Under long-standing regulations of the U.S. Department of Labor (“DOL”), employee contributions to 401(k) plans become plan assets on the earlier of (a) the earliest date on which the contributions can reasonably be segregated from the employer’s general assets, or (b) the 15th business day of the month following the month in which the contributions were withheld from the employee’s wages. The result of this rule is that employee contributions not deposited into the 401(k) plan trust on a timely basis are treated as “prohibited transaction” loans to the employer, resulting in excise taxes imposed by the IRS and civil penalties imposed by the DOL. In more egregious cases, criminal penalties are also imposed by the DOL.
While many employers have attempted to rely on the “15th business day of the next month” part of the rule, the DOL has consistently been quick to point out that this maximum deadline only applies if the “as soon as can be reasonably segregated” part of the rule does not apply first, and in the view of the DOL, the “as soon as can be reasonably segregated” deadline almost always comes first. In many audit cases, the DOL has considered 401(k) deposits made more than a few days after the applicable payroll date to be prohibited transactions.
The difficulty in applying the rule has been that, until recently, the DOL has refused to state a definitive standard, indicating only that the application of the “as soon as can be reasonably segregated” deadline is applied on a facts and circumstances basis. Therefore, even employers making good-faith efforts to comply have not been able to achieve any level of certainty.
On February 29, 2008, the DOL issued a proposed amendment to the plan asset regulations. The amendment creates a “safe harbor” under which employee contributions deposited into the plan trust not later than the 7th business day following the payroll date on which the contributions were withheld from the employees’ wages will be deemed to have been contributed in compliance with the “as soon as can be reasonably segregated” standard. The total period during which deposits can be made in accordance with the safe harbor will actually be at least 9 calendar days (as at least two weekend days will always be included in any such period).
Importantly, the new safe harbor applies only to “small plans,” defined to mean plans with fewer than 100 participants at the beginning of the plan year. For this purpose, employees who are eligible to contribute but are not actually contributing are counted as participants. The DOL has requested comments with regard to whether a safe harbor should be available for sponsors of large plans; a large plan safe harbor may or may not be included in the final version of the regulations.
Although the amendment to the regulations will not technically be effective until the final version of the amendment is issued, the DOL has indicated that in the meantime it will not assert any violation in the case of a small plan sponsor that complies with the 7 business day safe harbor described in the proposed amendment. Therefore, the practical effect of the amendment is immediate.
While the new 7 business day rule is merely a safe harbor (i.e., an employer not complying with the 7 business day rule could still argue that deposits made after the 7th business day are compliant with the “as soon as can be reasonably segregated” deadline on a facts and circumstances basis), compliance with the safe harbor is encouraged by the DOL. In fact, the new rule could serve as a double-edged sword, as it appears that an employer not complying with the safe harbor will bear the burden of demonstrating that compliance with the safe harbor could not have been reasonably expected due to circumstances unique to the employer.
All factors considered, the regulation amendment is a welcome and long-awaited change, as it will finally allow employers (at least sponsors of small plans) to enjoy a level of comfort not previously available. All employers should review their payroll and 401(k) contribution practices as soon as possible to determine whether compliance with the safe harbor is being achieved, and should make any adjustments necessary to achieve compliance.