Some not-for-profit health systems that set up 401(k) retirement plans last year may be surprised by reinstated Internal Revenue Service tests they must pass to keep the tax-favored status of their plans.
The issue applies to not-for-profit systems that have 401(k) plans and are part of a controlled group that also has for-profit companies with 401(k)s. A controlled group is a group of companies that are at least 80% owned by a parent company.
In 1996 Congress lifted a 10-year ban, allowing not-for-profit organizations to create 401(k)s, mostly so that the tremendously popular plans could be offered to not-for-profits. Previously, not-for-profits typically sponsored 403(b) plans. The main difference between the plans' structures is that 401(k) plan sponsors need to pass special nondiscrimination tests to keep their tax-favored status; one of those is called a ratio percentage test, which ensures that the percentage of lower-paid employees eligible to join the 401(k) equals no less than 70% of the highly paid employees eligible.
In controlled groups, the test is run collectively. The 403(b) plans do not need to run any type of fairness test. While the tests for 401(k)s may seem arduous, the plans allow more flexibility than 403(b)s in the way employees can invest their assets.
Last year, the IRS realized that not-for-profits creating new 401(k)s might need time to adjust to the new rules. For one year, it allowed not-for-profits with 401(k) plans that were part of a controlled group with for-profit units having 401(k)s, to exclude the for-profit's plan participants when applying the ratio test.
The IRS hasn't issued guidance on how to handle the test this year; the exemption was valid only for 1997. Several experts are interpreting the silence to mean the IRS is going back to its old rule, saying that in a controlled group situation, all 401(k) sponsors must do this test collectively.
"It may be a problem because all of a sudden in 1998 the not-for-profit company is going to have to look at all employees," for the ratio percentage test, says Dennis Coleman, principal at Kwasha Lipton Group in Fort Lee, N.J. If they fail the test, they lose their tax-favored status, which is the main reason for offering a 401(k).
Chris Cumming, vice president at Purchase, N.Y.-based Diversified Investment Advisors, says larger systems with for-profit subsidiaries probably face such a situation.
"I think a lot of people are going to be caught by surprise," says Cumming, who recently worked on a 401(k) conversion for Midcoast Health Services, a Brunswick, Maine-based system.
While there's no generic solution, Midcoast found a way to avoid the IRS issue. The system froze its 403(b) plan and created a 401(k) plan for its not-for-profit employees; it also had a 401(k) plan in a for-profit unit for certain physicians and administrative employees. Last year, it merged the two 401(k)s into a not-for-profit plan because it wanted to consolidate administrative procedures, and to include highly compensated employees, who had been left out of the for-profit 401(k) plan.
Although it wasn't Midcoast's intent, it avoided facing the IRS testing problem by merging the two plans.