Is a Mid-Year Change to a Profit Sharing Allocation Legit?
Sometimes a plan sponsor may wish to retroactively reduce the plan’s allocation formula for the year. It may be possible, but caution should be used.
Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans, and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security, and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in New York is representative of a common question on plan amendments.
"A 401(k) plan provides for a uniform allocation formula for its discretionary profit-sharing contribution. Can the plan sponsor amend the plan to change the allocation formula for the 2025 plan year to reduce contributions, or is it too late?"
Highlights of the discussion
The answer is—it depends on when plan participants accrue a right to the allocation formula for the year, as explained in the following paragraphs.
As the end of a plan year draws near, a plan sponsor may wish to explore changing or amending the plan’s allocation formula for the year. The IRS addressed the circumstances in which a plan sponsor can make a mid-year change to a plan’s allocation formula in Technical Advice Memorandum (TAM) 9735001.
The plan referenced in the TAM case had a profit-sharing allocation formula based on a uniform percentage of compensation. The plan sponsor made a profit-sharing contribution for the 1992 plan year in January 1993 but did not immediately allocate the contribution among participants. On March 15, 1993, the plan sponsor adopted an amendment to the plan which purported to change the allocation formula for the 1992 plan year.
In this case, the IRS ruled that an amendment adopted after the end of the plan year to change the allocation formula would violate the anti-cutback rules of IRC § 411(d)(6). The IRS reasoned that once participants have met the annual allocation requirements for the profit-sharing contribution, they become “vested” in the current allocation formula. Therefore, the allocation formula, once vested, cannot be subsequently changed by plan amendment to reduce a right or benefit for the year. (Note: Some exceptions apply for retroactive amendments that would increase participant benefits.)
If, pursuant to TAM 9735001, an allocation formula cannot be changed after the end of the plan year, what then is the deadline for adopting an amendment to change a plan’s allocation formula mid-year? Under the IRS’s guidance in TAM 9735001, the allocation conditions imposed by the plan would determine the outcome. For example, many plans may require participants to work 1,000 hours during the plan year and/or be employed on the last day of the plan year to receive an allocation of any profit-sharing contribution for that year. Below are the retroactive amendment deadlines for common allocation requirements. Of course, a plan sponsor has the right to amend the plan’s allocation formulas on a prospective basis.
If a plan requires that a participant be employed on the last day of the plan year, then the plan sponsor could amend the allocation formula at any time before the last day of the plan year.
If a plan requires only that a participant work 1,000 hours during the plan year to share in the profit-sharing contribution, then an amendment adopted in November or December would likely be too late, as many participants, presumably, would have already accrued 1,000 hours of service for the year and become “vested” in the existing allocation formula.
Similarly, suppose the plan required 501 hours of service to receive a contribution. The sponsor would only be able to change the allocation method up until the date on which the first participant works their 501st hour for the year. After that point, changing the method would eliminate a benefit the participant has already earned.
If the plan does not provide any allocation conditions for the profit-sharing contribution, then any mid-year change to the allocation formula would violate the anti-cutback rule, as the existing allocation formula would become protected as of the first day of the plan year. Therefore, any amendment would need to be adopted before the beginning of the plan year.
Conclusion
It may be possible for a plan sponsor to amend the plan’s allocation formula to retroactively reduce contributions for the plan year, but caution should be used. It all depends on when participants become vested in the current allocation formula. In most cases, plan sponsors can amend a plan’s allocation formulas on a prospective basis.
