, the QNECs arenot disproportionate under paragraph (a)(6)(iv) of thissection because no QNEC for an NHCE exceeds theproduct of the plan's applicable contribution rate (2%)and that NHCE's compensation.

(v) Because the rules of paragraph (a)(6) of thissection are satisfied, the 2% QNECs may be takeninto account in applying the ADP test of section401(k)(3) and paragraph (a)(1) of this section. The6% nonelective contributions, however, may not betaken into account because they are not QNECs.

(vi) If the 2% QNECs are taken into account, theADP for the HCEs is 4.5%, and the actual deferralpercentage for the NHCEs is 2.6%. Because 4.5% isnot more than two percentage points greater than 2.6percent, and not more than two times 2.6, the cash ordeferred arrangement satisfies the ADP test of section401(k)(3) under paragraph (a)(1)(ii) of this section.

Example 5. (i) The facts are the same as Example4, except the plan uses the prior year testing method.In addition, the NHCE ADP for the 2005 plan year(the prior plan year) is 0.8% and no QNECs are con-tributed for the 2005 plan year during 2005 or 2006.

(ii) In 2007, it is determined that the elective con-tributions alone do not satisfy the ADP test of sec-tion 401(k)(3) and paragraph (a)(1) of this section for

2006 because the 2006 ADP for the eligible HCEs,consisting of employees M and N, is 2.5% and the2005 ADP for the eligible NHCEs is 0.8%. An addi-tional QNEC of 2% of compensation is made for eacheligible NHCE in 2007 and allocated for 2005.

(iii) The 2% QNECs that are made in 2007 and al-located for the 2005 plan year do not satisfy the tim-ing requirement of paragraph (a)(6)(i) of this sectionfor the applicable year for the 2005 plan year becausethey were not contributed before the last day of the2006 plan year. Accordingly, the 2% QNECs do notsatisfy the rules of paragraph (a)(6) of this section andmay not be taken into account in applying the ADPtest of section 401(k)(3) and paragraph (a)(1) of thissection for the 2006 plan year. The cash or deferredarrangement fails to be a qualified cash or deferredarrangement unless the ADP failure is corrected un-der paragraph (b) of this section.

Example 6. (i) The facts are the same as Exam-ple 4, except that the ADP for the HCEs is 4.6%and there is no 6% nonelective contribution underthe plan. The employer would like to take into ac-count the 2% QNEC in determining the ADP for theNHCEs but not in determining the ADP for the HCEs.

(ii) The elective contributions alone fail the re-quirements of section 401(k) and paragraph (a)(1) ofthis section because the HCE ADP for the plan year(4.6%) exceeds 0.75% (0.6% x 1.25) and 1.2% (0.6%x 2).

(iii) The 2% QNECs may not be taken into ac-count in determining the ADP of the NHCEs becausethey fail to satisfy the requirements relating to sec-tion 401(a)(4) set forth in paragraph (a)(6)(ii) of thissection. This is because the amount of nonelectivecontributions, excluding those QNECs that wouldbe taken into account under the ADP test, would be2% of compensation for the HCEs and 0% for theNHCEs. Therefore, the cash or deferred arrangementfails to be a qualified cash or deferred arrangement

unless the ADP failure is corrected under paragraph(b) of this section.

Example 7. (i) The facts are the same as Example6, except that Employee R receives a QNEC in anamount of $500 and no QNECs are made on behalfof the other employees.

(ii) If the QNEC could be taken into account un-der paragraph (a)(6) of this section, the ADP for theNHCEs would be 2.6% and the plan would satisfy theADP test. The QNEC is disproportionate under para-graph (a)(6)(iv) of this section, and cannot be takeninto account under paragraph (a)(6) of this section, tothe extent it exceeds the greater of 5% and two timesthe plan's representative contribution rate (0%), mul-tiplied by Employee R's compensation. The plan'srepresentative contribution rate is 0% because it is thelowest applicable contribution rate among a group ofNHCEs that is at least half of all NHCEs, or all theNHCEs who are employed on the last day of the planyear. Therefore, the QNEC may be taken into accountunder the ADP test only to the extent it does not ex-ceed 5% times Employee R's compensation (or $250)and the cash or deferred arrangement fails to satisfythe ADP test and must correct under paragraph (b) ofthis section.

Example 8. (i) The facts are the same as in Ex-ample 4 except that the plan changes from the currentyear testing method to the prior year testing methodfor the following plan year (2006 plan year). TheADP for the HCEs for the 2006 plan year is 3.5%.

(ii) The 2% QNECs may not be taken into accountin determining the ADP for the NHCEs for the appli-cable year (2005 plan year) in satisfying the ADP testfor the 2006 plan year because they were taken intoaccount in satisfying the ADP test for the 2005 planyear. Accordingly, the NHCE ADP for the applicableyear is 0.6%. The elective contributions for the planyear fail the requirements of section 401(k) and para-graph (a)(1) of this section because the HCE ADP for

September 2, 2003 461 2003-35 I.R.B.

the plan year (3.5%) exceeds the ADP limit of 1.2%(the greater of 0.75% (0.6% x 1.25) and 1.2% (0.6% x2)), determined using the applicable year ADP for theNHCEs. Therefore, the cash or deferred arrangementfails to be a qualified cash or deferred arrangementunless the ADP failure is corrected under paragraph(b) of this section.

Example 9. (i)(A) Employer N maintains PlanX, a profit sharing plan that contains a cash or de-ferred arrangement and that uses the current year test-ing method. Plan X provides for employee contribu-tions, elective contributions, and matching contribu-tions. Matching contributions on behalf of nonhighlycompensated employees are qualified matching con-tributions (QMACs) and are contributed during the

2005 plan year. Matching contributions on behalf ofhighly compensated employees are not QMACs, be-cause they fail to satisfy the nonforfeitability require-ment of §1.401(k)–1(c). The elective contributionsand matching contributions with respect to HCEs forthe 2005 plan year are shown in the following table:

ElectiveContributions

Total MatchingContributions

Matchingcontributions

that arenot QMACs

QMACs

Highly compensated employees 15% 5% 5% 0%

(B) The elective contributions and matching contributions with respect to the NHCEs for the 2005 plan year are shown in thefollowing table:

ElectiveContributions

Total MatchingContributions

Matchingcontributions

that arenot QMACs

QMACs

Nonhighly compensated employees 11% 4% 0% 4%

(ii) The plan fails to satisfy the ADP test of section401(k)(3)(A) and paragraph (a)(1) of this section be-cause the ADP for HCEs (15%) is more than 125% ofthe ADP for NHCEs (11%), and more than 2 percen-tage points greater than 11%. However, the plan pro-

vides that QMACs may be used to meet the require-ments of section 401(k)(3)(A)(ii) provided that theyare not used for any other ADP or ACP test. QMACsequal to 1% of compensation are taken into accountfor each NHCE in applying the ADP test. After this

adjustment, the applicable ADP and ACP (taking intoaccount the provisions of §1.401(m)–2(a)(5)(ii)) forthe plan year are as follows:

Actual Deferral Percentage Actual Contribution Percentage

HCEs 15% 5%

Nonhighly compensated employees 12% 3%

(iii) The elective contributions and QMACstaken into account for purposes of the ADP test ofsection 401(k)(3) satisfy the requirements of section401(k)(3)(A)(ii) under paragraph (a)(1)(ii) of thissection because the ADP for HCEs (15%) is notmore than the ADP for NHCEs multiplied by 1.25(12% x 1.25 = 15%).

(b) Correction of excess contribu-tions—(1) Permissible correction meth-ods—(i) In general. A cash or deferredarrangement does not fail to satisfy therequirements of section 401(k)(3) andparagraph (a)(1) of this section if the em-ployer, in accordance with the terms ofthe plan that includes the cash or deferredarrangement, uses any of the followingcorrection methods—

(A) Qualified nonelective contribu-tions or qualified matching contributions.The employer makes qualified nonelec-tive contributions or qualified matchingcontributions that are taken into account

under this section and, in combinationwith other amounts taken into accountunder paragraph (a) of this section, allowthe cash or deferred arrangement to satisfythe requirements of paragraph (a)(1) ofthis section.

(B) Excess contributions distributed.Excess contributions are distributed inaccordance with paragraph (b)(2) of thissection.

(C) Excess contributions recharacter-ized. Excess contributions are recharacter-ized in accordance with paragraph (b)(3)of this section.

(ii) Combination of correction meth-ods. A plan may provide for the use ofany of the correction methods describedin paragraph (b)(1)(i) of this section, maylimit elective contributions in a mannerdesigned to prevent excess contributions

from being made, or may use a combina-tion of these methods, to avoid or correctexcess contributions. A plan may requireor permit an HCE to elect whether anyexcess contributions are to be recharac-terized or distributed. If the plan usesa combination of correction methods,any contribution made under paragraph(b)(1)(i)(A) of this section must be takeninto account before application of the cor-rection methods in paragraph (b)(1)(i)(B)or (C) of this section.

(iii) Exclusive means of correction.A failure to satisfy the requirements ofparagraph (a)(1) of this section may notbe corrected using any method other thanthe ones described in paragraphs (b)(1)(i)and (ii) of this section. Thus, excesscontributions for a plan year may notremain unallocated or be allocated to asuspense account for allocation to one or

2003-35 I.R.B. 462 September 2, 2003

more employees in any future year. Inaddition, excess contributions may notbe corrected using the retroactive cor-rection rules of §1.401(a)(4)–11(g). See§1.401(a)(4)–11(g)(3)(vii) and (5).

(2) Corrections through distribu-tion—(i) General rule. This paragraph(b)(2) contains the rules for correction ofexcess contributions through a distribu-tion from the plan. Correction througha distribution generally involves a 4 stepprocess. First, the plan must determine,in accordance with paragraph (b)(2)(ii)of this section, the total amount of ex-cess contributions that must be distributedunder the plan. Second, the plan mustapportion the total amount of excess con-tributions among HCEs in accordancewith paragraph (b)(2)(iii) of this section.Third, the plan must determine the incomeallocable to excess contributions in ac-cordance with paragraph (b)(2)(iv) of thissection. Finally, the plan must distributethe apportioned excess contributions andallocable income in accordance with para-graph (b)(2)(v) of this section. Paragraph(b)(2)(vi) of this section provides rulesrelating to the tax treatment of these dis-tributions. Paragraph (b)(2)(vii) providesother rules relating to these distributions.

(ii) Calculation of total amount tobe distributed. The following proce-dures must be used to determine the totalamount of the excess contributions to bedistributed—

(A) Calculate the dollar amount ofexcess contributions for each HCE. Theamount of excess contributions attribut-able to a given HCE for a plan year isthe amount (if any) by which the HCE'scontributions taken into account under thissection must be reduced for the HCE'sADR to equal the highest permitted ADRunder the plan. To calculate the highestpermitted ADR under a plan, the ADRof the HCE with the highest ADR is re-duced by the amount required to cause thatHCE's ADR to equal the ADR of the HCEwith the next highest ADR. If a lesserreduction would enable the arrangementto satisfy the requirements of paragraph(b)(2)(ii)(C) of this section, only thislesser reduction is used in determining thehighest permitted ADR.

(B) Determination of the total amountof excess contributions. The process de-scribed in paragraph (b)(2)(ii)(A) of this

section must be repeated until the arrange-ment would satisfy the requirements ofparagraph (b)(2)(ii)(C) of this section. Thesum of all reductions for all HCEs deter-mined under paragraph (b)(2)(ii)(A) of thissection is the total amount of excess con-tributions for the plan year.

(C) Satisfaction of ADP. A cash ordeferred arrangement satisfies this para-graph (b)(2)(ii)(C) if the arrangementwould satisfy the requirements of para-graph (a)(1)(ii) of this section if the ADRfor each HCE were determined afterthe reductions described in paragraph(b)(2)(ii)(A) of this section.

(iii) Apportionment of total amount ofexcess contributions among the HCEs.The following procedures must be used inapportioning the total amount of excesscontributions determined under paragraph(b)(2)(ii) of this section among the HCEs:

(A) Calculate the dollar amount of ex-cess contributions for each HCE. The con-tributions of the HCE with the highest dol-lar amount of contributions taken into ac-count under this section are reduced by theamount required to cause that HCE's con-tributions to equal the dollar amount of thecontributions taken into account under thissection for the HCE with the next highestdollar amount of contributions taken ac-count under this section. If a lesser ap-portionment to the HCE would enable theplan to apportion the total amount of ex-cess contributions, only the lesser appor-tionment would apply.

(B) Limit on amount apportioned toany individual. For purposes of thisparagraph (b)(2)(iii), the amount of con-tributions taken into account under thissection with respect to an HCE who is aneligible employee in more than one planof an employer is determined by takinginto account all contributions otherwisetaken into account with respect to suchHCE under any plan of the employerduring the plan year of the plan beingtested as being made under the plan beingtested. However, the amount of excesscontributions apportioned for a plan yearwith respect to any HCE must not exceedthe amount of contributions actually con-tributed to the plan for the HCE for theplan year. Thus, in the case of an HCEwho is an eligible employee in more thanone plan of the same employer to whichelective contributions are made and whoseADR is calculated in accordance with

paragraph (a)(3)(ii) of this section, theamount required to be distributed underthis paragraph (b)(2)(iii) shall not exceedthe contributions actually contributed tothe plan and taken into account under thissection for the plan year.

(C) Apportionment to additional HCEs.The procedure in paragraph (b)(2)(iii)(A)of this section must be repeated until thetotal amount of excess contributions de-termined under paragraph (b)(2)(ii) of thissection have been apportioned.

(iv) Income allocable to excess contri-butions—(A) General rule. The incomeallocable to excess contributions is equalto the sum of the allocable gain or loss forthe plan year and, to the extent the excesscontributions are or will be credited withallocable gain or loss for the period afterthe close of the plan year (gap period), theallocable gain or loss for the gap period.

(B) Method of allocating income. Aplan may use any reasonable method forcomputing the income allocable to excesscontributions, provided that the methoddoes not violate section 401(a)(4), is usedconsistently for all participants and for allcorrective distributions under the plan forthe plan year, and is used by the plan for al-locating income to participant's accounts.See §1.401(a)(4)–1(c)(8).

(C) Alternative method of allocatingplan year income. A plan may allocateincome to excess contributions for theplan year by multiplying the income forthe plan year allocable to the electivecontributions and other amounts takeninto account under this section (includingcontributions made for the plan year),by a fraction, the numerator of which isthe excess contributions for the employeefor the plan year, and the denominator ofwhich is the account balance attributableto elective contributions and other con-tributions taken into account under thissection as of the beginning of the plan year(including any additional amount of suchcontributions made for the plan year).

(D) Safe harbor method of allocat-ing gap period income. A plan may usethe safe harbor method in this paragraph(b)(2)(iv)(D) to determine income onexcess contributions for the gap period.Under this safe harbor method, incomeon excess contributions for the gap periodis equal to 10% of the income allocableto excess contributions for the plan yearthat would be determined under paragraph

September 2, 2003 463 2003-35 I.R.B.

(b)(2)(iv)(C) of this section, multiplied bythe number of calendar months that haveelapsed since the end of the plan year.For purposes of calculating the numberof calendar months that have elapsed un-der the safe harbor method, a correctivedistribution that is made on or before thefifteenth day of a month is treated as madeon the last day of the preceding month anda distribution made after the fifteenth dayof a month is treated as made on the lastday of the month.

(E) Alternative method for allocatingplan year and gap period income. Aplan may determine the allocable gainor loss for the aggregate of the plan yearand the gap period by applying the al-ternative method provided by paragraph(b)(2)(iv)(C) of this section to this ag-gregate period. This is accomplished bysubstituting the income for the plan yearand the gap period for the income for theplan year and by substituting the contribu-tions taken into account under this sectionfor the plan year and the gap period forthe contributions taken account under thissection for the plan year in determining thefraction that is multiplied by that income.

(v) Distribution. Within 12 months af-ter the close of the plan year in which theexcess contribution arose, the plan mustdistribute to each HCE the excess contribu-tions apportioned to such HCE under para-graph (b)(2)(iii) of this section and the al-locable income. Except as otherwise pro-vided in this paragraph (b)(2)(v) and para-graph (b)(4)(i) of this section, a distribu-tion of excess contributions must be in ad-dition to any other distributions made dur-ing the year and must be designated as acorrective distribution by the employer. Inthe event of a complete termination of theplan during the plan year in which an ex-cess contribution arose, the corrective dis-tribution must be made as soon as adminis-tratively feasible after the date of termina-tion of the plan, but in no event later than12 months after the date of termination. Ifthe entire account balance of an HCE isdistributed prior to when the plan makes adistribution of excess contributions in ac-cordance with this paragraph (b)(2), thedistribution is deemed to have been a cor-rective distribution of excess contributions(and income) to the extent that a correctivedistribution would otherwise have been re-quired.

(vi) Tax treatment of corrective distri-butions—(A) General rule. Except as pro-vided in paragraph (b)(2)(vi)(B) of thissection, a corrective distribution of excesscontributions (and income) that is madewithin 21/2 months after the end of the planyear for which the excess contributionswere made is includible in the employee'sgross income on the earliest date any elec-tive contributions by the employee duringthe plan year would have been received bythe employee had the employee originallyelected to receive the amounts in cash. Acorrective distribution of excess contribu-tions (and income) that is made more than21/2 months after the end of the plan yearfor which the contributions were made isincludible in the employee's gross incomein the employee's taxable year in whichdistributed. Regardless of when the cor-rective distribution is made, it is not subjectto the early distribution tax of section 72(t).See paragraph (b)(4) of this section for ad-ditional rules relating to the employer ex-cise tax on amounts distributed more than21/2 months after the end of the plan year.See also §1.402(c)–2, A–4 for restrictionson rolling over distributions that are excesscontributions.

(B) Rule for de minimis distributions.If the total amount of excess contribu-tions, determined under this paragraph(b)(2), and excess aggregate contributionsdetermined under §1.401(m)–2(b)(2) dis-tributed to a recipient under a plan for anyplan year is less than $100 (excluding in-come), a corrective distribution of excesscontributions (and income) is includiblein the gross income of the recipient in thetaxable year of the recipient in which thecorrective distribution is made.

(vii) Other rules—(A) No employee orspousal consent required. A correctivedistribution of excess contributions (andincome) may be made under the terms ofthe plan without regard to any notice orconsent otherwise required under sections411(a)(11) and 417.

(B) Treatment of corrective distribu-tions as elective contributions. Excesscontributions are treated as employer con-tributions for purposes of sections 404 and415 even if distributed from the plan.

(C) No reduction of required minimumdistribution. A distribution of excesscontributions (and income) is not treatedas a distribution for purposes of deter-mining whether the plan satisfies the

minimum distribution requirements ofsection 401(a)(9). See §1.401(a)(9)–5,Q&A–9(b).

(D) Partial distributions. Any distribu-tion of less than the entire amount of excesscontributions (and allocable income) withrespect to any HCE is treated as a pro ratadistribution of excess contributions and al-locable income.

(viii) Examples. The following exam-ples illustrate the application of this para-graph (b)(2). For purposes of these exam-ples, none of the plans provide for catch-upcontributions under section 414(v). Theexamples are as follows:

Example 1. (i) Plan P, a calendar year profit-shar-ing plan that includes a cash or deferred arrange-ment, provides for distribution of excess contribu-tions to HCEs to the extent necessary to satisfy theADP test. Employee A, an HCE, has elective con-tributions of $12,000 and $200,000 in compensation,for an ADR of 6%, and Employee B, a second HCE,has elective contributions of $8,960 and compensa-tion of $128,000, for an ADR of 7%. The ADP forthe NHCEs is 3%. Under the ADP test, the ADP ofthe two HCEs under the plan may not exceed 5% (i.e.,2 percentage points more than the ADP of the NHCEsunder the plan). The ADP for the 2 HCEs under theplan is 6.5%. Therefore, there must be a correction ofexcess contributions.

(ii) The total amount of excess contributions forthe HCEs is determined under paragraph (b)(2)(ii) ofthis section as follows: the elective contributions ofEmployee B (the HCE with the highest ADR) are re-duced by $1,280 in order to reduce his ADR to 6%($7,680/$128,000), which is the ADR of EmployeeA.

(iii) Because the ADP of the HCEs determined af-ter the $1,280 reduction to Employee B still exceeds5%, further reductions in elective contributions arenecessary in order to reduce the ADP of the HCEsto 5%. The elective contributions of Employee A andEmployee B are each reduced by 1% of compensa-tion ($2,000 and $1,280 respectively). Because theADP of the HCEs determined after the reductionsequals 5%, the plan would satisfy the requirementsof (a)(1)(ii) of this section.

(iv) The total amount of excess contributions($4,560 = $1,280+$2,000+$1,280) is apportionedamong the HCEs under paragraph (b)(2)(iii) of thissection first to the HCE with the highest amount ofelective contributions. Therefore, Employee A isapportioned $3,040 (the amount required to causeEmployee A's elective contributions to equal the nexthighest dollar amount of elective contributions).

(v) Because the total amount of excess contribu-tions has not been apportioned, further apportionmentis necessary. The balance ($1,520) of the total amountof excess contributions is apportioned equally amongEmployee A and Employee B ($760 to each).

(vi) Therefore, the cash or deferred arrangementwill satisfy the requirements of paragraph (a)(1) ofthis section if, by the end of the 12 month period fol-lowing the end of the 2006 plan year, Employee Areceives a corrective distribution of excess contribu-tions equal to $3,800 ($3,040 + $760) and allocable

2003-35 I.R.B. 464 September 2, 2003

income and Employee B receives a corrective distri-bution of $760 and allocable income.

Example 2. (i) The facts are the same as in Exam-ple 1, except Employee A's ADR is based on $3,000of elective contributions to this plan and $9,000 ofelective contributions to another plan of the employer.

(ii) The total amount of excess contributions($4,560 = $1,280+$2,000+$1,280) is apportionedamong the HCEs under paragraph (b)(2)(iii) of thissection first to the HCE with the highest amountof elective contributions. The amount of electivecontributions for Employee A is $12,000. Therefore,Employee A is apportioned $3,040 (the amount re-quired to cause Employee A's elective contributionsto equal the next highest dollar amount of elec-tive contributions). However, pursuant to paragraph(b)(2)(iii)(B) of this section, no more than the amountactually contributed to the plan may be apportionedto an HCE. Accordingly, no more than $3,000 maybe apportioned to Employee A. Therefore, the re-maining $1,560 must be apportioned to Employee B.

(ii) The cash or deferred arrangement will satisfythe requirements of paragraph (a)(1) of this section if,by the end of the 12 month period following the end ofthe 2006 plan year, Employee A receives a correctivedistribution of excess contributions equal to $3,000(total amount of elective contributions actually con-tributed to the plan for Employee A) and allocableincome and Employee B receives a corrective distri-bution of $1,560 and allocable income.

Example 3. (i) The facts are the same as in Exam-ple 1. The plan allocates income on a daily basis. Thecorrective distributions are made in February 2007.The excess contribution that must be distributed toEmployee A as a corrective distribution is $3,800.This amount must be increased (or decreased) to re-flect gains (or losses) allocable to that amount dur-ing the 2006 plan year. The plan uses a reasonablemethod that satisfies paragraph (b)(2)(iv)(B) of thissection to determine the gain during the 2006 planyear allocable to the $3,800 as $145. Therefore, as ofthe end of the 2006 plan year, the amount of correc-tive distribution that is required would be $3,945.

(ii) Because the plan allocates income on a dailybasis, excess contributions are credited with gain orloss during the gap period. Therefore, the correctivedistribution must include income allocable to $3,945through the date of distribution. For the period fromJanuary 1 through the date of distribution, the incomeallocable to $3,945 is $105. Therefore, the plan willsatisfy the requirements of paragraph (a)(1) of thissection if Employee A receives a corrective distribu-tion of $4,050.

Example 4. (i) The facts are the same as in Exam-ple 1. The plan determines plan year income using thealternative method for calculating income providedin paragraph (b)(2)(iv)(C) of this section and usingthe portion of the participant's account attributableto elective contributions, including elective contribu-tions made for the plan year. The plan uses the safeharbor method provided in paragraph (b)(2)(iv)(D) ofthis section for allocating gap period income. Thecorrective distribution is made during the last weekof February 2007. At the beginning of the 2006 planyear, $100,000 of Employee A's plan account was at-tributable to elective contributions. During the 2006

plan year, $10,000 in elective contributions were con-tributed to the plan for Employee A. The income allo-cable to Employee A's account attributable to electivecontributions for the 2006 plan year is $8,000.

(ii) Therefore, the plan year income allocable tothe $3,800 corrective distribution for Employee Ais $266.65 ($8,000 multiplied by $3,800 divided by$110,000). Therefore, as of the end of the 2006 planyear, the amount of corrective distribution that is re-quired is $4,066.65. This amount must be increasedby the gap period income of $53.32 (10% multipliedby $266.65 (2006 plan year income attributable to theexcess contribution) multiplied by 2 (number of cal-endar months since end of 2006 plan year). There-fore, the plan will satisfy the requirements of para-graph (a)(1) of this section if Employee A receives acorrective distribution of $4,119.97.

Example 5. (i) The facts are the same as in Ex-ample 4, except that the plan provides for quarterlyvaluations based on the account balance at the end ofthe quarter.

(ii) Because the plan's method for allocating in-come does not allocate any income to amounts dis-tributed during the quarter, Employee A will not becredited with an allocation of income with respect tothe amount distributed. Accordingly, Plan P need notplan adjust the distribution of excess contribution forincome during the gap period and thus satisfies para-graph (a)(1) of this section if Employee A receives acorrective distribution of $4,066.65.

(3) Recharacterization of excess contri-butions—(i) General rule. Excess contri-butions are recharacterized in accordancewith this paragraph (b)(3) only if the ex-cess contributions that would have to bedistributed under (b)(2) of this section ifthe plan was correcting through distribu-tion of excess contributions are recharac-terized as described in paragraph (b)(3)(ii)of this section, and all of the conditions setforth in paragraph (b)(3)(iii) of this sectionare satisfied.

(ii) Treatment of recharacterized excesscontributions. Recharacterized excesscontributions are includible in the em-ployee's gross income as if such amountswere distributed under paragraph (b)(2) ofthis section. The recharacterized excesscontributions must be treated as employeecontributions for purposes of section 72,sections 401(a)(4) and 401(m). This re-quirement is not treated as satisfied unlessthe payor or plan administrator reportsthe recharacterized excess contributionsas employee contributions to the InternalRevenue Service and the employee bytimely providing such federal tax formsand accompanying instructions and timelytaking such other action as prescribedby the Commissioner in revenue rulings,notices and other guidance publishedin the Internal Revenue Bulletin (see601.601(d)(2) of this chapter) as well as

the applicable federal tax forms and ac-companying instructions.

(iii) Additional rules—(A) Time ofrecharacterization. Excess contributionsmay not be recharacterized under thisparagraph (b)(3) after 21/2 months afterthe close of the plan year to which therecharacterization relates. Recharacteri-zation is deemed to have occurred on thedate on which the last of those HCEs withexcess contributions to be recharacterizedis notified in accordance with paragraph(b)(3)(ii) of this section.

(B) Employee contributions must bepermitted under plan. The amount ofrecharacterized excess contributions, incombination with the employee contribu-tions actually made by the HCE, may notexceed the maximum amount of employeecontributions (determined without regardto the ACP test of section 401(m)(2)) per-mitted under the provisions of the plan asin effect on the first day of the plan year.

(C) Treatment of recharacterized ex-cess contributions. Recharacterized ex-cess contributions continue to be treated asemployer contributions for all other pur-poses under the Internal Revenue Code,including sections 401(a) (other than sec-tions 401(a)(4) and 401(m)), 404, 409,411, 412, 415, 416, and 417. Thus, forexample, recharacterized excess contribu-tions remain subject to the requirements of§1.401(k)–1(c) and (d); must be deductedunder section 404; and are treated as em-ployer contributions described in section415(c)(2)(A) and §1.415–6(b).

(4) Rules applicable to all correc-tions—(i) Coordination with distributionof excess deferrals—(A) Treatment of ex-cess deferrals that reduce excess contribu-tions. The amount of excess contributions(and allocable income) to be distributedunder paragraph (b)(2) of this section orthe amount of excess contributions rechar-acterized under paragraph (b)(3) of thissection with respect to an employee fora plan year, is reduced by any amountspreviously distributed to the employeefrom the plan to correct excess deferralsfor the employee's taxable year endingwith or within the plan year in accordancewith section 402(g)(2).

(B) Treatment of excess contributionsthat reduce excess deferrals. Under§1.402(g)–1(e), the amount required to bedistributed to correct an excess deferral toan employee for a taxable year is reduced

September 2, 2003 465 2003-35 I.R.B.

by any excess contributions (and allocableincome) previously distributed or excesscontributions recharacterized with respectto the employee for the plan year begin-ning with or within the taxable year. Theamount of excess contributions includiblein the gross income of the employee, andthe amount of excess contributions re-ported by the payer or plan administratoras includible in the gross income of theemployee, does not include the amount ofany reduction under §1.402(g)–1(e)(6).

(ii) Forfeiture of match on distributedexcess contributions. A matching contri-bution is taken into account under section401(a)(4) even if the match is with re-spect to an elective contribution that isdistributed or recharacterized under thisparagraph (b). This requires that, aftercorrection of excess contributions, eachlevel of matching contributions be cur-rently and effectively available to a groupof employees that satisfies section 410(b).See §1.401(a)(4)–4(e)(3)(iii)(G). Thus, aplan that provides the same rate of match-ing contributions to all employees will notmeet the requirements of section 401(a)(4)if elective contributions are distributedunder this paragraph (b) to HCEs to theextent needed to meet the requirements ofsection 401(k)(3), while matching contri-butions attributable to those elective con-tributions remain allocated to the HCEs'accounts. Under section 411(a)(3)(G)and §1.411(a)–4(b)(7), a plan may for-feit matching contributions attributableto excess contributions, excess aggregatecontributions or excess deferrals to avoida violation of section 401(a)(4). Seealso §1.401(a)(4)–11(g)(vii)(B) regardingthe use of additional allocations to theaccounts of NHCEs for the purpose ofcorrecting a discriminatory rate of match-ing contributions.

(iii) Permitted forfeiture of QMAC. Pur-suant to section 401(k)(8)(E), a qualifiedmatching contribution is not treated as for-feitable under §1.401(k)–1(c) merely be-cause under the plan it is forfeited in ac-cordance with paragraph (b)(4)(ii) of thissection.

(iv) No requirement for recalculation.If excess contributions are distributed orrecharacterized in accordance with para-graphs (b)(2) and (3) of this section, thecash or deferred arrangement is treated asmeeting the nondiscrimination test of sec-tion 401(k)(3) regardless of whether the

ADP for the HCEs, if recalculated after thedistributions or recharacterizations, wouldsatisfy section 401(k)(3).

(v) Treatment of excess contribu-tions that are catch-up contributions. Acash or deferred arrangement does notfail to meet the requirements of section401(k)(3) and paragraph (a)(1) of this sec-tion merely because excess contributionsthat are catch-up contributions becausethey exceed the ADP limit, as described in§1.414(v)–1(b)(1)(iii), are not corrected inaccordance with this paragraph (b).

(5) Failure to timely correct—(i) Fail-ure to correct within 21/2 months after endof plan year. If a plan does not correct ex-cess contributions within 21/2 months af-ter the close of the plan year for whichthe excess contributions are made, the em-ployer will be liable for a 10% excise taxon the amount of the excess contributions.See section 4979 and §54.4979–1 of thischapter. Qualified nonelective contribu-tions and qualified matching contributionsproperly taken into account under para-graph (a)(6) of this section for a plan yearmay enable a plan to avoid having excesscontributions, even if the contributions aremade after the close of the 21/2 month pe-riod.

(ii) Failure to correct within 12 monthsafter end of plan year. If excess contribu-tions are not corrected within 12 monthsafter the close of the plan year for whichthey were made, the cash or deferred ar-rangement will fail to satisfy the require-ments of section 401(k)(3) for the planyear for which the excess contributions aremade and all subsequent plan years duringwhich the excess contributions remain inthe trust.

(c) Additional rules for prior year test-ing method—(1) Rules for change in test-ing method—(i) General rule. A plan ispermitted to change from the prior yeartesting method to the current year test-ing method for any plan year. A planis permitted to change from the currentyear testing method to the prior year test-ing method only in situations described inparagraph (c)(1)(ii) of this section. Forpurposes of this paragraph (c)(1), a planthat uses the safe harbor method describedin §1.401(k)–3 or a SIMPLE 401(k) planis treated as using the current year testingmethod for that plan year.

(ii) Situations permitting a change tothe prior year testing method. The situa-tions described in this paragraph (c)(1)(ii)are:

(A) The plan is not the result of the ag-gregation of two or more plans, and thecurrent year testing method was used underthe plan for each of the 5 plan years preced-ing the plan year of the change (or if lesser,the number of plan years the plan has beenin existence, including years in which theplan was a portion of another plan).

(B) The plan is the result of the aggre-gation of two or more plans, and for eachof the plans that are being aggregated (theaggregating plans), the current year test-ing method was used for each of the 5plan years preceding the plan year of thechange (or if lesser, the number of planyears since that aggregating plan has beenin existence, including years in which theaggregating plan was a portion of anotherplan).

(C) A transaction described in section410(b)(6)(C)(i) and §1.410(b)–2(f) occursand—

(1) As a result of the transaction, theemployer maintains both a plan using theprior year testing method and a plan usingthe current year testing method; and

(2) The change from the current yeartesting method to the prior year testingmethod occurs within the transition perioddescribed in section 410(b)(6)(C)(ii).

(2) Calculation of ADP under the prioryear testing method for the first planyear—(i) Plans that are not successorplans. If, for the first plan year of any plan(other than a successor plan), the plan usesthe prior year testing method, the plan ispermitted to use either that first plan yearas the applicable year for determining theADP for eligible NHCEs, or use 3% asthe ADP for eligible NHCEs, for applyingthe ADP test for that first plan year. Aplan (other than a successor plan) thatuses the prior year testing method but haselected for its first plan year to use thatyear as the applicable year is not treated aschanging its testing method in the secondplan year and is not subject to the limita-tions on double counting on QNECs underparagraph (a)(6)(vi) of this section for thesecond plan year.

(ii) First plan year defined. For pur-poses of this paragraph (c)(2), the firstplan year of any plan is the first year in

2003-35 I.R.B. 466 September 2, 2003

which the plan provides for elective con-tributions. Thus, the rules of this para-graph (c)(2) do not apply to a plan (withinthe meaning of §1.410(b)–7(b)) for a planyear if for such plan year the plan is ag-gregated under §1.401(k)–1(b)(4) with anyother plan that provides for elective contri-butions in the prior year.

(iii) Successor plans. A plan is a suc-cessor plan if 50% or more of the eligi-ble employees for the first plan year wereeligible employees under a qualified cashor deferred arrangement maintained by theemployer in the prior year. If a plan thatis a successor plan uses the prior year test-ing method for its first plan year, the ADPfor the group of NHCEs for the applicableyear must be determined under paragraph(c)(4) of this section.

(3) Plans using different testing meth-ods for the ADP and ACP test. Exceptas otherwise provided in this paragraph(c)(3), a plan may use the current year test-ing method or prior year testing method forthe ADP test for a plan year without regardto whether the current year testing methodor prior year testing method is used for theACP test for that year. For example, a planmay use the prior year testing method forthe ADP test and the current year testingmethod for its ACP test for the plan year.However, plans that use different testingmethods under this paragraph (c)(3) can-not use—

(i) The recharacterization method ofparagraph (b)(3) of this section to correctexcess contributions for a plan year;

(ii) The rules of §1.401(m)–2(a)(6)(ii)to take elective contributions into accountunder the ACP test (rather than the ADPtest); or

(iii) The rules of paragraph (a)(6)(v) ofthis section to take qualified matching con-tributions into account under the ADP test(rather than the ACP test).

(4) Rules for plan coveragechanges—(i) In general. A plan thatuses the prior year testing method and ex-periences a plan coverage change duringa plan year satisfies the requirements ofthis section for that year only if the planprovides that the ADP for the NHCEs forthe plan year is the weighted average ofthe ADPs for the prior year subgroups.

(ii) Optional rule for minor plan cov-erage changes. If a plan coverage change

occurs and 90% or more of the total num-ber of the NHCEs from all prior year sub-groups are from a single prior year sub-group, then, in lieu of using the weightedaverages described in paragraph (c)(4)(i)of this section, the plan may provide thatthe ADP for the group of eligible NHCEsfor the prior year under the plan is theADP of the NHCEs for the prior year ofthe plan under which that single prior yearsubgroup was eligible.

(iii) Definitions. The following defini-tions apply for purposes of this paragraph(c)(4):

(A) Plan coverage change. The termplan coverage change means a change inthe group or groups of eligible employeesunder a plan on account of—

(1) The establishment or amendment ofa plan;

(2) A plan merger or spinoff under sec-tion 414(l);

(3) A change in the way plans (withinthe meaning of §1.410(b)–7(b)) arecombined or separated for purposes of§1.401(k)–1(b)(4) (e.g., permissivelyaggregating plans not previously aggre-gated under §1.410(b)–7(d), or ceasingto permissively aggregate plans under§1.410(b)–7(d));

(4) A reclassification of a substantialgroup of employees that has the same ef-fect as amending the plan (e.g., a transferof a substantial group of employees fromone division to another division); or

(5) A combination of any of paragraphs(c)(4)(iii)(A)(1) through (4) of this section.

(B) Prior year subgroup. The termprior year subgroup means all NHCEsfor the prior plan year who, in the prioryear, were eligible employees under aspecific plan maintained by the employerthat included a qualified cash or deferredarrangement and who would have beeneligible employees in the prior year underthe plan being tested if the plan coveragechange had first been effective as of thefirst day of the prior plan year instead offirst being effective during the plan year.The determination of whether an NHCEis a member of a prior year subgroup ismade without regard to whether the NHCEterminated employment during the prioryear.

(C) Weighted average of the ADPsfor the prior year subgroups. The termweighted average of the ADPs for theprior year subgroups means the sum, for

all prior year subgroups, of the adjustedADPs for the plan year. The term adjustedADP with respect to a prior year subgroupmeans the ADP for the prior plan year ofthe specific plan under which the membersof the prior year subgroup were eligibleemployees on the first day of the prior planyear, multiplied by a fraction, the numer-ator of which is the number of NHCEs inthe prior year subgroup and denominatorof which is the total number of NHCEs inall prior year subgroups.

(iv) Examples. The following examplesillustrate the application of this paragraph(c)(4):

Example 1. (i) Employer B maintains twocalendar year plans, Plan O and Plan P, each ofwhich includes a cash or deferred arrangement.The plans were not permissively aggregated under§1.410(b)–7(d) for the 2005 plan year. Both plansuse the prior year testing method. Plan O had 300eligible employees who were NHCEs for the 2005plan year, and their ADP for that year was 6%.Sixty of the eligible employees who were NHCEsfor the 2005 plan year under Plan O, terminatedtheir employment during that year. Plan P had 100eligible employees who were NHCEs for 2005, andthe ADP for those NHCEs for that plan was 4%.Plan O and Plan P are permissively aggregated under§1.410(b)–7(d) for the 2006 plan year.

(ii) The permissive aggregation of Plan O andPlan P for the 2006 plan year under § 1.410(b)–7(d)is a plan coverage change that results in treatingthe plans as one plan (Plan OP) for purposes of§1.401(k)–1(b)(4). Therefore, the prior year ADPfor the NHCEs under Plan OP for the 2006 plan yearis the weighted average of the ADPs for the prioryear subgroups: the Plan O prior year subgroup andthe Plan P prior year subgroup.

(iii) The Plan O prior year subgroup consists ofthe 300 employees who, in the 2005 plan year, wereeligible NHCEs under Plan O and who would havebeen eligible under Plan OP for the 2005 plan year ifPlan O and Plan P had been permissively aggregatedfor that plan year. The Plan P prior year subgroupconsists of the 100 employees who, in the 2005 planyear, were eligible NHCEs under Plan P and wouldhave been eligible under Plan OP for the 2005 planyear if Plan O and Plan P had been permissively ag-gregated for that plan year.

(iv) The weighted average of the ADPs for theprior year subgroups is the sum of the adjusted ADPfor the Plan O prior year subgroup and the adjustedADP for the Plan P prior year subgroup. The adjustedADP for the Plan O prior year subgroup is 4.5%, cal-culated as follows: 6% (the ADP for the NHCEs un-der Plan O for the 2005 plan year) x 300/400 (thenumber of NHCEs in the Plan O prior year subgroupdivided by the total number of NHCEs in all prior yearsubgroups). The adjusted ADP for the Plan P prioryear subgroup is 1%, calculated as follows: 4% (theADP for the NHCEs under Plan P for the 2005 planyear) x 100/400 (the number of NHCEs in the PlanP prior year subgroup divided by the total number ofNHCEs in all prior year subgroups). Thus, the prioryear ADP for NHCEs under Plan OP for the 2006

September 2, 2003 467 2003-35 I.R.B.

plan year is 5.5% (the sum of adjusted ADPs for theprior year subgroups, 4.5% plus 1%).

(v) As provided in paragraph (c)(4)(iii)(B) of thissection, the determination of whether an NHCE isa member of a prior year subgroup is made withoutregard to whether that NHCE terminated employedduring the prior year. Thus, the prior ADP for theNHCEs under Plan OP for the 2006 plan year is un-affected by the termination of the 60 NHCEs coveredby Plan O during the 2005 plan year.

Example 2. (i) The facts are the same as Example1, except that the 60 employees who terminated em-ployment during the 2005 plan are instead spun-off toanother plan.

(ii) The permissive aggregation of Plan O andPlan P for the 2006 plan year under §1.410(b)–7(d)is a plan coverage change that results in treatingthe plans as one plan (Plan OP) for purposes of§1.401(k)–1(b)(4) and the spin-off of the 60 employ-ees is a plan coverage change. Therefore, the prioryear ADP for the NHCEs under Plan OP for the 2006plan year is the weighted average of the ADPs for theprior year subgroups: the Plan O prior year subgroupand the Plan P prior year subgroup.

(iii) For purposes of determining the prior yearsubgroups, the employees who would have been eli-gible employees in the prior year under the plan be-ing tested are determined as if both plan coveragechanges had first been effective as of the first dayof the prior plan year. The Plan O prior year sub-group consists of the 240 employees who, in the 2005plan year, were eligible NHCEs under Plan O andwould have been eligible under Plan OP for the 2005plan year if the spin-off had occurred at the begin-ning of the 2005 plan year and Plan O and Plan P hadbeen permissively aggregated under §1.410(b)–7(d)for that plan year. The Plan P prior year subgroupconsists of the 100 employees who, in the 2005 planyear, were eligible NHCEs under Plan P and wouldhave been eligible under Plan OP for the 2005 planyear if Plan O and Plan P had been permissively ag-gregated under §1.410(b)–7(d) for that plan year.

(iv) The weighted average of the ADPs for theprior year subgroups is the sum of the adjusted ADPwith respect to the prior year subgroup consisting ofeligible NHCEs from Plan O and the adjusted ADPwith respect to the prior year subgroup consisting ofeligible NHCEs from Plan P. The adjusted ADP forthe prior year subgroup consisting of eligible NHCEsunder Plan O is 4.23%, calculated as follows: 6% (theADP for the NHCEs under Plan O for the 2005 planyear) x 240/340 (the number of NHCEs in that prioryear subgroup divided by the total number of NHCEsin all prior year subgroups). The adjusted ADP for theprior year subgroup consisting of the eligible NHCEsfrom Plan P is 1.18%, calculated as follows: 4% (theADP for the NHCEs under Plan P for the 2005 planyear) x 100/340 (the number of NHCEs in that prioryear subgroup divided by the total number of NHCEsin all prior year subgroups). Thus, the prior year ADPfor NHCEs under Plan OP for the 2006 plan year is5.41% (the sum of adjusted ADPs for the prior yearsubgroups, 4.23% plus 1.18%).

Example 3. (i) The facts are the same as in Exam-ple 1, except that instead of Plan O and Plan P beingpermissively aggregated for the 2006 plan year, 200of the employees eligible under Plan O were spun-offfrom Plan O and merged into Plan P.

(ii) The spin-off from Plan O and merger to Plan Pfor the 2006 plan year are plan coverage changes forPlan P. Therefore, the prior year ADP for the NHCEsunder Plan P for the 2006 plan year is the weightedaverage of the ADPs for the prior year subgroups un-der Plan P. There are 2 subgroups under Plan P forthe 2006 plan year. The Plan O prior year subgroupconsists of the 200 employees who, in the 2005 planyear, were eligible NHCEs under Plan O and whowould have been eligible under Plan P for the 2005plan year if the spin-off and merger had occurred onthe first day of the 2005 plan year. The Plan P prioryear subgroup consists of the 100 employees who, inthe 2005 plan year, were eligible NHCEs under PlanP for the 2005 plan year.

(iii) The weighted average of the ADPs for theprior year subgroups is the sum of the adjusted ADPfor the Plan O prior year subgroup and the adjustedADP for the Plan P prior year subgroup. The adjustedADP for the Plan O prior year subgroup is 4.0%, cal-culated as follows: 6% (the ADP for the NHCEs un-der Plan O for the 2005 plan year) x 200/300 (thenumber of NHCEs in the Plan O prior year subgroupdivided by the total number of NHCEs in all prior yearsubgroups). The adjusted ADP for the Plan P prioryear subgroup is 1.33%, calculated as follows: 4%(the ADP for the NHCEs under Plan P for the 2005plan year) x 100/300 (the number of NHCEs in thePlan P prior year subgroup divided by the total num-ber of NHCEs in all prior year subgroups). Thus, theprior year ADP for NHCEs under Plan P for the 2006plan year is 5.33% (the sum of adjusted ADPs for the2 prior year subgroups, 4.0% plus 1.33%).

(iv) The spin-off from Plan O for the 2006 planyear is a plan coverage change for Plan O. There-fore, the prior year ADP for the NHCEs under PlanO for the 2006 plan year is the weighted average ofthe ADPs for the prior year subgroups under Plan O.In this case, there is only one prior year subgroup un-der Plan O, the employees who were NHCEs of Em-ployer B for the 2005 plan year and who were eli-gible for the 2005 plan year under Plan O. Becausethere is only one prior year subgroup under Plan O,the weighted average of the ADPs for the prior yearsubgroup under Plan O is equal to the NHCE ADP forthe prior year (2005 plan year) under Plan O, or 6%.

Example 4. (i) Employer C maintains a calendaryear plan, Plan Q, which includes a cash or deferredarrangement that uses the prior year testing method.Plan Q covers employees of Division A and Divi-sion B. In 2005, Plan Q had 500 eligible employeeswho were NHCEs, and the ADP for those NHCEs for2005 was 2%. Effective January 1, 2006, EmployerC amends the eligibility provisions under Plan Q toexclude employees of Division B effective January 1,2006. In addition, effective on that same date, Em-ployer C establishes a new calendar year plan, PlanR, which includes a cash or deferred arrangement thatuses the prior year testing method. The only eligibleemployees under Plan R are the 100 employees of Di-vision B who were eligible employees under Plan Q.

(ii) Plan R is a successor plan, within the meaningof paragraph (c)(2)(iii) of this section (because all ofthe employees were eligible employees under Plan Qin the prior year). Therefore, Plan R cannot use thefirst plan year rule set forth in paragraph (c)(2)(i) ofthis section.

(iii) The amendment to the eligibility provisionsof Plan Q and the establishment of Plan R are plan

coverage changes within the meaning of paragraph(c)(4)(iii)(A) of this section for Plan Q and Plan R.Accordingly, each plan must determine the NHCEADP for the 2006 plan year under the rules set forthin paragraph (c)(4) of this section.

(iv) The prior year ADP for NHCEs under Plan Qis the weighted average of the ADPs for the prior yearsubgroups. Plan Q has only one prior year subgroup(because the only NHCEs who would have been eli-gible employees under Plan Q for the 2005 plan yearif the amendment to the Plan Q eligibility provisionshad occurred as of the first day of that plan year wereeligible employees under Plan Q). Therefore, for pur-poses of the 2006 plan year under Plan Q, the ADPfor NHCEs for the prior year is the weighted averageof the ADPs for the prior year subgroups, or 2%, thesame as if the plan amendment had not occurred.

(v) Similarly, Plan R has only one prior year sub-group (because the only NHCEs who would havebeen eligible employees under Plan R for the 2005plan year if the plan were established as of the firstday of that plan year were eligible employees underPlan Q). Therefore, for purposes of the 2006 testingyear under Plan R, the ADP for NHCEs for the prioryear is the weighted average of the ADPs for the prioryear subgroups, or 2%, the same as that of Plan Q.

Example 5. (i) The facts are the same as in Exam-ple 4, except that the provisions of Plan R extend eli-gibility to 50 hourly employees who previously werenot eligible employees under any qualified cash or de-ferred arrangement maintained by Employer C.

(ii) Plan R is a successor plan (because 100 ofPlan R's 150 eligible employees were eligible em-ployees under another qualified cash or deferred ar-rangement maintained by Employer C in the prioryear). Therefore, Plan R cannot use the first plan yearrule set forth in paragraph (c)(2)(i) of this section.

(iii) The establishment of Plan R is a plan cover-age change that affects Plan R. Because the 50 hourlyemployees were not eligible employees under anyqualified cash or deferred arrangement of EmployerC for the prior plan year, they do not comprise a prioryear subgroup. Accordingly, Plan R still has only oneprior year subgroup. Therefore, for purposes of the2006 testing year under Plan R, the ADP for NHCEsfor the prior year is the weighted average of the ADPsfor the prior year subgroups, or 2%, the same as thatof Plan Q.

§1.401(k)–3 Safe harbor requirements.

(a) ADP test safe harbor. A cash or de-ferred arrangement satisfies the ADP safeharbor provision of section 401(k)(12) fora plan year if the arrangement satisfiesthe safe harbor contribution requirement ofparagraph (b) or (c) of this section for theplan year, the notice requirement of para-graph (d) of this section, the plan year re-quirements of paragraph (e) of this sec-tion, and the additional rules of paragraphs(f), (g) and (h) of this section, as applica-ble. Pursuant to section 401(k)(12)(E)(ii),the safe harbor contribution requirement ofparagraph (b) or (c) of this section must besatisfied without regard to section 401(l).

2003-35 I.R.B. 468 September 2, 2003

The contributions made under paragraphs(b) and (c) of this section are referred toas safe harbor nonelective contributionsand safe harbor matching contributions, re-spectively.

(b) Safe harbor nonelective contribu-tion requirement—(1) General rule. Thesafe harbor nonelective contribution re-quirement of this paragraph is satisfied if,under the terms of the plan, the employeris required to make a qualified nonelectivecontribution on behalf of each eligibleNHCE equal to at least 3% of the em-ployee's safe harbor compensation.

(2) Safe harbor compensation de-fined. For purposes of this section, safeharbor compensation means compensa-tion as defined in §1.401(k)–6 (whichincorporates the definition of compen-sation in §1.414(s)–1); provided, how-ever, that the rule in the last sentence of§1.414(s)–1(d)(2)(iii) (which generallypermits a definition of compensation toexclude all compensation in excess of aspecified dollar amount) does not apply indetermining the safe harbor compensationof NHCEs. Thus, for example, the planmay limit the period used to determinesafe harbor compensation to the eligibleemployee's period of participation.

(c) Safe harbor matching contributionrequirement—(1) In general. The safeharbor matching contribution requirementof this paragraph (c) is satisfied if, un-der the plan, qualified matching contribu-tions are made on behalf of each eligi-ble NHCE in an amount determined un-der the basic matching formula of sec-tion 401(k)(12)(B)(i)(I), as described inparagraph (c)(2) of this section, or underan enhanced matching formula of section401(k)(12)(B)(i)(II), as described in para-graph (c)(3) of this section.

(2) Basic matching formula. Underthe basic matching formula, each eligibleNHCE receives qualified matching con-tributions in an amount equal to the sumof—

(i) 100% of the amount of the em-ployee's elective contributions that do notexceed 3% of the employee's safe harborcompensation; and

(ii) 50% of the amount of the em-ployee's elective contributions that exceed3% of the employee's safe harbor com-pensation but that do not exceed 5% of theemployee's safe harbor compensation.

(3) Enhanced matching formula. Un-der an enhanced matching formula, eacheligible NHCE receives a matching con-tribution under a formula that, at any rateof elective contributions by the employee,provides an aggregate amount of qualifiedmatching contributions at least equal to theaggregate amount of qualified matchingcontributions that would have been pro-vided under the basic matching formula ofparagraph (c)(2) of this section. In addi-tion, under an enhanced matching formula,the ratio of matching contributions on be-half of an employee under the plan for aplan year to the employee's elective con-tributions may not increase as the amountof an employee's elective contributions in-creases.

(4) Limitation on HCE matching contri-butions. The safe harbor matching contri-bution requirement of this paragraph (c) isnot satisfied if the ratio of matching con-tributions made on account of an HCE'selective contributions under the cash ordeferred arrangement for a plan year tothose elective contributions is greater thanthe ratio of matching contributions to elec-tive contributions that would apply withrespect to any eligible NHCE with elec-tive contributions at the same percentageof safe harbor compensation.

(5) Use of safe harbor match not pre-cluded by certain plan provisions—(i)Safe harbor matching contributions onemployee contributions. The safe harbormatching contribution requirement of thisparagraph (c) will not fail to be satisfiedmerely because safe harbor matchingcontributions are made on both electivecontributions and employee contributionsif safe harbor matching contributions aremade with respect to the sum of electivecontributions and employee contributionson the same terms as safe harbor matchingcontributions are made with respect toelective contributions. Alternatively, thesafe harbor matching contribution require-ment of this paragraph (c) will not failto be satisfied merely because safe har-bor matching contributions are made onboth elective contributions and employeecontributions if safe harbor matching con-tributions on elective contributions arenot affected by the amount of employeecontributions.

(ii) Periodic matching contributions.The safe harbor matching contributionrequirement of this paragraph (c) will not

fail to be satisfied merely because theplan provides that safe harbor matchingcontributions will be made separately withrespect to each payroll period (or withrespect to all payroll periods ending withor within each month or quarter of a planyear) taken into account under the plan forthe plan year, provided that safe harbormatching contributions with respect to anyelective contributions made during a planyear quarter are contributed to the plan bythe last day of the immediately followingplan year quarter.

(6) Permissible restrictions on electivecontributions by NHCEs—(i) Generalrule. The safe harbor matching contri-bution requirement of this paragraph (c)is not satisfied if elective contributionsby NHCEs are restricted, unless the re-strictions are permitted by this paragraph(c)(6).

(ii) Restrictions on election periods. Aplan may limit the frequency and dura-tion of periods in which eligible employ-ees may make or change cash or deferredelections under a plan. However, an em-ployee must have a reasonable opportunity(including a reasonable period after receiptof the notice described in paragraph (d) ofthis section) to make or change a cash ordeferred election for the plan year. For pur-poses of this paragraph (c)(6)(ii), a 30-dayperiod is deemed to be a reasonable periodto make or change a cash or deferred elec-tion.

(iii) Restrictions on amount of electivecontributions. A plan is permitted to limitthe amount of elective contributions thatmay be made by an eligible employeeunder a plan, provided that each NHCEwho is an eligible employee is permitted(unless the employee is restricted underparagraph (c)(6)(v) of this section) tomake elective contributions in an amountthat is at least sufficient to receive the max-imum amount of matching contributionsavailable under the plan for the plan year,and the employee is permitted to elect anylesser amount of elective contributions.However, a plan may require eligible em-ployees to make cash or deferred electionsin whole percentages of compensation orwhole dollar amounts.

(iv) Restrictions on types of compen-sation that may be deferred. A plan maylimit the types of compensation that maybe deferred by an eligible employee undera plan, provided that each eligible NHCE

September 2, 2003 469 2003-35 I.R.B.

is permitted to make elective contribu-tions under a definition of compensationthat would be a reasonable definitionof compensation within the meaning of§1.414(s)–1(d)(2). Thus, the definition ofcompensation from which elective con-tributions may be made is not required tosatisfy the nondiscrimination requirementof §1.414(s)–1(d)(3).

(v) Restrictions due to limitations un-der the Internal Revenue Code. A planmay limit the amount of elective contribu-tions made by an eligible employee undera plan—

(A) Because of the limitations of sec-tion 402(g) or section 415; or

(B) Because, on account of a hard-ship distribution, an employee's abilityto make elective contributions has beensuspended for 6 months in accordancewith §1.401(k)–1(d)(3)(iv)(E).

(7) Examples. The following examplesillustrate the safe harbor contribution re-quirement of this paragraph (c):

Example 1. (i) Beginning January 1, 2006,Employer A maintains Plan L covering employees(including HCEs and NHCEs) in Divisions D and E.Plan L contains a cash or deferred arrangement andprovides qualified matching contributions equal to100% of each eligible employee's elective contribu-tions up to 3% of compensation and 50% of the next2% of compensation. For purposes of the matchingcontribution formula, safe harbor compensation isdefined as all compensation within the meaning ofsection 415(c)(3) (a definition that satisfies section414(s)). Also, each employee is permitted to makeelective contributions from all safe harbor com-pensation within the meaning of section 415(c)(3)and may change a cash or deferred election at anytime. Plan L limits the amount of an employee'selective contributions for purposes of section 402(g)and section 415, and, in the case of a hardshipdistribution, suspends an employee's ability to makeelective contributions for 6 months in accordancewith §1.401(k)–1(d)(3)(iv)(E). All contributionsunder Plan L are nonforfeitable and are subject to thewithdrawal restrictions of section 401(k)(2)(B). PlanL provides for no other contributions and EmployerA maintains no other plans. Plan L is maintained ona calendar-year basis and all contributions for a planyear are made within 12 months after the end of theplan year.

(ii) Based on these facts, matching contributionsunder Plan L are safe harbor matching contributionsbecause they are qualified matching contributionsequal to the basic matching formula. Accordingly,Plan L satisfies the safe harbor contribution require-ment of this paragraph (c).

Example 2. (i) The facts are the same as in Exam-ple 1, except that instead of providing a basic match-ing contribution, Plan L provides a qualified match-ing contribution equal to 100% of each eligible em-ployee's elective contributions up to 4% of safe harborcompensation.

(ii) Plan L's formula is an enhanced matching for-mula because each eligible NHCE receives safe har-bor matching contributions at a rate that, at any rate ofelective contributions, provides an aggregate amountof qualified matching contributions at least equal tothe aggregate amount of qualified matching contribu-tions that would have been received under the basicsafe harbor matching formula, and the rate of match-ing contributions does not increase as the rate of anemployee's elective contributions increases. Accord-ingly, Plan L satisfies the safe harbor contribution re-quirement of this paragraph (c).

Example 3. (i) The facts are the same as in Exam-ple 1, except that instead of permitting each employeeto make elective contributions from all compensationwithin the meaning of section 415(c)(3), each em-ployee's elective contributions under Plan L are lim-ited to 15% of the employee's “basic compensation.”Basic compensation is defined under Plan L as com-pensation within the meaning of section 415(c)(3),but excluding overtime pay.

(ii) The definition of basic compensation underPlan L is a reasonable definition of compensationwithin the meaning of §1.414(s)–1(d)(2).

(iii) Plan L will not fail to satisfy the safe harborcontribution requirement of this paragraph (c) merelybecause Plan L limits the amount of elective contri-butions and the types of compensation that may bedeferred by eligible employees, provided that each el-igible NHCE may make elective contributions equalto at least 4% of the employee's safe harbor compen-sation.

Example 4. (i) The facts are the same as in Exam-ple 1, except that Plan L provides that only employeesemployed on the last day of the plan year will receivea safe harbor matching contribution.

(ii) Even if the plan that provides for employeecontributions and matching contributions satisfies theminimum coverage requirements of section 410(b)(1)taking into account this last-day requirement, Plan Lwould not satisfy the safe harbor contribution require-ment of this paragraph (c) because safe harbor match-ing contributions are not made on behalf of all eligibleNHCEs who make elective contributions.

(iii) The result would be the same if, instead ofproviding safe harbor matching contributions underan enhanced formula, Plan L provides for a 3% safeharbor nonelective contribution that is restricted to el-igible employees under the cash or deferred arrange-ment who are employed on the last day of the planyear.

Example 5. (i) The facts are the same as in Ex-ample 1, except that instead of providing qualifiedmatching contributions under the basic matching for-mula to employees in both Divisions D and E, em-ployees in Division E are provided qualified match-ing contributions under the basic matching formula,while safe harbor matching contributions continue tobe provided to employees in Division D under the en-hanced matching formula described in Example 2.

(ii) Even if Plan L satisfies §1.401(a)(4)–4 withrespect to each rate of matching contributions avail-able to employees under the plan, the plan would failto satisfy the safe harbor contribution requirement ofthis paragraph (c) because the rate of matching con-tributions with respect to HCEs in Division D at a rateof elective contributions between 3% and 5% wouldbe greater than that with respect to NHCEs in Divi-sion E at the same rate of elective contributions. For

example, an HCE in Division D who would have a4% rate of elective contributions would have a rateof matching contributions of 100% while an NHCEin Division E who would have the same rate of elec-tive contributions would have a lower rate of match-ing contributions.

(d) Notice requirement—(1) Generalrule. The notice requirement of this para-graph (d) is satisfied for a plan year if eacheligible employee is given written noticeof the employee's rights and obligationsunder the plan and the notice satisfies thecontent requirement of paragraph (d)(2) ofthis section and the timing requirement ofparagraph (d)(3) of this section.

(2) Content requirement—(i) Generalrule. The content requirement of this para-graph (d)(2) is satisfied if the notice is—

(A) Sufficiently accurate and compre-hensive to inform the employee of the em-ployee's rights and obligations under theplan; and

(B) Written in a manner calculated to beunderstood by the average employee eligi-ble to participate in the plan.

(ii) Minimum content requirement.Subject to the requirements of paragraph(d)(2)(iii) of this section, a notice is notconsidered sufficiently accurate and com-prehensive unless the notice accuratelydescribes—

(A) The safe harbor matching contribu-tion or safe harbor nonelective contribu-tion formula used under the plan (includ-ing a description of the levels of safe har-bor matching contributions, if any, avail-able under the plan);

(B) Any other contributions under theplan or matching contributions to anotherplan on account of elective contributionsor employee contributions under the plan(including the potential for discretionarymatching contributions) and the conditionsunder which such contributions are made;

(C) The plan to which safe harbor con-tributions will be made (if different thanthe plan containing the cash or deferred ar-rangement);

(D) The type and amount of compensa-tion that may be deferred under the plan;

(E) How to make cash or deferredelections, including any administrativerequirements that apply to such elections;

(F) The periods available under the planfor making cash or deferred elections;

(G) Withdrawal and vesting provisionsapplicable to contributions under the plan;and

2003-35 I.R.B. 470 September 2, 2003

(H) Information that makes it easyto obtain additional information aboutthe plan (including an additional copyof the summary plan description) suchas telephone numbers, addresses and, ifapplicable, electronic addresses, of indi-viduals or offices from whom employeescan obtain such plan information.

(iii) References to SPD. A plan will notfail to satisfy the content requirements ofthis paragraph (d)(2) merely because, inthe case of information described in para-graph (d)(2)(ii)(B) of this section (relat-ing to any other contributions under theplan), paragraph (d)(2)(ii)(C) of this sec-tion (relating to the plan to which safe har-bor contributions will be made) or para-graph (d)(2)(ii)(D) of this section (relatingto the type and amount of compensationthat may be deferred under the plan), thenotice cross-references the relevant por-tions of a summary plan description thatprovides the same information that wouldbe provided in accordance with such para-graphs and that has been provided (or isconcurrently provided) to employees.

(3) Timing requirement—(i) Generalrule. The timing requirement of thisparagraph (d)(3) is satisfied if the noticeis provided within a reasonable periodbefore the beginning of the plan year (or,in the year an employee becomes eligi-ble, within a reasonable period beforethe employee becomes eligible). The de-termination of whether a notice satisfiesthe timing requirement of this paragraph(d)(3) is based on all of the relevant factsand circumstances.

(ii) Deemed satisfaction of timing re-quirement. The timing requirement of thisparagraph (d)(3) is deemed to be satisfiedif at least 30 days (and no more than 90days) before the beginning of each planyear, the notice is given to each eligibleemployee for the plan year. In the case ofan employee who does not receive the no-tice within the period described in the pre-vious sentence because the employee be-comes eligible after the 90th day beforethe beginning of the plan year, the tim-ing requirement is deemed to be satisfiedif the notice is provided no more than 90days before the employee becomes eligi-ble (and no later than the date the em-ployee becomes eligible). Thus, for ex-ample, the preceding sentence would ap-ply in the case of any employee eligible

for the first plan year under a newly estab-lished plan that provides for elective con-tributions, or would apply in the case of thefirst plan year in which an employee be-comes eligible under an existing plan thatprovides for elective contributions.

(e) Plan year requirement—(1) Gen-eral rule. Except as provided in this para-graph (e) or in paragraph (f) of this section,a plan will fail to satisfy the requirementsof section 401(k)(12) and this section un-less plan provisions that satisfy the rules ofthis section are adopted before the first dayof the plan year and remain in effect foran entire 12-month plan year. Moreover,if, as described under paragraph (g)(4) ofthis section, safe harbor matching or non-elective contributions will be made to an-other plan for a plan year, provisions speci-fying that the safe harbor contributions willbe made in the other plan and providingthat the contributions will be QNECs orQMACs must also be adopted before thefirst day of that plan year.

(2) Initial plan year. A newly es-tablished plan (other than a successorplan within the meaning of §1.401(k)–2(c)(2)(iii)) will not be treated as violat-ing the requirements of this paragraph(e) merely because the plan year is lessthan 12 months, provided that the planyear is at least 3 months long (or, in thecase of a newly established employer thatestablishes the plan as soon as administra-tively feasible after the employer comesinto existence, a shorter period). Simi-larly, a cash or deferred arrangement willnot fail to satisfy the requirement of thisparagraph (e) if it is added to an existingprofit sharing, stock bonus, or pre-ERISAmoney purchase pension plan for the firsttime during that year provided that—

(i) The plan is not a successor plan; and(ii) The cash or deferred arrangement is

made effective no later than 3 months priorto the end of the plan year.

(3) Change of plan year. A plan thathas a short plan year as a result of changingits plan year will not fail to satisfy the re-quirements of paragraph (e)(1) of this sec-tion merely because the plan year has lessthan 12 months, provided that—

(i) The plan satisfied the requirementsof this section for the immediately preced-ing plan year; and

(ii) The plan satisfies the requirementsof this section for the immediately follow-ing plan year.

(4) Final plan year. A plan that termi-nates during a plan year will not fail to sat-isfy the requirements of paragraph (e)(1)of this section merely because the finalplan year is less than 12 months, providedthat—

(i) The plan would satisfy the require-ments of paragraph (g) of this section,treating the termination of the plan as areduction or suspension of safe harbormatching contributions, other than therequirement that employees have a rea-sonable opportunity to change their cashor deferred elections and, if applicable,employee contribution elections; or

(ii) The plan termination is in connec-tion with a transaction described in section410(b)(6)(C) or the employer incurs a sub-stantial business hardship comparable to asubstantial business hardship described insection 412(d).

(f) Plan amendments adopting safeharbor nonelective contributions—(1)General rule. Notwithstanding paragraph(e)(1) of this section, a plan that providesfor the use of the current year testingmethod may be amended after the firstday of the plan year and no later than 30days before the last day of the plan year toadopt the safe harbor method of this sec-tion using nonelective contributions underparagraph (b) of this section, but onlyif the plan provides the contingent andfollow-up notices described in this sec-tion. A plan amendment made pursuantto this paragraph (f)(1) for a plan yearmay provide for the use of the safe harbormethod described in this section solely forthat plan year and a plan sponsor is notlimited in the number of years for which itis permitted to adopt an amendment pro-viding for the safe harbor method of thissection using nonelective contributionsunder paragraph (b) of this section.

(2) Contingent notice provided. A plansatisfies the requirement to provide thecontingent notice under this paragraph(f)(2) if it provides a notice that would sat-isfy the requirements of paragraph (d) ofthis section, except that, in lieu of settingforth the safe harbor contributions usedunder the plan as set forth in paragraph(d)(2)(ii)(A) of this section, the noticespecifies that the plan may be amendedduring the plan year to include the safeharbor nonelective contribution and that,if the plan is amended, a follow-up noticewill be provided.

September 2, 2003 471 2003-35 I.R.B.

(3) Follow-up notice requirement. Aplan satisfies the requirement to providea follow-up notice under this paragraph(f)(3) if, no later than 30 days before thelast day of the plan year, each eligible em-ployee is given a notice that states that thesafe harbor nonelective contributions willbe made for the plan year. This noticeis permitted to be combined with a con-tingent notice provided under paragraph(f)(2) of this section for the next plan year.

(g) Permissible reduction or suspensionof safe harbor matching contributions —(1) General rule. A plan that provides forsafe harbor matching contributions will notfail to satisfy the requirements of section401(k)(3) for a plan year merely becausethe plan is amended during a plan year toreduce or suspend safe harbor matchingcontributions on future elective contribu-tions (and, if applicable, employee contri-butions) provided that—

(i) All eligible employees are providedthe supplemental notice in accordancewith paragraph (g)(2) of this section;

(ii) The reduction or suspension of safeharbor matching contributions is effectiveno earlier than the later of 30 days aftereligible employees are provided the no-tice described in paragraph (g)(2) of thissection and the date the amendment isadopted;

(iii) Eligible employees are given a rea-sonable opportunity (including a reason-able period after receipt of the supplemen-tal notice) prior to the reduction or suspen-sion of safe harbor matching contributionsto change their cash or deferred electionsand, if applicable, their employee contri-bution elections;

(iv) The plan is amended to provide thatthe ADP test will be satisfied for the entireplan year in which the reduction or suspen-sion occurs using the current year testingmethod described in §1.401(k)–2(a)(2)(ii);and

(v) The plan satisfies the requirementsof this section (other than this paragraph(g)) with respect to amounts deferredthrough the effective date of the amend-ment.

(2) Notice of suspension requirement.The notice of suspension requirement ofthis paragraph (g)(2) is satisfied if eacheligible employee is given a written noticethat explains—

(i) The consequences of the amendmentwhich reduces or suspends matching con-tributions on future elective contributionsand, if applicable, employee contributions;

(ii) The procedures for changing theircash or deferred election and, if applicable,their employee contribution elections; and

(iii) The effective date of the amend-ment.

(h) Additional rules—(1) Contributionstaken into account. A contribution is takeninto account for purposes of this sectionfor a plan year if and only if the contribu-tion would be taken into account for suchplan year under the rules of §1.401(k)–2(a)or 1.401(m)–2(a). Thus, for example, asafe harbor matching contribution must bemade within 12 months of the end of theplan year. Similarly, an elective contribu-tion that would be taken into account for aplan year under §1.401(k)–2(a)(4)(i)(B)(2)must be taken into account for such planyear for purposes of this section, even if thecompensation would have been receivedafter the close of the plan year.

(2) Use of safe harbor nonelectivecontributions to satisfy other nondiscrim-ination tests. A safe harbor nonelectivecontribution used to satisfy the non-elective contribution requirement underparagraph (b) of this section may also betaken into account for purposes of deter-mining whether a plan satisfies section401(a)(4). Thus, these contributions arenot subject to the limitations on qual-ified nonelective contributions under§1.401(k)–2(a)(6)(ii), but are subject tothe rules generally applicable to nonelec-tive contributions under section 401(a)(4).See §1.401(a)(4)–1(b)(2)(ii). However,pursuant to section 401(k)(12)(E)(ii), tothe extent they are needed to satisfy thesafe harbor contribution requirement ofparagraph (b) of this section, safe har-bor nonelective contributions may notbe taken into account under any plan forpurposes of section 401(l) (including theimputation of permitted disparity under§1.401(a)(4)–7).

(3) Early participation rules. Section401(k)(3)(F) and §1.401(k)–2(a)(1)(iii)(A),which provide an alternative nondis-crimination rule for certain plans thatprovide for early participation, do notapply for purposes of section 401(k)(12)and this section. Thus, a plan is nottreated as satisfying this section withrespect to the eligible employees who

have not completed the minimum ageand service requirements of section410(a)(1)(A) unless the plan satisfies therequirements of this section with respectto such eligible employees.

(4) Satisfying safe harbor contributionrequirement under another defined contri-bution plan. Safe harbor matching or non-elective contributions may be made to theplan that contains the cash or deferred ar-rangement or to another defined contribu-tion plan that satisfies section 401(a) or403(a). If safe harbor contributions aremade to another defined contribution plan,the safe harbor plan must specify the planto which the safe harbors are made andcontribution requirement of paragraph (b)or (c) of this section must be satisfied inthe other defined contribution plan in thesame manner as if the contributions weremade to the plan that contains the cash ordeferred arrangement. Consequently, theplan to which the contributions are mademust have the same plan year as the plancontaining the cash and deferred arrange-ment and each employee eligible under theplan containing the cash or deferred ar-rangement must be eligible under the sameconditions under the other defined contri-bution plan. The plan to which the safeharbor contributions are made need not bea plan that can be aggregated with the planthat contains the cash or deferred arrange-ment.

(5) Contributions used only once. Safeharbor matching or nonelective contribu-tions cannot be used to satisfy the require-ments of this section with respect to morethan one plan.

§1.401(k)–4 SIMPLE 401(k) planrequirements.

(a) General rule. A cash or deferredarrangement satisfies the SIMPLE 401(k)plan provision of section 401(k)(11) for aplan year if the arrangement satisfies therequirements of paragraphs (b) through (i)of this section for that year. A plan thatcontains a cash or deferred arrangementthat satisfies this section is referred to asa SIMPLE 401(k) plan. Pursuant to sec-tion 401(k)(11), a SIMPLE 401(k) plan istreated as satisfying the ADP test of sec-tion 401(k)(3)(A)(ii) for that year.

(b) Eligible employer—(1) Generalrule. A SIMPLE 401(k) plan must be

2003-35 I.R.B. 472 September 2, 2003

established by an eligible employer. Eligi-ble employer for purposes of this sectionmeans, with respect to any plan year,an employer that had no more than 100employees who received at least $5,000of SIMPLE compensation, as defined inparagraph (e)(5) of this section, from theemployer for the prior calendar year.

(2) Special rule. An eligible employerthat establishes a SIMPLE 401(k) plan fora plan year and that fails to be an eligi-ble employer for any subsequent plan year,is treated as an eligible employer for the2 plan years following the last plan yearthe employer was an eligible employer. Ifthe failure is due to any acquisition, dispo-sition, or similar transaction involving aneligible employer, the preceding sentenceapplies only if the provisions of section410(b)(6)(C)(i) are satisfied.

(c) Exclusive plan—(1) General rule.The SIMPLE 401(k) plan must be the ex-clusive plan for each SIMPLE 401(k) planparticipant for the plan year. This require-ment is satisfied if there are no contribu-tions made, or benefits accrued, for ser-vices during the plan year on behalf ofany SIMPLE 401(k) plan participant un-der any other qualified plan maintained bythe employer. Other qualified plan for pur-poses of this section means any plan, con-tract, pension, or trust described in section219(g)(5)(A) or (B).

(2) Special rule. A SIMPLE 401(k)plan will not be treated as failing the re-quirements of this paragraph (c) merelybecause any SIMPLE 401(k) plan partic-ipant receives an allocation of forfeituresunder another plan of the employer.

(d) Election and notice—(1) Generalrule. An eligible employer establishing ormaintaining a SIMPLE 401(k) plan mustsatisfy the election and notice require-ments in paragraphs (d)(2) and (d)(3) ofthis section.

(2) Employee elections—(i) Initial planyear of participation. For the plan year inwhich an employee first becomes eligibleunder the SIMPLE 401(k) plan, the em-ployee must be permitted to make a cashor deferred election under the plan duringa 60-day period that includes either the daythe employee becomes eligible or the daybefore.

(ii) Subsequent plan years. For eachsubsequent plan year, each eligible em-ployee must be permitted to make or mod-ify his cash or deferred election during the

60-day period immediately preceding suchplan year.

(iii) Election to terminate. An eligibleemployee must be permitted to terminatehis cash or deferred election at any time.If an employee does terminate his cash ordeferred election, the plan is permitted toprovide that such employee cannot haveelective contributions made under the planfor the remainder of the plan year.

(3) Employee notices. The employermust notify each eligible employee withina reasonable time prior to each 60-dayelection period, or on the day the electionperiod starts, that he or she can make a cashor deferred election, or modify a prior elec-tion, if applicable, during that period. Thenotice must state whether the eligible em-ployer will make the matching contribu-tions described in paragraph (e)(3) of thissection or the nonelective contributions de-scribed in paragraph (e)(4) of this section.

(e) Contributions—(1) General rule.A SIMPLE 401(k) plan satisfies the con-tribution requirements of this paragraph(e) for a plan year only if no contributionsmay be made to the SIMPLE 401(k) planduring such year, other than contributionsdescribed in this paragraph (e) and rollovercontributions described in §1.402(c)–2,Q&A–1(a).

(2) Elective contributions. Subject tothe limitations on annual additions un-der section 415, each eligible employeemust be permitted to make an electionto have up to $10,000 of elective contri-butions made on the employee's behalfunder the SIMPLE 401(k) plan for a planyear. The $10,000 limit is increased be-ginning in 2006 in the same manner asthe $160,000 amount is adjusted undersection 415(d), except that pursuant tosection 408(p)(2)(E)(ii) the base periodshall be the calendar quarter beginningJuly 1, 2004, and any increase which isnot a multiple of $500 is rounded to thenext lower multiple of $500.

(3) Matching contributions. Each planyear, the eligible employer must contributea matching contribution to the account ofeach eligible employee on whose behalfelective contributions were made for theplan year. The amount of the matchingcontribution must equal the lesser of theeligible employee's elective contributionsfor the plan year or 3% of the eligible em-ployee's SIMPLE compensation for the en-tire plan year.

(4) Nonelective contributions. For anyplan year, in lieu of contributing matchingcontributions described in paragraph (e)(3)of this section, an eligible employer may,in accordance with plan terms, contribute anonelective contribution to the account ofeach eligible employee in an amount equalto 2% of the eligible employee's SIMPLEcompensation for the entire plan year. Theeligible employer may limit the nonelec-tive contributions to those eligible employ-ees who received at least $5,000 of SIM-PLE compensation from the employer forthe entire plan year.

(5) SIMPLE compensation. Exceptas otherwise provided, the term SIMPLEcompensation for purposes of this sectionmeans the sum of wages, tips, and othercompensation from the eligible employersubject to federal income tax withholding(as described in section 6051(a)(3)) andthe employee's elective contributions madeunder any other plan, and if applicable,elective deferrals under a section 408(p)SIMPLE IRA plan, a section 408(k)(6)SARSEP, or a plan or contract that satis-fies the requirements of section 403(b),and compensation deferred under a section457 plan, required to be reported by theemployer on Form W–2 (as described insection 6051(a)(8)). For self-employed in-dividuals, SIMPLE compensation meansnet earnings from self-employment de-termined under section 1402(a) prior tosubtracting any contributions made underthe SIMPLE 401(k) plan on behalf of theindividual.

(f) Vesting. All benefits attributable tocontributions described in paragraph (e) ofthis section must be nonforfeitable at alltimes.

(g) Plan year. The plan year of a SIM-PLE 401(k) plan must be the whole cal-endar year. Thus, in general, a SIMPLE401(k) plan can be established only on Jan-uary 1 and can be terminated only on De-cember 31. However, in the case of anemployer that did not previously maintaina SIMPLE 401(k) plan, the establishmentdate can be as late as October 1 (or later inthe case of an employer that comes into ex-istence after October 1 and establishes theSIMPLE 401(k) plan as soon as adminis-tratively feasible after the employer comesinto existence).

(h) Other rules. A SIMPLE 401(k) planis not treated as a top-heavy plan undersection 416. See section 416(g)(4)(G).

September 2, 2003 473 2003-35 I.R.B.

§1.401(k)–5 Special rules for mergers,acquisitions and similar events.[Reserved].

§1.401(k)–6 Definitions.

Unless otherwise provided, the defini-tions of this section govern for purposes ofsection 401(k) and the regulations thereun-der.

Actual contribution percentage (ACP)test. Actual contribution percentage testor ACP test means the test described in§1.401(m)–2(a)(1).

Actual deferral percentage (ADP). Ac-tual deferral percentage or ADP means theADP of the group of eligible employees asdefined in §1.401(k)–2(a)(2).

Actual deferral percentage (ADP)test. Actual deferral percentage test orADP test means the test described in§1.401(k)–2(a)(1).

Actual deferral ratio (ADR). Actualdeferral ratio or ADR means the ADRof an eligible employee as defined in§1.401(k)–2(a)(3).

Cash or deferred arrangement. Cashor deferred arrangement is defined in§1.401(k)–1(a)(2).

Cash or deferred election. Cashor deferred election is defined in§1.401(k)–1(a)(3).

Compensation. Compensation meanscompensation as defined in section 414(s)and §1.414(s)–1. The period used to de-termine an employee's compensation fora plan year must be either the plan yearor the calendar year ending within theplan year. Whichever period is selectedmust be applied uniformly to determinethe compensation of every eligible em-ployee under the plan for that plan year.A plan may, however, limit the periodtaken into account under either methodto that portion of the plan year or cal-endar year in which the employee wasan eligible employee, provided that thislimit is applied uniformly to all eligibleemployees under the plan for the planyear. In the case of an HCE whose ADRis determined under §1.401(k)–2(a)(3)(ii),period of participation includes peri-ods under another plan for which elec-tive contributions are aggregated under§1.401(k)–2(a)(3)(ii). See also section401(a)(17) and §1.401(a)(17)–1(c)(1).

Current year testing method. Currentyear testing method means the testing

method described in §1.401(k)–2(a)(2)(ii)or §1.401(m)–2(a)(2)(ii) under which theapplicable year is the current plan year.

Elective contributions. Elective con-tributions means employer contributionsmade to a plan pursuant to a cash or de-ferred election under a cash or deferredarrangement (whether or not the arrange-ment is a qualified cash or deferred ar-rangement under §1.401(k)–1(a)(4)).

Eligible employee—(1) General rule.Eligible employee means an employee whois directly or indirectly eligible to make acash or deferred election under the plan forall or a portion of the plan year. For exam-ple, if an employee must perform purelyministerial or mechanical acts (e.g., formalapplication for participation or consent topayroll withholding) in order to be eligibleto make a cash or deferred election for aplan year, the employee is an eligible em-ployee for the plan year without regard towhether the employee performs the acts.

(2) Conditions on eligibility. An em-ployee who is unable to make a cash ordeferred election because the employeehas not contributed to another plan isalso an eligible employee. By contrast,if an employee must perform additionalservice (e.g., satisfy a minimum periodof service requirement) in order to be eli-gible to make a cash or deferred electionfor a plan year, the employee is not aneligible employee for the plan year unlessthe service is actually performed. See§1.401(k)–1(e)(5), however, for certainlimits on the use of minimum service re-quirements. An employee who would beeligible to make elective contributions butfor a suspension due to a distribution, aloan, or an election not to participate in theplan, is treated as an eligible employee forpurposes of section 401(k)(3) for a planyear even though the employee may notmake a cash or deferred election by reasonof the suspension. Finally, an employeedoes not fail to be treated as an eligibleemployee merely because the employeemay receive no additional annual additionsbecause of section 415(c)(1).

(3) Certain one-time elections. An em-ployee is not an eligible employee merelybecause the employee, upon commencingemployment with the employer or upon theemployee's first becoming eligible to makea cash or deferred election under any ar-rangement of the employer, is given the

one-time opportunity to elect, and the em-ployee does in fact elect, not to be eligi-ble to make a cash or deferred election un-der the plan or any other plan maintainedby the employer (including plans not yetestablished) for the duration of the em-ployee's employment with the employer.This rule applies in addition to the rulesin §1.401(k)–1(a)(3)(v) relating to the def-inition of a cash or deferred election. Inno event is an election made after De-cember 23, 1994, treated as a one-time ir-revocable election under this paragraph ifthe election is made by an employee whopreviously became eligible under anotherplan (whether or not terminated) of the em-ployer.

Eligible HCE. Eligible HCE means aneligible employee who is an HCE.

Eligible NHCE. Eligible NHCE meansan eligible employee who is not an HCE.

Employee. Employee means an em-ployee within the meaning of §1.410(b)–9.

Employee stock ownership plan(ESOP). Employee stock ownership planor ESOP means the portion of a planthat is an ESOP within the meaning of§1.410(b)–7(c)(2).

Employer. Employer means an em-ployer within the meaning of §1.410(b)–9.

Excess contributions. Excess contri-butions means, with respect to a planyear, the amount of total excess contri-butions apportioned to an HCE under§1.401(k)–2(b)(2)(iii).

Excess deferrals. Excess deferralsmeans excess deferrals as defined in§1.402(g)–1(e)(3).

Highly compensated employee (HCE).Highly compensated employee or HCE hasthe meaning provided in section 414(q).

Matching contributions. Matching con-tributions means matching contributionsas defined in §1.401(m)–1(a)(2).

Nonelective contributions. Nonelectivecontributions means employer contribu-tions (other than matching contributions)with respect to which the employee maynot elect to have the contributions paidto the employee in cash or other benefitsinstead of being contributed to the plan.

Non-employee stock ownership plan(non-ESOP). Non-employee stock owner-ship plan or non-ESOP means the portionof a plan that is not an ESOP within themeaning of §1.410(b)–7(c)(2).

2003-35 I.R.B. 474 September 2, 2003

Non-highly compensated employee(NHCE). Non-highly compensated em-ployee or NHCE means an employee whois not an HCE.

Plan. Plan is defined in§1.401(k)–1(b)(4).

Pre-ERISA money purchase pensionplan. (1) Pre-ERISA money purchasepension plan is a pension plan—

(i) That is a defined contribution plan(as defined in section 414(i));

(ii) That was in existence on June 27,1974, and as in effect on that date, includeda salary reduction agreement; and

(iii) Under which neither the employeecontributions nor the employer contri-butions, including elective contributions,may exceed the levels (as a percentage ofcompensation) provided for by the contri-bution formula in effect on June 27, 1974.

(2) A plan was in existence on June 27,1974, if it was a written plan adopted on orbefore that date, even if no funds had yetbeen paid to the trust associated with theplan.

Prior year testing method. Prioryear testing method means the test-ing method under which the appli-cable year is the prior plan year, asdescribed in §1.401(k)–2(a)(2)(ii) or§1.401(m)–2(a)(2)(ii).

Qualified matching contributions(QMACs). Qualified matching con-tributions or QMACs means matchingcontributions that, except as providedotherwise in §1.401(k)–1(c) and (d), sat-isfy the requirements of §1.401(k)–1(c)and (d) as though the contributions wereelective contributions, without regardto whether the contributions are actu-ally taken into account under the ADPtest under §1.401(k)–2(a)(6) or the ACPtest under §1.401(m)–2(a)(6). Thus, thematching contributions must satisfy thevesting requirements of §1.401(k)–1(c)and be subject to the distribution re-quirements of §1.401(k)–1(d) when theyare contributed to the plan. See also§1.401(k)–2(b)(4)(iii) for a rule providingthat a matching contribution does not failto qualify as a QMAC solely because itis forfeitable under section 411(a)(3)(G)because it is a matching contribution withrespect to an excess deferral, excess con-tribution, or excess aggregate contribution.

Qualified nonelective contributions(QNECs). Qualified nonelective con-tributions or QNECs means employer

contributions, other than elective con-tributions or matching contributions,that, except as provided otherwise in§1.401(k)–1(c) and (d), satisfy the re-quirements of §1.401(k)–1(c) and (d)as though the contributions were elec-tive contributions, without regard towhether the contributions are actuallytaken into account under the ADP testunder §1.401(k)–2(a)(6) or the ACP testunder §1.401(m)–2(a)(6). Thus, the non-elective contributions must satisfy thevesting requirements of §1.401(k)–1(c)and be subject to the distribution require-ments of §1.401(k)–1(d) when they arecontributed to the plan.

Rural cooperative plans. Rural cooper-ative plan means a plan described in sec-tion 401(k)(7).

Par. 3. Sections 1.401(m)–0 through1.401(m)–2 are revised and sections1.401(m)–3 through 1.401(m)–5 areadded to read as follows:

§1.401(m)–0 Table of contents.

This section contains first a list of sec-tion headings and then a list of the para-graphs in each section in §§1.401(m)–1through 1.401(m)–5.

LIST OF SECTIONS

§1.401(m)–1 Employee contributions andmatching contributions.§1.401(m)–2 ACP test.§1.401(m)–3 Safe harbor requirements.§1.401(m)–4 Special rules for mergers, ac-quisitions and similar events. [Reserved].§1.401(m)–5 Definitions.

LIST OF PARAGRAPHS

§1.401(m)–1 Employee contributions andmatching contributions.

(a) General nondiscrimination rules.(1) Nondiscriminatory amount of contribu-tions.(i) Exclusive means of amounts testing.(ii) Testing benefits, rights and features.(2) Matching contributions.(i) In general.(ii) Employer contributions made on ac-count of an employee contribution or elec-tive deferral.(iii) Employer contributions not on ac-count of an employee contribution orelective deferral.

(3) Employee contributions.(i) In general.(ii) Certain contributions not treated as em-ployee contributions.(iii) Qualified cost-of-living arrangements.(b) Nondiscrimination requirements foramount of contributions.(1) Matching contributions and employeecontributions.(2) Automatic satisfaction by certain plans.(3) Anti-abuse provisions.(4) Aggregation and restructuring.(i) In general.(ii) Aggregation of employee contributionsand matching contributions within a plan.(iii) Aggregation of plans.(A) In general.(B) Arrangements with inconsistent ACPtesting methods.(iv) Disaggregation of plans and separatetesting.(A) In general.(B) Restructuring prohibited.(v) Certain disaggregation rules not appli-cable.(c) Additional requirements.(1) Separate testing for employee contribu-tions and matching contributions.(2) Plan provision requirement.(d) Effective date.

§1.401(m)–2 ACP test.

(a) Actual contribution percentage (ACP)test.(1) In general.(i) ACP test formula.(ii) HCEs as sole eligible employees.(iii) Special rule for early participation.(2) Determination of ACP.(i) General rule.(ii) Determination of applicable year undercurrent year and prior year testing method.(3) Determination of ACR.(i) General rule.(ii) ACR of HCEs eligible under more thanone plan.(A) General rule.(B) Plans not permitted to be aggregated.(iii) Example.(4) Employee contributions and matchingcontributions taken into account under theACP test.(i) Employee contributions.(ii) Recharacterized elective contributions.(iii) Matching contributions.(5) Matching contributions not taken intoaccount under the ACP test.

September 2, 2003 475 2003-35 I.R.B.

(i) General rule.(ii) Disproportionate matching contribu-tions.(A) Matching contributions in excess of100%.(B) Representative matching rate.(C) Definition of matching rate.(iii) Qualified matching contributions usedto satisfy the ADP test.(iv) Matching contributions taken into ac-count under safe harbor provisions.(v) Treatment of forfeited matching contri-butions.(6) Qualified nonelective contributions andelective contributions that may be takeninto account under the ACP test.(i) Timing of allocation.(ii) Elective contributions taken into ac-count under the ACP test.(iii) Requirement that amount satisfy sec-tion 401(a)(4).(iv) Aggregation must be permitted.(v) Disproportionate contributions nottaken into account.(A) General rule.(B) Definition of representative contribu-tion rate.(C) Definition of applicable contributionrate.(vi) Contribution only used once.(7) Examples.(b) Correction of excess aggregate contri-butions.(1) Permissible correction methods.(i) In general.(A) Additional contributions.(B) Excess aggregate contributions dis-tributed or forfeited.(ii) Combination of correction methods.(iii) Exclusive means of correction.(2) Correction through distribution.(i) General rule.(ii) Calculation of total amount to be dis-tributed.(A) Calculate the dollar amount of excessaggregate contributions for each HCE.(B) Determination of the total amount ofexcess aggregate contributions.(C) Satisfaction of ACP.(iii) Apportionment of total amount ofexcess aggregate contributions among theHCEs.(A) Calculate the dollar amount of excessaggregate contributions for each HCE.(B) Limit on amount apportioned to anyHCE.(C) Apportionment to additional HCEs.

(iv) Income allocable to excess aggregatecontributions.(A) General rule.(B) Method of allocating income.(C) Alternative method of allocating in-come for the plan year.(D) Safe harbor method of allocating gapperiod income.(E) Alternative method of allocating planyear and gap period income.(F) Allocable income for recharacterizedelective contributions.(v) Distribution and forfeiture.(vi) Tax treatment of corrective distribu-tions.(A) General rule.(B) Rule for de minimis distributions.(3) Other rules.(i) No employee or spousal consent re-quired.(ii) Treatment of corrective distributionsand forfeited contributions as employercontributions.(iii) No reduction of required minimumdistribution.(iv) Partial correction.(v) Matching contributions on excess con-tributions, excess deferrals and excess ag-gregate contributions.(A) Corrective distributions not permitted.(B) Coordination with section 401(a)(4).(vi) No requirement for recalculation.(4) Failure to timely correct.(i) Failure to correct within 21/2 monthsafter end of plan year.(ii) Failure to correct within 12 months af-ter end of plan year.(5) Examples.(c) Additional rules for prior year testingmethod.(1) Rules for change in testing method.(2) Calculation of ACP under the prior yeartesting method for the first plan year.(i) Plans that are not successor plans.(ii) First plan year defined.(iii) Plans that are successor plans.(3) Plans using different testing methodsfor the ACP and ADP test.(4) Rules for plan coverage change.(i) In general.(ii) Optional rule for minor plan coveragechanges.(iii) Definitions.(A) Plan coverage change.(B) Prior year subgroup.(C) Weighted average of the ACPs for theprior year subgroups.(iv) Examples.

§1.401(m)–3 Safe harbor requirements.

(a) ACP test safe harbor.(b) Safe harbor nonelective contributionrequirement.(c) Safe harbor matching contribution re-quirement.(d) Limitation on contributions.(1) General rule.(2) Matching rate must not increase.(3) Limit on matching contributions.(4) Limitation on rate of match.(5) HCEs participating in multiple plans.(6) Permissible restrictions on elective de-ferrals by NHCEs.(i) General rule.(ii) Restrictions on election periods.(iii) Restrictions on amount of contribu-tions.(iv) Restrictions on types of compensationthat may be deferred.(v) Restrictions due to limitations underthe Internal Revenue Code.(e) Notice requirement.(f) Plan year requirement.(1) General rule.(2) Initial plan year.(3) Change of plan year.(4) Final plan year.(g) Plan amendments adopting nonelectivesafe harbor contributions.(h) Permissible reduction or suspension ofsafe harbor matching contributions.(1) General rule.(2) Notice of suspension requirement.(i) Reserved.(j) Other rules.(1) Contributions taken into account.(2) Use of safe harbor nonelective contri-butions to satisfy other nondiscriminationtests.(3) Early participation rules.(4) Satisfying safe harbor contribution re-quirement under another defined contribu-tion plan.(5) Contributions used only once.(6) Plan must satisfy ACP with respect toemployee contributions.§1.401(m)–4 Special rules for mergers, ac-quisitions and similar events. [Reserved].

§1.401(m)–5 Definitions.

§1.401(m)–1 Employee contributions andmatching contributions.

(a) General nondiscriminationrules—(1) Nondiscriminatory amountof contributions—(i) Exclusive means of

2003-35 I.R.B. 476 September 2, 2003

amounts testing. A defined contributionplan does not satisfy section 401(a) for aplan year unless the amount of employeecontributions and matching contributionsto the plan for the plan year satisfies sec-tion 401(a)(4). The amount of employeecontributions and matching contributionsunder a plan satisfies the requirements ofsection 401(a)(4) with respect to amountsif and only if the amount of employeecontributions and matching contributionssatisfies the nondiscrimination test of sec-tion 401(m) under paragraph (b) of thissection and the plan satisfies the additionalrequirements of paragraph (c) of this sec-tion. See §1.401(a)(4)–1(b)(2)(ii)(B).

(ii) Testing benefits, rights and fea-tures. A plan that provides for employeecontributions or matching contributionsmust satisfy the requirements of section401(a)(4) relating to benefits, rights andfeatures in addition to the requirementregarding amounts described in paragraph(a)(1)(i) of this section. For example,the right to make each level of employeecontributions and the right to each levelof matching contributions under the planare benefits, rights or features subject tothe requirements of section 401(a)(4).See §1.401(a)(4)–4(e)(3)(i) and (iii)(F)through (G).

(2) Matching contributions—(i) Ingeneral. For purposes of section 401(m),this section and §§1.401(m)–2 through1.401(m)–5, matching contributions are—

(A) Any employer contribution (includ-ing a contribution made at the employer'sdiscretion) to a defined contribution planon account of an employee contribution toa plan maintained by the employer;

(B) Any employer contribution (includ-ing a contribution made at the employer'sdiscretion) to a defined contribution planon account of an elective deferral; and

(C) Any forfeiture allocated on the basisof employee contributions, matching con-tributions, or elective deferrals.

(ii) Employer contributions made onaccount of an employee contribution orelective deferral. Whether an employercontribution is made on account of anemployee contribution or an elective de-ferral is determined on the basis of all therelevant facts and circumstances, includ-ing the relationship between the employercontribution and employee actions outsidethe plan. An employer contribution madeto a defined contribution plan on account

of contributions made by an employeeunder an employer-sponsored savingsarrangement that are not held in a planthat is intended to be a qualified plan or aplan described in §1.402(g)–1(b) is not amatching contribution.

(iii) Employer contributions not on ac-count of an employee contribution or elec-tive deferral. An employer contribution isnot a matching contribution made on ac-count of an elective deferral if it is con-tributed before the cash or deferred elec-tion is made or before the employee's per-formance of services with respect to whichthe elective deferral is made (or when thecash that is subject to the cash or deferredelection would be currently available, ifearlier). In addition, an employer contri-bution is not a matching contribution madeon account of an employee contribution ifit is contributed before the employee con-tribution.

(3) Employee contributions—(i) Ingeneral. For purposes of section 401(m),this section and §§1.401(m)–2 through1.401(m)–5, employee contributions arecontributions to a plan that are designatedor treated at the time of contribution asafter-tax employee contributions (e.g.,by treating the contributions as taxableincome subject to applicable withholdingrequirements) and are allocated to an indi-vidual account for each eligible employeeto which attributable earnings and lossesare allocated. See §1.401(k)–1(a)(2)(ii).The term employee contributions in-cludes—

(A) Employee contributions to the de-fined contribution portion of a plan de-scribed in section 414(k);

(B) Employee contributions applied tothe purchase of whole life insurance pro-tection or survivor benefit protection undera defined contribution plan;

(C) Amounts attributable to excesscontributions within the meaning ofsection 401(k)(8)(B) that are recharac-terized as employee contributions under§1.401(k)–2(b)(3); and

(D) Employee contributions to a plan orcontract that satisfies the requirements ofsection 403(b).

(ii) Certain contributions not treated asemployee contributions. The term em-ployee contributions does not include re-payment of loans, repayment of distribu-tions described in section 411(a)(7)(C), or

employee contributions that are transferredto the plan from another plan.

(iii) Qualified cost-of-living arrange-ments. Employee contributions to aqualified cost-of-living arrangement de-scribed in section 415(k)(2)(B) are treatedas employee contributions to a definedcontribution plan, without regard to therequirement that the employee contribu-tions be allocated to an individual accountto which attributable earnings and lossesare allocated.

(b) Nondiscrimination requirements foramount of contributions—(1) Matchingcontributions and employee contributions.The matching contributions and employeecontributions under a plan satisfy thisparagraph (b) for a plan year only if theplan satisfies—

(i)The ACP test of section 401(m)(2)described in §1.401(m)–2;

(ii) The ACP safe harbor provisionsof section 401(m)(11) described in§1.401(m)–3; or

(iii) The SIMPLE 401(k) provisions ofsections 401(k)(11) and 401(m)(10) de-scribed in §1.401(k)–4.

(2) Automatic satisfaction by cer-tain plans. Notwithstanding paragraph(b)(1) of this section, the requirements ofthis section are treated as satisfied withrespect to employee contributions andmatching contributions under a collec-tively bargained plan (or the portion ofa plan) that automatically satisfies sec-tion 410(b). See §§1.401(a)(4)–1(c)(5)and 1.410(b)–2(b)(7). Additionally, therequirements of sections 401(a)(4) and410(b) do not apply to a governmen-tal plan (within the meaning of section414(d)) maintained by a state or local gov-ernment or political subdivision thereof(or agency or instrumentality thereof). Seesections 401(a)(5)(G), 403(b)(12)(C) and410(c)(1)(A).

(3) Anti-abuse provisions. Sections1.401(m)–1 through 1.401(m)–5 aredesigned to provide simple, practicalrules that accommodate legitimate planchanges. At the same time, the rules areintended to be applied by employers in amanner that does not make use of changesin plan testing procedures or other planprovisions to inflate inappropriately theACP for NHCEs (which is used as abenchmark for testing the ACP for HCEs)or to otherwise manipulate the nondis-crimination testing requirements of this

September 2, 2003 477 2003-35 I.R.B.

paragraph (b). Further, this paragraph (b)is part of the overall requirement that ben-efits or contributions not discriminate infavor of HCEs. Therefore, a plan will notbe treated as satisfying the requirementsof this paragraph (b) if there are repeatedchanges to plan testing procedures or planprovisions that have the effect of distortingthe ACP so as to increase significantly thepermitted ACP for HCEs, or otherwisemanipulate the nondiscrimination rules ofthis paragraph, if a principal purpose ofthe changes was to achieve such a result.

(4) Aggregation and restructuring—(i)In general. This paragraph (b)(4) con-tains the exclusive rules for aggregatingand disaggregating plans that provide foremployee contributions and matching con-tributions for purposes of this section and§§1.401(m)–2 through 1.401(m)–5.

(ii) Aggregation of employee contribu-tions and matching contributions withina plan. Except as otherwise specificallyprovided in this paragraph (b)(4) and§1.401(m)–3(f)(1), a plan must be subjectto a single test under paragraph (b)(1) ofthis section with respect to all employeecontributions and matching contributionsand all eligible employees under theplan. Thus, for example, if two groupsof employees are eligible for matchingcontributions under a plan, all employeecontributions and matching contributionsunder the plan must be subject to a singletest, even if they have significantly dif-ferent features, such as different rates ofmatch.

(iii) Aggregation of plans—(A) Ingeneral. The term plan means a planwithin the meaning of §1.410(b)–7(a) and(b), after application of the mandatorydisaggregation rules of §1.410(b)–7(c),and the permissive aggregation rules of§1.410(b)–7(d), as modified by paragraph(b)(4)(v) of this section. Thus, for ex-ample, two plans (within the meaning of§1.410(b)–7(b)) that are treated as a singleplan pursuant to the permissive aggrega-tion rules of §1.410(b)–7(d) are treatedas a single plan for purposes of sections401(k) and 401(m).

(B) Arrangements with inconsistentACP testing methods. Pursuant to para-graph (b)(4)(ii) of this section, a singletesting method must apply with respect toall employee contributions and matchingcontributions and all eligible employees

under a plan. Thus, in applying the permis-sive aggregation rules of §1.410(b)–7(d),an employer may not aggregate plans(within the meaning of §1.410(b)–7(b))that apply inconsistent testing methods.For example, a plan (within the meaningof §1.410(b)–7) that applies the currentyear testing method may not be aggre-gated with another plan that applies theprior year testing method. Similarly, anemployer may not aggregate a plan (withinthe meaning of §1.410(b)–7) that is usingthe ACP safe harbor provisions of section401(m)(11) and another plan that is usingthe ACP test of section 401(m)(2).

(iv) Disaggregation of plans and sepa-rate testing—(A) In general. If employeecontributions or matching contributionsare included in a plan (within the meaningof §1.410(b)–7(b)) that is mandatorilydisaggregated under the rules of section410(b) (as modified by this paragraph(b)(4)), the matching contributions andemployee contributions under that planmust be disaggregated in a consistentmanner. For example, in the case ofan employer that is treated as operatingqualified separate lines of business undersection 414(r), if the eligible employeesunder a plan which provides for employeecontributions or matching contributionsare in more than one qualified separate lineof business, only those employees withineach qualified separate line of businessmay be taken into account in determiningwhether each disaggregated portion of theplan complies with the requirements ofsection 401(m), unless the employer is ap-plying the special rule for employer-wideplans in §1.414(r)–1(c)(2)(ii) with re-spect to the plan. Similarly, if a plan thatprovides for employee contributions ormatching contributions under which em-ployees are permitted to participate beforethey have completed the minimum age andservice requirements of section 410(a)(1)applies section 410(b)(4)(B) for determin-ing whether the plan complies with section410(b)(1), then the plan must be treatedas two separate plans, one comprisingall eligible employees who have met theminimum age and service requirements ofsection 410(a)(1) and one comprising alleligible employees who have not met theminimum age and service requirements ofsection 410(a)(1), unless the plan is usingthe rule in §1.401(m)–2(a)(1)(iii)(A).

(B) Restructuring prohibited. Restruc-turing under §1.401(a)(4)–9(c) may notbe used to demonstrate compliance withthe requirements of section 401(m). See§1.401(a)(4)–9(c)(3)(ii).

(v) Certain disaggregation rules notapplicable. The mandatory disaggre-gation rules relating to section 401(k)plans and section 401(m) plans set forthin §1.410(b)–7(c)(1) and to ESOP andnon-ESOP portions of a plan set forthin §1.410(b)–7(c)(2) shall not apply forpurposes of this section and §§1.401(m)–2through 1.401(m)–5. Accordingly,notwithstanding §1.410(b)–7(d)(2), anESOP and a non-ESOP which are dif-ferent plans (within the meaning of§1.410(b)–7(b)) are permitted to be aggre-gated for these purposes.

(c) Additional requirements—(1) Sepa-rate testing for employee contributionsand matching contributions. Under§1.410(b)–7(c)(1), the group of em-ployees who are eligible to make em-ployee contributions or eligible to receivematching contributions must satisfy therequirements of section 410(b) as if thoseemployees were covered under a separateplan. The determination of whether theseparate plan satisfies the requirementsof section 410(b) must be made withoutregard to the modifications to the dis-aggregation rules set forth in paragraph(b)(4)(v) of this section. In addition, ex-cept as expressly permitted under section401(k), 410(b)(2)(A)(ii), or 416(c)(2)(A),employee contributions, matching contri-butions and elective contributions takeninto account under §1.401(m)–2(a)(6) maynot be taken into account for purposes ofdetermining whether any other contribu-tions under any plan (including the planto which the employee contributions ormatching contributions are made) satisfythe requirements of section 401(a). Seealso §1.401(a)(4)–11(g)(3)(vii) for specialrules relating to corrections of violationsof the minimum coverage requirements ordiscriminatory rates of matching contribu-tions.

(2) Plan provision requirement. Aplan that provides for employee contribu-tions or matching contributions satisfiesthis section only if it provides that thenondiscrimination requirements of section401(m) will be met. Thus, the plan mustprovide for satisfaction of one of the spe-cific alternatives described in paragraph

2003-35 I.R.B. 478 September 2, 2003

(b)(1) of this section and, if with respect tothat alternative there are optional choices,which of the optional choices will apply.For example, a plan that uses the ACPtest of section 401(m)(2), as described inparagraph (b)(1)(i) of this section, mustspecify whether it is using the currentyear testing method or prior year testingmethod. Additionally, a plan that usesthe prior year testing method must spec-ify whether the ACP for eligible NHCEsfor the first plan year is 3% or the ACPfor the eligible NHCEs for the first planyear. Similarly, a plan that uses the safeharbor method of section 401(m)(11), asdescribed in paragraph (b)(1)(ii) of thissection, must specify whether the safeharbor contribution will be the nonelectivesafe harbor contribution or the matchingsafe harbor contribution and is not per-mitted to provide that ACP testing willbe used if the requirements for the safeharbor are not satisfied. For purposes ofthis paragraph (c)(2), a plan may incorpo-rate by reference the provisions of section401(m)(2) and §1.401(m)–2 if that is thenondiscrimination test being applied.

(d) Effective date. This section and§§1.401(m)–2 through 1.401(m)–5 applyto plan years that begin on or after the datethat is 12 months after the issuance of theseregulations in final form.

§1.401(m)–2 ACP test.

(a) Actual contribution percentage(ACP) test—(1) In general—(i) ACP testformula. A plan satisfies the ACP test fora plan year only if—

(A) The ACP for the eligible HCEs forthe plan year is not more than the ACP forthe eligible NHCEs for the applicable yearmultiplied by 1.25; or

(B) The excess of the ACP for the eli-gible HCEs for the plan year over the ACPfor the eligible NHCEs for the applicableyear is not more than 2 percentage points,and the ACP for the eligible HCEs for theplan year is not more than the ACP forthe eligible NHCEs for the applicable yearmultiplied by 2.

(ii) HCEs as sole eligible employees. If,for the applicable year there are no eligibleNHCEs (i.e., all of the eligible employeesunder the plan for the applicable year areHCEs), the plan is deemed to satisfy theACP test.

(iii) Special rule for early participation.If a plan providing for employee contribu-tions or matching contributions providesthat employees are eligible to participatebefore they have completed the minimumage and service requirements of section410(a)(1)(A), and if the plan applies sec-tion 410(b)(4)(B) in determining whetherthe plan meets the requirements of section410(b)(1), then in determining whether theplan meets the requirements under para-graph (a)(1) of this section either—

(A) Pursuant to section 401(m)(5)(C),the ACP test is performed under the plan(determined without regard to disaggrega-tion under §1.410(b)–7(c)(3)), using theACP for all eligible HCEs for the plan yearand the ACP of eligible NHCEs for the ap-plicable year, disregarding all NHCEs whohave not met the minimum age and servicerequirements of section 410(a)(1)(A); or

(B) Pursuant to §1.401(m)–1(b)(4), theplan is disaggregated into separate plansand the ACP test is performed separatelyfor all eligible employees who have com-pleted the minimum age and service re-quirements of section 410(a)(1)(A) and forall eligible employees who have not com-pleted the minimum age and service re-quirements of section 410(a)(1)(A).

(2) Determination of ACP—(i) Generalrule. The ACP for a group of eligible em-ployees (either eligible HCEs or eligibleNHCEs) for a plan year or applicable yearis the average of the ACRs of eligible em-ployees in the group for that year. TheACP for a group of eligible employees iscalculated to the nearest hundredth of apercentage point.

(ii) Determination of applicable yearunder current year and prior year testingmethod. The ACP test is applied usingthe prior year testing method or the cur-rent year testing method. Under the prioryear testing method, the applicable yearfor determining the ACP for the eligibleNHCEs is the plan year immediately pre-ceding the plan year for which the ACP testis being calculated. Under the prior yeartesting method, the ACP for the eligibleNHCEs is determined using the ACRs forthe eligible employees who were NHCEsin that preceding plan year, regardless ofwhether those NHCEs are eligible employ-ees or NHCEs in the plan year for whichthe ACP test is being performed. Under

the current year testing method, the appli-cable year for determining the ACP for el-igible NHCEs is the same plan year as theplan year for which the ACP test is beingcalculated. Under either method, the ACPfor the eligible HCEs is determined usingthe ACRs of eligible employees who areHCEs for the plan year for which the ACPtest is being performed. See paragraph (c)of this section for additional rules for theprior year testing method.

(3) Determination of ACR—(i) Generalrule. The ACR of an eligible employee forthe plan year or applicable year is the sumof the employee contributions and match-ing contributions taken into account withrespect to such employee (determined un-der the rules of paragraphs (a)(4) and (a)(5)of this section), and the qualified nonelec-tive and elective contributions taken intoaccount under paragraph (a)(6) of this sec-tion for the year, divided by the employee'scompensation taken into account for theyear. The ACR is calculated to the near-est hundredth of a percentage point. If noemployee contributions, matching contri-butions, elective contributions, or qualifiednonelective contributions are taken into ac-count under this section with respect to aneligible employee for the year, the ACR ofthe employee is zero.

(ii) ACR of HCEs eligible under morethan one plan—(A) General rule. Pur-suant to section 401(m)(2)(B), the ACRof an HCE who is an eligible employeein more than one plan of an employer towhich matching contributions or employeecontributions are made is calculated bytreating all contributions with respect tosuch HCE under any such plan as beingmade under the plan being tested. Thus,the ACR for such an HCE is calculated byaccumulating all matching contributionsand employee contributions under any plan(other than a plan described in paragraph(a)(3)(ii)(B) of this section) that would betaken into account under this section forthe plan year, if the plan under which thecontribution was made applied this sectionand had the same plan year. For example,in the case of a plan with a 12-month planyear, the ACR for the plan year of that planfor an HCE who participates in multipleplans of the same employer that provide formatching contributions or employee con-tributions is the sum of all such contri-butions during such 12-month period thatwould be taken into account with respect

September 2, 2003 479 2003-35 I.R.B.

to the HCE under all plans in which theHCE is an eligible employee, divided bythe HCE's compensation for that 12-monthperiod (determined using the compensa-tion definition for the plan being tested),without regard to the plan year of the otherplans and whether those plans are satisfy-ing this section or §1.401(m)–3.

(B) Plans not permitted to be aggre-gated. Contributions under plans thatare not permitted to be aggregated under§1.401(m)–1(b)(4) (determined withoutregard to the prohibition on aggregatingplans with inconsistent testing methodsset forth in §1.401(m)–1(b)(4)(iii)(B)and the prohibition on aggregating planswith different plan years set forth in§1.410(b)–7(d)(5)) are not aggregatedunder this paragraph (a)(3)(ii).

(iii) Example. The following exam-ple illustrates the application of para-graph (a)(3)(ii) of this section. See also§1.401(k)–2(a)(3)(iii) for additional ex-amples of the application of the parallelrule under section 401(k)(3)(A). The ex-ample is as follows:

Example. Employee A, an HCE with compen-sation of $120,000, is eligible to make employeecontributions under Plan S and Plan T, two calen-dar-year profit-sharing plans of Employer H. PlanS and Plan T use the same definition of compensa-tion. Plan S provides a match equal to 50% of eachemployee's contributions and Plan T has no match.During the current plan year, Employee A elects tocontribute $4,000 in employee contributions to PlanT and $4,000 in employee contributions to Plan S.There are no other contributions made on behalf ofEmployee A. Each plan must calculate Employee A'sACR by dividing the total employee contributionsby Employee A and matching contributions underboth plans by $120,000. Therefore, Employee A'sACR under each plan is 8.33% ($4,000+ $4,000+$2,000/$120,000).

(4) Employee contributions and match-ing contributions taken into account underthe ACP test—(i) Employee contributions.An employee contribution is taken into ac-count in determining the ACR for an eligi-ble employee for the plan year or applica-ble year in which the contribution is made.For purposes of the preceding sentence, anamount withheld from an employee's pay(or a payment by the employee to an agentof the plan) is treated as contributed at thetime of such withholding (or payment) ifthe funds paid are transmitted to the trustwithin a reasonable period after the with-holding (or payment).

(ii) Recharacterized elective contribu-tions. Excess contributions recharacter-ized in accordance with §1.401(k)–2(b)(3)

are taken into account as employee con-tributions for the plan year that includesthe time at which the excess contributionis includible in the gross income of the em-ployee under §1.401(k)–2(b)(3)(ii)(A).

(iii) Matching contributions. A match-ing contribution is taken into account indetermining the ACR for an eligible em-ployee for a plan year or applicable yearonly if each of the following requirementsis satisfied—

(A) The matching contribution is allo-cated to the employee's account under theterms of the plan as of a date within thatyear;

(B) The matching contribution is madeon account of (or the matching contri-bution is allocated on the basis of) theemployee's elective deferrals or employeecontributions for that year; and

(C) The matching contribution is actu-ally paid to the trust no later than the end ofthe 12-month period immediately follow-ing the year that contains that date.

(5) Matching contributions not takeninto account under the ACP test—(i) Gen-eral rule. Matching contributions that donot satisfy the requirements of paragraph(a)(4)(iii) of this section may not be takeninto account in the ACP test for the planyear with respect to which the contribu-tions were made, or for any other planyear. Instead, the amount of the match-ing contributions must satisfy the require-ments of section 401(a)(4) (without regardto the ACP test) for the plan year for whichthey are allocated under the plan as if theywere nonelective contributions and werethe only nonelective contributions for thatyear. See §§1.401(a)(4)–1(b)(2)(ii)(B) and1.410(b)–7(c)(1).

(ii) Disproportionate matching contri-butions—(A) Matching contributions inexcess of 100%. A matching contributionwith respect to any employee contributionor elective deferral for an NHCE is nottaken into account under the ACP test tothe extent the matching rate with respectto the employee contribution or electivedeferral exceeds the greater of 100% and2 times the plan's representative matchingrate.

(B) Representative matching rate. Forpurposes of this paragraph (a)(5)(ii), theplan's representative matching rate is thelowest matching rate for any eligibleNHCE among a group of NHCEs thatconsists of half of all eligible NHCEs in

the plan for the plan year who make elec-tive deferrals or employee contributionsfor the plan year (or, if greater, the lowestmatching rate for all eligible NHCEs inthe plan who are employed by the em-ployer on the last day of the plan year andwho make elective deferrals or employeecontributions for the plan year).

(C) Definition of matching rate. Forpurposes of this paragraph (a)(5)(ii), thematching rate for an employee is thematching contributions made for suchemployee divided by the elective deferralsor employee contributions that are beingmatched.

(iii) Qualified matching contributionsused to satisfy the ADP test. Qualifiedmatching contributions that are takeninto account for the ADP test of section401(k)(3) under §1.401(k)–2(a)(6) arenot taken into account in determining aneligible employee's ACR.

(iv) Matching contributions taken intoaccount under safe harbor provisions. Aplan that satisfies the ACP safe harborrequirements of section 401(m)(11) fora plan year but nonetheless must satisfythe requirements of this section becauseit provides for employee contributionsfor such plan year is permitted to applythis section disregarding all matchingcontributions with respect to all eligibleemployees. In addition, a plan that satis-fies the ADP safe harbor requirements of§1.401(k)–3 for a plan year using quali-fied matching contributions but does notsatisfy the ACP safe harbor requirementsof section 401(m)(11) for such plan year ispermitted to apply this section by exclud-ing matching contributions with respect toall eligible employees that do not exceed4% of each employee's compensation. Ifa plan disregards matching contributionspursuant to this paragraph (a)(5)(iv), thedisregard must apply with respect to alleligible employees.

(v) Treatment of forfeited matching con-tributions. A matching contribution that isforfeited because the contribution to whichit relates is treated as an excess contribu-tion, excess deferral, or excess aggregatecontribution is not taken into account forpurposes of this section.

(6) Qualified nonelective contributionsand elective contributions that may betaken into account under the ACP test.Qualified nonelective contributions andelective contributions may be taken into

2003-35 I.R.B. 480 September 2, 2003

account in determining the ACR for aneligible employee for a plan year or ap-plicable year, but only to the extent thecontributions satisfy the following re-quirements—

(i) Timing of allocation. The quali-fied nonelective contribution is allocatedto the employee's account as of a datewithin that year (within the meaning of§1.401(k)–2(a)(4)(i)(A)) and the electivecontribution satisfies §1.401(k)–2(a)(4)(i).Consequently, under the prior year test-ing method, in order to be taken into ac-count in calculating the ACP for the groupof eligible NHCEs for the applicable year,a qualified nonelective contribution mustbe contributed no later than the end of the12-month period following the applicableyear even though the applicable year is dif-ferent than the plan year being tested.

(ii) Elective contributions taken intoaccount under the ACP test. Elective con-tributions may be taken into account forthe ACP test only if the cash or deferredarrangement under which the elective con-tributions are made is required to satisfythe ADP test in §1.401(k)–2(a)(1) and,then only to the extent that the cash ordeferred arrangement would satisfy thattest, including such elective contributionsin the ADP for the plan year or applicableyear. Thus, for example, elective deferralsmade pursuant to a salary reduction agree-ment under an annuity described in section403(b) are not permitted to be taken intoaccount in an ACP test. Similarly, electivecontributions under a cash or deferred ar-rangement that is using the section 401(k)safe harbor described in §1.401(k)–3 cannot be taken into account in an ACP test.

(iii) Requirement that amount satisfysection 401(a)(4). The amount of non-elective contributions, including thosequalified nonelective contributions takeninto account under this paragraph (a)(6)and those qualified nonelective contribu-tions taken into account for the ADP testunder paragraph §1.401(k)–2(a)(6), andthe amount of nonelective contributions,excluding those qualified nonelectivecontributions taken into account underthis paragraph (a)(6) for the ACP testand those qualified nonelective contri-butions taken into account for the ADPtest under paragraph §1.401(k)–2(a)(6),satisfies the requirements of section401(a)(4). See §1.401(a)(4)–1(b)(2). In

the case of an employer that is apply-ing the special rule for employer-wideplans in §1.414(r)–1(c)(2)(ii) with re-spect to the plan, the determination ofwhether the qualified nonelective contri-butions satisfy the requirements of thisparagraph (a)(6)(iii) must be made on anemployer-wide basis regardless of whetherthe plans to which the qualified nonelec-tive contributions are made are satisfyingthe requirements of section 410(b) on anemployer-wide basis. Conversely, in thecase of an employer that is treated as oper-ating qualified separate lines of business,and does not apply the special rule for em-ployer-wide plans in §1.414(r)–1(c)(2)(ii)with respect to the plan, then the determi-nation of whether the qualified nonelectivecontributions satisfy the requirements ofthis paragraph (a)(6)(iii) is not permittedto be made on an employer-wide basisregardless of whether the plans to whichthe qualified nonelective contributions aremade are satisfying the requirements ofsection 410(b) on that basis.

(iv) Aggregation must be permitted.The plan that provides for employee ormatching contributions and the plan orplans to which the qualified nonelectivecontributions or elective contributions aremade are plans that would be permitted tobe aggregated under §1.401(m)–1(b)(4).If the plan year of the plan that providesfor employee or matching contributionsis changed to satisfy the requirementunder §1.410(b)–7(d)(5) that aggregatedplans have the same plan year, qualifiednonelective contributions and electivecontributions may be taken into accountin the resulting short plan year only ifsuch qualified nonelective and electivecontributions could have been taken intoaccount under an ADP test for a plan withthat same short plan year.

(v) Disproportionate contributions nottaken into account—(A) General rule.Qualified nonelective contributions cannotbe taken into account for an applicableyear for an NHCE to the extent suchcontributions exceed the product thatNHCE's compensation and the greater of5% and 2 times the plan's representativecontribution rate. Any qualified non-elective contribution taken into accountin an ADP test under §1.401(k)–2(a)(6)(including the determination of the repre-sentative contribution rate for purposes of

§1.401(k)–2(a)(6)(iv)(B)) is not permittedto be taken into account for purposes ofthis paragraph (a)(6) (including the deter-mination of the representative contributionrate for purposes of paragraph (a)(6)(v)(B)of this section).

(B) Definition of representative contri-bution rate. For purposes of this paragraph(a)(6)(v), the plan's representative contri-bution rate is the lowest applicable contri-bution rate of any eligible NHCE amonga group of eligible NHCEs that consistsof half of all eligible NHCEs for the planyear (or, if greater, the lowest applicablecontribution rate of any eligible NHCE inthe group of all eligible NHCEs for the ap-plicable year and who is employed by theemployer on the last day of the applicableyear).

(C) Definition of applicable contribu-tion rate. For purposes of this paragraph(a)(6)(v), the applicable contribution ratefor an eligible NHCE is the sum of thematching contributions taken into accountunder this section for the employee forthe plan year and the qualified nonelectivecontributions made for that employee forthe plan year, divided by that employee'scompensation for the same period.

(vi) Contribution only used once. Qual-ified nonelective contributions can not betaken into account under this paragraph(a)(6) to the extent such contributionsare taken into account for purposes ofsatisfying any other ACP test, any ADPtest, or the requirements of §1.401(k)–3,1.401(m)–3 or 1.401(k)–4. Thus, for ex-ample, qualified nonelective contributionsthat are made pursuant to §1.401(k)–3(b)cannot be taken into account under theACP test. Similarly, if a plan switchesfrom the current year testing method tothe prior year testing method pursuant to§1.401(m)–2(c)(1), qualified nonelectivecontributions that are taken into accountunder the current year testing method fora plan year may not be taken into accountunder the prior year testing method for thenext plan year.

(7) Examples. The following examplesillustrate the application of this paragraph(a). See §1.401(k)–2(a)(6) for additionalexamples of the parallel rules under sec-tion 401(k)(3)(A). The examples are as fol-lows:

Example 1. (i) Employer L maintains Plan U,a profit-sharing plan under which $.50 matchingcontributions are made for each dollar of employee

September 2, 2003 481 2003-35 I.R.B.

contributions. Plan U uses the current year test-ing method. The chart below shows the average

employee contributions (as a percentage of compen-sation) and matching contributions (as a percentageof compensation) for Plan U's highly compensated

employees and nonhighly compensated employeesfor the 2006 plan year:

EmployeeContributions

MatchingContributions

Actual Contribution Percentage

Highly compensated employees 4% 2% 6%

Nonhighly compensated employees 3% 1.5% 4.5%

(ii) The matching rate for all NHCEs is 50% andthus the matching contributions are not disproportion-ate under paragraph (a)(5)(ii) of this section. Accord-ingly, they are taken into account in determining theACR of eligible employees, as shown in the follow-ing table.

(iii) Because the ACP for the HCEs (6.0%) ex-ceeds 5.63% (4.5% x 1.25), Plan U does not satisfythe ACP test under paragraph (a)(1)(i)(A) of this sec-tion. However, because the ACP for the HCEs does

not exceed the ACP for the NHCEs by more than 2percentage points and the ACP for the HCEs does notexceed the ACP for the NHCEs multiplied by 2 (4.5%x 2 = 9%), the plan satisfies the ACP test under para-graph (a)(1)(i)(B) of this section.

Example 2. (i) Employees A through F are eligi-ble employees in Plan V, a profit-sharing plan of Em-ployer M that includes a cash or deferred arrangementand permits employee contributions. Under Plan V,a $.50 matching contribution is made for each dollar

of elective contributions and employee contributions.Plan V uses the current year testing method and doesnot provide for elective contributions to be taken intoaccount in determining an eligible employee's ACR.For the 2006 plan year, Employees A and B are HCEsand the remaining employees are NHCEs. The com-pensation, elective contributions, employee contribu-tions, and matching contributions for the 2006 planyear are shown in the following table:

Employee Compensation Elective Contributions EmployeeContributions

Matching Contributions

A $190,000 $15,000 $3,500 $9,250

B 100,000 $5,000 $10,000 $7,500

C 85,000 $12,000 $0 $6,000

D 70,000 $9,500 $0 $4,750

E 40,000 $10,000 $0 $5,000

F 10,000 $0 $0 $0

(ii) The matching rate for all NHCEs is 50% andthus the matching contributions are not disproportion-ate under paragraph (a)(5)(ii) of this section. Accord-

ingly, they are taken into account in determining theACR of eligible employees, as shown in the follow-ing table:

Employee Compensation EmployeeContributions

Matching Contributions ACR %

A $190,000 $3,500 $9,250 6.71

B 100,000 $10,000 $7,500 17.50

C 85,000 $0 $6,000 7.06

D 70,000 $0 $4,750 6.79

E 40,000 $0 $5,000 12.50

F 10,000 $0 $0 0

(iii) The ACP for the HCEs is 12.11% ((6.71%+ 17.50%)/2). The ACP for the NHCEs is 6.59%((7.06% + 6.79% + 12.50% + 0.%)/4). Plan V failsto satisfy the ACP test under paragraph (a)(1)(i)(A)of this section because the ACP of highly compen-sated employees is more than 125% of the ACP of thenonhighly compensated employees (6.59% x 1.25 =8.24%). In addition, Plan V fails to satisfy the ACPtest under paragraph (a)(1)(i)(B) of this section be-cause the ACP for the HCEs exceeds the ACP of the

other employees by more than 2 percentage points(6.59% + 2% = 8.59%). Therefore, the plan failsto satisfy the requirements of section 401(m)(2) andparagraph (a)(1) of this section unless the ACP fail-ure is corrected under paragraph (b) of this section.

Example 3. (i) The facts are the same as Example2, except that the plan provides that the nonhighlycompensated employees' elective contributions maybe used to meet the requirements of section 401(m)to the extent needed under that section.

(ii) Pursuant to paragraph (a)(6)(ii) of this sec-tion, the $10,000 of elective contributions for Em-ployee E may be taken into account in determiningthe ACP rather than the ADP to the extent that theplan satisfies the requirements of §1.401(k)–2(a)(1)excluding from the ADP this $10,000. In this case,if the $10,000 were excluded from the ADP for theNHCEs, the ADP for the highly compensated em-ployees is 6.45% (7.89% + 5.00%)/2 and the ADPfor the nonhighly compensated employees would be

2003-35 I.R.B. 482 September 2, 2003

6.92% (14.12% + 13.57% + 0% +0%)/4) and the planwould satisfy the requirements of §1.401(k)–2(a)(1)excluding from the ADP the elective contributionsfor NHCEs that are taken into account under section401(m).

(iii) After taking into account the $10,000 of elec-tive contributions for Employee E in the ACP test,the ACP for the nonhighly compensated employees is

12.84% (7.06% + 6.79% + 37.50 % + 0%)/4. There-fore the plan satisfies the ACP test because the ACPfor the HCEs (12.11%) is less than 1.25 times theACP for the nonhighly compensated employees.

Example 4. (i) The facts are the same as Exam-ple 2, except that Plan V provides for a higher than50% match rate on the elective contributions and em-ployee contributions for all NHCEs. The match rate is

defined as the rate, rounded up to the next whole per-cent, necessary to allow the plan to satisfy the ACPtest, but not in excess of 100%. In this case, an in-crease in the match rate from 50% to 74% will be suf-ficient to allow the plan to satisfy the ACP test. Thus,for the 2006 plan year, the compensation, electivecontributions, employee contributions, matching con-tributions at a 74% match rate of the eligible NHCEs(employees C through F) are shown in the followingtable:

Employee Compensation Elective Contributions EmployeeContributions

Matching Contributions

C $85,000 $12,000 $0 $8,880

D 70,000 $9,500 $0 $7,030

E 40,000 $10,000 $0 $7,400

F 10,000 $0 $0 $0

(ii) The matching rate for all NHCEs is 74% andthus the matching contributions are not disproportion-ate under paragraph (a)(5)(ii) of this section. There-fore, the matching contributions may be taken into ac-count in determining the ACP for the NHCEs.

(iii) The ACP for the NHCEs is 9.75% (10.45%+ 10.04% + 18.50% + 0%)/4. Because the ACP forthe HCEs (12.11%) is less than 1.25 times the ACPfor the NHCEs, the plan satisfies the requirements ofsection 401(m).

Example 5. (i) The facts are the same as Exam-ple 4, except that: Employee E's elective contribu-tions are $2,000 (rather than $10,000) and pursuantto paragraph (a)(6)(ii) of this section, the $2,000 ofelective contributions for Employee E are taken intoaccount in determining the ACP rather than the ADP.In addition, Plan V provides that the higher matchrate is not limited to 100% and applies only for aspecified group of nonhighly compensated employ-ees. The only member of that group is Employee E.

Under the plan provision, the higher match rate is a400% match. Thus, for the 2006 plan year, the com-pensation, elective contributions, employee contribu-tions, matching contributions of the eligible NHCEs(employees C through F) are shown in the followingtable:

Employee Compensation Elective Contributions EmployeeContributions

Matching Contributions

C $85,000 $12,000 $0 $6,000

D 70,000 $9,500 $0 $4,750

E 40,000 $2,000 $0 $8,000

F 10,000 $0 $0 $0

(ii) If the entire matching contribution made onbehalf of Employee E were taken into account underthe ACP test, Plan V would satisfy the test, becausethe ACP for the NHCEs would be 9.71% (7.06% +6.79% + 25.00% + 0%)/4. Because the ACP for theHCEs (12.11%) is less than 1.25 times what the ACPfor the NHCEs would be, the plan would satisfy therequirements of section 401(m).

(iii) Pursuant to paragraph (a)(5)(ii) of this sec-tion, however, matching contributions for an eligibleNHCE that are based on a matching rate in excessof the greater of 100% and twice the plan's repre-sentative matching rate cannot be taken into accountin applying the ACP test. The plan's representativematching rate is the lowest matching rate for any el-igible employee in a group of NHCEs that is at leasthalf of all eligible employees who are NHCEs in theplan for the plan year who make elective contribu-tions or employee contributions for the plan year. ForPlan V, the group of NHCEs who make such contribu-tions consists of Employees C, D and E. The match-ing rates for these three employees are 50%, 50% and400% respectively. The lowest matching rate for a

group of NHCEs that is at least 1/2 of all the NHCEswho make elective contributions or employee con-tributions (or 2 NHCEs) is 50%. Because 400% ismore than twice the plan's representative matchingrate, only the matching contributions made on behalfof Employee E that do not exceed 100% (or in thiscase $2,000) satisfy the requirements of paragraph(a)(5)(ii) of this section and may be taken into ac-count under the ACP test. Accordingly, the ACP forthe NHCEs is 5.96% (7.06% + 6.79% + 10% + 0%)/4and the plan fails to satisfy the requirements of sec-tion 401(m)(2) and paragraph (a)(1) of this sectionunless the ACP failure is corrected under paragraph(b) of this section.

Example 6. (i) The facts are the same as Exam-ple 2, except that Plan V provides a QNEC equal to13% of pay for Employee F that will be taken intoaccount under the ACP test to the extent the contribu-tions satisfy the requirements of paragraph (a)(6) ofthis section.

(ii) Pursuant to paragraph (a)(6)(v) of this section,a QNEC cannot be taken into account in determiningan NHCE's ACR to the extent it exceeds the greater of

5% and the product of the employee's compensationand the plan's representative contribution rate. Theplan's representative contribution rate is two times thelowest applicable contribution rate for any eligibleemployee in a group of NHCEs that is at least half ofall eligible employees who are NHCEs in the plan forthe plan year. For Plan V, the applicable contributionrates for Employees C, D, E and F are 7.06%, 6.79%,12.5% and 13% respectively. The lowest applicablerate for a group of NHCEs that is at least 1/2 of all theNHCEs is 12.50% (the lowest applicable rate for thegroup of NHCEs that consists of Employees E and F).

(iii) Under paragraph (a)(6)(v)(B) of this section,the plan's representative contribution rate is 2 times12.50% or 25.00%. Accordingly, the QNECs for Em-ployee F can be taken into account under the ACP testonly to the extent they do not exceed 25.00% of com-pensation. In this case, all of the QNECs for Em-ployee F may be taken into account under the ACPtest.

(iv) After taking into account the QNECs for Em-ployee F, the ACP for the NHCEs is 9.84% (7.06%+ 6.79% + 12.50% + 13%)/4. Because the ACP for

September 2, 2003 483 2003-35 I.R.B.

the HCEs (12.11%) is less than 1.25 times the ACPfor the NHCEs, the plan satisfies the requirements ofsection 401(m)(2) and paragraph (a)(1) of this sec-tion.

(b) Correction of excess aggregatecontributions—(1) Permissible correc-tion methods—(i) In general. A planthat provides for employee contributionsor matching contributions does not failto satisfy the requirements of section401(m)(2) and paragraph (a)(1) of thissection if the employer, in accordancewith the terms of the plan, uses either ofthe following correction methods—

(A) Additional contributions. The em-ployer makes additional contributions thatare taken into account for the ACP test un-der this section that, in combination withthe other contributions taken into accountunder this section, allow the plan to satisfythe requirements of paragraph (a)(1) of thissection.

(B) Excess aggregate contributions dis-tributed or forfeited. Excess aggregatecontributions are distributed or forfeited inaccordance with paragraph (b)(2) of thissection.

(ii) Combination of correction methods.A plan may provide for the use of either ofthe correction methods described in para-graph (b)(1)(i) of this section, may limitemployee contributions or matching con-tributions in a manner that prevents excessaggregate contributions from being made,or may use a combination of these meth-ods, to avoid or correct excess aggregatecontributions. If a plan uses a combina-tion of correction methods, any contribu-tions made under paragraph (b)(1)(i)(A) ofthis section must be taken into account be-fore application of the correction methodin paragraph (b)(1)(i)(B) of this section.

(iii) Exclusive means of correction. Afailure to satisfy the requirements of para-graph (a)(1) of this section may not be cor-rected using any method other than onedescribed in paragraph (b)(1)(i) or (ii) ofthis section. Thus, excess aggregate con-tributions for a plan year may not be cor-rected by forfeiting vested matching con-tributions, distributing nonvested match-ing contributions, recharacterizing match-ing contributions, or not making match-ing contributions required under the termsof the plan. Similarly, excess aggregatecontributions for a plan year may not re-main unallocated or be allocated to a sus-pense account for allocation to one or more

employees in any future year. In addi-tion, excess aggregate contributions maynot be corrected using the retroactive cor-rection rules of §1.401(a)(4)–11(g). See§1.401(a)(4)–11(g)(3)(vii) and (5).

(2) Correction through distribu-tion—(i) General rule. This paragraph(b)(2) contains the rules for correction ofexcess aggregate contributions througha distribution from the plan. Correctionthrough a distribution generally involvesa four step process. First, the plan mustdetermine, in accordance with paragraph(b)(2)(ii) of this section, the total amountof excess aggregate contributions thatmust be distributed under the plan. Sec-ond, the plan must apportion the totalamount of excess aggregate contributionsamong the HCEs in accordance with para-graph (b)(2)(iii) of this section. Third,the plan must determine the income al-locable to excess aggregate contributionsin accordance with paragraph (b)(2)(iv)of this section. Finally, the plan mustdistribute the apportioned contributions,together with allocable income (or forfeitthe apportioned matching contributions,if forfeitable) in accordance with para-graph (b)(2)(v) of this section. Paragraph(b)(2)(vi) of this section provides rulesrelating to the tax treatment of these dis-tributions.

(ii) Calculation of total amount tobe distributed. The following proceduresmust be used to determine the total amountof the excess aggregate contributions to bedistributed—

(A) Calculate the dollar amount ofexcess aggregate contributions for eachHCE. The amount of excess aggregatecontributions attributable to an HCE for aplan year is the amount (if any) by whichthe HCE's contributions taken into accountunder this section must be reduced for theHCE's ACR to equal the highest permittedACR under the plan. To calculate thehighest permitted ACR under a plan, theACR of the HCE with the highest ACR isreduced by the amount required to causethat HCE's ACR to equal the ACR ofthe HCE with the next highest ACR. Ifa lesser reduction would enable the planto satisfy the requirements of paragraph(b)(2)(ii)(C) of this section, only this lesserreduction applies.

(B) Determination of the total amountof excess aggregate contributions.The process described in paragraph

(b)(2)(ii)(A) of this section must berepeated until the plan would satisfy therequirements of paragraph (b)(2)(ii)(C)of this section. The sum of all reductionsfor all HCEs determined under paragraph(b)(2)(ii)(A) of this section is the totalamount of excess aggregate contributionsfor the plan year.

(C) Satisfaction of ACP. A plan sat-isfies this paragraph (b)(2)(ii)(C) if theplan would satisfy the requirements ofparagraph (a)(1)(i) of this section if theACR for each HCE were determined af-ter the reductions described in paragraph(b)(2)(ii)(A) of this section.

(iii) Apportionment of total amount ofexcess aggregate contributions among theHCEs. The following procedures must beused in apportioning the total amount ofexcess aggregate contributions determinedunder paragraph (b)(2)(ii) of this sectionamong the HCEs—

(A) Calculate the dollar amount ofexcess aggregate contributions for eachHCE. The contributions with respect tothe HCE with the highest dollar amountof contributions taken account under thissection are reduced by the amount re-quired to cause that HCE's contributionsto equal the dollar amount of contribu-tions taken into account under this sectionfor the HCE with the next highest dollaramount of such contributions. If a lesserapportionment to the HCE would enablethe plan to apportion the total amount ofexcess aggregate contributions, only thelesser apportionment would apply.

(B) Limit on amount apportioned toany HCE. For purposes of this paragraph(b)(2)(iii), the contributions for an HCEwho is an eligible employee in more thanone plan of an employer to which matchingcontributions and employee contributionsare made is determined by adding togetherall contributions otherwise taken into ac-count in determining the ACR of the HCEunder the rules of paragraph (a)(3)(ii)of this section. However, the amount ofcontributions apportioned with respect toan HCE must not exceed the amount ofcontributions taken into account under thissection that were actually made on behalfof the HCE to the plan for the plan year.Thus, in the case of an HCE who is aneligible employee in more than one planof the same employer to which employeecontributions or matching contributionsare made and whose ACR is calculated

2003-35 I.R.B. 484 September 2, 2003

in accordance with paragraph (a)(3)(ii) ofthis section, the amount distributed underthis paragraph (b)(2)(iii) will not exceedsuch contributions actually contributed tothe plan for the plan year that are takeninto account under this section for the planyear.

(C) Apportionment to additional HCEs.The procedure in paragraph (b)(2)(iii)(A)of this section must be repeated until thetotal amount of excess aggregate contribu-tions have been apportioned.

(iv) Income allocable to excess ag-gregate contributions—(A) General rule.The income allocable to excess aggregatecontributions is equal to the sum of theallocable gain or loss for the plan yearand, to the extent the excess aggregatecontributions are or will be credited withallocable gain or loss for the period afterthe close of the plan year (the gap period),the allocable gain or loss for the gap pe-riod.

(B) Method of allocating income. Aplan may use any reasonable method forcomputing the income allocable to excessaggregate contributions, provided that themethod does not violate section 401(a)(4),is used consistently for all participants andfor all corrective distributions under theplan for the plan year, and is used by theplan for allocating income to participants'accounts. See §1.401(a)(4)–1(c)(8).

(C) Alternative method of allocating in-come for the plan year. A plan may allo-cate income to excess aggregate contribu-tions for the plan year by multiplying theincome for the plan year allocable to em-ployee contributions, matching contribu-tions and other amounts taken into accountunder this section (including the contribu-tions for the year), by a fraction, the nu-merator of which is the excess aggregatecontributions for the employee for the planyear, and the denominator of which is theaccount balance attributable to employeecontributions and matching contributionsand other amounts taken into account un-der this section as of the beginning of theplan year (including any additional suchcontributions for the plan year).

(D) Safe harbor method of allocat-ing gap period income. A plan may usethe safe harbor method in this paragraph(b)(2)(iv)(D) to determine income on ex-cess aggregate contributions for the gapperiod. Under this safe harbor method,income on excess aggregate contributions

for the gap period is equal to 10% of theincome allocable to excess aggregate con-tributions for the plan year that would bedetermined under paragraph (b)(2)(iv)(C)of this section, multiplied by the numberof calendar months that have elapsed sincethe end of the plan year. For purposes ofcalculating the number of calendar monthsthat have elapsed under the safe harbormethod, a corrective distribution that ismade on or before the fifteenth day of amonth is treated as made on the last dayof the preceding month and a distributionmade after the fifteenth day of a monthis treated as made on the last day of themonth.

(E) Alternative method of allocatingplan year and gap period income. Aplan may determine the allocable gainor loss for the aggregate of the plan yearand the gap period by applying the al-ternative method provided by paragraph(b)(2)(iv)(C) of this section to that ag-gregate period. This is accomplished bysubstituting the income for the plan yearand the gap period for the income for theplan year and by substituting the contribu-tions taken into account under this sectionfor the plan year and the gap period for thecontributions taken into account for theplan year in determining the fraction thatis multiplied by that income.

(F) Allocable income for recharacter-ized elective contributions. If recharacter-ized elective contributions are distributedas excess aggregate contributions, theincome allocable to the excess aggregatecontributions is determined as if rechar-acterized elective contributions had beendistributed as excess contributions. Thus,income must be allocated to the rechar-acterized amounts distributed using themethods in §1.401(k)–2(b)(2)(iv).

(v) Distribution and forfeiture. Within12 months after the close of the plan yearin which the excess aggregate contributionarose, the plan must distribute to each HCEthe contributions apportioned to such HCEunder paragraph (b)(2)(iii) of this section(and the allocable income) to the extentthey are vested or forfeit such amounts, ifforfeitable. Except as otherwise providedin this paragraph (b)(2)(v), a distributionof excess aggregate contributions must bein addition to any other distributions madeduring the year and must be designated as acorrective distribution by the employer. Inthe event of a complete termination of the

plan during the plan year in which an ex-cess aggregate contribution arose, the cor-rective distribution must be made as soonas administratively feasible after the dateof termination of the plan, but in no eventlater than 12 months after the date of termi-nation. If the entire account balance of anHCE is distributed prior to when the planmakes a distribution of excess aggregatecontributions in accordance with this para-graph (b)(2), the distribution is deemed tohave been a corrective distribution of ex-cess aggregate contributions (and income)to the extent that a corrective distributionwould otherwise have been required.

(vi) Tax treatment of corrective distri-butions—(A) General rule. Except as oth-erwise provided in paragraph (b)(2)(vi)(B)of this section, a corrective distributionof excess aggregate contributions (and in-come) that is made within 21/2 months af-ter the end of the plan year for which theexcess aggregate contributions were madeis includible in the employee's gross in-come for the taxable year of the employeeending with or within the plan year forwhich the excess aggregate contributionswere made. A corrective distribution of ex-cess aggregate contributions (and income)that is made more than 21/2 months afterthe plan year for which the excess aggre-gate contributions were made is includiblein the employee's gross income in the tax-able year of the employee in which dis-tributed. The portion of the distributionthat is treated as an investment in the con-tract under section 72 is determined with-out regard to any plan contributions otherthan those distributed as excess aggregatecontributions. Regardless of when the cor-rective distribution is made, it is not sub-ject to the early distribution tax of section72(t). See paragraph (b)(4) of this sec-tion for additional rules relating to the em-ployer excise tax on amounts distributedmore than 21/2 months after the end of theplan year. See also §1.402(c)–2, A–4 pro-hibiting rollover of distributions that areexcess aggregate contributions.

(B) Rule for de minimis distributions.If the total amount of excess aggregatecontributions determined under this para-graph (b)(2), and excess contributionsdetermined under §1.401(k)–2(b)(2) dis-tributed to a recipient under a plan for anyplan year is less than $100 (excluding in-come), a corrective distribution of excessaggregate contributions (and income) is

September 2, 2003 485 2003-35 I.R.B.

includible in gross income in the recipi-ent's taxable year in which the correctivedistribution is made.

(3) Other rules—(i) No employee orspousal consent required. A distributionof excess aggregate contributions (and in-come) may be made under the terms ofthe plan without regard to any notice orconsent otherwise required under sections411(a)(11) and 417.

(ii) Treatment of corrective distri-butions and forfeited contributions asemployer contributions. Excess aggregatecontributions (other than amounts attribut-able to employee contributions), includingforfeited matching contributions, aretreated as employer contributions forpurposes of sections 404 and 415 evenif distributed from the plan. Forfeitedmatching contributions that are reallo-cated to the accounts of other participantsfor the plan year in which the forfeitureoccurs are treated under section 415 asannual additions for the participants towhose accounts they are reallocated andfor the participants from whose accountsthey are forfeited.

(iii) No reduction of required minimumdistribution. A distribution of excessaggregate contributions (and income) isnot treated as a distribution for purposesof determining whether the plan satisfiesthe minimum distribution requirementsof section 401(a)(9). See §1.401(a)(9)–5,A–9(b).

(iv) Partial correction. Any distributionof less than the entire amount of excessaggregate contributions (and allocable in-come) is treated as a pro rata distributionof excess aggregate contributions and allo-cable income.

(v) Matching contributions on excesscontributions, excess deferrals and excessaggregate contributions—(A) Correctivedistributions not permitted. A matchingcontribution may not be distributed merelybecause the contribution to which it relatesis treated as an excess contribution, excessdeferral, or excess aggregate contribution.

(B) Coordination with section401(a)(4). A matching contribution is

taken into account under section 401(a)(4)even if the match is distributed, unless thedistributed contribution is an excess aggre-gate contribution. This requires that, aftercorrection of excess aggregate contribu-tions, each level of matching contributionsbe currently and effectively available to agroup of employees that satisfies section410(b). See §1.401(a)(4)–4(e)(3)(iii)(G).Thus, a plan that provides the same rate ofmatching contributions to all employeeswill not meet the requirements of sec-tion 401(a)(4) if employee contributionsare distributed under this paragraph (b)to HCEs to the extent needed to meetthe requirements of section 401(m)(2),while matching contributions attribut-able to employee contributions remainallocated to the HCEs' accounts. Thisis because the level of matching con-tributions will be higher for a groupof employees that consists entirely ofHCEs. Under section 411(a)(3)(G) and§1.411(a)–4(b)(7), a plan may forfeitmatching contributions attributable toexcess contributions, excess aggregatecontributions and excess deferrals to avoida violation of section 401(a)(4). See also§1.401(a)(4)–11(g)(3)(vii)(B) regardingthe use of additional allocations to theaccounts of NHCEs for the purpose ofcorrecting a discriminatory rate of match-ing contributions. A plan is permitted toprovide for which contributions are to bedistributed to satisfy the ACP test so as toavoid discriminatory matching rates thatwould otherwise violate section 401(a)(4).For example, the plan may provide thatunmatched employee contributions willbe distributed before matched employeecontributions.

(vi) No requirement for recalculation.If the distributions and forfeitures de-scribed in paragraph (b)(2) of this sectionare made, the employee contributionsand matching contributions are treated asmeeting the nondiscrimination test of sec-tion 401(m)(2) regardless of whether theACP for the HCEs, if recalculated after thedistributions and forfeitures, would satisfysection 401(m)(2).

(4) Failure to timely correct—(i) Fail-ure to correct within 21/2 months after endof plan year. If a plan does not correctexcess aggregate contributions within 21/2months after the close of the plan year forwhich the excess aggregate contributionsare made, the employer will be liable fora 10% excise tax on the amount of theexcess aggregate contributions. See sec-tion 4979 and §54.4979–1 of this chapter.Qualified nonelective contributions prop-erly taken into account under paragraph(a)(6) of this section for a plan year mayenable a plan to avoid having excess ag-gregate contributions, even if the contribu-tions are made after the close of the 21/2month period.

(ii) Failure to correct within 12 monthsafter end of plan year. If excess aggregatecontributions are not corrected within 12months after the close of the plan year forwhich they were made, the plan will fail tomeet the requirements of section 401(a)(4)for the plan year for which the excess ag-gregate contributions were made and allsubsequent plan years in which the excessaggregate contributions remain in the trust.

(5) Examples. The following examplesillustrate the application of this paragraph.See also §1.401(k)–2(b) for additional ex-amples of the parallel correction rules ap-plicable to cash or deferred arrangements.For purposes of these examples, none ofthe plans provide for catch-up contribu-tions under section 414(v). The examplesare as follows:

Example 1. (i) Employer L maintains a plan thatprovides for employee contributions and fully vestedmatching contributions. The plan provides that fail-ures of the ACP test are corrected by distribution. In2006, the ACP for the eligible NHCEs is 6%. Thus,the ACP for the eligible HCEs may not exceed 8%.The three HCEs who participate have the followingcompensation, contributions, and ACRs:

2003-35 I.R.B. 486 September 2, 2003

Employee Compensation Employee contributions andmatching contributions

Actual Contribution Ratio

A 200,000 14,000 7%

B 150,000 13,500 9

C 100,000 12,000 12

Average 9.33%

(ii) The total amount of excess aggregate contri-butions for the HCEs is determined under paragraph(b)(2)(ii) of this section as follows: the matchingand employee contributions of Employee C (the HCEwith the highest ACR) is reduced by 3% of compen-sation (or $3,000) in order to reduce the ACR of thatHCE to 9%, which is the ACR of Employee B.

(iii) Because the ACP of the HCEs determinedafter the $3,000 reduction still exceeds 8%, furtherreductions in matching contributions and employeecontributions are necessary in order to reduce theACP of the HCEs to 8%. The employee contributionsand matching contributions for Employees B and Care reduced by an additional .5% of compensation or$1,250 ($750 and $500 respectively). Because theACP of the HCEs determined after the reductionsnow equals 8%, the plan would satisfy the require-ments of (a)(1)(ii) of this section.

(iv) The total amount of excess aggregate con-tributions ($4,250) is apportioned among the HCEsunder paragraph (b)(2)(iii) of this section first to theHCE with the highest amount of matching contribu-tions and employee contributions. Therefore, Em-ployee A is apportioned $500 (the amount required to

cause A's matching contributions and employee con-tributions to equal the next highest dollar amount ofmatching contributions and employee contributions).

(v) Because the total amount of excess aggregatecontributions has not been apportioned, further ap-portionment is necessary. The balance ($3,750) of thetotal amount of excess aggregate contributions is ap-portioned equally among Employees A and B ($1,500to each, the amount required to cause their contri-butions to equal the next highest dollar amount ofmatching contributions and employee contributions).

(vi) Because the total amount of excess aggre-gate contributions has not been apportioned, furtherapportionment is necessary. The balance ($750) ofthe total amount of excess aggregate contributions isapportioned equally among Employees A, B and C($250 to each, the amount required to allocate the to-tal amount of excess aggregate contributions for theplan).

(vii) Therefore, the plan will satisfy the require-ments of paragraph (a)(1) of this section if, by theend of the 12 month period following the end of the2006 plan year, Employee A receives a corrective dis-tribution of excess aggregate contributions equal to

$2,250 ($500 + $1,500 + $250) and allocable income,Employee B receives a corrective distribution of $250and allocable income and Employee C receives a cor-rective distribution of $1,750 ($1,500 + $250) and al-locable income.

Example 2. (i) Employee D is the sole HCE whois eligible to participate in a cash or deferred arrange-ment maintained by Employer M. The plan that in-cludes the arrangement, Plan X, permits employeecontributions and provides a fully vested matchingcontribution equal to 50% of elective contributions.Plan X is a calendar year plan. Plan X corrects ex-cess contributions by recharacterization and providesthat failures of the ACP test are corrected by distri-bution. For the 2006 plan year, D's compensation is$200,000, and D's elective contributions are $15,000.The actual deferral percentages and actual contribu-tion percentages for Employee D and the other eligi-ble employees under Plan X are shown in the follow-ing table:

Actual Deferral Percentage Actual Contribution Percentage

Employee D 7.5% 3.75%

NHCEs 4% 2%

(ii) In February 2007, Employer M determinesthat D's actual deferral ratio must be reduced to 6%,or $12,000, which requires a recharacterization of$3,000 as an employee contribution. This increasesD's actual contribution ratio to 5.25% ($7,500 inmatching contributions plus $3,000 recharacterizedas employee contributions, divided by $200,000 incompensation). Since D's actual contribution ratiomust be limited to 4% for Plan X to satisfy the actualcontribution percentage test, Plan X must distribute1.25% or $2,500 of D's employee contributionsand matching contributions together with allocableincome. If $2,500 in matching contributions andallocable income is distributed, this will correct theexcess aggregate contributions and will not result ina discriminatory rate of matching contributions. SeeExample 8.

Example 3. (i) The facts are the same as in Ex-ample 2, except that Employee D also had electivecontributions under Plan Y, maintained by an em-ployer unrelated to M. In January 2007, D requestsand receives a distribution of $1,200 in excess defer-rals from Plan X. Pursuant to the terms of Plan X, Dforfeits the $600 match on the excess deferrals to cor-rect a discriminatory rate of match.

(ii) The $3,000 that would otherwise have beenrecharacterized for Plan X to satisfy the actual de-ferral percentage test is reduced by the $1,200 al-ready distributed as an excess deferral, leaving $1,800to be recharacterized. See §1.401(k)–2(b)(4)(i)(A).D's actual contribution ratio is now 4.35% ($7,500in matching contributions plus $1,800 in recharacter-ized contributions less $600 forfeited matching con-tributions attributable to the excess deferrals, dividedby $200,000 in compensation).

(iii) The matching and employee contributions forEmployee D must be reduced by .35% of compen-sation in order to reduce the ACP of the HCEs to4%. The plan must provide for forfeiture of addi-tional matching contributions to prevent a discrimi-natory rate of matching contributions. See Example8.

Example 4. (i) The facts are the same as in Exam-ple 3, except that D does not request a distribution ofexcess deferrals until March 2007. Employer X hasalready recharacterized $3,000 as employee contribu-tions.

(ii) Under §1.402(g)–1(e)(6), the amount ofexcess deferrals is reduced by the amount of excesscontributions that are recharacterized. Because the

amount recharacterized is greater than the excessdeferrals, Plan X is neither required nor permittedto make a distribution of excess deferrals, and therecharacterization has corrected the excess deferrals.

Example 5. (i) For the 2006 plan year, EmployeeF defers $10,000 under Plan M and $6,000 under PlanN. Plans M and N, which have calendar plan years aremaintained by unrelated employers. Plan M providesa fully vested, 100% matching contribution, does nottake elective contributions into account under section401(m) or take matching contributions into accountunder section 401(k) and provides that excess contri-butions and excess aggregate contributions are cor-rected by distribution. Under Plan M, Employee F isallocated excess contributions of $600 and excess ag-gregate contributions of $1,600. Employee F timelyrequests and receives a distribution of the $1,000 ex-cess deferral from Plan M and, pursuant to the termsof Plan M, forfeits the corresponding $1,000 match-ing contribution.

(ii) No distribution is required or permitted tocorrect the excess contributions because $1,000 hasbeen distributed by Plan M as excess deferrals. Thedistribution required to correct the excess aggregate

September 2, 2003 487 2003-35 I.R.B.

contributions (after forfeiting the matching contribu-tion) is $600 ($1,600 in excess aggregate contribu-tions minus $1,000 in forfeited matching contribu-tions). If Employee F had corrected the excess de-ferrals of $1,000 by withdrawing $1,000 from PlanN, Plan M would have had to correct the $600 excesscontributions in Plan M by distributing $600. SinceEmployee F then would have forfeited $600 (insteadof $1,000) in matching contributions, Employee Fwould have had $1,000 ($1,600 in excess aggregatecontributions minus $600 in forfeited matching con-tributions) remaining of excess aggregate contribu-tions in Plan M. These would have been corrected bydistributing an additional $1,000 from Plan M.

Example 6. (i) Employee G is the sole highlycompensated employee in a profit sharing plan un-der which the employer matches 100% of employeecontributions up to 2% of compensation, and 50% ofemployee contributions up to the next 4% of com-pensation. For the 2008 plan year, Employee G hascompensation of $100,000 and makes a 7% employeecontribution of $7,000. Employee G receives a 4%matching contribution or $4,000. Thus, EmployeeG's actual contribution ratio (ACR) is 11%. The ac-tual contribution percentage for the nonhighly com-pensated employees is 5%, and the employer deter-mines that Employee G's ACR must be reduced to 7%to comply with the rules of section 401(m).

(ii) In this case, the plan satisfies the require-ments of section if it distributes the unmatchedemployee contributions of $1,000, and $2,000 ofmatched employee contributions with their relatedmatches of $1,000. This would leave Employee Gwith 4% employee contributions, and 3% matchingcontributions, for an ACR of 7%. Alternatively,the plan could distribute all matching contributionsand satisfy this section. However, the plan couldnot distribute $4,000 of Employee G's employeecontributions without forfeiting the related matchingcontributions because this would result in a discrim-inatory rate of matching contributions. See alsoExample 7.

Example 7. (i) Employee H is an HCE in Em-ployer X's profit sharing plan, which matches 100%of employee contributions up to 5% of compensation.The matching contribution is vested at the rate of 20%per year. In 2006, Employee H makes $5,000 in em-ployee contributions and receives $5,000 of match-ing contributions. Employee H is 60% vested in thematching contributions at the end of the 2006 planyear. In February 2007, Employer X determines thatEmployee H has excess aggregate contributions of$1,000. The plan provides that only matching contri-butions will be distributed as excess aggregate contri-butions.

(ii) Employer X has two options available in dis-tributing Employee H's excess contributions. Thefirst option is to distribute $600 of vested matchingcontributions and forfeit $400 of nonvested match-ing contributions. These amounts are in proportionto Employee H's vested and nonvested interests in allmatching contributions. The second option is to dis-tribute $1,000 of vested matching contributions, leav-ing the nonvested matching contributions in the plan.

(iii) If the second option is chosen, the plan mustalso provide a separate vesting schedule for vestingthese nonvested matching contributions. This is nec-essary because the nonvested matching contributions

must vest as rapidly as they would have had no dis-tribution been made. Thus, 50% must vest in each ofthe next 2 years.

(iv) The plan will not satisfy the nondiscrimina-tory availability requirement of section 401(a)(4) ifonly nonvested matching contributions are distributedbecause the effect is that matching contributions forHCEs vest more rapidly than those for NHCEs. See§1.401(m)–1(e)(4).

Example 8. (i) Employer Y maintains a calen-dar year profit sharing plan that includes a cash ordeferred arrangement. Elective contributions arematched at the rate of 100%. After-tax employeecontributions are permitted under the plan only fornonhighly compensated employees and are matchedat the same rate. No employees make excess defer-rals. Employee J, a highly compensated employee,makes an $8,000 elective contribution and receivesan $8,000 matching contribution.

(ii) Employer Y performs the actual deferral per-centage (ADP) and the actual contribution percent-age (ACP). To correct failures of the ADP and ACPtests, the plan distributes to A $1,000 of excess contri-butions and $500 of excess aggregate contributions.After the distributions, Employee J's contributionsfor the year are $7,000 of elective contributions and$7,500 of matching contributions. As a result, Em-ployee J has received a higher effective rate of match-ing contributions than nonhighly compensated em-ployees ($7,000 of elective contributions matched by$7,500 is an effective matching rate of 107 percent).If this amount remains in Employee J's account with-out correction, it will cause the plan to fail to sat-isfy section 401(a)(4), because only a highly com-pensated employee receives the higher matching con-tribution rate. The remaining $500 matching contri-bution may be forfeited (but not distributed) undersection 411(a)(3)(G), if the plan so provides. Theplan could instead correct the discriminatory rate ofmatching contributions by making additional alloca-tions to the accounts of nonhighly compensated em-ployees. See §1.401(a)(4)–11(g)(3)(vii)(B) and (6),Example 7.

(c) Additional rules for prior year test-ing method—(1) Rules for change in test-ing method. A plan is permitted to changefrom the prior year testing method to thecurrent year testing method for any planyear. A plan is permitted to change fromthe current year testing method to the prioryear testing method only in situations de-scribed in §1.401(k)–2(c)(1)(ii). For pur-poses of this paragraph (c)(1), a plan thatuses the safe harbor method described in§1.401(m)–3 or a SIMPLE 401(k) plan istreated as using the current year testingmethod for that plan year

(2) Calculation of ACP under the prioryear testing method for the first planyear—(i) Plans that are not successorplans. If, for the first plan year of any plan(other than a successor plan), a plan usesthe prior year testing method, the plan ispermitted to use either that first plan yearas the applicable year for determining the

ACP for the eligible NHCEs, or 3% as theACP for eligible NHCEs, for applying theACP test for that first plan year. A plan(other than a successor plan) that uses theprior year testing method but has electedfor its first plan year to use that year as theapplicable year for determining the ACPfor the eligible NHCEs is not treated aschanging its testing method in the secondplan year and is not subject to the limita-tions on double counting under paragraph(a)(6)(vi) of this section for the secondplan year.

(ii) First plan year defined. For pur-poses of this paragraph (c)(2), the firstplan year of any plan is the first year inwhich the plan provides for employeecontributions or matching contributions.Thus, the rules of this paragraph (c)(2) donot apply to a plan (within the meaningof §1.410(b)–7) for a plan year if for suchplan year the plan is aggregated under§1.401(m)–1(b)(4) with any other planthat provides for employee or matchingcontributions in the prior year.

(iii) Plans that are successor plans. Aplan is a successor plan if 50% or moreof the eligible employees for the first planyear were eligible employees under an-other plan maintained by the employer inthe prior year that provides for employeecontributions or matching contributions. Ifa plan that is a successor plan uses the prioryear testing method for its first plan year,the ACP for the group of NHCEs for theapplicable year must be determined underparagraph (c)(4) of this section.

(3) Plans using different testing meth-ods for the ACP and ADP test. Exceptas otherwise provided in this paragraph(c)(3), a plan may use the current year test-ing method or prior year testing method forthe ACP test for a plan year without regardto whether the current year testing methodor prior year testing method is used for theADP test for that year. For example, a planmay use the prior year testing method forthe ACP test and the current year testingmethod for its ADP test for the plan year.However, plans that use different testingmethods under this paragraph (c)(3) can-not use —

(i) The recharacterization method of§1.401(k)–2(b)(3) to correct excess con-tributions for a plan year;

(ii) The rules of paragraph (a)(6)(ii) ofthis section to take elective contributions

2003-35 I.R.B. 488 September 2, 2003

into account under the ACP test (ratherthan the ADP test); or

(iii) The rules of paragraph §1.401(k)–2(a)(6) to take qualified matching contri-butions into account under the ADP test(rather than the ACP test).

(4) Rules for plan coverage change—(i)In general. A plan that uses the prior yeartesting method that experiences a plan cov-erage change during a plan year satisfiesthe requirements of this section for thatyear only if the plan provides that the ACPfor the NHCEs for the plan year is theweighted average of the ACPs for the prioryear subgroups.

(ii) Optional rule for minor plan cov-erage changes. If a plan coverage changeoccurs and 90% or more of the total num-ber of the NHCEs from all prior year sub-groups are from a single prior year sub-group, then, in lieu of using the weightedaverages described in paragraph (c)(4)(i)of this section, the plan may provide thatthe ACP for the group of eligible NHCEsfor the prior year under the plan is theACP of the NHCEs for the prior year ofthe plan under which that single prior yearsubgroup was eligible.

(iii) Definitions. The following defini-tions apply for purposes of this paragraph(c)(4)—

(A) Plan coverage change. The termplan coverage change means a change inthe group or groups of eligible employeesunder a plan on account of—

(1) The establishment or amendment ofa plan;

(2) A plan merger or spinoff under sec-tion 414(l);

(3) A change in the way plans (withinthe meaning of §1.410(b)–7) are com-bined or separated for purposes of§1.401(m)–1(b)(4) (e.g., permissivelyaggregating plans not previously aggre-gated under §1.410(b)–7(d), or ceasingto permissively aggregate plans under§1.410(b)–7(d));

(4) A reclassification of a substantialgroup of employees that has the same ef-fect as amending the plan (e.g., a transferof a substantial group of employees fromone division to another division); or

(5) A combination of any of paragraphs(c)(4)(iii)(A)(1) through (4) of this section.

(B) Prior year subgroup. The termprior year subgroup means all NHCEs forthe prior plan year who, in the prior year,were eligible employees under a specific

plan that provides for employee contribu-tions or matching contributions maintainedby the employer and who would have beeneligible employees in the prior year underthe plan being tested if the plan coveragechange had first been effective as of thefirst day of the prior plan year instead offirst being effective during the plan year.The determination of whether an NHCE isa member of a prior year subgroup is madewithout regard to whether the NHCE ter-minated employment during the prior year.

(C) Weighted average of the ACPsfor the prior year subgroups. The termweighted average of the ACPs for theprior year subgroups means the sum, forall prior year subgroups, of the adjustedACPs for the plan year. The term adjustedACP with respect to a prior year subgroupmeans the ACP for the prior plan year ofthe specific plan under which the membersof the prior year subgroup were eligibleemployees on the first day of the prior planyear, multiplied by a fraction, the numer-ator of which is the number of NHCEs inthe prior year subgroup and denominatorof which is the total number of NHCEs inall prior year subgroups.

(iv) Example. The following exampleillustrate the application of this paragraph(c)(4). See also §1.401(k)–2(c)(4) for ex-amples of the parallel rules applicable tothe ADP test. The example is as follows:

Example. (i) Employer B maintains two plans,Plan N and Plan P, each of which provides foremployee contributions or matching contributions.The plans were not permissively aggregated under§ 1.410(b)–7(d) for the 2005 testing year. Both plansuse the prior year testing method. Plan N had 300eligible employees who were NHCEs for 2005, andtheir ACP for that year was 6%. Plan P had 100eligible employees who were NHCEs for 2005, andthe ACP for those NHCEs for that plan was 4%.Plan N and Plan P are permissively aggregated under§ 1.410(b)–7(d) for the 2006 plan year.

(ii) The permissive aggregation of Plan N andPlan P for the 2006 testing year under § 1.410(b)–7(d)is a plan coverage change that results in treating theplans as one plan (Plan NP). Therefore, the prior yearACP for the NHCEs under Plan NP for the 2006 test-ing year is the weighted average of the ACPs for theprior year subgroups.

(iii) The first step in determining the weighted av-erage of the ACPs for the prior year subgroups is toidentify the prior year subgroups. With respect tothe 2006 testing year, an employee is a member ofa prior year subgroup if the employee was an NHCEof Employer B for the 2005 plan year, was an eligibleemployee for the 2005 plan year under any section401(k) plan maintained by Employer B, and wouldhave been an eligible employee in the 2005 plan yearunder Plan NP if Plan N and Plan P had been permis-sively aggregated under §1.410(b)–7(d) for that plan

year. The NHCEs who were eligible employees un-der separate plans for the 2005 plan year compriseseparate prior year subgroups. Thus, there are twoprior year subgroups under Plan NP for the 2006 test-ing year: the 300 NHCEs who were eligible employ-ees under Plan N for the 2005 plan year and the 100NHCEs who were eligible employees under Plan Pfor the 2005 plan year.

(iv) The weighted average of the ACPs for theprior year subgroups is the sum of the adjusted ACPwith respect to the prior year subgroup that consists ofthe NHCEs who were eligible employees under PlanN, and the adjusted ACP with respect to the prior yearsubgroup that consists of the NHCEs who were eligi-ble employees under Plan P. The adjusted ACP for theprior year subgroup that consists of the NHCEs whowere eligible employees under Plan N is 4.5%, cal-culated as follows: 6% (the ACP for the NHCEs un-der Plan N for the prior year) x 300/400 (the numberof NHCEs in that prior year subgroup divided by thetotal number of NHCEs in all prior year subgroups),which equals 4.5%. The adjusted ACP for the prioryear subgroup that consists of the NHCEs who wereeligible employees under Plan P is 1%, calculated asfollows: 4% (the ACP for the NHCEs under Plan Pfor the prior year) x 100/400 (the number of NHCEsin that prior year subgroup divided by the total num-ber of NHCEs in all prior year subgroups), whichequals 1%. Thus, the prior year ACP for NHCEs un-der Plan NP for the 2006 testing year is 5.5% (the sumof adjusted ACPs for the prior year subgroups, 4.5%plus 1%).

§1.401(m)–3 Safe harbor requirements.

(a) ACP test safe harbor. Matchingcontributions under a plan satisfy theACP safe harbor provisions of section401(m)(11) for a plan year if the plansatisfies the safe harbor contribution re-quirement of paragraphs (b) or (c) of thissection for the plan year, the limitations onmatching contributions of paragraph (d)of this section, the notice requirement ofparagraph (e) of this section, the plan yearrequirements of paragraph (f) of this sec-tion, and the additional rules of paragraphs(g), (h) and (j) of this section, as applica-ble. Pursuant to section 401(k)(12)(E)(ii),the safe harbor contribution requirementof paragraphs (b) and (c) of this sectionmust be satisfied without regard to section401(l). The contributions made underparagraphs (b) and (c) of this section arereferred to as safe harbor nonelectivecontributions and safe harbor matchingcontributions, respectively.

(b) Safe harbor nonelective contribu-tion requirement. A plan satisfies the safeharbor nonelective contribution require-ment of this paragraph (b) if it satisfiesthe safe harbor nonelective contributionrequirement of §1.401(k)–3(b).

September 2, 2003 489 2003-35 I.R.B.

(c) Safe harbor matching contributionrequirement. A plan satisfies the safe har-bor matching contribution requirement ofthis paragraph (c) if it satisfies the safe har-bor matching contribution requirement of§1.401(k)–3(c).

(d) Limitation on contributions–(1)General rule. A plan that provides formatching contributions meets the require-ments of this section only if it satisfies thelimitations on contributions set forth inthis paragraph (d).

(2) Matching rate must not increase. Aplan that provides for matching contribu-tions meets the requirements of this para-graph (d) only if the ratio of matching con-tributions on behalf of an employee underthe plan for a plan year to the employee'selective deferrals and employee contribu-tions, does not increase as the amount ofan employee's elective deferrals and em-ployee contributions increases.

(3) Limit on matching contributions. Aplan that provides for matching contribu-tions satisfies the requirements of this sec-tion only if—

(i) Matching contributions are notmade with respect to elective defer-rals or employee contributions that ex-ceed 6% of the employee's safe harborcompensation (within the meaning of§1.401(k)–3(b)(2)); and

(ii) Matching contributions that are dis-cretionary do not exceed 4% of the em-ployee's safe harbor compensation.

(4) Limitation on rate of match. Aplan meets the requirements of this sec-tion only if the ratio of matching contribu-tions on behalf of an HCE to that HCE'selective deferrals or employee contribu-tions (or the sum of elective deferrals andemployee contributions) for that plan yearis no greater than the ratio of matchingcontributions to elective deferrals or em-ployee contributions (or the sum of electivedeferrals and employee contributions) thatwould apply with respect to any NHCE forwhom the elective deferrals or employeecontributions (or the sum of elective de-ferrals and employee contributions) are thesame percentage of safe harbor compensa-tion. An employee is taken into accountfor purposes of this paragraph (d)(4) if theemployee is an eligible employee underthe cash or deferred arrangement with re-spect to which the contributions requiredby paragraph (b) or (c) of this section arebeing made for a plan year. A plan will not

fail to satisfy this paragraph (d)(4) merelybecause the plan provides that matchingcontributions will be made separately withrespect to each payroll period (or with re-spect to all payroll periods ending withor within each month or quarter of a planyear) taken into account under the planfor the plan year, provided that matchingcontributions with respect to any electivedeferrals or employee contributions madeduring a plan year quarter are contributedto the plan by the last day of the immedi-ately following plan year quarter.

(5) HCEs participating in multipleplans. The rules of section 401(m)(2)(B)and §1.401(m)–2(a)(3)(ii) apply for pur-poses of determining the rate of matchingcontributions under paragraph (d)(4) ofthis section. However, a plan will notfail to satisfy the safe harbor matchingcontribution requirements of this sectionmerely because an HCE participates dur-ing the plan year in more than one planthat provides for matching contributions,provided that —

(i) The HCE is not simultaneously aneligible employee under two plans thatprovide for matching contributions main-tained by an employer for a plan year; and

(ii) The period used to determine com-pensation for purposes of determiningmatching contributions under each suchplan is limited to periods when the HCEparticipated in the plan.

(6) Permissible restrictions on electivedeferrals by NHCEs—(i) General rule.A plan does not satisfy the safe harborrequirements of this section, if electivedeferrals or employee contributions byNHCEs are restricted, unless the restric-tions are permitted by this paragraph(d)(6).

(ii) Restrictions on election periods. Aplan may limit the frequency and dura-tion of periods in which eligible employ-ees may make or change contribution elec-tions under a plan. However, an employeemust have a reasonable opportunity (in-cluding a reasonable period after receipt ofthe notice described in paragraph (e) of thissection) to make or change a contributionelection for the plan year. For purposes ofthis section, a 30-day period is deemed tobe a reasonable period to make or changea contribution election.

(iii) Restrictions on amount of con-tributions. A plan is permitted to limitthe amount of contributions that may be

made by an eligible employee under aplan, provided that each NHCE who isan eligible employee is permitted (unlessthe employee is restricted under para-graph (d)(6)(v) of this section) to makecontributions in an amount that is at leastsufficient to receive the maximum amountof matching contributions available un-der the plan for the plan year, and theemployee is permitted to elect any lesseramount of contributions. However, a planmay require eligible employees to makecontribution elections in whole percent-ages of compensation or whole dollaramounts.

(iv) Restrictions on types of compensa-tion that may be deferred. A plan maylimit the types of compensation that maybe deferred or contributed by an eligibleemployee under a plan, provided that eacheligible NHCE is permitted to make con-tributions under a definition of compen-sation that would be a reasonable defini-tion of compensation within the meaningof §1.414(s)–1(d)(2). Thus, the defini-tion of compensation from which contri-butions may be made is not required to sat-isfy the nondiscrimination requirement of§1.414(s)–1(d)(3).

(v) Restrictions due to limitations underthe Internal Revenue Code. A plan maylimit the amount of contributions made byan eligible employee under a plan—

(A) Because of the limitations of sec-tion 402(g) or section 415; or

(B) Because, on account of a hard-ship distribution, an employee's abilityto make contributions has been sus-pended for 6 months in accordance with§1.401(k)–1(d)(3)(iv)(E).

(e) Notice requirement. A plan satisfiesthe notice requirement of this paragraph(e) if it satisfies the notice requirement of§1.401(k)–3(d).

(f) Plan year requirement —(1) Gen-eral rule. Except as provided in this para-graph (f) or in paragraph (g) of this section,a plan will fail to satisfy the requirementsof section 401(m)(11) and this section un-less plan provisions that satisfy the rulesof this section are adopted before the firstday of that plan year and remain in effectfor an entire 12-month plan year. More-over, if, as described in paragraph (j)(4) ofthis section, safe harbor matching or non-elective contributions will be made to an-other plan for a plan year, provisions speci-fying that the safe harbor contributions will

2003-35 I.R.B. 490 September 2, 2003

be made in the other plan and providingthat the contributions will be QNECs orQMACs must be also be adopted beforethe first day of that plan year.

(2) Initial plan year. A newly es-tablished plan (other than a successorplan within the meaning of §1.401(m)–2(c)(2)(iii)) will not be treated as violatingthe requirements of this paragraph (f)merely because the plan year is less than12 months, provided that the plan year isat least 3 months long (or, in the case ofa newly established employer that estab-lishes the plan as soon as administrativelyfeasible after the employer comes into ex-istence, a shorter period). Similarly, a planwill not fail to satisfy the requirements ofthis paragraph (f) for the first plan yearin which matching contributions are pro-vided under the plan provided that—

(i) The plan is not a successor plan; and(ii) The amendment providing for

matching contributions is made effectiveat the same time as the adoption of a cashor deferred arrangement that satisfies therequirements of §1.401(k)–3, taking intoaccount the rules of §1.401(k)–3(e)(2).

(3) Change of plan year. A plan thathas a short plan year as a result of changingits plan year will not fail to satisfy the re-quirements of paragraph (f)(1) of this sec-tion merely because the plan year has lessthan 12 months, provided that—

(i) The plan satisfied the requirementsof this section for the immediately preced-ing plan year; and

(ii) The plan satisfies the requirementsof this section for the immediately follow-ing plan year.

(4) Final plan year. A plan that termi-nates during a plan year will not fail to sat-isfy the requirements of paragraph (f)(1)of this section merely because the finalplan year is less than 12 months, providedthat—

(i) The plan would satisfy the require-ments of paragraph (h) of this section,treating the termination of the plan as areduction or suspension of safe harbormatching contributions, other than therequirement that employees have a rea-sonable opportunity to change their cashor deferred elections and, if applicable,employee contribution elections; or

(ii) The plan termination is in connec-tion with a transaction described in section410(b)(6)(C) or the employer incurs a sub-stantial business hardship, comparable to a

substantial business hardship described insection 412(d).

(g) Plan amendments adopting non-elective safe harbor contributions.Notwithstanding paragraph (f)(1) of thissection, a plan that provides for the useof the current year testing method maybe amended after the first day of the planyear and no later than 30 days beforethe last day of the plan year to adopt thesafe harbor method of this section usingnonelective contributions under paragraph(b) of this section if the plan satisfies therequirements of §1.401(k)–3(f).

(h) Permissible reduction or suspen-sion of safe harbor matching contribu-tions—(1) General rule. A plan thatprovides for safe harbor matching con-tributions will not fail to satisfy the re-quirements of section 401(m)(2) for a planyear merely because the plan is amendedduring a plan year to reduce or suspendsafe harbor matching contributions onfuture elective deferrals and, if applicable,employee contributions provided—

(i) All eligible employees are providedthe supplemental notice in accordancewith paragraph (h)(2) of this section;

(ii) The reduction or suspension of safeharbor matching contributions is effectiveno earlier than the later of 30 days aftereligible employees are provided the no-tice described in paragraph (h)(2) of thissection and the date the amendment isadopted;

(iii) Eligible employees are given a rea-sonable opportunity (including a reason-able period after receipt of the supplemen-tal notice) prior to the reduction or suspen-sion of safe harbor matching contributionsto change their cash or deferred electionsand, if applicable, their employee contri-bution elections;

(iv) The plan is amended to providethat the ACP test will be satisfied forthe entire plan year in which the re-duction or suspension occurs using thecurrent year testing method described in§1.401(m)–2(a)(1)(ii); and

(v) The plan satisfies the requirementsof this section (other than this paragraph(h)) with respect to amounts deferredthrough the effective date of the amend-ment.

(2) Notice of suspension requirement.The notice of suspension requirement ofthis paragraph (h)(2) is satisfied if eacheligible employee is given a written notice

that satisfies the content requirements of§1.401(k)–3(e)(3).

(i) [Reserved](j) Other rules—(1) Contributions

taken into account. A contribution istaken into account for purposes of thissection for a plan year under the samerules as §1.401(k)–3(h)(1).

(2) Use of safe harbor nonelectivecontributions to satisfy other nondiscrim-ination tests. A safe harbor nonelectivecontribution used to satisfy the nonelectivecontribution requirement under paragraph(b) of this section may also be takeninto account for purposes of determiningwhether a plan satisfies section 401(a)(4)under the same rules as §1.401(k)–3(h)(2).

(3) Early participation rules. Sec-tion 401 (m)(5)(C) and §1.401(m)–2(a)(1)(iii)(A) which provide an alter-native nondiscrimination rule for certainplans that provide for early participation,does not apply for purposes of section401(m)(11) and this section. Thus, a planis not treated as satisfying this sectionwith respect to the eligible employeeswho have not completed the minimumage and service requirements of section410(a)(1)(A) unless the plan satisfies therequirements of this section with respectto such eligible employees.

(4) Satisfying safe harbor contributionrequirement under another defined contri-bution plan. Safe harbor matching or non-elective contributions may be made to an-other defined contribution plan under thesame rules as §1.401(k)–3(h)(4). Conse-quently, each NHCE under the plan pro-viding for matching contributions must beeligible under the same conditions underthe other defined contribution plan and theplan to which the contributions are mademust have the same plan year as the planproviding for matching contributions.

(5) Contributions used only once. Safeharbor matching or nonelective contribu-tions cannot be used to satisfy the require-ments of this section with respect to morethan one plan.

(6) Plan must satisfy ACP with respectto employee contributions. If the plan pro-vides for employee contributions, in addi-tion to satisfying the requirements of thissection, it must also satisfy the ACP test of§1.401(m)–2. See §1.401(m)–2(a)(5)(iii)for specials rules under which the ACPtest is permitted to be run taking into ac-count only employee contributions when

September 2, 2003 491 2003-35 I.R.B.

this section is satisfied with respect to thematching contributions.

§1.401(m)–4 Special rules for mergers,acquisitions and similar events.[Reserved]

§1.401(m)–5 Definitions.

Unless otherwise provided, the defini-tions of this section govern for purposes ofsection 401(m) and the regulations there-under.

Actual contribution percentage(ACP). Actual contribution percentageor ACP means the ACP of the groupof eligible employees as defined in§1.401(m)–2(a)(2)(i).

Actual contribution percentage (ACP)test. Actual contribution percentage testor ACP test means the test described in§1.401(m)–2(a)(1).

Actual contribution ratio (ACR). Ac-tual contribution ratio or ACR means theACR of an eligible employee as defined in§1.401(m)–2(a)(3).

Actual deferral percentage (ADP)test. Actual deferral percentage test orADP test means the test described in§1.401(k)–2(a)(1).

Compensation. Compensation meanscompensation as defined in section 414(s)and §1.414(s)–1. The period used to de-termine an employee's compensation for aplan year must be either the plan year or thecalendar year ending within the plan year.Whichever period is selected must be ap-plied uniformly to determine the compen-sation of every eligible employee under theplan for that plan year. A plan may, how-ever, limit the period taken into accountunder either method to that portion of theplan year or calendar year in which the em-ployee was an eligible employee, providedthat this limit is applied uniformly to alleligible employees under the plan for theplan year. See also section 401(a)(17) and§1.401(a)(17)–1(c)(1). For this purpose,in case of an HCE whose ACR is deter-mined under §1.401(m)–2(a)(3)(ii), periodof participation includes periods under an-other plan for which matching contribu-tions or employee contributions are aggre-gated under §1.401(m)–2(a)(3)(ii).

Current year testing method. Cur-rent year testing method means thetesting method under which the appli-cable year is the current plan year, as

described in §1.401(m)–2(a)(2)(ii) or1.401(k)–2(a)(2)(ii).

Elective contributions. Elective contri-butions means elective contributions as de-fined in §1.401(k)–6.

Elective deferrals. Elective deferralsmeans elective deferrals described in sec-tion 402(g)(3).

Eligible employee—(1) General rule.Eligible employee means an employee whois directly or indirectly eligible to make anemployee contribution or to receive an al-location of matching contributions (includ-ing matching contributions derived fromforfeitures) under the plan for all or a por-tion of the plan year. For example, if anemployee must perform purely ministerialor mechanical acts (e.g., formal applica-tion for participation or consent to pay-roll withholding) in order to be eligible tomake an employee contribution for a planyear, the employee is an eligible employeefor the plan year without regard to whetherthe employee performs these acts.

(2) Conditions on eligibility. An em-ployee who is unable to make employeecontributions or to receive an allocationof matching contributions because the em-ployee has not contributed to another planis also an eligible employee. By contrast, ifan employee must perform additional ser-vice (e.g., satisfy a minimum period of ser-vice requirement) in order to be eligible tomake an employee contribution or to re-ceive an allocation of matching contribu-tions for a plan year, the employee is not aneligible employee for the plan year unlessthe service is actually performed. An em-ployee who would be eligible to make em-ployee contributions but for a suspensiondue to a distribution, a loan, or an electionnot to participate in the plan, is treated asan eligible employee for purposes of sec-tion 401(m) for a plan year even though theemployee may not make employee contri-butions or receive an allocation of match-ing contributions by reason of the suspen-sion. Finally, an employee does not fail tobe treated as an eligible employee merelybecause the employee may receive no ad-ditional annual additions because of sec-tion 415(c)(1).

(3) Certain one-time elections. An em-ployee is not an eligible employee merelybecause the employee, upon commencingemployment with the employer or upon theemployee's first becoming eligible under

any plan of the employer providing for em-ployee or matching contributions, is givena one-time opportunity to elect, and theemployee in fact does elect, not to be eli-gible to make employee contributions or toreceive allocations of matching contribu-tions under the plan or any other plan main-tained by the employer (including plansnot yet established) for the duration ofthe employee's employment with the em-ployer. In no event is an election made af-ter December 23, 1994, treated as one-timeirrevocable election under this paragraph ifthe election is made by an employee whopreviously became eligible under anotherplan (whether or not terminated) of the em-ployer.

Eligible HCE. Eligible HCE means aneligible employee who is an HCE.

Eligible NHCE. Eligible NHCE meansan eligible employee who is not an HCE.

Employee. Employee means an em-ployee within the meaning of §1.410(b)–9.

Employee contributions. Employeecontributions means employee contribu-tions as defined in 1.401(m)–1(a)(3).

Employee stock ownership plan(ESOP). Employee stock ownership planor ESOP means the portion of a planthat is an ESOP within the meaning of§1.410(b)–7(c)(2).

Employer. Employer means an em-ployer within the meaning of §1.410(b)–9.

Excess aggregate contributions. Excessaggregate contributions means, with re-spect to a plan year, the amount of excessaggregate contributions apportioned to anHCE under §1.401(m)–2(b)(2)(iii).

Excess contributions. Excess contribu-tion means with respect to a plan year, theamount of excess contribution apportionedto an HCE under §1.401(k)–2(b)(2)(iii).

Excess deferrals. Excess deferralsmeans excess deferrals as defined in§1.402(g)–1(e)(3).

Highly compensated employee (HCE).Highly compensated employee or HCE hasthe meaning provided in section 414(q).

Matching contributions. Matching con-tribution is defined in §1.401(m)–1(a)(2).

Nonelective contributions. Nonelectivecontributions means employer contribu-tions (other than matching contributions)with respect to which the employee maynot elect to have the contributions paidto the employee in cash or other benefitsinstead of being contributed to the plan.

2003-35 I.R.B. 492 September 2, 2003

Non-employee stock ownership plan(non-ESOP). Non-employee stock owner-ship plan or non-ESOP means the portionof a plan that is not an ESOP within themeaning of §1.410(b)–7(c)(2).

Non-highly compensated employee(NHCE). Non-highly compensated em-ployee or NHCE means an employee whois not an HCE.

Plan. Plan means plan as defined in§1.401(m)–1(b)(4).

Prior year testing method. Prioryear testing method means the test-ing method under which the appli-cable year is the prior plan year, asdescribed in §1.401(m)–2(a)(2)(ii) or§1.401(k)–2(a)(2)(ii).

Qualified matching contributions(QMAC). Qualified matching contri-butions or QMAC means matching con-tributions that satisfy the requirementsof §1.401(k)–1(c) and (d) at the time thecontribution is made, without regard towhether the contributions are actuallytaken into account as elective contribu-tions under §1.401(k)–2(a)(6). See also§1.401(k)–2(b)(4)(iii) for a rule providingthat a matching contribution does not failto qualify as a QMAC solely because itis forfeitable under section 411(a)(3)(G)because it is a matching contribution withrespect to an excess deferral, excess con-tribution, or excess aggregate contribution.

Qualified nonelective contributions(QNEC). Qualified nonelective contribu-tions or QNEC means employer contri-butions, other than elective contributionsor matching contributions, that satisfy therequirements of §1.401(k)–1(c) and (d) atthe time the contribution is made, withoutregard to whether the contributions areactually taken into account under the ADPtest under §1.401(k)–2(a)(6) or the ADPtest under §1.401(m)–2(a)(6).

Judith B. Tomaso,Acting Deputy Commissioner for

Services and Enforcement.

(Filed by the Office of the Federal Register on July 16, 2003,8:45 a.m., and published in the issue of the Federal Registerfor July 17, 2003, 68 F.R. 42475)

Notice of Proposed Rulemaking;Notice of Public Hearing;and Withdrawal of PreviouslyProposed Regulations

Credit for Increasing ResearchActivities

REG–133791–02 andREG–105606–99

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemaking;notice of public hearing; and withdrawal ofpreviously proposed regulations.

SUMMARY: This document containsproposed regulations relating to the com-putation and allocation of the credit forincreasing research activities for membersof a controlled group of corporations or agroup of trades or businesses under com-mon control. These proposed regulationsreflect changes made to section 41 by theRevenue Reconciliation Act of 1989 andthe Small Business Job Protection Act of1996, which introduced the alternativeincremental research credit. This doc-ument also provides notice of a publichearing on these proposed regulationsand withdraws the proposed regulations(REG–105606–99, 2000–1 C.B. 421 [65FR 258]) published in the Federal Registeron January 4, 2000.

DATES: Written or electronic commentsmust be received by October 23, 2003. Re-quests to speak and outlines of the topics tobe discussed at the public hearing sched-uled for November 13, 2003, at 10 a.m.must be received by October 23, 2003.

ADDRESSES: Send submissions to:CC:PA:RU (REG–133791–02), room5226, Internal Revenue Service, POB7604, Ben Franklin Station, Washington,DC 20044. Submissions may also behand delivered Monday through Fridaybetween the hours of 8 a.m. and 4 p.m. to:CC:PA:RU (REG–133791–02), Courier'sDesk, Internal Revenue Service, 1111Constitution Avenue, NW, Washington,DC 20224. Alternatively, taxpayers maysubmit comments electronically via the In-ternet by submitting comments directly tothe IRS Internet site at: www.irs.gov/regs.

The public hearing will be held in room4718, Internal Revenue Building, 1111Constitution Avenue, NW, Washington,DC 20224.

FOR FURTHER INFORMATIONCONTACT: Concerning these proposedregulations, Jolene J. Shiraishi at (202)622–3120 (not a toll-free call); concerningsubmissions of comments, the hearing,and to be placed on the building accesslist to attend the hearing, Guy Traynor at(202) 622–7180 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

Background

On January 4, 2000, Treasury and theIRS published in the Federal Register(REG–105606–99, 2000–1 C.B. 421 [65FR 258]) proposed amendments to theregulations under section 41(f) (2000proposed regulations) relating to the com-putation and allocation of the credit forincreasing research activities (researchcredit) for members of a controlled groupof corporations or a group of trades or busi-nesses under common control (controlledgroup). The 2000 proposed regulationsreflected changes made to section 41 bythe Revenue Reconciliation Act of 1989(the 1989 Act) and the Small Business JobProtection Act of 1996. Treasury and theIRS received written comments from twocommentators. A public hearing was heldon April 26, 2000. After considering thewritten comments and the statements atthe public hearing, Treasury and the IRSare withdrawing the 2000 proposed regu-lations and are proposing new regulations.

Summary of Comments andExplanation of Provisions

Overview

These new proposed regulations formembers of a controlled group undersection 41(f) follow the research creditcomputation rule contained in the 2000proposed regulations. The computation ofthe research credit for a controlled group(group credit) under these new proposedregulations is done by treating all of themembers of a controlled group as a singletaxpayer. Unlike the 2000 proposed reg-ulations, these new proposed regulationsthen allocate the group credit among the

September 2, 2003 493 2003-35 I.R.B.

members of the controlled group basedon the relative amounts of each individualmember's stand-alone entity credit — thecredit, if any, that a member of a controlledgroup would be entitled to claim if it werenot a member of a controlled group. Thesenew proposed regulations generally willapply to taxable years beginning on orafter the date that final regulations arepublished in the Federal Register.

Computation of the Group Credit

Section 41(f)(1)(A)(i) provides that indetermining the amount of the researchcredit under section 41, “all members ofthe same controlled group of corporationsshall be treated as a single taxpayer.” Sec-tion 41(f)(1)(B)(i) provides a similar rulefor a group of trades or businesses undercommon control. Accordingly, for pur-poses of determining the amount of thegroup credit, the 2000 proposed regula-tions applied all of the section 41 compu-tational rules on an aggregate basis. Thecommentators agreed that with respect tothe computation of the group credit, the2000 proposed regulations are consistentwith the provisions of section 41(f). Thesenew proposed regulations, therefore, donot change the method for computing thegroup credit. These new proposed reg-ulations, however, clarify the applicationof the start-up company rules under sec-tion 41(c)(3)(B) to a controlled group withrespect to the computation of the groupcredit.

Allocation of the Group Credit AmongMembers of the Controlled Group

Section 41(f)(1)(A)(ii) provides that“the [portion of the group] credit (if any)allowable by this section to each suchmember shall be its proportionate sharesof the qualified research expenses andbasic research payments giving rise to thecredit.” Section 41(f)(1)(B)(ii) provides asimilar rule for a group of trades or busi-nesses under common control. These newproposed regulations apply these provi-sions by allocating the group credit basedon the relative amounts of each individualmember's stand-alone entity credit.

2000 Proposed Regulations

The 2000 proposed regulations al-located the group credit based on the

amounts by which each individual mem-ber's qualified research expenses (QREs)exceeded a base amount for that member.An individual member's base amount, forpurposes of allocating the group creditunder the 2000 proposed regulations, wasdetermined by applying the controlledgroup's fixed-base percentage to the mem-ber's average annual gross receipts for thefour taxable years preceding the credityear. The group credit was allocated toa member having an excess amount ofQREs by multiplying the group creditby a fraction having the individual mem-ber's excess amount as the numerator andthe aggregate excess amount of all themembers of the controlled group as thedenominator. A similar allocation methodwas provided for the credit for basic re-search payments and for the alternativeincremental research credit.

The preamble to the 2000 proposedregulations stated that the purpose of thismethod was to allocate the group credit to“those members whose share of currentyear qualified research expenses exceedstheir share of the [controlled group's] baseamount.” In particular, the preamble notedthat in providing a rule that reflects theincremental nature of the research credit,Treasury and the IRS declined to followcomments noting that amendments tosection 41 made by the 1989 Act requiredthat the allocation of the group credit bebased on the relative amounts of totalQREs incurred separately by members ofthe controlled group:

In proposing rules for the allocationof the credit, Treasury and the IRSconsidered, but were not persuadedby, certain taxpayers' argument thatthe elimination of the word “increase”from the allocation rule in the statuterequires that the credit be allocatedon the basis of the gross amount ofqualified research expenses incurred bythe various members of the controlledgroup. Treasury and the IRS believethat elimination of the word “increase”was necessitated by the 1989 statu-tory amendments to the computationof the research credit, which afford acredit in certain circumstances evenwhere the taxpayer (or each memberof a controlled group) is decreasingits gross amount of qualified researchexpenses (e.g., because the taxpayer'sgross receipts also are decreasing).

However, there is no indication thatthe elimination of the word “increase”was intended to suggest that the creditbe allocated without regard to its in-cremental nature. To the contrary, thestatutory prescription that the credit beallocated according to each member'sproportionate share of the qualifiedresearch expenses “giving rise to” thecredit supports a rule that allocates thecredit to those members whose shareof current year qualified research ex-penses exceeds their share of the baseamount.

Comments on the 2000 ProposedRegulations

Two commentators submitted a seriesof comments in response to the 2000 pro-posed regulations. As noted above, bothcommentators agreed that the method forcomputing the group credit contained inthe 2000 proposed regulations is consistentwith the provisions of section 41(f). Thecommentators diverged significantly, how-ever, with respect to the method for allocat-ing the group credit. The first commenta-tor supported the allocation rule containedin the 2000 proposed regulations. Thesecond commentator reiterated the earlierexpressed view that the allocation of thegroup credit should be done on the basisof each member's total QREs (gross QREsmethod).

The second commentator set out anumber of reasons why a gross QREsmethod should be adopted instead of themethod contained in the 2000 proposedregulations. In particular, the commen-tator stated that a gross QREs method isthe only method consistent with the plainmeaning of section 41(f). As a relatedpoint, the commentator claimed that astatutory amendment made by the 1989Act supports its plain meaning argument.The commentator also noted that the al-location method contained in the 2000proposed regulations, by incorporatingboth individual member and controlledgroup elements, was at odds with the com-putation method provided by the statuteand failed to allocate rationally the groupcredit.

Treasury and the IRS continue to be-lieve that, compared to a gross QREsmethod, an allocation method based ona group member's QREs in excess of a

2003-35 I.R.B. 494 September 2, 2003

base amount more fully carries out thepurposes of section 41 in general andthe section 41(f) controlled group creditrules. The research credit is not, andhas never been, a credit computed as apercentage of total qualifying expenses.Rather, the research credit generally isallowed only when a taxpayer's QREsexceed a base amount. Prior to the 1989Act, the research credit was computed bymultiplying the credit rate by the excess ofthe taxpayer's current year QREs over thetaxpayer's average QREs for the precedingthree years. The 1989 Act significantlymodified the computation of the researchcredit while retaining the incrementalapproach of the pre-1989 Act credit. Ingeneral, the research credit computation isbased on whether and the extent to whicha taxpayer increases the proportion of itsQREs relative to its recent gross receipts,compared to a historical base period. Ul-timately, this computation measures theextent to which a taxpayer's current yearQREs exceed a base amount.

Treasury and the IRS conclude thatthe controlled group allocation rules setout in section 41(f) were not intended toresult in the allocation of the group creditto individual members of the group in amanner wholly at odds with the incre-mental nature of the research credit. Thelegislative history to the research credit,as originally enacted in 1981, indicatesthat the group credit rules were enacted toensure that the research credit would be al-lowed only for actual increases in researchexpenditures. These rules were intendedto prevent taxpayers from creating artifi-cial increases in research expenditures byshifting expenditures among commonlycontrolled or otherwise related persons.H. Rep. No. 97–201, 1981–2 C.B. (Vol.2) 364, and S. Rep. 97–144, 1981–2 C.B.(Vol. 2) 442. In effect, the group creditcomputation rule serves as a cap on themaximum amount of credit that the mem-bers of the group, in the aggregate, mayclaim. A rule that then allocates the groupcredit based solely on the total amountof QREs incurred by each individualmember, however, would be inconsistentwith the incremental nature of the creditand would not further the purpose of thesection 41(f) group credit rules.

As during the consideration of the 2000proposed regulations, Treasury and theIRS do not find persuasive the second

commentator's argument that a plain read-ing of the statute, following the deletionof the phrase “increase in” in sections41(f)(1)(A)(ii) and 41(f)(1)(B)(ii) by the1989 Act, mandates a gross QREs methodfor allocating the group credit. Priorto the 1989 Act, for example, section41(f)(1)(A)(ii) provided that the researchcredit, if any, allowable to each memberof a controlled group was the member's“proportionate share of the increase inqualified research expenses giving rise tothe credit.” The phrase “increase in” wasdeleted by the 1989 Act. The commenta-tor maintained that a gross QREs methodgives effect to the phrase “giving rise tothe credit” as well as to the deletion of thephrase “increase in” from the statute bythe 1989 Act because “each dollar of thegroup's QREs gives rise to [the] excessover the group's base amount” or “(s)tatedotherwise, if you eliminate a dollar ofqualified research expenses from anymember of the group, the group's creditwill be reduced proportionately.”

The reason for the deletion of thephrase “increase in” is not addressed inthe legislative history to the 1989 Act.The changes to the computation of theresearch credit made by the 1989 Act,however, made a taxpayer's QREs forprior years, other than taxable years be-ginning after December 31, 1983, andbefore January 1, 1989 (base years), ir-relevant to the computation of the credit.Instead, the amount of the research creditnow depends on whether and the extent towhich a taxpayer increases the proportion(compared to that of the base years) of itsQREs relative to its average annual grossreceipts from the prior four years. Ac-cordingly, although the research credit isstill based on the amount by which currentyear QREs exceed a base amount, thatbase amount, unlike the general researchcredit computation prior to the 1989 Act,is not a rolling average of QREs incurredin the three years prior to the credit year.Treasury and the IRS, therefore, concludethat the deletion of the phrase “increasein” was intended to reflect this change,and not to indicate that the allocation ofthe group credit was to be made using agross QREs method.

The second commentator noted, inarguing that the allocation method in the2000 proposed regulations impermissiblymixed controlled group and individual

member calculations, that the allocationmethod favors those members whose cur-rent ratio of QREs to recent gross receiptsexceeds the controlled group's fixed-basepercentage, regardless of whether thatmember's ratio, in fact, was increasing ordecreasing. As stated by the commentator,“[t]he group's fixed-base percentage canbe wildly different from the fixed-basepercentage for an individual memberdepending on the individual member'sseparate QREs and separate gross receiptsduring the [base years]. In other words,the amount of group credit that would beallocated to an individual member underthe 2000 proposed regulations may bearlittle or no relationship to what the indi-vidual member would be entitled to ona stand-alone basis, depending on howsimilar the individual member's separatefixed-base percentage was to the group'sfixed-base percentage.

Proposed Allocation Rule

After considering the statute, the leg-islative history, the written comments,and the statements at the public hearing,Treasury and the IRS have determinedthat the allocation method contained in the2000 proposed regulations does not fullycarry out the purpose of the research creditstatute and, in particular, the amendmentsmade by the 1989 Act. Treasury and theIRS continue to believe that the methodfor allocating the group credit must takeinto account the incremental nature of thecredit. In considering the consequencesof the allocation method contained in the2000 proposed regulations, as highlightedby the commentators, Treasury and theIRS believe that the method may not, incertain cases, appropriately balance thepurpose of the group credit computationand allocation rules contained in section41(f) with the general purpose of theresearch credit, which is to encourageresearch activities.

Accordingly, these new proposed reg-ulations allocate the group credit amongthe members of the controlled group byfirst computing each individual member'sstand-alone entity credit and then multi-plying the group credit by the ratio that themember's stand-alone entity credit bears tothe sum of the stand-alone entity credits ofall the members of the controlled group.This new allocation method ensures that

September 2, 2003 495 2003-35 I.R.B.

the amount of group credit allocated toeach individual member will be propor-tionate to the amount of research credit thatthe individual member would have beenentitled to claim had it not been part ofa controlled group. This new allocationmethod therefore addresses the concernsexpressed by the commentators that the al-location method contained in the 2000 pro-posed regulations could result in individ-ual members receiving little or no researchcredit — or, conversely, a disproportion-ately greater amount of research credit —compared to what they would have beenentitled to on a stand-alone basis, solely asa result of being part of a controlled group.

Special Allocation Rule for ConsolidatedGroups

In the preamble to the 2000 pro-posed regulations, Treasury and the IRSrequested comments with respect to a spe-cial rule that would treat all members ofa consolidated group within a controlledgroup as a single member for purposesof allocating the group credit among themembers of a controlled group. After con-sidering the comments received, Treasuryand the IRS have decided not to proposea special allocation rule for consolidatedgroups.

Effective Date

The 2000 proposed regulations pro-vided that they would be effective, whenfinalized, for taxable years ending on orafter the date the proposed regulationswere filed with the Federal Register (i.e.,December 29, 1999). The 2000 proposedregulations, however, were proposed to beretroactive in certain instances to preventabuse:

To prevent taxpayers that are membersof a controlled group from togetherclaiming in excess of 100% of thecredit with respect to prior taxableyears, the rules for allocating the groupcredit would apply to any taxable yearbeginning after December 31, 1989,in which, as a result of inconsistentmethods of allocation, the members ofa controlled group as a whole claimedmore than 100% of the allowable groupcredit. In the case of a group whosemembers have different taxable yearsand whose members used inconsistentmethods of allocation, the members of

the group as a whole shall be deemedto have claimed more than 100% of theallowable group credit.The two commentators disagreed as to

the appropriateness of this proposed effec-tive date. In particular, the second com-mentator stated that it would be “uncon-scionable” for final regulations containingthe allocation method set out in the 2000proposed regulations to be applied retroac-tively. The second commentator thereforeproposed that final regulations be appliedprospectively and that for prior years, tax-payers be permitted to rely on final reg-ulations or any other method that is rea-sonable, including a gross QREs method.Finally, the second commentator disputed“that there is a potential for abuse if mem-bers of a controlled group take inconsistentmethods of allocation for past years. Thefact that members of the same controlledgroup may, in the aggregate, claim morethan 100% of the group's Research Creditshould not make any difference.”

The group credit rules in section 41(f)provide for a total group credit. There isnothing in the statute or the legislative his-tory that suggests that it then should bepermissible for the members of the con-trolled group to claim, in the aggregate,an amount of research credit exceeding thegroup credit. Treasury and the IRS con-tinue to believe that the purpose of the sec-tion 41(f) group credit rules would be un-dermined if the members of a controlledgroup applied different allocation meth-ods to claim more than 100 percent of thegroup credit. The preamble to the 2000proposed regulations and those proposedregulations themselves eliminated any am-biguity that may have existed with respectto the Treasury and IRS position on thispoint.

Accordingly, Treasury and the IRS pro-pose that final regulations be effective fortaxable years beginning on or after thedate that these regulations are published inthe Federal Register as final regulations.Treasury and the IRS further propose thatthe final regulations be retroactive in lim-ited circumstances to prevent abuse. Gen-erally, a taxpayer may use any reasonablemethod of computing and allocating thecredit for taxable years beginning beforethe date these regulations are publishedin the Federal Register as final regula-tions. However, paragraph (b) relating tothe computation of the group credit and

paragraph (c), relating to the allocation ofthe group credit, will apply to taxable yearsending on or after December 29, 1999, ifthe members of a controlled group, as awhole, claimed more than 100 percent ofthe amount that would be allowable underparagraph (b). In the case of a controlledgroup whose members have different tax-able years and whose members use incon-sistent methods of allocation, the membersof the controlled group shall be deemed tohave, as a whole, claimed more than 100percent of the amount that would be allow-able under paragraph (b).

Special Analyses

It has been determined that these pro-posed regulations do not constitute asignificant regulatory action as definedin Executive Order 12866. Therefore,a regulatory assessment is not required.It also has been determined that section553(b) of the Administrative ProcedureAct (5 U.S.C. chapter 5) and the Regula-tory Flexibility Act (5 U.S.C. chapter 6)do not apply to these proposed regulations.Pursuant to section 7805(f) of the InternalRevenue Code, these proposed regulationswill be submitted to the Administratorof the Small Business Administration forcomment on their impact on small busi-ness.

* * * * *

Withdrawal of Proposed Amendmentsto the Regulations

Accordingly, under the authority of 26U.S.C. 7805, the notice of proposed rule-making (REG–105606–99, 2000–1 C.B.421 [65 FR 258]) published in the FederalRegister on January 4, 2000, is withdrawn.

Proposed Amendments to theRegulations

Accordingly, 26 CFR part 1 is proposedto be amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * *Par. 2. In §1.41–0, the table of contents

is amended as follows:1. The entry for §1.41–6(a)(4) is re-

vised.

2003-35 I.R.B. 496 September 2, 2003

2. The entries for §1.41–6(b) through(e) are revised.

3. New entries are added for §1.41–6(f)through (i).

The revisions and additions read as fol-lows:

§1.41–0 Table of contents.

* * * * *

§1.41–6 Aggregation of expenditures.

(a)* * *(4) Definition of group credit.(b) Computation of the group credit.(1) In general.(2) Start-up companies.(c) Allocation of the group credit.(1) In general.(2) Stand-alone entity credit.(d) Examples.(e) For taxable years beginning before Jan-uary 1, 1990.(f) Tax accounting periods used.(1) In general.(2) Special rule where timing of researchis manipulated.(g) Membership during taxable year inmore than one group.(h) Intra-group transactions.(1) In general.(2) In-house research expenses.(3) Contract research expenses.(4) Lease payments.(5) Payment for supplies.(i) Effective date.

* * * * *Par. 3. Section 1.41–6 is amended as

follows:1. Paragraph (a)(1) is revised.2. Paragraph (a)(4) is revised.3. Paragraph (b) is revised.4. Paragraphs (c), (d), and (e) are re-

designated as paragraph (f), (g), and (h),respectively.

5. New paragraphs (c), (d), and (e) areadded.

6. Newly designated paragraph (f)(1) isrevised.

7. New paragraph (i) is added.The revisions and additions read as fol-

lows:

§1.41–6 Aggregation of expenditures.

(a) * * * (1) In general. To determinethe amount of research credit (if any) al-lowable to a trade or business that at theend of its taxable year is a member of acontrolled group of corporations or a groupof trades or businesses under common con-trol, a taxpayer must —

(i) Compute the group credit in the man-ner described in paragraph (b) of this sec-tion, and

(ii) Allocate the group credit among themembers of the group in the manner de-scribed in paragraph (c) of this section.

* * * * *(4) Definition of group credit. For pur-

poses of this section, the term group credit

means the research credit (if any) allow-able to a controlled group of corporationsor a group of trades or businesses undercommon control.

(b) Computation of the group credit —(1) In general. All members of a controlledgroup of corporations or a group of tradesor businesses under common control aretreated as a single taxpayer for purposes ofcomputing the research credit. The groupcredit is computed by applying all of thesection 41 computational rules on an ag-gregate basis.

(2) Start-up companies. A controlledgroup of corporations or a group of tradesor businesses under common control istreated as a start-up company for purposesof determining the group's fixed-basepercentage under section 41(c)(3)(B)(ii)only if each member of the group quali-fies as a start-up company under section41(c)(3)(B)(i).

(c) Allocation of the group credit — (1)In general. To determine the amount of thegroup credit (if any) computed under para-graph (b) of this section that is allocated toa member of the group, a taxpayer must —

(i) Compute the member's stand-aloneentity credit; and

(ii) Multiply the group credit by the ra-tio that the member's stand-alone entitycredit bears to the sum of the stand-aloneentity credits of all the members of thegroup:

member’s stand-alone entity creditgroup credit ×

sum of all the members’ stand-alone entity credits

(2) Stand-alone entity credit. For pur-poses of this section, the term stand-aloneentity credit means the research credit (ifany) that would be allowable to a mem-ber of a group if the credit were computedwithout regard to section 41(f). In comput-ing a member's stand-alone entity credit, ataxpayer must use the same method (i.e.,the computation method provided in sec-tion 41(a) or the elective method providedin section 41(c)(4)) that was used to com-pute the group credit. Therefore, if the

research credit determined under section41(a) is not allowable to the group and thegroup credit is computed using the alter-native incremental research credit (AIRC)rules of section 41(c)(4), each member'sstand-alone entity credit also must be com-puted using the AIRC rules, even if theresearch credit determined under section41(a) would be allowable to a member ifthat member were not a part of the group.

(d) Examples. The following examplesillustrate the provisions of this section:

Example 1. Research credit — (i) Facts. A, B,and C, all of which are calendar-year taxpayers, aremembers of a controlled group of corporations. Nei-ther A, B, nor C made any basic research paymentsfor their taxable year ending December 31, 2003. Forpurposes of computing the group credit for the 2003taxable year (the credit year), A, B, and C had the fol-lowing:

September 2, 2003 497 2003-35 I.R.B.

A B CGroup

Aggregate

Credit Year Qualified Research Expenses (QREs) $200x $20x $110x $330x

1984–1988 QREs $40x $10x $100x $150x

1984–1988 Gross Receipts $1,000x $350x $150x $1,500x

Average Annual Gross Receipts for 4 Years Preceding theCredit Year

$1,200x $200x $300x $1,700x

(ii) Computation of the group credit — (A) In gen-eral. The research credit allowable to the group iscomputed as if the three corporations were one tax-payer. The group credit is equal to 20 percent ofthe excess of the group's aggregate credit year QREs($330x) over the group's base amount ($170x). Thegroup credit is 0.20 × ($330x − $170x), which equals$32x.

(B) Group's base amount — (1) Computation.The group's base amount equals the greater of: thegroup's fixed-base percentage (10 percent) multi-plied by the group's aggregate average annual grossreceipts for the 4 taxable years preceding the credit

year ($1,700x), or the group's minimum base amount($165x). The group's base amount, therefore, is$170x, which is the greater of: 0.10 × $1,700x,which equals $170x, or $165x.

(2) Group's minimum base amount. The group'sminimum base amount is 50 percent of the group'saggregate credit year QREs. The group's minimumbase amount is 0.50 × $330x, which equals $165x.

(3) Group's fixed-base percentage. The group'sfixed-base percentage is the lesser of: the ratio thatthe group's aggregate QREs for the taxable years be-ginning after December 31, 1983, and before January1, 1989, bears to the group's aggregate gross receipts

for the same period, or 16 percent (the statutory min-imum). The group's fixed-base percentage, therefore,is 10 percent, which is the lesser of: $150x/$1,500x,which equals 10 percent, or 16 percent.

(iii) Allocation of the group credit. The groupcredit of $32x is allocated among the members of thegroup based on the ratio that each member's stand-alone entity credit bears to the sum of the stand-aloneentity credits of all the members of the controlledgroup. The $32x group credit is allocated as follows:

A B C Total

Stand-Alone Entity Credit $20x $2x $11x $33x

Allocation Ratio (Stand-Alone Entity Credit/Sumof Stand-Alone Entity Credits)

20/33 2/33 11/33

Multiplied by: Group Credit $32x $32x $32x

Equals: Credit Allocated to Member $19.39x $1.94x $10.67x $32x

Example 2. Member is a start-up company —(i) Facts. D, E, and F, all of which are calendar-year taxpayers, are members of a controlled group

of corporations. F is a start-up company under sec-tion 41(c)(3)(B)(i). D and E are not start-up compa-nies under section 41(c)(3)(B)(i). Neither D, E, norF made any basic research payments during the 2003

taxable year. For purposes of computing the groupcredit for the 2003 taxable year (the credit year), D,E, and F had the following:

D E FGroup

Aggregate

Credit Year QREs $200x $20x $50x $270x

1984–1988 QREs $55x $15x $0x $70x

1984–1988 Gross Receipts $1,000x $400x $0x $1,400x

Average Annual Gross Receipts for 4 Years Preceding theCredit Year

$1,200x $200x $0x $1,400x

(ii) Computation of the group credit — (A) In gen-eral. The research credit allowable to the group iscomputed as if the three corporations were one tax-payer. The group credit is equal to 20 percent ofthe excess of the group's aggregate credit year QREs($270x) over the group's base amount ($135x). Thegroup credit is 0.20 × ($270x − $135x), which equals$27x.

(B) Group's base amount — (1) Computation.The group's base amount equals the greater of: thegroup's fixed-base percentage (5 percent) multipliedby the group's aggregate average annual gross re-ceipts for the 4 taxable years preceding the credityear ($1,400x), or the group's minimum base amount($135x). The group's base amount, therefore, is$135x, which is the greater of: 0.05 × $1,400x,which equals $70x, or $135x.

(2) Group's minimum base amount. The group'sminimum base amount is 50 percent of the group'saggregate credit year QREs. The group's minimumbase amount is 0.50 × $270x, which equals $135x.

2003-35 I.R.B. 498 September 2, 2003

(3) Group's fixed-base percentage. Becauseonly one member of the group, F, is a start-upcompany under section 41(c)(3)(B)(i), the groupis not a start-up company under paragraph (b)(2)of this section. Therefore, the group's fixed-basepercentage is the lesser of: the ratio that the group'saggregate QREs for the taxable years beginning after

December 31, 1983, and before January 1, 1989,bears to the group's aggregate gross receipts for thesame period, or 16 percent (the statutory minimum).The group's fixed-base percentage, therefore, is 5percent, which is the lesser of: $70x/$1,400x, whichequals 5 percent, or 16 percent.

(iii) Allocation of the group credit. The groupcredit of $27x is allocated among the members of thegroup based on the ratio that each member's stand-alone entity credit bears to the sum of stand-alone en-tity credits of all the members of the controlled group.The $27x group credit is allocated as follows:

D E F Total

Stand-Alone Entity Credit $20x $2x $5x $27x

Allocation Ratio (Stand-Alone Entity Credit/Sumof Stand-Alone Entity Credits)

20/27 2/27 5/27

Multiplied by: Group Credit $27x $27x $27x

Equals: Credit Allocated to Member $20x $2x $5x $27x

Example 3. Group is a start-up company — (i)Facts. G, H, and I, all of which are calendar-year tax-payers, are members of a controlled group of corpora-tions. Each of G, H, and I qualifies as a start-up com-pany under section 41(c)(3)(B)(i). The 2003 taxableyear is the fifth taxable year beginning after Decem-ber 31, 1993, for which each of G, H, and I has QREs.

Because each of G, H, and I qualifies as a start-upcompany under section 41(c)(3)(B)(i), the group istreated as a start-up company under paragraph (b)(2)of this section. The 2003 taxable year is the fifthtaxable year beginning after December 31, 1993, forwhich the group has QREs. Neither G, H, nor I madeany basic research payments during the 2003 taxable

year. For purposes of computing the group credit forthe 2003 taxable year (the credit year), G, H, and Ihad the following:

G H IGroup

Aggregate

Credit Year QREs $225x $25x $100x $380x

1984–1988 QREs $0x $0x $0x $0x

1984–1988 Gross Receipts $0x $0x $0x $0x

Average Annual Gross Receipts for 4 Years Preceding theCredit Year

$1,600x $340x $300x 2,240x

(ii) Computation of the group credit — (A) In gen-eral. The research credit allowable to the group iscomputed as if the three corporations were one tax-payer. The group credit is equal to 20 percent ofthe excess of the group's aggregate credit year QREs($380x) over the group's base amount ($190x). Thegroup credit is 0.20 × ($380x − $190x), which equals$38x.

(B) Group's base amount — (1) Computation.The group's base amount equals the greater of: thegroup's fixed-base percentage (3 percent) multipliedby the group's aggregate average annual gross re-ceipts for the 4 taxable years preceding the credit

year ($2,240x), or the group's minimum base amount($190x). The group's base amount, therefore, is$190x, which is the greater of: 0.03 x $2,240x,which equals $67.2x, or $190x.

(2) Group's minimum base amount. The group'sminimum base amount is 50 percent of the group'saggregate credit year QREs. The group's minimumbase amount is 0.50 × $380x, which equals $190x.

(3) Group's fixed-base percentage. Each mem-ber of the group is a start-up company under sec-tion 41(c)(3)(B)(i), therefore, the group is a start-upcompany under paragraph (b)(2) of this section. Be-cause the 2003 taxable year is the fifth taxable year

beginning after December 31, 1993, for which thegroup has QREs, under section 41(c)(3)(B)(ii)(I), thegroup's fixed-base percentage is 3 percent.

(iii) Allocation of the group credit. The groupcredit of $38x is allocated among the members of thegroup based on the ratio that each member's stand-alone entity credit bears to the sum of stand-alone en-tity credits of all the members of the controlled group.The $38x group credit is allocated as follows:

G H I Total

Stand-Alone Entity Credit $25.5x $2.5x $10x $38x

Allocation Ratio (Stand-Alone Entity Credit/Sumof Stand-Alone Entity Credits)

25.5/38 2.5/38 10/38

Multiplied by: Group Credit $38x $38x $38x

Equals: Credit Allocated to Member $25.5x $2.5x $10x $38x

September 2, 2003 499 2003-35 I.R.B.

Example 4. Group alternative incrementalresearch credit — (i) Facts. J, K, and L, all ofwhich are calendar-year taxpayers, are members ofa controlled group of corporations. The research

credit under section 41(a) is not allowable to thegroup for the 2003 taxable year because the group'saggregate QREs for the 2003 taxable year are lessthan the group's base amount. The group credit is

computed using the AIRC rules of section 41(c)(4).For purposes of computing the group credit for the2003 taxable year (the credit year), J, K, and L hadthe following:

J K LGroup

Aggregate

Credit Year QREs $0x $20x $110x $130x

Average Annual Gross Receipts for 4 Years Preceding theCredit Year

$1,200x $200x $300x $1,700x

(ii) Computation of the group credit. The re-search credit allowable to the group is computed as ifthe three corporations were one taxpayer. The groupcredit is equal to the sum of: 2.65 percent of so muchof the group's aggregate QREs for the taxable yearas exceeds 1 percent of the group's aggregate averageannual gross receipts for the 4 taxable years preced-ing the credit year, but does not exceed 1.5 percent of

such average; 3.2 percent of so much of the group'saggregate QREs as exceeds 1.5 percent of such av-erage but does not exceed 2 percent of such average;and 3.75 percent of so much of such QREs as exceeds2 percent of such average. The group credit is [0.0265× [($1,700x × 0.015) − ($1,700x × 0.01)]] + [0.032 ×[($1,700x × 0.02) − ($1,700x × 0.015)]] + [0.0375 ×[$130x − ($1,700x × 0.02)]], which equals $4.10x.

(iii) Allocation of the group credit. The groupcredit is allocated to each member of the group bymultiplying the group credit by the ratio that eachmember's stand-alone entity credit bears to the sumof the stand-alone entity credits of all the membersof the group. The $4.10x group credit is allocated asfollows:

J K L Total

Stand-Alone Entity Credit $0x $.66x $3.99x $4.65x

Allocation Ratio (Stand-Alone Entity Credit/Sumof Stand-Alone Entity Credits)

0/4.65 0.66/4.65 3.99/4.65

Multiplied by: Group Credit $4.10x $4.10x $4.10x

Equals: Credit Allocated to Member $0x $.58x $3.52x $4.10x

(e) For taxable years beginning beforeJanuary 1, 1990. For taxable years begin-ning before January 1, 1990, see §1.41–6as contained in 26 CFR part 1, revisedApril 1, 2003.

(f) Tax accounting periods used — (1)In general. The credit allowable to a mem-ber of a controlled group of corporationsor a group of trades or businesses undercommon control is that member's share ofthe group credit computed as of the end ofthat member's taxable year. In computingthe group credit for a group whose mem-bers have different taxable years, a mem-ber generally should treat the taxable yearof another member that ends with or withinthe credit year of the computing memberas the credit year of that other member.For example, M, N, and O are membersof a controlled group of corporations. Mand N file a calendar year consolidated re-turn. O files a separate return using a fis-cal year ending June 30. For purposes ofcomputing the group credit at the end ofthe M's and N's (the computing members')calendar year on December 31, O's fiscalyear ending June 30, which ends within the

M's and N's calendar year, is treated as O'scredit year.

* * * * *(i) Effective date. Paragraphs (a)(1),

(a)(4), (b), (c), (d), and (f)(1) of thissection 1.41–6 are applicable for taxableyears beginning on or after the date theseregulations are published in the FederalRegister as final regulations. Generally, ataxpayer may use any reasonable methodof computing and allocating the creditfor taxable years beginning before thedate these regulations are published inthe Federal Register as final regulations.However, paragraph (b) relating to thecomputation of the group credit and para-graph (c), relating to the allocation of thegroup credit, will apply to taxable yearsending on or after December 29, 1999, ifthe members of a controlled group, as awhole, claimed more than 100 percent ofthe amount that would be allowable underparagraph (b). In the case of a controlledgroup whose members have differenttaxable years and whose members useinconsistent methods of allocation, themembers of the controlled group shall be

deemed to have, as a whole, claimed morethan 100 percent of the amount that wouldbe allowable under paragraph (b).

Robert E. Wenzel,Deputy Commissioner for Ser-

vices and Enforcement.

(Filed by the Office of the Federal Register on July 28, 2003,8:45 a.m., and published in the issue of the Federal Registerfor July 29, 2003, 68 F.R. 44499)

Notice of Proposed Rulemakingand Notice of Public Hearing

Real Estate MortgageInvestment Conduits;Application of Section 446With Respect to InducementFees

REG–162625–02

AGENCY: Internal Revenue Service(IRS), Treasury.

2003-35 I.R.B. 500 September 2, 2003

ACTION: Notice of proposed rulemakingand notice of public hearing.

SUMMARY: This document containsproposed regulations relating to the propertiming and source of income from feesreceived to induce the acquisition ofnoneconomic residual interests in RealEstate Mortgage Investment Conduits(REMICs). The proposed regulationswould apply to taxpayers who receiveinducement fees in connection with be-coming the holder of a noneconomicREMIC residual interest. This documentalso provides notice of a public hearing onthe proposed regulations.

DATES: Written or electronic commentsmust be received by October 20, 2003.Outlines of topics to be discussed at thepublic hearing scheduled for November18, 2003, at 10:00 a.m. must be receivedby October 28, 2003.

ADDRESSES: Send submissions toCC:PA:RU (REG–162625–02), room5226, Internal Revenue Service, POB7604, Ben Franklin Station, Washington,DC 20044. Submissions may be handdelivered Monday through Friday be-tween the hours of 8 a.m. and 4 p.m. to:CC:PA:RU (REG–162625–02), Courier'sDesk, Internal Revenue Service, 1111Constitution Avenue, NW, Washington,DC. Alternatively, taxpayers may submitelectronic comments via the IRS Internetsite at: www.irs.gov/regs. The public hear-ing will be held in the IRS Auditorium,1111 Constitution Avenue, NW, Washing-ton, DC.

FOR FURTHER INFORMATIONCONTACT: Concerning the proposedregulations, John W. Rogers III at (202)622–3950; concerning submissions ofcomments, the hearing, and/or to beplaced on the building access list to at-tend the hearing, Treena Garrett, at (202)622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposedamendments to the Income Tax Regu-lations (26 CFR part 1) under sections446(b) (relating to general rules for meth-ods of accounting), 860C (relating to other

definitions and special rules applicableto REMICs), and 863(a) (relating to spe-cial rules for determining source) of theInternal Revenue Code of 1986 (Code).The proposed regulations prescribe certainaccounting rules for taking an inducementfee into income over a period that is relatedto the period during which the applicableREMIC is expected to generate taxableincome or net loss allocable to the holderof the noneconomic residual interest. Theproposed regulations set forth two safeharbor methods of accounting for induce-ment fees. The proposed regulations alsocontain a rule clarifying that an induce-ment fee is income from sources withinthe United States.

Explanation of Provisions

Final regulations governing REMICs,issued in 1992, contain rules governing thetransfer of noneconomic residual interests.Those regulations do not, however, containrules that address the transferee's treatmentof the fee received to induce the acquisitionof a REMIC noneconomic residual inter-est.

An inducement fee is paid to a trans-feree of a noneconomic residual interestbecause, under sections 860C(a)(1) and860E(a)(1) of the Code, the holder of aREMIC residual interest must take into ac-count the REMIC's taxable income or netloss. The holder of a noneconomic resid-ual interest will receive insufficient distri-butions to cover the resulting tax liabilities,and a transferee will, therefore, require aninducement fee to become the holder of thenoneconomic residual interest.

In its earlier years, a REMIC typicallyaccrues more taxable interest income thandeductible interest expense. As a result, inits earliest years, the REMIC will have netincome (generally referred to as phantomincome) taxable to the residual holder.This phenomenon generally will reverse,resulting in REMIC net loss (phantomloss) in later years.

Following release of the final REMICregulations, the IRS and the Treasury De-partment received requests for guidance onthe proper method of accounting to be usedby taxpayers for inducement fee income.The proposed regulations provide rules re-lating to the proper timing and source ofincome from an inducement fee receivedin connection with becoming the holder

of a noneconomic residual interest in aREMIC.

The proposed regulations provide that,to clearly reflect income, an inducementfee must be included in income over a pe-riod that is reasonably related to the periodduring which the applicable REMIC is ex-pected to generate taxable income or netloss allocable to the holder of the noneco-nomic residual interest. The proposed reg-ulations provide that an inducement feegenerally may not be taken into account ina single tax year.

The proposed regulations set forth twosafe harbor methods of accounting for in-ducement fees. These safe harbor methodsare:

(1) A book method, under which aninducement fee is recognized for federalincome tax purposes in the same amountsand over the same period in which that in-ducement fee is included in income by thetaxpayer for financial reporting purposes,provided that the period is not shorterthan the period over which the applicableREMIC is expected to generate taxableincome; and

(2) A method under which the induce-ment fee is recognized for federal incometax purposes ratably over the remaininganticipated weighted average life of theREMIC determined as of the time thenoneconomic residual interest is trans-ferred to the taxpayer. This method isbased on rules in the final REMIC regu-lations for taking into account a REMICsponsor's unrecognized gain or loss on aREMIC residual interest upon the forma-tion of a REMIC.

Additionally, the proposed regulationscontain a rule that applies if a holder ofa residual interest sells or otherwise dis-poses of the residual interest. Under thisrule, the holder must take into account, atthe time of the sale or other disposition,any unrecognized portion of the induce-ment fee for that residual interest. Trans-actions to which section 381(c)(4) appliesare excluded from this rule because section381 and the regulations thereunder pro-vide for the carryover of tax attributes, in-cluding methods of accounting. The IRSand the Treasury Department consideredexcluding other non-recognition transac-tions, such as contributions under sections351 or 721. These other transactions, how-ever, do not provide for the carryover oftax attributes. The proposed regulations,

September 2, 2003 501 2003-35 I.R.B.

therefore, do not permit continued defer-ral of the unrecognized portion of an in-ducement fee following these other trans-actions.

The proposed regulations also containa rule clarifying that an inducement feeis income from sources within the UnitedStates.

The IRS and the Treasury Departmentrequest comments on other possible safeharbor methods of accounting for these in-ducement fees. In particular, commentsare requested on whether a safe harbormethod that recognizes inducement feesproportionally to the anticipated future fi-nancing costs for funding the net tax liabil-ities of the noneconomic residual interestwould be of general use to taxpayers and, ifso, what factors should be used under thatsafe harbor method for determining a tax-payer's anticipated future financing costs.

The proposed regulations state that thetreatment of inducement fees is a methodof accounting that must be applied con-sistently to all inducement fees receivedin connection with noneconomic REMICresidual interests. Thus, if a taxpayer usesa safe harbor method, the taxpayer mustuse that same safe harbor method for all in-ducement fees received in connection withany noneconomic REMIC residual inter-ests held by the taxpayer.

The proposed regulations regarding thetiming for inclusion of inducement fees inincome, if finalized as proposed, would ap-ply for taxable years ending on or afterpublication of the final regulations in theFederal Register. The IRS and the Trea-sury Department request comments withrespect to whether the applicability of theregulations should be limited to transac-tions arising on or after the effective dateof these regulations and whether some de-lay in the effective date of these regulationsis warranted.

The proposed regulations clarifying thesource of inducement fees, if finalized asproposed, would apply for taxable yearsending on or after publication of the finalregulations in the Federal Register.

A taxpayer may not change its methodof accounting for inducement fees with-out securing the prior consent of the Com-missioner. The Commissioner may pre-scribe terms and conditions necessary toobtain the Commissioner's consent to ef-fect a change in method of accounting and

to prevent amounts from being duplicatedor omitted. See sections 446 and 481;§1.446–1(e)(3). The terms and conditionsthat may be prescribed by the Commis-sioner may include terms and conditionsthat require the change in method of ac-counting to be effected on a cut-off basis orwith an adjustment under section 481(a).The IRS and the Treasury Department re-quest comments on how best to effect anychange in method of accounting necessi-tated by these regulations.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a significantregulatory action as defined in ExecutiveOrder 12866. Therefore, a regulatory as-sessment is not required. It has also beendetermined that section 553(b) of the Ad-ministrative Procedure Act (5 U.S.C. chap-ter 5) does not apply to these regulations,and because the regulations do not im-pose a collection of information on smallentities, the Regulatory Flexibility Act (5U.S.C. chapter 6) does not apply. Pursuantto section 7805(f) of the Code, the noticeof proposed rulemaking will be submittedto the Chief Counsel for Advocacy of theSmall Business Administration for com-ment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any electronic or writtencomments (a signed original and eight (8)copies) that are submitted timely to theIRS. The IRS and the Treasury Departmentspecifically request comments on the clar-ity of the proposed rules and how they maybe made easier to understand. The IRSand the Treasury Department also specifi-cally request comments on the safe harbormethods provided in the regulations andsuggestions for other possible safe harbormethods of accounting for these induce-ment fees. All comments will be availablefor public inspection and copying.

A public hearing has been scheduled forNovember 18, 2003, beginning at 10:00a.m. in the IRS Auditorium, 1111 Con-stitution Avenue, NW, Washington, DC.Due to building security procedures, vis-itors must enter at the Constitution Av-enue entrance. In addition, all visitorsmust present photo identification to enter

the building. Because of access restric-tions, visitors will not be admitted beyondthe immediate entrance area more than 30minutes before the hearing starts. For in-formation about having your name placedon the building access list to attend thehearing, see the “FOR FURTHER INFOR-MATION CONTACT” section of this pre-amble.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing. Persons who wish topresent oral comments at the hearing mustsubmit electronic or written comments andan outline of the topics to be discussedand the time to be devoted to each topic(a signed original and eight (8) copies) byOctober 28, 2003. A period of 10 minuteswill be allotted to each person for makingcomments. An agenda showing the sched-uling of the speakers will be prepared af-ter the deadline for receiving outlines haspassed. Copies of the agenda will be avail-able free of charge at the hearing.

Drafting Information

The principal authors of these regu-lations are John W. Rogers III, Office ofAssociate Chief Counsel (Financial In-stitutions & Products), and Courtney L.Shepardson, Office of Division Counsel(Large and Midsize Business). However,other personnel from the IRS and theTreasury Department participated in theirdevelopment.

* * * * *

Proposed Amendments to theRegulations

Accordingly, 26 CFR part 1 is proposedto be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 is amended by adding an entry innumerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Section 1.446–6 also issued under 26

U.S.C 446 and 26 U.S.C. 860G * * *Par. 2. Section 1.446–6 is added to read

as follows:

§1.446–6 REMIC inducement fees.

(a) Purpose. This section provides spe-cific timing rules for the clear reflection ofincome from an inducement fee received

2003-35 I.R.B. 502 September 2, 2003

in connection with becoming the holderof a noneconomic REMIC residual inter-est. An inducement fee must be includedin income over a period reasonably relatedto the period during which the applicableREMIC is expected to generate taxable in-come or net loss allocable to the holder ofthe noneconomic residual interest.

(b) Definitions. For purposes of thissection—(1) Applicable REMIC. The ap-plicable REMIC is the REMIC that issuedthe noneconomic residual interest with re-spect to which the inducement fee is paid.

(2) Inducement fee. An inducement feeis the amount paid to induce a person to be-come the holder of a noneconomic residualinterest in an applicable REMIC.

(3) Noneconomic residual interest. AREMIC residual interest is a noneconomicresidual interest if it is a noneconomicresidual interest within the meaning of§1.860E–1(c)(2).

(4) Remaining anticipated weightedaverage life. The remaining antici-pated weighted average life is the an-ticipated weighted average life deter-mined using the methodology set forth in§1.860E–1(a)(3)(iv) applied as of the dateof acquisition of the noneconomic residualinterest.

(5) REMIC. The term REMIC has thesame meaning in this section as given in§1.860D–1.

(c) General rule. All taxpayers, regard-less of their overall method of accounting,must recognize an inducement fee over theremaining expected life of the applicableREMIC in a manner that reasonably re-flects, without regard to this paragraph, theafter-tax costs and benefits of holding thatnoneconomic residual interest.

(d) Special rule on disposition of aresidual interest. If any portion of aninducement fee received with respect tothe acquisition of a noneconomic resid-ual interest in an applicable REMIC hasnot been recognized in full by the holderas of the time the holder sells, or other-wise disposes of, that residual interest inthe applicable REMIC (in a transactionother than a transaction to which section381(c)(4) applies), then the holder mustinclude the unrecognized portion of theinducement fee in income at that time.

(e) Safe harbors. If inducement feesare recognized in accordance with a

method described in this paragraph (e),that method complies with the require-ments of paragraph (c) of this section.

(1) The book method. Under the bookmethod, an inducement fee is recognizedin accordance with the method of account-ing, and over the same period, that is usedby the taxpayer for financial reportingpurposes (including consolidated financialstatements to shareholders, partners, ben-eficiaries, other proprietors and for creditpurposes), provided that the inducementfee is included in income for financialreporting purposes over a period that is notshorter than the period during which theapplicable REMIC is expected to generatetaxable income.

(2) The modified REMIC regulatorymethod. Under the modified REMICregulatory method, the inducement feeis recognized ratably over the remaininganticipated weighted average life of the ap-plicable REMIC as if the inducement feewere unrecognized gain being included ingross income under §1.860F–2(b)(4)(iii).

(3) Additional safe harbor methods.The Commissioner, by revenue rulingor revenue procedure published in theInternal Revenue Bulletin, may provideadditional safe harbor methods for recog-nizing inducement fees on noneconomicREMIC residual interests.

(f) Method of accounting. The treat-ment of inducement fees is a method ofaccounting to which the provisions ofsections 446 and 481 and the regulationsthereunder apply. A taxpayer is generallypermitted to adopt a method of account-ing for inducement fees that satisfies therequirements of paragraph (c) of this sec-tion. Once a taxpayer adopts a methodof accounting for inducement fees, thatmethod must be applied consistently to allinducement fees received in connectionwith noneconomic REMIC residual inter-ests and may be changed only with theconsent of the Commissioner, as providedby section 446(e) and the regulations andprocedures thereunder.

(g) Effective date. This section is appli-cable for taxable years ending on or afterthe date this document is published as a fi-nal regulation in the Federal Register.

Par. 3. Section 1.860A–0 is amendedby adding an entry in the outline for§1.860C–1(d) to read as follows:

§1.860A–0 Outline of REMIC provisions.

* * * * *

§1.860C–1 Taxation of holders of residualinterests.

* * * * *(d) Treatment of REMIC inducement

fees.

* * * * *Par. 4. Section 1.860C–1 is amended

by adding paragraph (d) to read as follows:

§1.860C–1 Taxation of holders of residualinterests.

* * * * *(d) For rules on the proper account-

ing for income from inducement fees, see§1.446–6.

Par. 5. Section 1.863–0 is amended by:1. Adding an entry for §1.863–1(d).2. Redesignating the entry for §1.863–

1(e) as §1.863–1(f)3. Adding a new entry for §1.863–1(e).The additions read as follows:

§1.863–0 Table of contents.

* * * * *

§1.863–1 Allocation of gross income.

* * * * *(d) Scholarships, fellowship grants,

grants, prizes and awards.(e) REMIC inducement fees.

* * * * *Par. 6. Section 1.863–1 is amended as

follows:1. Paragraph (e) is revised.2. Paragraph (f) is added.The revision and addition reads as fol-

lows:

§1.863–1 Allocation of gross income.

* * * * *(e) REMIC inducement fees.

An inducement fee (as defined in§1.446–6(b)(2)) shall be treated as in-come from sources within the UnitedStates.

(f) Effective dates. The rules of para-graphs (a), (b) and (c) of this section willapply to taxable years beginning after De-cember 30, 1996. However, taxpayers may

September 2, 2003 503 2003-35 I.R.B.

apply the rules of paragraphs (a), (b) and(c) of this section for taxable years begin-ning after July 11, 1995, and on or beforeDecember 30, 1996. For years beginningbefore December 30, 1996, see §1.863–1(as contained in 26 CFR part 1 revised asof April 1, 1996). See paragraph (d)(4) ofthis section for rules regarding the applica-bility date of paragraph (d) of this section.Paragraph (e) of this section is applicablefor taxable years ending on or after the datethis document is published as a final regu-lation in the Federal Register.

Robert E. Wenzel,Deputy Commissioner for Ser-

vices and Enforcement.

(Filed by the Office of the Federal Register on July 18, 2003,8:45 a.m., and published in the issue of the Federal Registerfor July 21, 2003, 68 F.R. 43055)

Notice of Proposed Rulemaking

Elimination of Forms ofDistribution in DefinedContribution Plans

REG–112039–03

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains pro-posed regulations that would modify thecircumstances under which certain formsof distribution previously available are per-mitted to be eliminated from qualified de-fined contribution plans. These proposedregulations affect qualified retirement plansponsors, administrators, and participants.

DATES: Written and electronic commentsand request for a public hearing must bereceived by October 6, 2003.

ADDRESSES: Send submissions to:CC:PA:RU (REG–112039–03), room5226, Internal Revenue Service, POB7604, Ben Franklin Station, Washington,DC 20044. Submissions may be handdelivered Monday through Friday be-tween the hours of 8 a.m. and 5 p.m. to:CC:PA:RU (REG–112039–03), Courier'sDesk, Internal Revenue Service, 1111Constitution Avenue, NW, Washington,DC. Alternatively, taxpayers may submit

comments electronically directly to theIRS Internet site at: www.irs.gov/regs.

FOR FURTHER INFORMATIONCONTACT: Concerning the regulations,Vernon S. Carter, 202–622–6060 (not atoll-free number); concerning submis-sions or hearing requests, Guy Traynor,202–622–7180 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Explanation of Provisions

This document contains proposedamendments to 26 CFR part 1 under sec-tion 411(d)(6) of the Internal RevenueCode of 1986 (Code) as amended by theEconomic Growth and Tax Relief Rec-onciliation Act of 2001 (EGTRRA) (115Stat. 117). Section 411(d)(6)(A) of theCode generally provides that a plan willnot be treated as satisfying the require-ments of section 411 if the accrued benefitof a participant is decreased by a planamendment. Section 411(d)(6)(B) priorto amendment by EGTRRA provided thatan amendment is treated as reducing anaccrued benefit if, with respect to benefitsaccrued before the amendment is adopted,the amendment has the effect of eithereliminating or reducing an early retire-ment benefit or a retirement-type subsidy,or, except as provided by regulations,eliminating an optional form of benefit.

The IRS published T.D. 8900, 2000–2C.B. 279 [65 FR 53901], in the Fed-eral Register on September 6, 2000. T.D.8900, which amended section §1.411(d)–4of the Income Tax Regulations, addedparagraph (e) of Q&A–2 to provide foradditional circumstances under which adefined contribution plan can be amendedto eliminate or restrict a participant’s rightto receive payment of accrued benefitsunder certain optional forms of benefit.

Section 1.411(d)–4, Q&A–2(e)(1) pro-vides that a defined contribution plan maybe amended to eliminate or restrict a par-ticipant’s right to receive payment of ac-crued benefits under a particular optionalform of benefit without violating the sec-tion 411(d)(6) anti-cutback rules if, oncethe plan amendment takes effect for a par-ticipant, the alternative forms of paymentthat remain available to the participant in-clude payment in a single-sum distributionform that is “otherwise identical” to theeliminated or restricted optional form of

benefit. The amendment cannot apply toa participant for any distribution with anannuity starting date before the earlier ofthe 90th day after the participant receives asummary that reflects the plan amendmentand that satisfies Department of Labor’srequirements for a summary of materialmodifications under 29 CFR 2520.104b–3,or the first day of the second plan year fol-lowing the plan year in which the amend-ment is adopted. Section §1.411(d)–4,Q&A–2(e)(2) provides that a single-sumdistribution form is “otherwise identical”to the optional form of benefit that is beingeliminated or restricted only if it is iden-tical in all respects (or would be identicalexcept that it provides greater rights to theparticipant), except for the timing of pay-ments after commencement. A single-sumdistribution form is not “otherwise identi-cal” to a specified installment form of ben-efit if the single-sum form:

• is not available for distribution on anydate on which the installment formcould have commenced;

• is not available in the same medium asthe installment form; or

• imposes any additional condition of el-igibility.

Further, an otherwise identical distributionform need not retain any rights or featuresof the eliminated or restricted optionalform of benefit to the extent those rights orfeatures would not be protected from elim-ination under the anti-cutback rules. Thesingle-sum distribution form would not,however, be disqualified from being anotherwise identical distribution form if thesingle-sum form provides greater rightsto participants than did the eliminated orrestricted optional form of benefits.

Section 645(a)(1) of EGTRRA revisedsection 411(d)(6) in a manner that issimilar to §1.411(d)–4, Q&A–2(e), butwithout the advance notice condition.Section 411(d)(6)(E) of the Code providesthat, except to the extent provided in reg-ulations, a defined contribution plan is nottreated as reducing a participant’s accruedbenefit where a plan amendment elim-inates a form of distribution previouslyavailable under the plan if a single-sumdistribution is available to the participantat the same time as the form of distributioneliminated by the amendment, and the

2003-35 I.R.B. 504 September 2, 2003

single-sum distribution is based on thesame or greater portion of the participant’saccount as the form of distribution elimi-nated by the amendment.

To reflect the addition of section411(d)(6)(E) by EGTRRA, these proposedregulations would amend §1.411(d)–4,Q&A–2(e). Under these amendments, theregulations would retain the rules underwhich a defined contribution plan may beamended to eliminate or restrict a partici-pant’s right to receive payment of accruedbenefits under a particular optional formof benefit without violating the section411(d)(6) anti-cutback rules if, once theplan amendment takes effect for a partic-ipant, the alternative forms of paymentthat remain available to the participantinclude payment in a single-sum distribu-tion. However, these proposed regulationswould remove the 90-day notice condi-tion previously applicable to these planamendments.1

Under section 101 of ReorganizationPlan No. 4 of 1978 (43 FR 47713), theSecretary of the Treasury has interpretivejurisdiction over the subject matter ad-dressed in these regulations for purposesof the Employee Retirement Income Se-curity Act of 1974 (ERISA), as well asthe Code. Section 204(g)(2) of ERISA, asamended by EGTRRA, provides a parallelrule to section 411(d)(6)(E) of the Codethat applies under Title I of ERISA, andauthorizes the Secretary of the Treasury toprovide exception to this parallel ERISArequirement. Therefore, these regulationsapply for purposes of the parallel require-ments of sections 204(g)(2) of ERISA,as well as for section 411(d)(6)(E) of theCode.

Effective Date and Applicability Date

The proposed regulations are proposedto apply on the date of publication of finalregulations in the Federal Register.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessmentis not required. It also has been determined

that section 553(b) of the AdministrativeProcedure Act (5 U.S.C. chapter 5) doesnot apply to these regulations, and becausethe regulation does not impose a collec-tion of information on small entities, theRegulatory Flexibility Act (5 U.S.C. chap-ter 6) does not apply. Pursuant to section7805(f) of the Code, this notice of pro-posed rulemaking will be submitted to theChief Counsel for Advocacy of the SmallBusiness Administration for comment onits impact on small business.

Drafting Information

The principal author of these regula-tions is Vernon S. Carter of the Officeof the Division Counsel/Associate ChiefCounsel (Tax Exempt and Government En-tities). However, other personnel from theIRS and Treasury participated in their de-velopment.

* * * * *

Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposedto be amended as follows:

Paragraph 1. The authority citation forpart 1 is amended to read in part as follows:

Authority: 26 U.S.C. 7805***Section 1.411(d)–4, Q&A–2(e) also is-

sued under 26 U.S.C. 411(d)(6)(E). * * *Par. 2. Section 1.411(d)–4, Q&A–2(e)

is revised to read as follows:

§1.411(d)–4 Section 411(d)(6) protectedbenefits.

* * * * *A–2: * * *(e) Permitted plan amendments affect-

ing alternative forms of payment underdefined contribution plans—(1) Generalrule. A defined contribution plan doesnot violate the requirements of section411(d)(6) merely because the plan isamended to eliminate or restrict the abilityof a participant to receive payment ofaccrued benefits under a particular op-tional form of benefit if, after the planamendment is effective with respect to theparticipant, the alternative forms of pay-ment available to the participant includepayment in a single-sum distribution form

that is otherwise identical to the optionalform of benefit that is being eliminated orrestricted.

(2) Otherwise identical single-sum dis-tribution. For purposes of this paragraph(e), a single-sum distribution form is oth-erwise identical to an optional form of ben-efit that is eliminated or restricted pur-suant to paragraph (e)(1) of this Q&A–2only if the single-sum distribution formis identical in all respects to the elimi-nated or restricted optional form of ben-efit (or would be identical except that itprovides greater rights to the participant)except with respect to the timing of pay-ments after commencement. For exam-ple, a single-sum distribution form is nototherwise identical to a specified install-ment form of benefit if the single-sum dis-tribution form is not available for distribu-tion on the date on which the installmentform would have been available for com-mencement, is not available in the samemedium of distribution as the installmentform, or imposes any condition of eligi-bility that did not apply to the installmentform. However, an otherwise identical dis-tribution form need not retain rights or fea-tures of the optional form of benefit that iseliminated or restricted to the extent thatthose rights or features would not be pro-tected from elimination or restriction un-der section 411(d)(6) or this section.

(3) Example. The following exampleillustrates the application of this paragraph(e):

Example. (i) P is a participant in Plan M, a quali-fied profit-sharing plan with a calendar plan year thatis invested in mutual funds. The distribution formsavailable to P under Plan M include a distribution ofP's vested account balance under Plan M in the formof distribution of various annuity contract forms (in-cluding a single life annuity and a joint and survivorannuity). The annuity payments under the annuitycontract forms begin as of the first day of the monthfollowing P's severance from employment (or as ofthe first day of any subsequent month, subject to therequirements of section 401(a)(9)). P has not pre-viously elected payment of benefits in the form ofa life annuity, and Plan M is not a direct or indirecttransferee of any plan that is a defined benefit plan ora defined contribution plan that is subject to section412. Distributions on the death of a participant aremade in accordance with plan provisions that complywith section 401(a)(11)(B)(iii)(I). On May 2, 2004,Plan M is amended so that, after the amendment iseffective, P is no longer entitled to any distributionin the form of the distribution of an annuity contract.

1 The Department of Labor has advised Treasury and the IRS that it should be noted that plans covered by Title I of ERISA will continue to be subject to the requirement under Title I thatplan amendments be described in a timely summary of material modifications (SMM) or a revised summary plan description (SPD) to be distributed to plan participants and beneficiaries inaccordance with applicable Department of Labor disclosure rules (see 29 CFR 2520.104b–3).

September 2, 2003 505 2003-35 I.R.B.

However, after the amendment is effective, P is en-titled to receive a single-sum cash distribution of P'svested account balance under Plan M payable as ofthe first day of the month following P's severancefrom employment (or as of the first day of any sub-sequent month, subject to the requirements of section401(a)(9)). The amendment does not apply to P if Pelects to have annuity payments begin before July 1,2004.

(ii) Plan M does not violate the requirementsof section 411(d)(6) (or section 401(a)(11)) merelybecause, as of July 1, 2004, the plan amendmenthas eliminated P's option to receive a distribution inany of the various annuity contract forms previouslyavailable.

(4) Effective date. This paragraph (e)is applicable on the date of publication offinal regulations in the Federal Register.

* * * * *

Robert E. Wenzel,Deputy Commissioner for Ser-

vices and Enforcement.

(Filed by the Office of the Federal Register on July 7, 2003,8:45 a.m., and published in the issue of the Federal Registerfor July 8, 2003, 68 F.R. 40581)

Notice of Proposed Rulemakingby Cross-Reference to TemporaryRegulations and Notice of PublicHearing

Prohibited Allocations ofSecurities in an S Corporation

REG–129709–03

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemakingby cross-reference to temporary regula-tions and notice of public hearing.

SUMMARY: In this issue of the Bulletin,the IRS is issuing temporary regulations(T.D. 9081) that provide guidance on iden-tifying disqualified persons and determin-ing whether a plan year is a nonalloca-tion year under section 409(p) and on thedefinition of synthetic equity under sec-tion 409(p)(5). These proposed regula-tions would generally affect plan spon-sors of, and participants in, ESOPs holdingstock of Subchapter S corporations. Thetext of those temporary regulations alsoserves as the text of these proposed regula-tions. This document also provides notice

of a public hearing on these proposed reg-ulations.

DATES: Written or electronic commentsmust be received by October 17, 2003.

Requests to speak (with outlines of oralcomments to be discussed) at the publichearing scheduled for November 17, 2003,at 10 a.m. must be received by October 27,2003.

ADDRESSES: Send submissions to:CC:PA:LPD:PR (REG–129709–03),room 5203, Internal Revenue Service,POB 7604, Ben Franklin Station, Wash-ington, DC 20044. Submissions may behand delivered Monday through Fridaybetween the hours of 8 a.m. and 5 p.m.to: CC:PA:LPD:PR (REG–129709–03),Courier's Desk, Internal Revenue Service,1111 Constitution Avenue, NW, Wash-ington, DC. Alternatively, taxpayers maysubmit comments electronically directly tothe IRS Internet site at www.irs.gov/regs.The public hearing will be held in room6718, Internal Revenue Building, 1111Constitution Avenue, NW, Washington,DC.

FOR FURTHER INFORMATIONCONTACT: Concerning the proposedregulations, John Ricotta at 622–6060;concerning submissions of comments,Sonya Cruse, (202) 622–4693 (nottoll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Temporary regulations (T.D. 9081)on page 420 of this issue of the Bulletinamend the Income Tax Regulations (26CFR part 1) relating to section 409(p).The temporary regulations contain rulesrelating to the identification of disqualifiedpersons and determination whether a planyear is a nonallocation year under section409(p) and the definition of synthetic eq-uity under section 409(p)(5). The text ofthose temporary regulations also servesas the text of these proposed regulations.The preamble to the temporary regulationsexplains the temporary regulations.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a significant

regulatory action as defined in ExecutiveOrder 12866. Therefore, a regulatory as-sessment is not required. It also has beendetermined that section 553(b) of the Ad-ministrative Procedure Act (5 U.S.C. chap-ter 5) does not apply to these regulations.Because §1.409(p)–1 imposes no new col-lection of information on small entities, aRegulatory Flexibility Analysis under theRegulatory Flexibility Act (5 U.S.C. chap-ter 6) is not required. Pursuant to section7805(f) of the Internal Revenue Code, thisnotice of proposed rulemaking will be sub-mitted to the Chief Counsel for Advocacyof the Small Business Administration forcomment on its impact on small business.

Comments and Requests for a PublicHearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any written comments (asigned original and eight (8) copies) thatare submitted timely to the IRS. All com-ments will be available for public inspec-tion and copying.

Comments are requested with respect toissues raised by S corporation ESOPs es-tablished by March 14, 2001, that will needto comply with the requirements of sec-tion 409(p) beginning in 2005. For theseESOPs, the inclusion of deferred compen-sation as synthetic equity can be avoidedby distributing such deferred compensa-tion before 2005. Some employers mayprefer other transition approaches. Forexample, a preferable transition approachmay be to spin off and terminate the por-tion of a plan benefitting disqualified per-sons. Comments are requested on whetherguidance is needed to address these possi-ble transition approaches.

Comments are also requested on issuesthat are reserved in the regulations with re-spect to whether certain interests in an Scorporation should be treated as syntheticequity, including the extent to which rightsto acquire assets of the S corporation oranother person are established for reason-able business purposes and should not betreated as synthetic equity. While com-ments can be filed as late as October 17,2003, commentators are encouraged to filecomments as early as possible because theIRS and Treasury intend to move forwardto address these issues as early as 2003.

2003-35 I.R.B. 506 September 2, 2003

Commentators may also wish to com-ment on section 409(p)-related issues thatare not directly raised in the proposed reg-ulations. For example, commentators maywish to comment on the extent to whichadministrative guidance may be needed onan interim basis to deal with specific struc-tures used to avoid or evade the purpose ofsection 409(p).

A public hearing has been scheduled forNovember 17, 2003, at 10 a.m. in room6718 of the Internal Revenue Building,1111 Constitution Avenue, NW, Washing-ton, DC. All visitors must present photoidentification to enter the building. Be-cause of access restrictions, visitors willnot be admitted beyond the immediate en-trance area more than 30 minutes beforethe hearing starts at the Constitution Av-enue entrance. For information about hav-ing your name placed on the building ac-cess list to attend the hearing, see the "FORFURTHER INFORMATION CONTACT"section of this preamble.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing. Persons who wish topresent oral comments at the hearing mustsubmit written comments and an outline

of the topics to be discussed and the timeto be devoted to each topic (signed orig-inal and eight (8) copies) by October 27,2003. A period of 10 minutes will beallotted to each person for making com-ments. An agenda showing the schedulingof the speakers will be prepared after thedeadline for receiving outlines has passed.Copies of the agenda will be available freeof charge at the hearing.

Drafting Information

The principal author of these regula-tions is John Ricotta of the Office of theDivision Counsel/Associate Chief Coun-sel (Tax Exempt and Government Enti-ties). However, other personnel from theIRS and Treasury participated in their de-velopment.

* * * * *

Proposed Amendments to theRegulations

Accordingly, 26 CFR part 1 is proposedto be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 is amended by an entry in numericalorder to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Section 1.409(p)–1 also issued under 26

U.S.C. 409(p)(7)(A). * * *Par. 2. Section 1.409(p)–1 is added to

read as follows:

§1.409(p)–1 Prohibited allocation ofsecurities in an S corporation.

[The text of proposed §1.409(p)–1 isthe same as the text of §1.409(p)–1T pub-lished elsewhere in this issue of the Bul-letin].

Robert E. Wenzel,Deputy Commissioner for Ser-

vices and Enforcement.

(Filed by the Office of the Federal Register on July 18, 2003,8:45 a.m., and published in the issue of the Federal Registerfor July 21, 2003, 68 F.R. 43058)

September 2, 2003 507 2003-35 I.R.B.

Definition of TermsRevenue rulings and revenue procedures(hereinafter referred to as “rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe the ef-fect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position is be-ing extended to apply to a variation of thefact situation set forth therein. Thus, ifan earlier ruling held that a principle ap-plied to A, and the new ruling holds that thesame principle also applies to B, the earlierruling is amplified. (Compare with modi-fied, below).

Clarified is used in those instanceswhere the language in a prior ruling isbeing made clear because the languagehas caused, or may cause, some confusion.It is not used where a position in a priorruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previously pub-lished ruling and points out an essentialdifference between them.

Modified is used where the substanceof a previously published position is beingchanged. Thus, if a prior ruling held that aprinciple applied to A but not to B, and thenew ruling holds that it applies to both A

and B, the prior ruling is modified becauseit corrects a published position. (Comparewith amplified and clarified, above).

Obsoleted describes a previously pub-lished ruling that is not considered deter-minative with respect to future transac-tions. This term is most commonly used ina ruling that lists previously published rul-ings that are obsoleted because of changesin laws or regulations. A ruling may alsobe obsoleted because the substance hasbeen included in regulations subsequentlyadopted.

Revoked describes situations where theposition in the previously published rulingis not correct and the correct position isbeing stated in a new ruling.

Superseded describes a situation wherethe new ruling does nothing more than re-state the substance and situation of a previ-ously published ruling (or rulings). Thus,the term is used to republish under the1986 Code and regulations the same po-sition published under the 1939 Code andregulations. The term is also used whenit is desired to republish in a single rul-ing a series of situations, names, etc., thatwere previously published over a period oftime in separate rulings. If the new rul-ing does more than restate the substance

of a prior ruling, a combination of termsis used. For example, modified and su-perseded describes a situation where thesubstance of a previously published rulingis being changed in part and is continuedwithout change in part and it is desired torestate the valid portion of the previouslypublished ruling in a new ruling that is selfcontained. In this case, the previously pub-lished ruling is first modified and then, asmodified, is superseded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling and thatlist is expanded by adding further names insubsequent rulings. After the original rul-ing has been supplemented several times, anew ruling may be published that includesthe list in the original ruling and the ad-ditions, and supersedes all prior rulings inthe series.

Suspended is used in rare situationsto show that the previous published rul-ings will not be applied pending somefuture action such as the issuance of newor amended regulations, the outcome ofcases in litigation, or the outcome of aService study.

AbbreviationsThe following abbreviations in current useand formerly used will appear in materialpublished in the Bulletin.

A—Individual.Acq.—Acquiescence.B—Individual.BE—Beneficiary.BK—Bank.B.T.A.—Board of Tax Appeals.C—Individual.C.B.—Cumulative Bulletin.CFR—Code of Federal Regulations.CI—City.COOP—Cooperative.Ct.D.—Court Decision.CY—County.D—Decedent.DC—Dummy Corporation.DE—Donee.Del. Order—Delegation Order.DISC—Domestic International Sales Corporation.DR—Donor.E—Estate.EE—Employee.E.O.—Executive Order.

ER—Employer.ERISA—Employee Retirement Income Security Act.EX—Executor.F—Fiduciary.FC—Foreign Country.FICA—Federal Insurance Contributions Act.FISC—Foreign International Sales Company.FPH—Foreign Personal Holding Company.F.R.—Federal Register.FUTA—Federal Unemployment Tax Act.FX—Foreign corporation.G.C.M.—Chief Counsel’s Memorandum.GE—Grantee.GP—General Partner.GR—Grantor.IC—Insurance Company.I.R.B.—Internal Revenue Bulletin.LE—Lessee.LP—Limited Partner.LR—Lessor.M—Minor.Nonacq.—Nonacquiescence.O—Organization.P—Parent Corporation.PHC—Personal Holding Company.PO—Possession of the U.S.

PR—Partner.PRS—Partnership.PTE—Prohibited Transaction Exemption.Pub. L.—Public Law.REIT—Real Estate Investment Trust.Rev. Proc.—Revenue Procedure.Rev. Rul.—Revenue Ruling.S—Subsidiary.S.P.R.—Statement of Procedural Rules.Stat.—Statutes at Large.T—Target Corporation.T.C.—Tax Court.T.D. —Treasury Decision.TFE—Transferee.TFR—Transferor.T.I.R.—Technical Information Release.TP—Taxpayer.TR—Trust.TT—Trustee.U.S.C.—United States Code.X—Corporation.Y—Corporation.Z —Corporation.

2003-35 I.R.B. i September 2, 2003

Numerical Finding List1

Bulletins 2003–27 through 2003–34

Announcements:

2003-45, 2003-28 I.R.B. 73

2003-46, 2003-30 I.R.B. 222

2003-47, 2003-29 I.R.B. 124

2003-48, 2003-28 I.R.B. 73

2003-49, 2003-32 I.R.B. 339

2003-50, 2003-30 I.R.B. 222

2003-52, 2003-32 I.R.B. 345

2003-53, 2003-32 I.R.B. 345

Notices:

2003-38, 2003-27 I.R.B. 9

2003-39, 2003-27 I.R.B. 10

2003-40, 2003-27 I.R.B. 10

2003-41, 2003-28 I.R.B. 49

2003-42, 2003-28 I.R.B. 49

2003-43, 2003-28 I.R.B. 50

2003-44, 2003-28 I.R.B. 52

2003-45, 2003-29 I.R.B. 86

2003-46, 2003-28 I.R.B. 53

2003-47, 2003-30 I.R.B. 132

2003-48, 2003-30 I.R.B. 133

2003-49, 2003-32 I.R.B. 294

2003-50, 2003-32 I.R.B. 295

2003-51, 2003-33 I.R.B. 361

2003-52, 2003-32 I.R.B. 296

2003-53, 2003-33 I.R.B. 362

2003-54, 2003-33 I.R.B. 363

2003-55, 2003-34 I.R.B. 395

2003-56, 2003-34 I.R.B. 396

2003-57, 2003-34 I.R.B. 397

Proposed Regulations:

REG-106736-00, 2003-28 I.R.B. 60

REG-107618-02, 2003-27 I.R.B. 13

REG-122917-02, 2003-27 I.R.B. 15

REG-131997-02, 2003-33 I.R.B. 366

REG-141669-02, 2003-34 I.R.B. 408

REG-116914-03, 2003-32 I.R.B. 338

REG-132483-03, 2003-34 I.R.B. 410

Revenue Procedures:

2003-45, 2003-27 I.R.B. 11

2003-46, 2003-28 I.R.B. 54

2003-47, 2003-28 I.R.B. 55

2003-48, 2003-29 I.R.B. 86

2003-49, 2003-29 I.R.B. 89

2003-50, 2003-29 I.R.B. 119

2003-51, 2003-29 I.R.B. 121

2003-52, 2003-30 I.R.B. 134

2003-53, 2003-31 I.R.B. 230

2003-54, 2003-31 I.R.B. 236

Revenue Procedures— Continued:

2003-55, 2003-31 I.R.B. 242

2003-56, 2003-31 I.R.B. 249

2003-57, 2003-31 I.R.B. 257

2003-58, 2003-31 I.R.B. 262

2003-59, 2003-31 I.R.B. 268

2003-60, 2003-31 I.R.B. 274

2003-61, 2003-32 I.R.B. 296

2003-62, 2003-32 I.R.B. 299

2003-63, 2003-32 I.R.B. 304

2003-64, 2003-32 I.R.B. 306

2003-65, 2003-32 I.R.B. 336

2003-66, 2003-33 I.R.B. 364

2003-67, 2003-34 I.R.B. 397

2003-68, 2003-34 I.R.B. 398

2003-69, 2003-34 I.R.B. 403

2003-70, 2003-34 I.R.B. 406

Revenue Rulings:

2003-70, 2003-27 I.R.B. 3

2003-71, 2003-27 I.R.B. 1

2003-72, 2003-33 I.R.B. 346

2003-73, 2003-28 I.R.B. 44

2003-74, 2003-29 I.R.B. 77

2003-75, 2003-29 I.R.B. 79

2003-76, 2003-33 I.R.B. 355

2003-77, 2003-29 I.R.B. 75

2003-78, 2003-29 I.R.B. 76

2003-79, 2003-29 I.R.B. 80

2003-80, 2003-29 I.R.B. 83

2003-81, 2003-30 I.R.B. 126

2003-82, 2003-30 I.R.B. 125

2003-83, 2003-30 I.R.B. 128

2003-84, 2003-32 I.R.B. 289

2003-85, 2003-32 I.R.B. 291

2003-86, 2003-32 I.R.B. 290

2003-87, 2003-29 I.R.B. 82

2003-88, 2003-32 I.R.B. 292

2003-90, 2003-33 I.R.B. 353

2003-91, 2003-33 I.R.B. 347

2003-92, 2003-33 I.R.B. 350

2003-93, 2003-33 I.R.B. 346

2003-94, 2003-33 I.R.B. 357

2003-95, 2003-33 I.R.B. 358

2003-96, 2003-34 I.R.B. 386

2003-97, 2003-34 I.R.B. 380

2003-98, 2003-34 I.R.B. 378

2003-99, 2003-34 I.R.B. 388

2003-100, 2003-34 I.R.B. 385

Treasury Decisions:

9061, 2003-27 I.R.B. 5

9062, 2003-28 I.R.B. 46

9067, 2003-32 I.R.B. 287

1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2003-1 through 2003-26 is in Internal Revenue Bulletin 2003-27,dated July 7, 2003.

September 2, 2003 ii 2003-35 I.R.B.

Findings List of Current Actions onPreviously Published Items1

Bulletins 2003-27 through 2003-34

Notices:

87-5

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

87-66

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

89-79

Modified and superseded by

Rev. Proc. 2003-47, 2003-28 I.R.B. 55

89-94

Modified by

Notice 2003-50, 2003-32 I.R.B. 295

94-46

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

95-50

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

95-53

Modified and superseded by

Notice 2003-55, 2003-34 I.R.B. 395

2001-4

Section III.C. superseded for 2004 and subsequent

calendar years by

Rev. Proc. 2003-64, 2003-32 I.R.B. 306

2001-70

Amplified by

Notice 2003-45, 2003-29 I.R.B. 86

2001-74

Amplified by

Notice 2003-45, 2003-29 I.R.B. 86

2002-1

Amplified by

Notice 2003-49, 2003-32 I.R.B. 294

Proposed Regulations:

EE-86-88 (LR-279-81)

Withdrawn by

REG-122917-02, 2003-27 I.R.B. 15

Revenue Procedures:

66-50

Modified, amplified, and superseded by

Rev. Proc. 2003-62, 2003-32 I.R.B. 299

68-23

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

Revenue Procedures— Continued:

68-41

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

77-12

Amplified, modified, and superseded by

Rev. Proc. 2003-51, 2003-29 I.R.B. 121

81-40

Modified and superseded by

Rev. Proc. 2003-62, 2003-32 I.R.B. 299

89-12

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

89-21

Superseded by

Rev. Proc. 2003-53, 2003-31 I.R.B. 230

90-19

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

90-32

Section 4 superseded by

Rev. Proc. 2003-55, 2003-31 I.R.B. 242Section 5 superseded by

Rev. Proc. 2003-56, 2003-31 I.R.B. 249Section 6 superseded by

Rev. Proc. 2003-57, 2003-31 I.R.B. 257Section 7 superseded by

Rev. Proc. 2003-59, 2003-31 I.R.B. 268Section 8 superseded by

Rev. Proc. 2003-60, 2003-31 I.R.B. 274

91-11

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

91-13

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

91-39

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

92-33

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

92-35

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

92-88

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

93-17

Obsoleted by

REG-132483-03, 2003-34 I.R.B. 408

Revenue Procedures— Continued:

94-46

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

95-10

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

95-11

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

95-39

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

96-17

Modified and superseded by

Rev. Proc. 2003-69, 2003-34 I.R.B. 402

96-30

Modified and amplified by

Rev. Proc. 2003-48, 2003-29 I.R.B. 86

2000-12

Modified by

Rev. Proc. 2003-64, 2003-32 I.R.B. 306

2000-15

Superseded by

Rev. Proc. 2003-61, 2003-32 I.R.B. 296

2002-9

Modified by

Rev. Proc. 2003-45, 2003-27 I.R.B. 11

Amplified and modified by

Rev. Proc. 2003-50, 2003-29 I.R.B. 119

Modified and amplified by

Rev. Proc. 2003-63, 2003-32 I.R.B. 304

Rev. Rul. 2003-81, 2003-30 I.R.B. 126

2002-13

Revoked by

Rev. Proc. 2003-68, 2003-34 I.R.B. 398

2002-33

Amplified and modified by

Rev. Proc. 2003-50, 2003-29 I.R.B. 119

2002-34

Superseded by

Rev. Proc. 2003-52, 2003-30 I.R.B. 134

2002-45

Revoked by

Rev. Proc. 2003-68, 2003-34 I.R.B. 398

2003-3

Modified by

Rev. Proc. 2003-48, 2003-29 I.R.B. 86

2003-15

Modified and superseded by

Rev. Proc. 2003-49, 2003-29 I.R.B. 89

1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2003-1 through 2003-26 is in Internal Revenue Bulletin 2003-27, dated July 7, 2003.

2003-35 I.R.B. iii September 2, 2003

Revenue Rulings:

53-56

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

54-139

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

54-396

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

55-105

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

55-372

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

56-128

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

56-160

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

56-212

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

56-220

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

56-271

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

56-344

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

56-448

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

56-451

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

56-586

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

56-680

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

56-681

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

57-116

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

Revenue Rulings— Continued:

57-296

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

57-542

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

58-92

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

59-108

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

58-618

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

59-120

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

59-122

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

59-233

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

59-326

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

59-356

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

59-400

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

59-412

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

60-49

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

60-246

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

60-262

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

60-307

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

61-96

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

Revenue Rulings— Continued:

63-157

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

63-224

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

63-248

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

64-147

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

64-177

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

64-285

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

65-110

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

62-260

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

65-273

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

66-4

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

66-23

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

66-290

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

67-186

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

67-189

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

67-326

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

68-309

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

68-388

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

September 2, 2003 iv 2003-35 I.R.B.

Revenue Rulings— Continued:

68-434

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

68-477

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

68-522

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

68-608

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

68-640

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

68-641

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

69-18

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

69-20

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

69-241

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

69-361

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

69-426

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

69-485

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

69-517

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

70-6

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

70-111

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

70-229

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

70-230

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

Revenue Rulings— Continued:

70-264

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

70-286

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

70-378

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

70-409

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

70-496

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

71-13

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

71-384

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

71-440

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

71-453

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

71-454

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

71-495

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

71-518

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

71-565

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

71-582

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

72-61

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

72-116

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

72-212

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

Revenue Rulings— Continued:

72-357

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

72-472

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

72-526

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

72-599

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

72-603

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

73-46

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

73-119

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

73-182

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

73-257

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

73-277

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

73-473

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

73-490

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

73-498

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

74-6

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

74-59

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

74-73

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

74-83

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

2003-35 I.R.B. v September 2, 2003

Revenue Rulings— Continued:

74-87

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

74-211

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

74-376

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

74-476

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

74-521

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

74-610

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-53

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-54

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-105

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-106

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-107

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-111

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-134

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-160

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-174

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-179

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-212

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

Revenue Rulings— Continued:

75-248

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-298

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-341

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-426

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-468

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-515

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

75-561

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

76-44

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

76-67

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

76-90

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

76-239

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

76-329

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

76-347

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

76-535

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

77-41

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

77-81

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

77-150

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

Revenue Rulings— Continued:

77-256

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

77-284

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

77-321

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

77-343

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

77-405

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

77-456

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

77-482

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

77-483

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

78-89

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

78-287

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

78-441

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

79-29

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

79-71

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

79-82

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

79-104

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

79-116

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

79-314

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

September 2, 2003 vi 2003-35 I.R.B.

Revenue Rulings— Continued:

79-410

Amplified by

Rev. Rul. 2003-90, 2003-33 I.R.B. 353

79-424

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

80-78

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

80-79

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

80-101

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

80-167

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

80-170

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

80-358

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

81-190

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

81-225

Clarified and amplified by

Rev. Rul. 2003-92, 2003-33 I.R.B. 350

81-247

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

82-164

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

82-226

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

83-101

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

83-119

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

84-28

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

84-30

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

Revenue Rulings— Continued:

85-55

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

85-136

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

86-52

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

87-1

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

88-7

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

89-72

Obsoleted by

Rev. Rul. 2003-99, 2003-34 I.R.B. 388

2003-35 I.R.B. vii September 2, 2003

INDEX

Internal Revenue Bulletins2003–27 through 2003–35

The abbreviation and number in parenthesisfollowing the index entry refer to the specificitem; numbers in roman and italic type follow-ing the parentheses refer to the Internal Rev-enue Bulletin in which the item may be foundand the page number on which it appears.

Key to Abbreviations:Ann AnnouncementCD Court DecisionDO Delegation OrderEO Executive OrderPL Public LawPTE Prohibited Transaction

ExemptionRP Revenue ProcedureRR Revenue RulingSPR Statement of Procedural

RulesTC Tax ConventionTD Treasury DecisionTDO Treasury Department Order

EMPLOYEE PLANS

Defined contribution plans, minimumvesting standards (REG–112039–03)35, 504

ESOPs, prohibited allocations of securi-ties in an S corporation (TD 9081) 35,420; (REG–129709–03) 35, 506

Excise tax:Reversion (RR 85) 32, 291Statute of limitations (RR 88) 32, 292

Full funding limitations, weighted aver-age interest rate for:July 2003 (Notice 48) 30, 133August 2003 (Notice 58) 35, 429

Group health plan, COBRA, small em-ployer plan exception (RR 70) 27, 3

Minimum funding, entry age normal (RR83) 30, 128

Proposed Regulations:26 CFR 1.401(k)–0, –1, revised;

1.401(k)–2 through –6, added;1.401(m)–0 through –2, revised;1.401(m)–3 through –5, added; re-tirement plans; cash or deferredarrangements under section 401(k)and matching contributions or em-ployee contributions under section401(m) (REG–108639–99) 35, 431

EMPLOYEEPLANS—Cont.

26 CFR 1.409(p)–1, added; prohibitedallocations of securities in an S cor-poration (REG–129709–03) 35, 506

26 CFR 1.411(d)–4, amended; elim-ination of forms of distributionin defined contribution plans(REG–112039–03) 35, 504

Regulations:26 CFR 1.409(p)–1T, added; prohib-

ited allocations of securities in an Scorporation (TD 9081) 35, 420

Retirement plans, cash or deferred ar-rangements under section 401(k) andmatching contributions or employeecontributions under section 401(m)(REG–108639–99) 35, 431

User fees for determination letters, elimi-nation (Notice 49) 32, 294

EMPLOYMENT TAX

Extension of time, automatic extensionto file certain information returns andexempt organization returns (TD 9061)27, 5; (REG–107618–02) 27, 13

Proposed Regulations:26 CFR 1.6081–1, amended;

1.6081–8, –9, added; 31.6081(a)–1,revised; automatic extension of timeto file certain information returnsand exempt organization returns(REG–107618–02) 27, 13

Regulations:26 CFR 1.6081–1T, removed; 1.6081–

8T, –9T, added; 31.6011(a)–5,amended; 31.6051–1(d)(2)(i)(c),amended; 31.6051–2(c), amended;31.6081(a)–1, amended; 31.6081(a)–1T, added; 602.101, amended;automatic extension of time to filecertain information returns and ex-empt organization returns (TD 9061)27, 5

ESTATE TAX

Charitable lead trusts, sample forms (No-tice 39) 27, 10

Charitable remainder annuity trusts:Inter vivos:

For a term of years (RP 54) 31, 236For one measuring life (RP 53) 31,

230

ESTATE TAX—Cont.With concurrent and consecutive in-

terests for two measuring lives(RP 56) 31, 249

With consecutive interests for twomeasuring lives (RP 55) 31, 242

Testamentary:For a term of years (RP 58) 31, 262For one measuring life (RP 57) 31,

257With concurrent and consecutive in-

terests for two measuring lives(RP 60) 31, 274

With consecutive interests for twomeasuring lives (RP 59) 31, 268

EXCISE TAX

Group health plan, COBRA, small em-ployer plan exception (RR 70) 27, 3

Statute of limitations for employee plans(RR 88) 32, 292

Stocks, option valuation for purposes ofgolden parachute payments (RP 68) 34,398

Tax on reversion of qualified plan assetsto employer (RR 85) 32, 291

EXEMPTORGANIZATIONS

Coverdell education savings account re-porting (Notice 53) 33, 362

Declaratory judgment suits (Ann 53) 32,345

Extension of time, automatic extensionto file certain information returns andexempt organization returns (TD 9061)27, 5; (REG–107618–02) 27, 13

Proposed Regulations:26 CFR 1.6081–1, amended;

1.6081–8, –9, added; 31.6081(a)–1,revised; automatic extension of timeto file certain information returnsand exempt organization returns(REG–107618–02) 27, 13

Regulations:26 CFR 1.6081–1T, removed; 1.6081–

8T, –9T, added; 31.6011(a)–5,amended; 31.6051–1(d)(2)(i)(c),amended; 31.6051–2(c), amended;31.6081(a)–1, amended; 31.6081(a)–1T, added; 602.101, amended;

September 2, 2003 viii 2003-35 I.R.B.

EXEMPTORGANIZATIONS—Cont.

automatic extension of time to filecertain information returns and ex-empt organization returns (TD 9061)27, 5

Revocations (Ann 48) 28, 73; (Ann 52)32, 345

GIFT TAX

Charitable lead trusts, sample forms (No-tice 39) 27, 10

Charitable remainder annuity trusts:Inter vivos:

For a term of years (RP 54) 31, 236For one measuring life (RP 53) 31,

230With concurrent and consecutive in-

terests for two measuring lives(RP 56) 31, 249

With consecutive interests for twomeasuring lives (RP 55) 31, 242

Testamentary:For a term of years (RP 58) 31, 262For one measuring life (RP 57) 31,

257With concurrent and consecutive in-

terests for two measuring lives(RP 60) 31, 274

With consecutive interests for twomeasuring lives (RP 59) 31, 268

INCOME TAX

Accounting, changes in accounting peri-ods, automatic approval for individuals(RP 62) 32, 299; (Ann 49) 32, 339

Advance refunding bonds, tax-exemptbonds (RR 78) 29, 76

Annuity contracts:Tax-free exchanges (Notice 51) 33,

361Tax-free exchanges and basis alloca-

tion (RR 76) 33, 355Assumption of a partner’s liabilities

not accounted for under section752(a) and (b) (TD 9062) 28, 46;(REG–106736–00) 28, 60

Backup withholding rate, reduced foramounts paid after December 31, 2002(Ann 45) 28, 73

California franchise tax, accrual of liabil-ities (RR 90) 33, 353

INCOME TAX—Cont.Charitable remainder annuity trusts:

Inter vivos:For a term of years (RP 54) 31, 236For one measuring life (RP 53) 31,

230With concurrent and consecutive in-

terests for two measuring lives(RP 56) 31, 249

With consecutive interests for twomeasuring lives (RP 55) 31, 242

Testamentary:For a term of years (RP 58) 31, 262For one measuring life (RP 57) 31,

257With concurrent and consecutive in-

terests for two measuring lives(RP 60) 31, 274

With consecutive interests for twomeasuring lives (RP 59) 31, 268

Child’s attainment of an age (RR 72) 33,346

Common trust fund, listed transaction,straddle, tax shelter (Notice 54) 33, 363

Compliance initiative, nonresident aliensand foreign corporations (Notice 38)27, 9

Controlled foreign corporations, insur-ance business treated as a domesticcorporation (RP 47) 28, 55

Corporations:Spin-offs, stock distributions:

Acquisition by an unrelated corpo-ration (RR 79) 29, 80

Requests for letter ruling or deter-mination letter (RP 48) 29, 86

Separation of two different busi-nesses within the same corporategroup:To concentrate on one business

(RR 74) 29, 77To resolve capital allocation

problem (RR 75) 29, 79Treatment of foreign stapled entity un-

der section 269B as domestic (No-tice 50) 32, 295

Credits:Enhanced oil recovery credit, 2003 in-

flation adjustment (Notice 43) 28, 50Increasing research activities credit,

aggregate computation and alloca-tion (REG–133791–02) 35, 493

Low-income housing credit:Carryovers to qualified states, 2003

National Pool (RP 67) 34, 397

INCOME TAX—Cont.Community service facility under

section 42(d)(4)(C) of the Code(RR 77) 29, 75

Owners of low-income housingprojects (REG–131997–02) 33,366

Satisfactory bond, “bond factor”amounts for the period:July through September 2003

(RR 93) 33, 346New markets tax credit, qualified

equity investments under section45D(b)(1)(C) (Notice 56) 34, 396

Nonconventional source fuel credit,qualified fuels under section29(c)(1)(C), solid fuel from coal,suspended private letter rulings(Ann 46) 30, 222

Declaratory judgment suits (Ann 53) 32,345

Deductions, limitations of section 277membership organizations (RR 73) 28,44

Depreciation of assets owned by a utility,used in the general business operations,asset class for (RR 81) 30, 126

Disaster relief for September 11, 2001,terrorist attack for:Additional first year depreciation, au-

tomatic extension (RP 50) 29, 119Depreciation and mid-quarter conven-

tion relief, automatic extension oftime to make election (Notice 45) 29,86

Disciplinary actions involving attorneys,certified public accountants, enrolledagents, and enrolled actuaries (Ann 50)30, 222

Electronic and magnetic filing:Requirements for submitting Form

8655 (RP 69) 34, 403Specifications for Forms 1098, 1099,

5498, and W-2G (RP 52) 30, 134Enhanced oil recovery credit, 2003 infla-

tion adjustment (Notice 43) 28, 50Entity classification for certain foreign el-

igible entities (Notice 46) 28, 53Equitable relief under section 66(c) or

section 6015(f) (RP 61) 32, 296Extension of time, automatic extension

to file certain information returns andexempt organization returns (TD 9061)27, 5; (REG–107618–02) 27, 13

2003-35 I.R.B. ix September 2, 2003

INCOME TAX—Cont.Extraterritorial income exclusion,

changes to Form 8873 and its in-structions (Ann 47) 29, 124

Foreign corporations, compliance initia-tive (Notice 38) 27, 9

Foreign earned income from a restrictedcountry (Notice 52) 32, 296

Foreign trusts, Canadian retirement plantrust reporting (Notice 57) 34, 397

Forms:8655, Reporting Agent Authorization

for Magnetic Tape/Electronic Filers,requirements (RP 69) 34, 403

8873, Extraterritorial Income Exclu-sion, changes to form and instruc-tions (Ann 47) 29, 124

Government obligations, state and subdi-visions:Allocation deadline for private activity

bond state ceiling (Notice 41) 28, 49Assignment deadline for private activ-

ity bond volume cap (Notice 42) 28,49

Carryforward election of unused pri-vate activity bond volume cap (RP46) 28, 54

Insurance companies:Foreign insurance companies, mini-

mum effectively connected net in-vestment income (RP 70) 34, 406

Life insurance companies, variablecontracts (RR 91) 33, 347

Life insurance contracts, change inbenefits (RR 95) 33, 358

Interest:Deductibility, note-forward contract

units (RR 97) 34, 380Investment:

Federal short-term, mid-term, andlong-term rates for:July 2003 (RR 71) 27, 1August 2003 (RR 94) 33, 357

Inventory:LIFO, price indexes used by depart-

ment stores for:May 2003 (RR 87) 29, 82June 2003 (RR 100) 34, 385

Valuation, acquired in liquidation oflump sum purchase (RP 51) 29, 121

Lease strips:Reallocation of income and deductions

among unrelated parties (RR 96) 34,386

Tax consequences (Notice 55) 34, 395Marginal production rates, 2003 (Notice

44) 28, 52

INCOME TAX—Cont.Marginal properties, oil and gas produc-

tion, depletion, 2003 percentages (No-tice 44) 28, 52

Methods of accounting:Cable television systems, depreciation

(RP 63) 32, 304LIFO, automatic consent (RP 45) 27,

11Uniform capitalization (Notice 59) 35,

429New York Liberty Bonds, tax-exempt

bonds (Notice 40) 27, 10Nonconventional source fuel credit, qual-

ified fuels under section 29(c)(1)(C),solid fuel from coal, suspended privateletter rulings (Ann 46) 30, 222

Nonresident aliens, compliance initiative(Notice 38) 27, 9

Partnerships, variable annuity or life in-surance contracts (RR 92) 33, 350

Penalties, requirements for waiverof information reporting penalties(REG–141669–02) 34, 408

Proposed Regulations:26 CFR 1.41–0, –6, amended; credit

for increasing research activities(REG–133791–02) 35, 493

26 CFR 1.42–6, –8, –12, –14,amended; section 42 carryoverand stacking rule amendments(REG-131997–02) 33, 366

26 CFR 1.83–7, amended; trans-fers of compensatory options(REG-116914–03) 32, 338

26 CFR 1.141–0, –12, –15, –16,amended; 1.142–0, –2, amended;remedial actions for tax-exemptbonds (REG–132483–03) 34, 410

26 CFR 1.358–7, added; 1.704–1,–2, amended; 1.705–1, amended;1.752–0, amended; 1.752–1, –5,amended; 1.752–6, –7, added;assumption of partner liabilities(REG–106736–00) 28, 60

26 CFR 1.421–1 through –7 , removed;1.421–7 redesignated as 1.421–1and amended; 1.421–8 redesignatedas 1.421–2 and amended; 1.422–1,–2, –4, –5, added; 1.422–4, re-moved; 1.422–5 redesignated as1.422–3; 1.423–1, –2, amended;1.425–1 redesignated as 1.424–1and amended; 1.6039–1, removed;1.6039–2 redesignated as 1.6039–1and revised; statutory options(REG–122917–02) 27, 15

INCOME TAX—Cont.26 CFR 1.446–6, added; 1.860A–0,

amended; 1.860C–1, amended;1.863–0, –1, amended; REMICs;application of section 446 withrespect to inducement fees(REG–162625–02) 35, 500

26 CFR 1.6081–1, amended;1.6081–8, –9, added; 31.6081(a)–1,revised; automatic extension of timeto file certain information returnsand exempt organization returns(REG–107618–02) 27, 13

26 CFR 301.6724–1, amended; waiverof information reporting penalties(REG–141669–02) 34, 408

Publications, 1220, Specifications for Fil-ing Forms 1098, 1099, 5498, and W-2GElectronically or Magnetically (RP 52)30, 134

Qualified census tracts, issuers of qual-ified mortgage bonds and mortgagecredit certificates; correction (RP 49)29, 89

Qualified tertiary injectant expenses andenhanced oil recovery credit (RR 82)30, 125

Real estate investment trusts (REITs):Loans from (RP 65) 32, 336Taxable REIT subsidiaries (TRSs) and

independent contractors, rents (RR86) 32, 290

Taxable subsidiaries (TSRs) (RP 66)33, 364

Regulated investment company (RIC), re-funded bonds (RR 84) 32, 289

Regulations:26 CFR 1.83–7, amended; 1.83–7T,

added; transfers of compensatoryoptions (TD 9067) 32, 287

26 CFR 1.752–6T, added; assumptionof partner liabilities (TD 9062) 28,46

26 CFR 1.6081–1T, removed; 1.6081–8T, –9T, added; 31.6011(a)–5,amended; 31.6051–1(d)(2)(i)(c),amended; 31.6051–2(c), amended;31.6081(a)–1, amended; 31.6081(a)–1T, added; 602.101, amended;automatic extension of time to filecertain information returns and ex-empt organization returns (TD 9061)27, 5

REMICs, residual interests, inducementfees (REG–162625–02) 35, 500

Revocations, exempt organizations (Ann48) 28, 73; (Ann 52) 32, 345

September 2, 2003 x 2003-35 I.R.B.

INCOME TAX—Cont.Rulings, obsolete (RR 99) 34, 388Statute of limitations on assessment as af-

fected by bankruptcy (RR 80) 29, 83Stocks:

Deduction for compensatory stock op-tion-related transactions followingcertain corporate transactions (RR98) 34, 378

Option valuation for purposes ofgolden parachute payments (RP68) 34, 398

Statutory options (REG–122917–02)27, 15

Transfers of compensatory stock op-tions (TD 9067) 32, 287; (REG-116914–03) 32, 338

Transfers of nonstatutory stock optionsto related persons (Notice 47) 30,132

Tax-exempt bonds:Advance refunding bonds (RR 78) 29,

76New York Liberty Bonds (Notice 40)

27, 10Remedial action rules, application

(REG–132483–03) 34, 410Withholding foreign partnership (WP)

and withholding foreign trust (WT)agreements (RP 64) 32, 306

2003-35 I.R.B. xi September 2, 2003*U.S. G.P.O.: 2003—496–919/60098