Internal Revenue Bulletin 2003-35 (PDF rendition): IRS Notices

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Bulletin No. 2003-35
September 2, 2003
HIGHLIGHTS
OF THIS ISSUE
These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be
relied 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 regulations
under section 41 of the Code provide guidance on the proper
method for computing and allocating the research credit for
members of a controlled group of corporations or a group of
trades or businesses under common control. A public hearing
is scheduled for November 13, 2003. REG–105606–99 with-
drawn.
REG–162625–02, page 500.
Proposed regulations under sectio
n 446 of the Code set out
rules relating to the proper timing
and source of income of fees
received to induce the acquisitio
n of noneconomic residual in-
terests in REMICs. A public heari
ng is scheduled for November
18, 2003.
EMPLOYEE PLANS
T.D. 9081, page 420.
REG–129709–03, page 506.
Temporary and proposed regulations under section 409(p) of
the Code provide guidance concerning the requirements for
employee 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 4
31
.
Proposed regulations
under sections 401(k) and 401(m) of the
Code provide guidance
on the requirements for certain retire-
ment plans containin
g cash or deferred arrangements and pro-
viding for matching c
ontributions or employee after-tax contri-
butions. These regu
lations 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 amend
section 1.411(d)–4, of the regulations to reflect the addition
of 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 be
amended, but remove the 90-day notice condition.
Notice 2003–58, page 429.
Weighted average interest rate updat
e.The weighted average
interest rate for August 2003 and the
resulting permissible
range of interest rates used to calc
ulate current liability for
purposes of the full funding limit
ation of section 412(c)(7) of
the Code are set forth.
ADMINISTRATIVE
Notice 2003–59, page 429.
Uniform capitalization; methods of accounting.This notice
modifies Notice 2003–36 to permit certain taxpayers to use
the automatic approval procedures of Rev. Proc. 2002–9 to
change their method of accounting to the simplified service
cost or simplified production method for self-constructed as-
sets for their most recent taxable year ending on or before
May 8, 2003. This notice also informs taxpayers that, in the
future, the Service and Treasury Department may provide guid-
ance under which the automatic approval procedures will no
longer apply to a method of accounting, effective for applica-
tions filed after such change is announced. Notice 2003–36
modified.
Find
ing Lists begin on page ii.
Index for July through August begins on page viii.

The IRS Mission
Provide AmericaÊs taxpayers top quality service by helping
them understand and meet their tax responsibilities and by
applying the tax law with integrity and fairness to all.
Introduction
The Internal Revenue Bulletin is the authoritative instrument of
the Commissioner of Internal Revenue for announcing official
rulings and procedures of the Internal Revenue Service and for
publishing Treasury Decisions, Executive Orders, Tax Conven-
tions, legislation, court decisions, and other items of general
interest. It is published weekly and may be obtained from the
Superintendent of Documents on a subscription basis. Bul-
letin contents are consolidated semiannually into Cumulative
Bulletins, 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 un
iform application of
the tax laws, including all rulings that s
upersede, revoke, mod-
ify, or amend any of those previously pub
lished in the Bulletin.
All published rulings apply retroacti
vely unless otherwise indi-
cated. Procedures relating solely
to matters of internal man-
agement are not published; howeve
r, statements of internal
practices and procedures that af
fect the rights and duties of
taxpayers are published.
Revenue rulings represent the conclusions of the Service on the
application of the law to the pivotal facts stated in the revenue
ruling. In those based on positions taken in rulings to taxpayers
or technical advice to Service field offices, identifying details
and information of a confidential nature are deleted to prevent
unwarranted invasions of privacy and to comply with statutory
requirements.
Rulings and procedures reported in the Bulletin do not have the
force and effect of Treasury Department Regulations, but they
may be used as precedents. Unpublished rulings will not be
relied on, used, or cited as precedents by Service personnel in
the disposition of other cases. In applying published rulings and
procedures, the effect of subsequent legislation, regulations,
court decisions, rulings, and procedures must be considered,
and Service personnel and others concerned are cautioned
against reaching the same conclusions in other cases unless
the 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 of
the 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 these
subjects are contained in the other Parts and Subparts. Also
included in this part are Bank Secrecy Act Administrative Rul-
ings. Bank Secrecy Act Administrative Rulings are issued by
the 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 index
for the matters published during the preceding months. These
monthly indexes are cumulated on a semiannual basis, and
are published in the first Bulletin of the succeeding semiannual
period, respectively.
The contents of this pu
blication 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, 20032003-35 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Code of 1986
Section 263A.—Capital-
ization and Inclusion in
Inventory of Certain Expenses
Taxpayers are informed that, in the future, the Ser-
vice and Treasury Department may provide guidance
under which the automatic approval procedures will
no 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-
tionsforTaxCreditEmployee
Stock Ownership Plans —
Prohibited Allocations of
Securities in an S-Corporation
T.D. 9081
DEPARTMENT OF
THE TREASURY
Internal Revenue Service
26 CFR Part 1
Prohibited Allocations of
Securities in an S Corporation
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Temporary regulations.
SUMMARY: This document contains
temporary regulations concerning re-
quirements for employee stock ownership
plans (ESOPs) holding stock of Sub-
chapter S corporations. The temporary
regulations provide guidance on identify-
ing disqualified persons and determining
whether a plan year is a nonallocation
year under section 409(p) and on the def-
inition of synthetic equity under section
409(p)(5). These temporary regulations
would generally affect plan sponsors of,
and participants in, ESOPs holding stock
of Subchapter S corporations. The text
of the temporary regulations also serves
as the text of the proposed regulations
(REG–129709–03) set forth in the notice
of proposed rulemaking on this subject on
page 506 of this issue of the Bulletin.
DATES:Effective Date:These regulations
are effective July 21, 2003.
Applicability Date:These temporary
regulations are applicable with respect to
plan years ending after October 20, 2003.
FOR FURTHER INFORMATION
CONTACT: John T. Ricotta at (202)
622–6060 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
Section 4975(e)(7) provides that an
ESOP is a defined contribution plan that is
designed to invest primarily in qualifying
employer securities and that is either a
stock bonus plan which is qualified, or
a stock bonus plan and money purchase
pension plan both of which are qualified,
under section 401(a). Section 4975(e)(7)
authorizes the Secretary to issue regula-
tions imposing additional requirements
for ESOPs (see §54.4975–11 of the Ex-
cise Tax Regulations). A plan is not
treated 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 receive
employer securities; put options); section
409(o) (relating to participants' distribu-
tion rights and payment requirements);
section 409(n) (relating to securities re-
ceived in transactions to which section
1042 applies); section 409(p) (relating to
prohibited allocations of securities in an
S corporation); section 664(g) (relating to
qualified gratuitous transfers of qualified
employer securities); and section 409(e)
(relating to participants' voting rights if
the employer has a registration-type class
of securities). As authorized by section
4975(e)(7), additional requirements are
imposed under §54.4975–11.
Section 1361(b)(1)(D) provides that a
Subchapter S corporation (S corporation)
may not have more than one class of stock.
Section 1361(b)(1)(B) provides that an S
corporation may not have as a shareholder
a person that is not an estate, a trust de-
scribed in section 1361(c)(2), an organi-
zation described in section 1361(c)(6), or
an individual. In 1996, section 1361(c)(6)
was amended to permit a qualified plan un-
der section 401(a) to be a shareholder in
an S corporation. Section 1316(a) of the
Small Business Job Protection Act of 1996
(SBJPA) (110 Stat. 1755) (1996).
Section 511(a)(1) imposes a tax on
the unrelated business taxable income
(as defined in section 512(a)) of organi-
zations described in section 511(a)(2),
which include plans that qualify under
section 401(a). Section 512(e)(1) pro-
vides that if an organization described in
section 1361(c)(6) holds stock in an S
corporation, the interest is treated as an
interest in an unrelated trade or business
and, notwithstanding the organization's
general tax-exempt status, all items of
income, loss, or deduction taken into ac-
count under section 1366(a) and any gain
or loss on the disposition of the stock in
the S corporation are taken into account in
computing the unrelated business taxable
income of the organization. In 1997, sec-
tion 512(e) was amended to provide that
section 512(e) does not apply to employer
securities (within the meaning of section
409(l)) held by an ESOP described in
section 4975(e)(7). Section 1523 of the
Taxpayer Relief Act of 1997 (TRA ’97)
(111 Stat. 788) (1997). Accordingly,
S corporation income allocable to stock
held by an ESOP is not subject to regular
income or unrelated business income tax,
but S corporation income allocable to
stock held by any other qualified plan or
tax-exempt entity under section 501(c)(3)
is subject to the unrelated business income
tax under section 511.
Congress became aware that the tax
exemption for earnings on S corporation
stock held by an ESOP may lead to inap-
propriate tax deferral or avoidance in some
cases. In order to address these concerns,
Congress enacted section 409(p) as part
of the Economic Growth and Tax Relief
Reconciliation Act of 2001 (EGTRRA)
(115 Stat. 38) (2001). Section 409(p) is
intended to limit the tax benefits of ESOPs
maintained by S corporations unless the
ESOP provides meaningful benefits to
rank-and-file employees. As explained in
the legislative history:
The Committee continues to believe
that S corporations should be able to en-
courage employee ownership through
an ESOP. The Committee does not be-
lieve, however, that ESOPs should be
used by S corporation owners to obtain
inappropriate tax deferral or avoidance.
Specifically, the Committee believes
that the tax deferral opportunities pro-
vided by an S corporation ESOP should
be limited to those situations in which
there is broad-based employee coverage
2003-35 I.R.B.420September 2, 2003

under the ESOP and the ESOP bene-
fits rank-and-file employees as well as
highly compensated employees and his-
torical owners.
H. R. Rep. No. 107–51, part 1, at 100
(2001).
Section 409(p)(1) requires an ESOP
holding employer securities consisting
ofstockinanScorporationtoprovide
that no portion of the assets of the plan
attributable to (or allocable in lieu of)
such employer securities may, during a
nonallocation year, accrue (or be allocated
directly or indirectly under any plan of
the employer meeting the requirements
of section 401(a)) for the benefit of any
disqualified person, as defined in section
409(p).
1
Section 409(p)(3)(A) provides that a
“nonallocation year” includes any plan
year during which the ownership of the S
corporation is so concentrated among dis-
qualified persons that they own at least 50
percent of its shares. Section 409(p)(3)(B)
provides that, in determining the shares
owned by an individual for purposes of
section 409(p)(3)(A), the attribution rules
of section 318(a) apply, with certain ex-
ceptions, and the individual is treated as
owning his or her deemed-owned ESOP
shares.
Under section 409(p)(4)(C)(i), the term
deemed-owned sharesincludes, with re-
spect to any person, the stock in the S
corporation constituting employer securi-
ties of an ESOP which is allocated to that
person under the ESOP, and that person's
share of the stock in the S corporation
whichisheldbytheESOPbutwhichisnot
allocated 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 “disqualified
person” depends on a person's ownership
of deemed-owned shares of S corporation
stock held by an ESOP (deemed-owned
ESOP shares). Section 409(p)(4) provides,
in general, that a “disqualified person”
means any person whose deemed-owned
ESOP shares are at least 10 percent of
the number of deemed-owned ESOP
or for whom the aggregate number of
deemed-owned ESOP shares of such per-
son and the members of such person's
family is at least 20 percent of the number
of deemed-owned ESOP shares.
The determination of whether someone
is a disqualified person and whether a plan
year 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). The
provisions relating to synthetic equity do
not 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, restricted
stock, deferred issuance stock right, or
similar interest or right that gives the
holder the right to acquire or receive
stock of the S corporation in the future.
Except to the extent provided in regu-
lations, synthetic equity also includes a
stock appreciation right, phantom stock
unit, or similar right to a future cash
payment based on the value of such
stockorappreciationinsuchvalue.
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 such
corporation on which such synthetic eq-
uity is based are generally treated as out-
standing stock in such corporation, and as
deemed-owned shares of such person, if
such treatment of synthetic equity results
either in the treatment of any person as
a disqualified person or the treatment of
any 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 synthetic
equity, then the inclusion of synthetic eq-
uity as outstanding stock does not cause
the person to fail to be treated as a disqual-
ified person or the year to fail to be treated
as a nonallocation year.
Section 409(p)(7)(A) authorizes the
Secretary to prescribe such regulations as
may be necessary to carry out the purposes
of section 409(p). As indicated by the leg-
islative history above, section 409(p) is
intended to limit the tax benefits of ESOPs
maintained by S corporations unless the
ESOP provides meaningful benefits to
rank-and-file employees. See H.R. Rep.
No. 107–51, part 1, at 100 (2001). Section
409(p)(7)(B) provides that the Secretary
may, by regulation or other guidance of
general applicability, provide that a nonal-
location year occurs in any case in which
the principal purpose of the ownership
structure of an S corporation constitutes
an avoidance or evasion of section 409(p).
“For example, this might apply if more
than 10 independent businesses are com-
binedinanScorporationownedbyan
ESOP in order to take advantage of the
income tax treatment of S corporations
ownedbyanESOP.”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 those
ESOPs eligible for a delayed effective date
applicable to certain ESOPs that were es-
tablished on or before March 14, 2001. See
Rev. 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 ownership
of any synthetic equity by a disqualified
person during a nonallocation year, and
the occurrence of the first nonallocation
year of an ESOP, as described in section
4979A(e)(2)(C).
Explanation of Provisions
Overview
Section 409(p) was enacted to address
concerns about ownership structures in-
volving S corporations and ESOPs that
concentrate the benefits of the ESOP in a
small number of persons. Under the statute
as amended, an ESOP is still permitted to
hold S corporation stock, provided that the
ESOP benefits a sufficiently broad-based
group of employees.
These temporary regulations reflect the
statutory language under section 409(p)(1)
prohibiting an accrual or allocation in a
nonallocation year, but do not provide ad-
ditional guidance on what constitutes a
prohibited accrual or allocation. It is ex-
pected that this issue will be addressed in
additional regulations.
An ESOP has a nonallocation year
for any plan year during which, at any
1
This definition is different from the definition of disqualified person for purposes of section 4975.
September 2, 20034212003-35 I.R.B.

time, disqualified persons hold at least 50
percent of the outstanding shares of stock
in the S corporation or 50 percent of the
outstanding shares of stock and synthetic
equity in the S corporation. These tem-
porary regulations provide guidance on
the rules applicable for this purpose. In
addition, pursuant to section 409(p)(7)(B),
these temporary regulations authorize the
Commissioner to provide that a nonallo-
cation year exists in any year in which
the principal purpose of the ownership
structure is avoidance or evasion of sec-
tion 409(p). These temporary regulations
also provide guidance on identification of
disqualified 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 acquire
stock 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 phantom
stock unit, stock appreciation right, or sim-
ilar interest.
In addition, under these temporary
regulations, synthetic equity includes two
other categories of interests or payments:
nonqualified deferred compensation (even
though it is neither payable in, nor cal-
culated by reference to, stock in the S
corporation) and rights to acquire interests
in certain related entities. In each case,
treatment of these interests as synthetic
equity is necessary to carry out the Con-
gressional purpose of section 409(p) of
limiting the tax deferral opportunities pro-
videdbyanScorporationESOPtothose
situations in which the benefits of the
ESOP ownership are available, at a min-
imum, to a broad group of rank-and-file
employees who have the opportunity to
be the primary beneficiaries of the growth
of the business through the ESOP. Unless
these interests are treated as synthetic
equity, the benefits associated with owner-
ship of an interest in an S Corporation by
means of the ESOP could be concentrated
in a small group, and diverted away from
the rank-and-file employees, through use
of these interests. In this respect, these
interests have the same effect as stock
appreciation rights payable in cash, which
are explicitly included in synthetic equity
by statute.
Nonqualified Deferred Compensation as
Synthetic Equity
Since the addition of section 409(p),
arrangements have been promoted to tax-
payers in which an S corporation that is
either entirely or substantially owned by
an ESOP is used to shelter the income
of an active business while the profits of
the business are primarily provided for
certain management employees of the
business through various obligations to
make future payments to the employees.
Typically in these arrangements, the obli-
gation to make future payments to the
management employees suppresses the
value of the company's stock that is allo-
cated to rank-and-file employees through
the ESOP, depriving them of the opportu-
nity to be the primary beneficiaries of the
growth of the business through the ESOP.
For example, under some of these ar-
rangements, the owners of the operating
company establish a management com-
pany and the operating company agrees
to pay management fees equal to sub-
stantially all (or most) of the profits of
the operating company. The management
company agrees to provide future com-
pensation to certain executives or other
employees of the operating company or
the management company in an amount
equal to substantially all of the profits of
the management company. Finally, the
management company elects to be treated
as an S corporation and transfers all, or a
substantial portion, of its stock to an ESOP
established to cover rank-and-file employ-
ees. Under this arrangement, the operating
company claims a deduction for the fees
paid to the management corporation. The
management corporation in turn retains
these fees to satisfy its obligations to pay
future compensation. Although the stock
of the management corporation is owned
by the ESOP, the ownership interest held
for rank-and-file employees through the
ESOP has a substantially reduced value.
Rather than being a mechanism for the
transfer of not only ownership, but also
the rights associated with ownership, to
the employees of the S corporation, the
ESOP is used as part of a structure de-
signed to shelter profits that will be paid
as future compensation for a small group
of executives or management employees.
These temporary regulations treat non-
qualified deferred compensation provided
by the S corporation or certain related enti-
ties as synthetic equity, including deferred
compensation that is neither payable in
stock of the S corporation nor calculated
by reference to stock of the S corpora-
tion. S Corporations that do not maintain
ESOPs typically do not provide nonquali-
fied deferred compensation to owners. By
treating nonqualified deferred compen-
sation provided by the S corporation (or
certain related entities) as synthetic equity,
these temporary regulations address own-
ership structures that are designed to avoid
or evade section 409(p) and provide guid-
ance allowing individuals to determine
when these interests result in a failure to
comply with section 409(p). Nonqualified
deferred compensation is appropriately
characterized as synthetic equity because
it functions similarly to other forms of syn-
thetic equity by diverting value away from
shareholders, thereby reducing the value
of the S corporation and diminishing the
ESOP's interest in the value that, absent
the nonqualified deferred compensation,
would be reflected in the shares of the S
corporation held by the ESOP. This effect
occurs even if the nonqualified deferred
compensation is a fixed dollar amount,
and even if such deferred compensation is
not payable in stock of the S corporation
or measured by reference to that stock (di-
rectly, such as a stock appreciation right
payable in cash, or less directly, such as
percentage of the future profits of the S
corporation).
Right to Acquire Assets as Synthetic
Equity
Under these temporary regulations,
rights to acquire stock or other similar
interests in a related entity are treated as
synthetic equity if the ownership of such
interests in the related entity is the only
significant asset of the S corporation and
the S corporation is the only significant
holder of stock (or other similar interests)
of the related entity. For this purpose,
related entities are entities in which the
S corporation holds an interest and with
respect to which income is passed through
to the S corporation. These rights are
2003-35 I.R.B.422September 2, 2003

properly treated as synthetic equity be-
cause they provide the holders of these
rights with an opportunity to benefit from
the S corporation ESOP structure that is
comparable to the opportunity provided
through synthetic equity issued directly by
the S corporation. Taking rights to acquire
stock or other similar interests in a related
entity into account as synthetic equity pro-
vides a method for identifying situations
in which the interests in the S corporation
(and its assets) have, directly or indirectly,
become concentrated in a manner that
should result in a nonallocation year under
section 409(p).
These temporary regulations provide
that synthetic equity does not include
rights to acquire goods or services at fair
market value in the ordinary course of
business. The temporary regulations do
not address, at this time, rights to ac-
quire other assets of the S Corporation
or assets of the related entity or other
related entities. This absence should not
be interpreted as a conclusion that a right
to acquire these other assets cannot be
synthetic equity. It may be appropriate
to treat the right to acquire assets of the
S Corporation, other than its interest in a
related entity (such as its ownership of a
manufacturing plant), as synthetic equity.
It may also be appropriate to treat rights to
acquire assets held by the related entity as
synthetic equity.
The temporary regulations also do not
address rights to acquire interests in related
entities if the ownership of such interests in
the related entity is not the only significant
asset of the S corporation or the S corpo-
ration is not the only significant holder of
stock (or other similar interests) of the re-
lated entity. Rights to acquire interests in
other related entities is reserved because,
for example, it may be appropriate in cases
in which a related entity is not the only sig-
nificant asset of the S Corporation to treat
as synthetic equity only a portion of the
value of the rights to acquire stock or other
similar interests inthe related entity.
The IRS and Treasury intend to issue
additional regulations providing guidance
on the definition of synthetic equity on a
number of issues, including issues identi-
fied as reserved in these temporary regula-
tions. For example, the IRS and Treasury
intend to issue additional guidance relating
to rights to acquire interests in other related
entities and rights to acquire assets of an
S corporation or related entity. The addi-
tional regulations areexpected to address
the treatment of these interests, including
how any such interests treated as synthetic
equity should be converted into shares of
synthetic equity in the S corporation and
whether such conversion should take into
account the extent to which income of the
related entity is allocated to a shareholder
that is subject to regular income tax or un-
related trade or business income tax. These
items are reserved in order to allow for ad-
ditional consideration of these issues, in-
cluding consideration of comments on the
proposed regulations accompanying these
regulations. The additional regulations are
expected to be issued in conjunction with
guidance 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 provision
treating acquisition rights as synthetic eq-
uity in certain situations. Specifically, this
treatment applies to an option or right to
acquire assets of the S corporation, or a re-
lated person, that is part of a structure that
provides rights to the holder comparable to
the 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 delegate
authority to the Commissioner to provide,
through revenue rulings, notices and other
guidance published in the Internal Rev-
enue Bulletin (see §601.601(d)(2)(ii)(b) of
this chapter), that synthetic equity includes
a right to acquire stock or other similar in-
terests in a related entity in cases in which
the S corporation's interest in the related
entity is not the only significant asset of
the S corporation or the S corporation is
not the only significant owner of the re-
lated entity.
Rights to Acquire Shares of Stock That are
Issued and Outstanding
The definition of synthetic equity pro-
vides that rights to acquire shares in an S
corporation with respect to shares that are,
at all times during the period when such
rights are effective, both issued and out-
standing and held by persons other than the
ESOP, S corporation, or a related entity are
not synthetic equity. These arrangements
include, for example, rights of first refusal
held by one shareholder in the S corpora-
tion with respect to the shares of another
taxable shareholder (i.e., shares held out-
side the tax-exempt structure created by
the ESOP). However, in certain limited
cases, a disqualified person who has the
right to acquire such issued and outstand-
ing stock is treated as owning the stock if
such treatment results in a nonallocation
year.
Conversion of Synthetic Equity
Synthetic equity that is determined by
reference to shares of S corporation stock
is treated as the corresponding number of
shares of stock. Synthetic equity that is de-
termined by reference to shares of stock
(or similar interests) in a related entity is
converted into an equivalent number of
shares of stock of the S corporation with
the same aggregate value as the number
of shares of stock (or similar interests) of
the related entity (with such value deter-
mined without regard to any lapse restric-
tion as defined at §1.83–3(i)). The value
of any other synthetic equity interest, such
as fixed dollar nonqualified deferred com-
pensation, is converted into an equivalent
number of shares of stock in the S corpo-
ration based on the present value of the
interest or right to nonqualified deferred
compensation (with such value determined
without regard to any lapse restriction as
defined at §1.83–3(i)) and the fair market
value of the S corporation shares on the de-
termination date (with both values deter-
mined as of any reasonable date during the
plan year).
Identification of Disqualified Persons
Under these temporary regulations,
a person is a disqualified person based
either on deemed-owned ESOP shares or
deemed-owned ESOP shares combined
with synthetic equity. Whether there is
a nonallocation year is then determined
by taking into account the holdings of all
disqualified persons, first based only on
outstanding shares of stock of the cor-
poration and then based on outstanding
shares of stock and synthetic equity of the
corporation. In accordance with the last
sentence of section 409(p)(5), synthetic
equity cannot result in a person who is
September 2, 20034232003-35 I.R.B.

treated as a disqualified person for a year,
or a year that is treated as a nonallocation
year, not being so treated. In addition,
these temporary regulations provide that,
in any year in which the Commissioner
provides that a nonallocation year occurs
because the principal purpose of the own-
ership structure of the S corporation is an
avoidance 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 these
temporary regulations relating to synthetic
equity, employees who benefit from non-
qualified deferred compensation arrange-
ments or who hold rights to acquire in-
terests in certain related entities will be
treated as owning synthetic equity and may
be treated as disqualified persons. As a re-
sult, certain plan years of the ESOP may be
treated as nonallocation years. This result
will not occur unless the aggregate inter-
est held by disqualified persons — through
synthetic 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 the
S corporation.
Effective Date
In the case of an ESOP holding stock
in an S corporation that is eligible for
the delayed effective date under sec-
tion 656(d)(2) of EGTRRA applicable
to certain ESOPs established on or be-
fore March 14, 2001, these temporary
regulations do not apply until plan years
beginning on or after January 1, 2005. For
an ESOP to which the delayed effective
date is not applicable, these temporary
regulations are applicable with respect
to plan years ending after October 20,
2003. The temporary regulations permit S
corporations to avoid having nonqualified
deferred compensation treated as synthetic
equity under paragraph (f)(2)(iv) of these
temporary regulations by distributing the
deferred compensation by July 21, 2004.
Request for Comments in Proposed
Regulations and Future Guidance
See the preamble of the cross-reference
notice of proposed rulemaking published
elsewhere in this issue of the Bulletin
which asks for comments with respect to
issues 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 Order
12866. Therefore, a regulatory assessment
is not required. It also has been deter-
mined that section 553(b) of the Admin-
istrative Procedure Act (5 U.S.C. chapter
5) does not apply to these regulations. For
the applicability of the Regulatory Flexi-
bility Act (5 U.S.C. chapter 6) refer to the
Special Analyses section of the preamble
to the cross-referencing notice of proposed
rulemaking published in this issue of the
Bulletin. Pursuant to section 7805(f) of
the Internal Revenue Code, these tempo-
rary regulations will be submitted to the
Chief Counsel for Advocacy of the Small
Business Administration for comment on
their impact.
Drafting Information
The principal author of these regula-
tions is John T. Ricotta of theOffice of the
Division Counsel/Associate Chief Coun-
sel (Tax Exempt and Government Enti-
ties). However, other personnel from the
IRS and Treasury participated in their de-
velopment.
*****
Amendments to the Regulations
Accordingly, 26 CFR par
t 1 is amended
as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.409(p)–1T is also issued un-
der26U.S.C.409(p)(7).***
Par. 2. Section 1.409(p)–1T is added to
read as follows:
§1.409(p)–1T P
rohibited allocation of
securities in a
n S corporation (temporary).
(a)Organization of this section. Sec-
tions 409(p) and 4979A apply if a non-
allocation year occurs in an employee
stock ownership plan (ESOP), as defined
in section 4975(e)(7), that holds shares
of stock of a Subchapter S corporation (S
corporation) that are employer securities
as defined in section 409(l). Paragraph (b)
of this section sets forth the general rule
under section 409(p)(1) and (2) prohibit-
ing an allocation to a disqualified person
in a nonallocation year. Paragraph (c) of
this section sets forth rules under section
409(p)(3), (5), and (7) for determining
whether a year is a nonallocation year,
generally based on whether disqualified
persons own at least 50 percent of the
shares of the S corporation, either tak-
ing into account only the outstanding
shares of the S corporation (including
shares held by the ESOP) or taking into
account both the outstanding shares and
synthetic equity of the S corporation.
Paragraphs (d), (e), and (f) of this sec-
tion contain definitions of a disqualified
person under section 409(p)(4) and (5),
deemed-owned ESOP shares under sec-
tion 409(p)(4)(C), and synthetic equity
under section 409(p)(6)(C).
(b)Prohibited accruals in a nonalloca-
tion year—(1)General rule.AnESOP
holding employer securities consisting of
stock in an S corporation must provide that
no 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 directly
or indirectly under any plan of the em-
ployer meeting the requirements of section
401(a)) for the benefit of any disqualified
person.
(2)Additional rules.[Reserved]
(c)Nonallocation year—(1)Definition
generally.Anonallocation yearmeans a
plan year of an ESOP during which, at any
time, the ESOP holds any employer securi-
ties that are shares of an S corporation and
either —
(i) Disqualified persons own at least
50 percent of the number of outstanding
shares of stock in the S corporation (in-
cluding deemed-owned ESOP shares), or
(ii) Disqualified persons own at least
50 percent of the aggregate number of
outstanding shares of stock (including
deemed-owned ESOP shares) and syn-
thetic equity in the S corporation.
(2)Attribution rules. For purposes of
this paragraph (c), the rules of section
318(a) apply to determine ownership of
shares in the S corporation (including
deemed-owned ESOP shares) and syn-
thetic equity. However, for this purpose,
section 318(a)(4) (relating to options to
2003-35 I.R.B.424September 2, 2003

acquire stock) is disregarded and, in apply-
ing section 318(a)(1), the members of an
individual's family include members of the
individual's family under paragraph (d)(2)
of this section. In addition, an individual
is treated as owning deemed-owned ESOP
shares of that individual notwithstanding
the employee trust exception in section
318(a)(2)(B)(i). If the attribution rules
in paragraph (f)(1) of this section apply,
then the rules of paragraph (f)(1) of this
section are applied before the rules of this
paragraph (c)(2).
(3)Special rule for avoidance or
evasion. Under section 409(p)(7)(B),
the Commissioner, in revenue rulings,
notices, and other guidance published
in the Internal Revenue Bulletin (see
§601.601(d)(2)(ii)(B) of this chapter),
may provide that a nonallocation year
occurs in any case in which the principal
purpose of the ownership structure of an
S corporation constitutes an avoidance or
evasion of section 409(p). For any year
that is a nonallocation year under this
paragraph (c)(3), the Commissioner may
treat any person as a disqualified person.
(4)Special rule for certain stock rights.
(i) For purposes of paragraph (c)(1) of this
section, a person is treated as owning stock
that the person has a right to acquire if,
at all times during the period when such
rights are effective, the stock that the per-
son has the right to acquire is both issued
and outstanding and is held by persons
other than the ESOP, the S corporation, or
a related entity (as defined in paragraph
(f)(2)(iii)(A)(4) of this section).
(ii) This paragraph (c)(4) applies only
if treating persons as owning the shares
described in paragraph (c)(4)(i) results
in 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 second
class of stock, anddoes not apply for
purposes of determining ownership of
deemed-owned ESOP shares or whether
an interest constitutes synthetic equity (see
the last sentence of paragraph (f)(2)(i)).
(d)Disqualified persons—(1)General
rule.Adisqualified personis any person
for whom —
(i) The number of such person's
deemed-owned ESOP shares is at least 10
percent of the number of deemed-owned
ESOP shares of the S corporation;
(ii) The aggregate number of such
person's deemed-owned ESOP shares
and synthetic equityshares is at least
10 percent of the aggregate number of
deemed-owned ESOPand synthetic eq-
uity shares of the S corporation;
(iii) The aggregate number of deemed-
owned ESOP shares of such person and of
the members of such person's family is at
least 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 equity
shares of such person and of the members
of such person's family is at least 20 per-
cent of the aggregate number of deemed-
owned ESOP and synthetic equity shares
of the S corporation.
(2)Treatment of family members; def-
inition. (i) Each member of the family of
any person who is a disqualified person un-
der paragraph (d)(1)(iii) or (iv) of this sec-
tion is a disqualified person.Member of
the familymeans, 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 lineal
descendant of the brother or sister; and
(D) the spouse of any individual de-
scribed in paragraph (d)(2)(ii) or (iii) of
this section.
(ii) A spouse of an individual who is
legally separated from such individual
under a decree of divorce or separate
maintenance 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 this
section (relating to avoidance or evasion of
section 409(p)) for a special rule permit-
ting any person to be treated as a disquali-
fied person in certainnonallocation years.
(e)Deemed-owned ESOP shares.
A person is treated as owning his
or her deemed-owned ESOP shares.
Deemed-owned ESOP sharesmean, with
respect to any person —
(1) Any shares of stock in the S corpo-
ration constituting employer securities that
are allocated to such person's account un-
der the ESOP; and
(2) Such person's share of the stock in
the S corporation that is held by the ESOP
but is not allocated to the account of any
participant or beneficiary (with such per-
son's share to be determined in the same
proportion as the most recent stock alloca-
tion under the ESOP).
(f)Synthetic equity—(1)Ownership
of synthetic equity. For purposes of sec-
tion 409(p) and this section, synthetic eq-
uity is treated as owned by a person in the
same manner as stock is treated as owned
by a person, directly or under the rules of
section 318(a)(2) and (3).Synthetic equity
means the rights described in paragraph
(f)(2) of this section.
(2)Synthetic equity—(i)Rights to ac-
quire stock of the S corporation. Synthetic
equityincludes any stock option, warrant,
restricted stock, deferred issuance stock
right, stock appreciation right payable in
stock, or similar interest or right that gives
the holder the right to acquire or receive
stock of the S corporation in the future.
Rights to acquire stock in an S corporation
with respect to stock that is, at all times
during the period when such rights are ef-
fective, both issued and outstanding and
held by persons other than the ESOP, the
S corporation, or a related entity, are not
synthetic equity (but see paragraph (c)(4)
of this section).
(ii)Special rule for certain stock rights.
Synthetic equityalso includes a right to
a future payment (payable in cash or any
other form other than stock of the S corpo-
ration) from an S corporation that is based
on the value of the stock of the S corpora-
tion or appreciation in such value, such as
a stock appreciation right with respect to
stock of an S corporation that is payable in
cash or a phantom stock unit with respect
tostockofanScorporation that is payable
in cash.
(iii)Rights to acquire assets of an S
corporation or related entity—(A)Rights
to acquire interests in a related entity—
(1)Treatment as synthetic equity. Syn-
thetic equityincludes a right to acquire
stock or other similar interests in a related
entity that is described in this paragraph
(f)(2)(iii)(A).
(2) Significant interests.Synthetic eq-
uityincludes a right to acquire stock or
other similar interests in a related entity if
such interests in the related entity are the
only significant asset of the S corporation
and the S corporation is the only signifi-
cant owner of the related entity. Whether
an asset is the only significant asset of the
September 2, 20034252003-35 I.R.B.

S corporation or the S corporation is the
only significant owner of the related entity
depends on the relevant facts and circum-
stances.
(3)Rights to acquire interests in other
related entities.[Reserved]
(4)Related entity. For purposes of this
section,related entitymeans any entity in
which the S corporation holds an interest
and 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 section
1361(b)(3).
(B)Rights to acquire assets of an S cor-
poration or related entity other than rights
to acquire stock or similar interests in a re-
lated entity—(1)General rule.[Reserved]
(2)Exception for rights to acquire
goods or services in ordinary course of
business.Synthetic equitydoes not include
rights to acquire goods or services at fair
market value in the ordinary course of
business.
(C)Authority to provide guidance.
The Commissioner, in revenue rulings,
notices, and other guidance published
in the Internal Revenue Bulletin (see
§601.601(d)(2)(ii)(B) of this chapter),
may provide thatsynthetic equityincludes
a right to acquire stock or other similar
interests in a related entity in cases in
which such interests in the related entity
are not the only significant asset of the S
corporation or the S corporation is not the
only significant owner of the related entity
if necessary to carry out the purposes of
section 409(p).
(D)Synthetic equity includes compara-
ble rights. An option or right to acquire
assets of the S corporation or another per-
son is treated as synthetic equity if such
option or right is part of a structure that
provides rights to the holder comparable to
the rights provided by arrangements iden-
tified as synthetic equity under this para-
graph (f)(2)(iii) and the principal purpose
of the structure is the avoidance or evasion
of 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 a
related entity, to which section 404(a)(5)
applies (including remuneration for which
a deduction would be permitted under sec-
tion 404(a)(5) if separate accounts were
maintained), any right to receive property
(towhichsection83applies)inafuture
year for the performance of services to
an S corporation, or related entity, and
any transfer of property (to which sec-
tion 83 applies) in connection with the
performance of services to an S corpora-
tion, or a related entity, to the extent that
the property is not substantially vested
within the meaning of §1.83–3(i) by the
end of the plan year in which transferred.
Synthetic equityalso includes any other
remuneration for services rendered to the
S corporation, or a related entity, under a
plan, or method or arrangement, deferring
the receipt of compensation to a date that
is after the 15th day of the 3
rd
calendar
month after the end of the entity's taxable
year in which the related services are ren-
dered, other than a plan that is an eligible
retirement plan within the meaning of
section 402(c)(7)(B).
(3)No overlap among shares of
deemed-owned ESOP shares or syn-
thetic equity. Synthetic equity under this
paragraph (f) does not include shares that
are deemed-owned ESOP shares. In ad-
dition, synthetic equity under a specific
subparagraph of this paragraph (f) does
not include anything that is synthetic eq-
uity under a preceding subparagraph of
this paragraph (f).
(4)Number of synthetic shares—(i)
Synthetic equity determined by reference to
S 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 synthetic
equity is treated as owning the correspond-
ing number of shares of stock. For exam-
ple, if a corporation grants an employee of
an S corporation an option to purchase 100
shares 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.Inthe
case of synthetic equity that is determined
by reference to shares of stock (or similar
interests) in a related entity, the person who
is entitled to the synthetic equity is treated
as owning shares of stock of the S corpo-
ration with the same aggregate value as the
number of shares of stock (or similar inter-
ests) of the related entity (with such value
determined without regard to any lapse re-
striction as defined at §1.83–3(i)).
(iii)Other synthetic equity. In the case
of any other synthetic equity, the person
who is entitled to the synthetic equity
is treated as owning a number of shares
of stock in the S corporation equal to
thepresentvalueofthesyntheticequity
(with such value determined without re-
gard to any lapse restriction as defined
at §1.83–3(i)) divided by the fair market
value of a share of the S corporation's
stock as of the same date. For purposes
of this paragraph (f)(4)(iii), the number
of shares of S corporation is permitted to
be determined as of the first day of the
ESOP's plan year, or any other reasonable
determination date or dates during a plan
year that is consistently used by the cor-
poration for this purpose for all persons.
The number of shares of synthetic equity
treated as owned for any period from a
determination date through the date im-
mediately preceding the next following
determination date is the number of shares
treated as owned on the first day of that
period.
(g)Examples. The rules of this section
are illustrated by the following examples:
Example 1.(i)Facts. Corporation X is a calen-
dar year S corporation
that maintains an ESOP. X has
a single class of common stock, of which there are a
total of 1,200 shares outstanding. X has no synthetic
equity. In 2006, ind
ividual A, who is not an employee
of X (and is not related to any employee of X), owns
100 shares directly, individual B owns 100 shares di-
rectly, and the rem
aining 1,000 shares are owned by
an ESOP maintained by X for its employees. The
ESOP's 1,000 shares are allocated to the accounts of
individuals wh
o are employees of X (none of whom
are related), as set forthin columns 1 and 2 in the fol-
lowing table:
2003-35 I.R.B.426September 2, 2003

1
Shareholders
2
Deemed-Owned ESOP Shares
(total of 1,000)
3
Percentage Deemed-Owned
ESOP Shares
4
Disqualified Person
B33033%Yes
C14514.5%Yes
D757.5%No
E303%No
F202%No
Other participants400 (none exceed 10 shares)1% or lessNo
(ii)Conclusion with respect to disqualified per-
sons. As shown in column 4 in the table above,
individuals B and C are disqualif
ied persons for
2006 under paragraph (d)(1) of this section because
each owns at least 10% of X's deemed-owned ESOP
shares.
(iii)Conclusion with respect to nonallocation
year. However, 2006 is not a nonallocation year
under section 409(p) because dis
qualified per-
sons do not own at least 50% of X's outstanding
shares (the 100 shares owned directly by B, B's
330 deemed-owned ESOP shares,
plus C's 145
deemed-owned ESOP shares equal only 47.9% of
the 1,200 outstanding shares of X).
Example 2.(i)Facts. The facts are t
he same as in
Example 1, except that, as shown in column 4 of the
table below, individual E has an option to acquire 500
shares of the common stock of X fro
mX:
1
Shareholders
2
Deemed-Owned
ESOP Shares
(total of 1,000)
3
Percentage
Deemed-Owned
ESOP Shares
4
Synthetic Equity
(500)
5
Percentage
Deemed-Owned
ESOP plus
Synthetic Equity
Shares (total of
1,500)
6
Disqualified Person
B33033%22%Yes (cols. 3 and 5)
C14514.5%9.7%Yes (col. 3)
D757.5%5%No
E303%50035.3%Yes (col. 5)
F202%1.3%No
Other participants400 (none exceed
10 shares)
1% or lessunder 1%No
(
ii)Conclusion with respect to disqualified per-
sons. E's option constitutes 500 shares of synthetic
equity. Accordingly,asshownincolumn6inthe
table above, individuals B, C, and E are disqualified
persons for 2006 because each owns at least 10% of
X's deemed-owned ESOP shares or X's total deemed-
owned ESOP and synthetic equity shares.
(iii)Conclusion with respect to nonallocation
year. The 100 shares owned directly by B, B's 330
deemed-owned ESOP shares, C's 145 deemed-owned
ESOP shares, E's 30 deemed-owned ESOP shares,
plus E's 500 synthetic equity shares equals 65% of
the 1,700 outstanding and synthetic equity shares of
X. Thus, 2006 is a nonallocation year for X's ESOP
under section 409(p) because disqualified persons
own at least 50% of X's total shares of outstanding
stock and synthetic equity. In addition, independent
of the preceding conclusion, 2006 would be a non-
allocation year because disqualified persons own at
least 50% of X's outstanding shares because the 100
shares owned directly by B, B's 330 deemed-owned
ESOP shares, C's 145 deemed-owned ESOP shares,
p
lus E's 30 deemed-owned ESOP shares equals
50.4% 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 March
14, 2001, and this section applies for plan
years ending after October 20, 2003, ex-
cept that paragraph (f)(2)(iv) of this section
is disregarded with respect to nonqualified
deferred compensation that is distributed
on or before July 21, 2004.
(2)Certain ESOPs established on or
before March 14, 2001.IfanESOPhold-
ing stock in an S corporation was estab-
lished on or before March 14, 2001, and
the election under section 1362(a) with re-
spect to that S Corporation was in effect
o
n March 14, 2001, section 409(p) and this
s
ection apply for plan years beginning on
or 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 Register
for July 21, 2003, 68 F.R. 42970)
September 2, 20034272003-35 I.R.B.

Section 446.—General Rule
for 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 guidance
under which the automatic approval procedures will
no 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 of
Residual Interests
For rules on the proper accounting for income
from inducement fees, see section 1.446-6. See
REG-162625-02, page 500.
Section 863.—Special Rules
for 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.428September 2, 2003

Part III. Administrative, Procedural, and Miscellaneous
Weighted Average Interest Rate
Update
Notice 2003–58
Sections 412(b)(5)(B) and 412(l)(7)
(C)(i) of the Internal Revenue Code
provide that the interest rates used to
calculate current liability for purposes of
determining the full funding limitation
under § 412(c)(7) and the required con-
tribution under § 412(l) must be within
a permissible range around the weighted
average of the rates of interest on 30-year
Treasury securities during the four-year
period ending on the last day before the
beginning 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 rates
used to calculate current liability for the
purpose of the full funding limitation of
§ 412(c)(7) of the Code.
Section 417(e)(3)(A)(ii)(II) of the Code
defines the applicable interest rate, which
must be used for purposes of determining
the minimum present value of a partici-
pant’s benefit under § 417(e)(1) and (2),
as the annual rate of interest on 30-year
Treasury securities for the month before
the date of distribution or such other time
as 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, notices
or other guidance published in the Internal
Revenue Bulletin.
The rate of interest on 30-year Treasury
Securities for July 2003 is 4.93 percent.
Pursuant to Notice 2002–26, 2002–1 C.B.
743, the Service has determined this rate
as the monthly average of the daily deter-
mination of yield on the 30-year Treasury
bond maturing in February 2031.
Section 405 of the Job Creation and
Worker Assistance Act of 2002 amended
§ 412(l)(7)(C) of the Code to provide that
for plan years beginning in 2002 and 2003
the permissible range is extended to 120
percent.
The following rates were determined
for the plan years beginning in the month
shown below.
MonthYear
Weighted
Average
90% to 110%
Permissible
Range
90% to 120%
Permissible
Range
August20035.314.78 to 5.854.78 to 6.38
Drafting Information
The principal authors of this notice
are Paul Stern and Tony Montanaro of
the Employee Plans, Tax Exempt and
Government Entities Division. For fur-
ther information regarding this notice,
please contact the Employee Plans’ tax-
payer assistance telephone service at
1–877–829–5500 (a toll-free number),
between the hours of 8:00 a.m. and
6:30 p.m. Eastern time, Monday through
Friday. Mr. Stern may be reached at
1–202–283–9703. Mr. Montanaro may
be reached at 1–202–283–9714. The tele-
phone numbers in two preceding sentences
are 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 accept
Forms 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 request
consent to change to either the simpli-
fied service cost method or the simplified
production method for self-constructed
assets under §§ 1.263A–1(h)(2)(i)(D)
and 1.263A–2(b)(2)(i)(D) of the Income
Tax Regulations. This notice informs
taxpayers that the Service and Treasury
Department have decided that a taxpayer
will be permitted, after May 8, 2003, to
timely file Forms 3115 to make these
changes under Rev. Proc. 2002–9 for
its most recent taxable year ending on
or before May 8, 2003. To qualify un-
der this notice, a taxpayer that wishes
to file a Form 3115 on or after August
13, 2003, must do so under Rev. Proc.
2002–9 requesting to make a change for
its most recent taxable year ending on or
before May 8, 2003, and in addition to
complying with the requirements of Rev.
Proc. 2002–9, must include the following
statement on top of the form: “Automatic
Change 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 May
8, 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 section
6.02(3)(a) of Rev. Proc. 2002–9, provided
that the taxpayer complies with the follow-
ing filing requirements. The taxpayer must
complete and file a Form 3115 in dupli-
cate. The original must be attached to the
taxpayer's amended federal income tax re-
turn for its most recent taxable year ending
on or before May 8, 2003. This amended
return must be filed no later than February
13, 2004. A copy of the Form 3115 must
be filed with the national office (see section
6.02(6)(a) of Rev. Proc. 2002–9 for the
address) no later than when the taxpayer's
amended return is filed.
For taxable years ending after May 8,
2003, Forms 3115 to make these changes
must be filed with the national office under
Rev. 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 apply
for one or more methods of accounting
for which taxpayers had been permitted
September 2, 20034292003-35 I.R.B.

to use the automatic consent procedures,
such change may be effective for Forms
3115 filed after such change is announced.
In such case, a taxpayer that has not filed
a copy of Form 3115 with the national
office 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 is
Scott 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.430September 2, 2003

Part IV. Items of General Interest
Notice of Proposed Rulemaking
and Notice of Public Hearing
Retirement Plans; Cash or
Deferred Arrangements Under
Section 401(k) and Matching
Contributions or Employee
Contributions Under Section
401(m) Regulations
REG–108639–99
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking
and 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 under
section 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. This
document also contains a notice of public
hearing on these proposed regulations.
DATES: Written and electronic comments
and requests to speak (with outlines of oral
comments) at a public hearing scheduled
for November 12, 2003, must be received
by October 22, 2003.
ADDRESSES: Send submissions to:
CC:PA:RU (REG–108639–99), room
5226, Internal Revenue Service, POB
7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand
delivered Monday through Friday be-
tween the hours of 8 a.m. and 4 p.m. to:
CC:PA:RU (REG–108639–99), Courier's
Desk, Internal Revenue Service, 1111
Constitution Avenue, NW, Washington,
DC. Alternatively, taxpayers may submit
comments electronically via the Inter-
net directly to the IRS Internet site at:
www.irs.gov/regs. The public hearing will
be held in the IRS Auditorium (7th Floor),
Internal Revenue Building, 1111 Consti-
tution Avenue, NW, Washington, DC.
FOR FURTHER INFORMATION
CONTACT: 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 building
access list to attend the hearing, LaNita
Van Dyke, (202) 622–7180 (not a toll-free
number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information con-
tained in this notice of proposed rulemak-
ing have been submitted to the Office of
Management and Budget for review in
accordance 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 of
Management and Budget, Attn: Desk Of-
ficer for the Department of the Treasury,
Office of Information and Regulatory
Affairs, Washington, DC 20503, with
copies to the Internal Revenue Service,
Attn: IRS Reports Clearance Officer,
W:CAR:MP:T:T:SP, Washington, DC
20224. Comments on the collections of
information should be received by Septem-
ber 15, 2003. Comments are specifically
requested 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 have
practical utility;
The accuracy of the estimated burden
associated with the proposed collection of
information (see below);
How the quality, utility, and clarity of
the information to be collected may be en-
hanced;
How the burden of complying with the
proposed collection of information may be
minimized, including through the appli-
cation of automated collection techniques
or other forms of information technology;
and
Estimates of capital or start-up costs
and costs of operation, maintenance, and
purchase of services to provide informa-
tion.
The collections of information in
these 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 required
by §§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 IRS
to comply with the requirements of sec-
tions 401(k)(12)(D) and401(m)(11)(A)(ii)
regarding notices that must be provided
to eligible participants to apprize them of
their rights and obligations under certain
plans. This information will be used by
participants to determine whether to par-
ticipate in the plan, and by the IRS to con-
firm that the plan complies with applicable
qualification requirements to avoid ad-
verse tax consequences. The information
required by §1.401(k)–4(d)(3) is required
by the IRS to comply with the require-
ments of section 401(k)(11)(B)(iii)(II)
regarding notices that must be provided
to eligible participants to apprize them
of their rights and obligations under cer-
tain plans. This information will be used
by participants to determine whether to
participate in the plan, and by the IRS to
confirm that the plan complies with appli-
cable qualification requirements to avoid
adverse tax consequences. The informa-
tion required by §1.401(k)–2(b)(3) will
be used by employees to file their income
tax returns and by the IRS to assess the
correct amount of tax. The information
provided under §1.40(k)–1(d)(3)(iii)(C)
will be used by employers in determining
whether to make hardship distributions to
participants. The collections of informa-
tion are mandatory. The respondents are
businesses 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, a
collection of information unless it displays
September 2, 20034312003-35 I.R.B.

a valid control number assigned by the Of-
fice of Management and Budget.
Books or records relating to a collection
of information must be retained as long
as their contents may become material in
the administration of any internal revenue
law. Generally, tax returns and tax return
information are confidential, as required
by 26 U.S.C. 6103.
Background
This document contains proposed new
comprehensive regulations setting forth
the 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 the
Code were last published in theFederal
Registerin 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, 1995–1
C.B. 54, published on December 22, 1994.
Since 1994, many significant changes have
been made to sections 401(k) and 401(m)
by the Small Business Job Protection
Act of 1996, Public Law 104–188 (110
Stat. 1755) (SBJPA), the Taxpayer Relief
Act of 1997, Public Law 105–34 (111
Stat. 788) (TRA ’97), and the Economic
Growth and Tax Relief Reconciliation Act
of 2001, Public Law 107–16 (115 Stat.
38) (EGTRRA).
The most substantial changes to the sec-
tion 401(k) and section 401(m) provisions
were made to the methodology for test-
ing the amount of elective contributions,
matching contributions, and employee
contributions for nondiscrimination. Sec-
tion 401(a)(4) prohibits discrimination in
contribution or benefits in favor of highly
compensated employees (within the mean-
ing of section 414(q)) (HCEs). Section
401(k) provides a special nondiscrimina-
tion test for elective contributions under a
cash or deferred arrangement that is part
of a profit-sharing plan, stock bonus plan,
pre-ERISA money purchase plan, or rural
cooperative plan, called the actual deferral
percentage (ADP) test. Section 401(m)
provides a parallel test for matching con-
tributions and employee contributions
under a defined contribution plan, called
the actual contribution percentage (ACP)
test. These special nondiscrimination
standards are provided in recognition of
the fact that the amount of elective contri-
butions and employee contributions (and
corresponding matching contributions) is
determined by the employee's utilization
of the contribution opportunity offered
under the plan. This is in contrast to the
situationinotherdefinedcontribution
plans where the amount of contributions
is determined by the amount the employer
decides to contribute.
Sections 401(k) and 401(m) provide
alternative methods for satisfying the
applicable nondiscrimination rules: a
mathematical comparison and a number
of design-based methods. The inherent
variation in the amount of contributions
among employees noted above, and the
fact that the economic situation of HCEs
may make them more likely to make elec-
tive or employee contributions, means that
the usual nondiscrimination test under
section 401(a)(4) — under which for each
HCE with a contribution level there must
be a specified number of nonhighly com-
pensated employees (NHCEs) with equal
or greater contributions — is not appropri-
ate. Instead, average rates of contribution
areusedintheADPandACPtests(with
a built-in differential permitted for HCEs)
and minimum standards for nonelective or
matching contributions are provided in the
design-based alternatives.
Prior to the enactment of SBJPA, sec-
tions 401(k) and 401(m) provided only for
mathematical comparison. Specifically,
the ADP and ACP tests compare the av-
erage of the rates of contributions of the
HCEs to the average of the rates of contri-
butions of the NHCEs. For this purpose,
the rate of contributions for an employee
is the amount of contributions for an
employee divided by the employee’s com-
pensation for the plan year. These tests
are satisfied if the average rate of HCE
contributions does not exceed 1.25 times
the average rate of contributions of the
NHCEs. Alternatively, these tests are
satisfied if the average rate of HCE contri-
butions does not exceed the average rate of
contributions of the NHCEs by more than
2 percentage points and is no more than 2
times the average rate of contributions of
the NHCEs. To the extent that these tests
are not satisfied, the statute provides for
correction through distribution to HCEs
(or forfeiture of nonvested matching con-
tributions) or, to the extent provided in
regulations, recharacterization of elective
contributions as after-tax contributions. In
addition, to the extent provided in regu-
lations, nonelective contributions can be
made to NHCEs and elective contributions
and certain matching contributions can be
moved between the ADP and ACP tests, in
order the reduce the discrepancy between
the average rates of contribution for the
HCEs and the NHCEs.
SBJPA added design-based alternative
methods of satisfying the ADP and ACP
tests. Under these methods, if a plan meets
certain contribution and notice require-
ments, the plan is deemed to satisfy the
nondiscrimination rules without regard
to actual utilization of the contribution
opportunity offered under the plan. These
regulations reflect this change and the
other changes that were made to sections
401(k) and 401(m) under SBJPA, TRA
’97 and EGTRRA since the issuance of
final regulations under those sections.
SBJPA made the following significant
changes affecting section 401(k) and sec-
tion 401(m) plans:
•The ADP test and ACP test were
amended to allow the use of prior year
data for NHCEs.
•The method of distributing t
o correct
failures of the ADP test or A
CP test
was changed to require dis
tribution to
the HCEs with the highest c
ontribu-
tions.
•Tax-exempt organizations and Indian
tribal governments are permitted to
maintain section 401(k) plans.
•A safe harbor alternative to the ADP
test and ACP test was introduced in or-
der to provide a design-based method
to satisfy the nondiscrimination tests.
•The SIMPLE 401
(k) plan (an alter-
native desig
n-based method to satisfy
the nondiscr
imination tests for small
employers t
hat corresponds to the pro-
visions of s
ection 408(p) for SIMPLE
IRA plans b
y providing for smaller
contribu
tions) was added.
•A special testing option was provided
for plans that permit participation be-
fore employees meet the minimum age
2003-35 I.R.B.432September 2, 2003

and service requirements, in order to
encourage 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 are
treated as automatically satisfying the
ADP and ACP tests.
•Matching contributions for self-em-
ployed individuals are no longer
treated as elective contributions.
EGTRRA made the following signifi-
cant changes affecting section 401(k) and
section 401(m) plans:
•Catch-up contributions were added to
provide for additional elective contri-
butions for participants age 50 or older.
•The Secretary was directed to change
the section 401(k) regulations to
shorten the period of time that an
employee is stopped from making
elective contributions under the safe
harbor rules for hardship distributions.
•Beginning in 2006, section 401(k)
plans will be permitted to allow em-
ployees to designate their elective
contributions as “Roth contributions”
that will be subject to taxation under
the 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 of
section 416.
•Distributions from section 401(k)
plans are permitted upon “severance
from 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 matching
contributions
•Matching contributions are taken into
account 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 statutory
changes and other items have been issued
by the IRS, including:
•Notice 97–2, 1997–1 C.B. 348, pro-
vided initial guidance on prior year
ADP and ACP testing and guidance on
correction of excess contributions and
excess aggregate contributions, includ-
ing distribution to the HCEs with the
highest 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 year
testing issues.
•Notice 98–52, 1998–2 C.B. 632, and
Notice 2000–3, 2000–1 C.B. 413, pro-
vided guidance on safe harbor section
401(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 related
to the changes made by EGTRRA.
These items of guidance are incorporated
into these proposed regulations with some
modifications and the proposed regula-
tions have been reorganized as indicated
in the tables of contents at proposed
§§1.401(k)–0 and 1.401(m)–0. Treasury
and the IRS believe that a single restate-
ment of the section 401(k) and section
401(m) rules serves the interests of plan
sponsors, third-partyadministrators, plan
participants, and plan beneficiaries.
The process of reviewing and integrat-
ing all existing administrative guidance
under sections 401(k) and 401(m) has led
Treasury and the IRS to reconsider certain
rules and to propose certain changes in
those rules. To the extent practicable,
this preamble identifies the substantive
changes and explains the underlying anal-
ysis. In many cases, the changes will
clarify or simplify existing guidance and
will reduce plan administrative burdens.
Treasury and the IRS appreciate the
fact that plan sponsors and third-party
administrators have developed systems
and practices in the application of existing
administrative guidance to the design and
operation of section401(k) and section
401(m) plans. In many cases, the details
of these systems and practices have been
determined through a plan sponsor's or
administrator's interpretation of specific
terms in existing guidance or, where no
guidance has been provided, through a
plan sponsor's or administrator's best legal
and practical judgment. As a result, these
systems and practices may differ from ad-
ministrator to administrator, from sponsor
to sponsor, or from plan to plan.
Treasury and the IRS also recognize
that certain of the substantive changes in
these proposed regulations will require
changes in plan design or plan operation.
However, the proposed regulations are not
otherwise intended to require significant
changes in plan systems and practices that
were developed under existing guidance
and that conform to the requirements of
sections 401(k) and 401(m). Therefore,
Treasury and the IRS specifically request
that plan sponsors and third-party admin-
istrators comment on points where the
proposed regulations might have the unin-
tended effect of requiring a change to plan
systems or practices so that Treasury and
the IRS can further evaluate whether such
a change is in fact appropriate or whether
Treasury and the IRS should instead make
an adjustment in the final regulations.
Explanation of Provisions
1. Rules Applicable to All Cash or
Deferred Arrangements
Section 401(k)(1) provides that a profit-
sharing, stock bonus, pre-ERISA money
purchase or rural cooperative plan will not
fail to qualify under section 401(a) merely
because it contains a qualified cash or de-
ferred arrangement. Section 1.401(k)–1
would set forth the general definition of a
cash or deferred arrangement (CODA), the
additional requirements that a CODA must
satisfy in order to be a qualified CODA,
and the treatment of contributions made
under 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 or
deferred election with respect to contribu-
tions to, or accruals or benefits under, a
plan intended to satisfy the requirements
September 2, 20034332003-35 I.R.B.

of section 401(a). A cash or deferred elec-
tion is any direct or indirect election by
an employee (or modification of an earlier
election) to have the employer either: 1)
provide an amount to the employee in the
form of cash or some other taxable benefit
that is not currently available; or 2) con-
tribute an amount to a trust, or provide an
accrual or other benefit, under a plan defer-
ring the receipt of compensation. A cash or
deferred election can include a salary re-
duction agreement, but the specific refer-
ence to a salary reduction agreement has
been eliminated as unnecessary. In addi-
tion, the proposed regulations would in-
corporate prior guidance on automatic en-
rollment, and thus would reflect the fact
that a CODA can specify that the default
that applies in the absence of an affirmative
election 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 a
CODA excludes contributions that are
treated as after-tax employee contribu-
tions at the time of the contribution and
contributions made pursuant to certain
one-time irrevocable elections, but would
also specify that a CODA does not include
an arrangement under which dividends
paid to an ESOP are either distributed to
a participant or reinvested in employer
securities in the ESOP pursuant to an
election by the participant or beneficiary
under section 404(k)(2)(A)(iii) as added
by EGTRRA.
The proposed regulations would also
specify that a contribution is made pur-
suant to a cash or deferred election only if
the contribution is made after the election
is made. Thus, a contribution made in an-
ticipation of an employee's election is not
treated as an elective contribution. Simi-
larly, the regulations would provide that a
contribution is made pursuant to a cash or
deferred election only if the contribution is
made after the employee's performance of
services which relate to the compensation
that, 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 made
no earlier than the date the compensation
would have been paid, but for the election,
is also treated as made pursuant to a cash or
deferred election). Accordingly, amounts
contributed in anticipation of future perfor-
mance of services generally would not be
treated as elective contributions under sec-
tion 401(k). These restrictions on the tim-
ing of contributions are consistent with the
fundamental premise of elective contribu-
tions, that these are contributions that are
paid to the plan as a result of an employee
election not to receive those amounts in
cash. Moreover, ensuring that contribu-
tions are made after the employee's elec-
tion furthers plan administrability.
The deductibility of these prefunded
elective contributions (as well as pre-
funded matching contributions) for the
taxable year in which the contribution was
made was addressed in Notice 2002–48,
2002–29 I.R.B.139. In that notice, the IRS
indicated that it was reviewing issues other
than the deductibility of prefunded contri-
butions but, pending additional guidance,
would not challenge the deductibility of
the contributions provided actual payment
is made during the taxable year for which
the deduction is claimed and the amount
deducted does not exceed the applicable
limit under section 404(a)(3)(A)(i). After
considering this issue, the IRS and Trea-
sury have concluded that the prefunding
of elective contributions and matching
contributions is inconsistent with sections
401(k) and 401(m). Thus, under these pro-
posed regulations, an employer would not
be able to prefund elective contributions
to accelerate the deduction for elective
contributions. Once these regulations are
finalized, employer contributions made
under the facts in Notice 2002–48 would
no longer be permitted to be taken into ac-
count under the ADP test or the ACP test
and would not satisfy any plan require-
ment to provide elective contributions or
matching contributions.
2. Qualified CODAs
A. General rules relating to qualified
CODAs
Elective contributions under a qualified
CODA are treated as employer contribu-
tions and generally are not included in the
employee's gross income at the time the
cash would have been received (but for the
cash or deferred election), or at the time
contributed to the plan. Elective contribu-
tions under a qualified CODA are included
in the employee's gross income however, if
the contributions are in excess of the sec-
tion 402(g) limit for a year, are designated
Roth contributions (under section 402A,
effective for tax years beginning after De-
cember 31, 2005) or are recharacterized as
after-tax contributions as part of a correc-
tion of an ADP test failure.
A CODA is not qualified unless it is
part of a profit sharing plan, stock bonus
plan, pre-ERISA money purchase plan,
or rural cooperative plan and provides
for an election between contributions to
the plan or payments directly in cash. In
addition, a CODA is not qualified unless it
meets the following requirements: 1) the
elective contributions under the CODA
satisfy either the ADP test set forth in sec-
tion 401(k)(3) or one of the design-based
alternatives in section 401(k)(11) or (12);
2) elective contributions under the CODA
are nonforfeitable at all times; 3) elective
contributions are distributable only on the
occurrence of certain events, including
attainment of age 59
1
/2, hardship, death,
disability, severance from employment,
or termination of the plan; 4) the group
of employees eligible to participate in the
CODA satisfies the coverage requirements
of section 410(b)(1); 5) no other bene-
fit (other than matching contributions or
another specified benefit) is conditioned,
directly or indirectly, upon the employee's
making or not making elective contribu-
tions under the CODA; and 6) no more
than 1 year of service is required for eli-
gibility to elect to make a cash or deferred
election.
Subject to certain exceptions, state and
local governmental plans are not allowed
1
The Department of Labor has advised Treasury and theIRS that, under Title I of the Employee Retirement Income Security Act of 1974 (ERISA), fiduciaries of a plan must ensure that
the plan is administered prudently and solely in the interest of plan participants and beneficiaries. While ERISA section 404(c) may serve to relievecertain fiduciaries from liability when
participants or beneficiaries exercise control over the assets in their individual accounts, the Department ofLabor has taken the position that a participant or beneficiary will not be considered
to 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 CFR
2550.404c–1 and 57 FR 46924.
2003-35 I.R.B.434September 2, 2003

to include a qualified CODA. Plans spon-
sored by Indian tribal governments and ru-
ral cooperatives are allowed to include a
qualified CODA.
B. Nondiscrimination rules applicable to
CODAs
As under the existing regulations, the
proposed regulations would provide that
the special nondiscrimination standards
set forth in section 401(k) are the exclusive
means by which a qualified CODA can
satisfy the nondiscrimination in amount
of contribution requirement of section
401(a)(4). These special nondiscrimi-
nation standards now include: the ADP
test, the ADP safe harbor and the SIM-
PLE 401(k) plan. Pursuant to section
401(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 respect
to the nondiscriminatory availability of
benefits, rights and features, including
the availability of each level of elective
contributions, matching contributions, and
after-tax employee contributions. The
provisions of the existing regulations re-
lated to compliance with sections 410(b)
and 401(a)(4) would be revised to clarify
the relationship of the rules under sections
410(b) and 401(a)(4) to the requirements
for a qualified CODA and to remove re-
dundant provisions. Except as provided
below, however, these rules are substan-
tively unchanged.
These proposed regulations are de-
signed to provide simple, practical
rules that accommodate legitimate plan
changes. At the same time, the rules
are intended to be applied by employers
in a manner that does not make use of
changes in plan testing procedures or
other plan provisions to inflate inappro-
priately the ADP for NHCEs (which is
used as a benchmark for testing the ADP
for HCEs) or to otherwise manipulate the
nondiscrimination testing requirements of
section 401(k). Further, these nondiscrim-
ination requirements are part of the overall
requirement that benefits or contributions
not discriminate in favor of HCEs. There-
fore, a plan will not be treated as satisfying
the requirements of section 401(k) if there
are 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 ADP
for HCEs, or otherwise manipulate the
nondiscrimination rules of section 401(k),
if a principal purpose of the changes was
to achieve such a result.
C. Aggregation and disaggregation of
plans
The proposed regulations would con-
solidate the rules in the existing regula-
tions regarding identification of CODAs
and plans for purposes of demonstrat-
ing compliance with the requirements of
section 401(k). As under the existing
regulations, all CODAs included in a plan
are treated as a single CODA for pur-
poses of applying the nondiscrimination
tests. For this purpose, a plan is generally
defined by reference to §1.410(b)–7(a)
and (b) after application of the mandatory
disaggregation rules of §1.410(b)–7(c)
(other than the mandatory disaggregation
of section 401(k) and section 401(m)
plans) and permissive aggregation rules
of §1.410(b)–7(d), as modified under
these regulations. For example, if a plan
covers collectively bargained employees
and noncollectively bargained employees,
the elective contributions for the separate
groups of employees must be subject to
separate nondiscrimination tests under
section 401(k). The proposed regula-
tions would also retain the special rules
in the existing regulations that permit
the aggregation of certain employees in
different collective bargaining units and
the prohibition on restructuring under
§1.401(a)(4)–9(c).
The proposed regulations would
change the treatment of a CODA under
a plan which includes an ESOP. Section
1.410(b)–7(c)(2) provides that the portion
of a plan that is an ESOP and the portion
that 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 separate
nondiscrimination tests: one for elective
contributions going into the ESOP portion
(and invested in employer stock) and one
for elective contributions going in the
non-ESOP portion of the plan. The addi-
tional testing results in increased expense
and administrative difficulty for the plan
and creates the possibility that the ESOP
portion or the non-ESOP portion may fail
the ADP test or ACP test because HCEs
maybemoreorlesslikelytoinvestin
employer securities than NHCEs.
Since the issuance of the existing regu-
lations, the use of an ESOP as the employer
stock fund in a section 401(k) plan has
become much more widespread. In light
of this development, the proposed regu-
lations would eliminate disaggregation of
the ESOP and non-ESOP portions of a
single section 414(l) plan for purposes of
ADP testing. The same rule would apply
for ACP testing under section 401(m). In
addition, the proposed regulations would
provide that, for purposes of applying the
ADP test or the ACP test, an employer
could permissively aggregate two section
414(l) plans, one that is an ESOP and one
that is not.
However, the exception to mandatory
disaggregation of ESOPs from non-ESOPs
set forth in these proposed regulations
would not apply for purposes of satisfying
section 410(b). Accordingly, the group
of eligible employees under the ESOP
and non-ESOP portions of the plan must
still separately satisfy the requirements of
sections 401(a)(4) and 410(b).
The proposed regulations would also
provide that a single testing method must
apply to all CODAs under a plan. This
has the effect of restricting an employer's
ability to aggregate section 414(l) plans for
purposes of section 410(b), if those plans
apply inconsistent testing methods. For
example, a plan that applies the ADP test
of section 401(k)(3) may not be aggregated
with a plan that uses the ADP safe harbor
of section 401(k)(12) for purposes of sec-
tion 410(b).
D. Restrictions on withdrawals
As discussed above, a qualified CODA
must provide that elective contributions
may only be distributed after certain
events, including hardship and severance
from employment. EGTRRA amended
section 401(k)(2)(B)(i)(I) by replacing
“separation from service” with “severance
from employment.” This change elimi-
nated the “same desk rule” as a standard
for distributions under section 401(k)
plans.
In addition, EGTRRA amended Code
section 401(k)(10) by deleting disposition
by a corporation of substantially all of the
September 2, 20034352003-35 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 as
the only distributable event described in
section 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) to
provide that the period during which an
employee 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)oftheexisting
regulations).
2
Notice 2001–56 and Notice 2002–4
provided guidance on these EGTRRA
changes 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 are
requested on whether a change in status
from employee to leased employee de-
scribed in section 414(n) should be treated
as a severance from employment that
would permit a distribution to be made.
In addition, the proposed regulations do
not include reference to “retirement” (in-
cluded in the existing regulation) as an
event allowing distribution because re-
tirement is not listed in the statute, and is
subsumed by severance from employment.
In addition to the statutory changes,
the rules relating to hardship distributions
have been reorganized in order to clarify
certain ambiguities, including the rela-
tionship between the generally applicable
rules, employee representations, and the
safe harbors provided under the existing
regulations. The existing regulations set
forth two basic requirements (i.e.,the
employee has an immediate and heavy
financial need and the distribution is nec-
essary to satisfy that need) followed by
safe harbor provisions. The proposed
regulations would retain those basic re-
quirements, but would clarify that each
safe harbor is separately applicable to
each basic requirement. In addition, the
proposed regulations would provide that
an employee representation used for pur-
poses of determining that a distribution
is necessary to satisfy an immediate and
heavy financial need must provide that the
need cannot reasonably be relieved by any
available distribution or nontaxable plan
loan (even if the distribution or loan would
not be sufficient to satisfy the financial
need), but need not provide that a loan
from a commercial source will be taken
if no such loan in an amount sufficient to
satisfy the need is available on reasonable
commercial terms.
The proposed regulations would also
modify the existing regulations to add
other types of defined contribution plans
to the list of plans that an employer may
maintain after the termination of the plan
that contains the qualified CODA while
still providing for distribution of elective
contributions upon plan termination. The
list of such plans has been expanded to
include not only an ESOP and a SEP,
but also a SIMPLE IRA plan, a plan or
contract that satisfies section 403(b) and a
section 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 the
restrictions on withdrawals continue after
the transfer. These proposed regulations
would also make explicit a requirement
that the transferor plan will fail to comply
with the restrictions on withdrawals if it
transfers elective contributions, QNECs,
or QMACs to a plan that does not provide
for these restrictions. However, a trans-
feror plan will not fail to comply with this
requirement if it reasonably concludes that
the transferee plan provides for restric-
tions on withdrawals. What constitutes a
basis for a reasonable conclusion would
be 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 requirements
set forth in the existing regulations that a
CODA 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 an
effective opportunity to elect to receive the
amount in cash no less than once during the
plan year. Under the proposed regulations,
whether an employee has an effective op-
portunity is determined based on all the
relevant 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 election
may be made, and any other conditions on
elections.
The proposed regulations would also
provide 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 of
section 401(k)(3) and the regulations under
proposed §1.401(k)–2, if that is the nondis-
crimination alternative being used. If, with
respect to the nondiscrimination alterna-
tive being used there are optional choices,
the plan must provide which of the optional
choices will apply. For example, a plan
that 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 uses
the prior year testing method must specify
whether the ADP for eligible NHCEs for
the first plan year is 3% or the ADP for
the eligible NHCEs for the first plan year.
Similarly, a plan that uses the safe har-
bor method must specify whether the safe
harbor 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 be
used if the requirements for the safe har-
bor are not satisfied. The safe harbors are
intended to provide employees with a min-
imum threshold in benefits in exchange for
easier compliance for the plan sponsor. It
would be inconsistent with this approach
to providing benefits to allow an employer
to deliver smaller benefits to NHCEs and
revert to testing.
The proposed regulations would retain
the existing rules relating to the section
401(k)(4)(A) prohibition on having ben-
efits (other than a match) contingent on
making or not making an elective contri-
bution. However, the proposed regulations
would specify that, in the case of a ben-
efit that requires an amount to be with-
held from an employee's pay, an employer
is 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 rollover
distribution. 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 under
sections 401(k) and 401(m).
2003-35 I.R.B.436September 2, 2003

contingent benefit rule merely because the
CODA restricts elective contributions to
amounts available after such withholding
from the employee's pay (after deduction
of all applicable income and employment
taxes). In addition, these proposed regu-
lations also reflect the amendment to sec-
tion 416(c)(2)(A) under which matching
contributions can be taken into account for
purposes of satisfying the top-heavy mini-
mum contribution requirement without vi-
olating the prohibition on making benefits
contingent on making or not making elec-
tive contributions.
To reflect the amendment of section
401(k)(4)(B) by SBJPA to allow tax ex-
empt organizations to maintain section
401(k) plans, the proposed regulations
would also eliminate the provision pro-
hibiting a tax-exempt employer from
adopting a section 401(k) plan.
As under the existing final regulations,
these proposed regulations would provide
that a partnership is permitted to main-
tain a CODA, and individual partners are
permitted 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 been
extended to sole proprietors. The provi-
sions of these regulations also reflect the
enactment of section 402(g)(8) (initially
section 402(g)(9) as enacted by TRA '97)
providing that matching contributions with
respect to partners and sole proprietors are
no 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 of
the applicable requirements to be a qual-
ified CODA). Because elective contribu-
tions under such an arrangement are not
entitled to the constructive receipt relief
set 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 rules
for a CODA that is applying the ADP test
contained in section 401(k)(3). Under the
ADP test, the percentage of compensation
deferred for the eligible HCEs is compared
annually to the percentage of compensa-
tion deferred for eligible NHCEs, and if
certain 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 the
contribution of additional employer contri-
butions.
Section 401(k)(3)(A), as amended by
SBJPA, generally provides for the use of
prior year data in determining the ADP of
NHCEs, while current year data is used for
HCEs. This testing option is referred to
as the prior year testing method. Alter-
natively, a plan may provide for the use
of current year data for determining the
ADPs for both NHCEs and HCEs, which is
known as the current year testing method.
The proposed regulations would use the
term applicable year to describe the year
for which the ADP is determined for the
NHCEs.
Section 401(k)(3)(F), as added by
SBJPA, provides that a plan benefitting
otherwise excludable employees and that,
pursuant to section 410(b)(4)(B), is being
treated as two separate plans for purposes
of section 410(b), is permitted to disregard
NHCEs who have not met the minimum
age and service requirements of section
410(a)(1)(A). Thus, the proposed regula-
tions would permit such a plan to perform
the ADP test by comparing the ADP for
all eligible HCEs for the plan year and the
ADP of eligible NHCEs for the applicable
year, disregarding all NHCEs who have
not met the minimum age and service
requirements of section 410(a)(1)(A). The
proposed regulations treat this rule as per-
missive. Accordingly, the new statutory
provision does not eliminate the exist-
ing testing option under which a plan
benefitting otherwise excludable employ-
ees is disaggregated into separate plans
where the ADP test is performed sepa-
rately for all eligible employees who have
completed the minimum age and service
requirements of section 410(a)(1)(A) and
for all eligible employees who have not
completed the minimum age and service
requirements of section 410(a)(1)(A).
B. Elective contributions used in the ADP
test
The proposed regulations would gen-
erally follow the existing regulations in
defining which elective contributions are
reflected in the ADP test and which ones
are not. The proposed regulations would
reflect the rule contained in the regula-
tions under section 414(v), under which
catch-up contributions that are in excess
of 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 distributed
are still taken into account under the ADP
test (with the exception of deferrals made
by NHCEs that were in violation of sec-
tion 401(a)(30)). The proposed regulations
retain the rule that elective contributions
must be paid to the trust within 12 months
after the end of the plan year. However, for
plans subject to Title I of ERISA, contribu-
tions must be paid to the trust much sooner
in order to satisfy the Department of La-
bor'sregulationsrelatingtowhenelective
contributions become plan assets.
Section 401(k)(3) provides that the ac-
tual deferral ratio (ADR) of an HCE who is
eligible to participate in 2 or more CODAs
of the same employer is calculated by treat-
ing all CODAs in which the employee is
eligible to participate as one CODA. The
existing regulations implement this rule
by aggregating the elective contributions
of such an HCE for all plan years that
end with or within a single calendar year.
This can yield an inappropriate result if
the plan years are different, because more
than 12 months of elective contributions
couldbeincludedinanemployee'sADR.
These proposed regulations would modify
this rule to provide that the ADR for each
HCE participating in more than one CODA
is determined by aggregating the HCE's
elective contributions that are within the
plan year of the CODA being tested. In
addition, the definition of period of partic-
ipation for purposes of determining com-
pensation would be modified to take into
September 2, 20034372003-35 I.R.B.

account periods of participation under an-
other plan where the elective contributions
must be aggregated for an HCE. As a re-
sult, even in the case of plans with dif-
ferent plan years, each of the employer's
CODAs will use 12 months of elective con-
tributions and 12 months of compensation
in determining the ADR for an HCE who
participates in multiple arrangements.
The proposed regulations would retain
the rule in the existing regulations that
provides that the HCE aggregation of
elective contributions under CODAs does
not apply where the CODAs are within
plans that cannot be aggregated under
§1.410(b)–7(d), but only after applying
the modifications to the section 410(b)
aggregation and disaggregation rules for
section 401(k) plans provided in the pro-
posed regulations. The non-application
of the HCE aggregation rule would have
less significance in light of the change
described above relating to the elimination
of the required disaggregation of ESOP
and non-ESOP plans. In addition, the
proposed regulations would clarify that,
in determining whether two plans could
be aggregated for this purpose, the prohi-
bition on aggregating plans with CODAs
that apply inconsistent testing methods set
forth under these proposed regulations and
the section 410(b) prohibition on aggre-
gating plans that have different plan years
would not apply.
C. Additional employer contributions used
in 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 qualified
matching contributions (i.e., nonelective
or matching contributions that satisfy the
vesting 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 has
failed the ADP test can correct this failure
by making additional qualified nonelec-
tive contributions (QNECs) or qualified
matching contributions (QMACs) for its
NHCEs. The proposed regulations would
no longer describe such contributions as
being treated as elective contributions un-
der the arrangement, but would nonethe-
less permit such contributions to be taken
into account under the ADP test.
As under the existing regulations, these
proposed regulations would provide that
QNECs must satisfy four requirements
in addition to the vesting and distribution
rules described above before they can be
taken into account under the ADP test: 1)
The amount of nonelective contributions,
including the QNECs that are used under
the ADP test or the ACP test, must satisfy
section 401(a)(4); 2) the nonelective con-
tributions, excluding the QNECs that are
used under the ADP test or the ACP test,
must satisfy section 401(a)(4); 3) the plan
to which the QNEC or QMAC is made
must be a plan that can be aggregated with
the plan maintaining the CODA; and 4) the
QNECs or QMACs must not be contingent
on the performance of services after the
allocation date and must be contributed
within 12 months after the end of the plan
year within which the contribution is to
be allocated.
3
Thus, in the case of a plan
using prior year ADP testing, any QNECs
that are to be allocated to the NHCEs for
the prior plan year must be contributed
before the last day of the current plan year
in order to be taken into account.
Some plans provide a correction mech-
anism for a failed ADP test that targets
QNECs to certain NHCEs in order to re-
duce the total contributions to NHCEs un-
der the correction. Under the method that
minimizes the total QNECs allocated to
NHCEs under the correction, the employer
makes a QNEC to the extent permitted by
the section 415 limits to the NHCE with
the lowest compensation during the year
in order to raise that NHCE's ADR. If the
plan still fails to pass the ADP test, the em-
ployer continues expanding the group of
NHCEs who receive QNECs to the next
lowest-paid NHCE until the ADP test is
satisfied. By using this bottom-up level-
ing technique, the employer can pass the
ADP test by contributing small amounts of
moneytoNHCEswhohaveverylowcom-
pensation for the plan year (for example,
an employee who terminated employment
in 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 high
percentage of compensation) contribution
to a terminated or other partial-year em-
ployee has a larger impact on the ADP test
than a more significant contribution to a
full-year employee.
The IRS and Treasury have been
concerned that, by using these types of
techniques, employers may pass the ADP
test by making high percentage QNECs
to a small number of employees with low
compensation rather than providing con-
tributions to a broader group of NHCEs.
In addition, the legislative history to
EGTRRA expresses Congressional intent
that the Secretary of the Treasury will use
his existing authority to address situations
where qualified nonelective contributions
are targeted to certain participants with
lower compensation in order to increase
the ADP of the NHCEs. (See EGTRRA
Conference Report, H.R. Conf. Rep.
107–84, 240).
Accordingly, the proposed regulations
would add a new requirement that a QNEC
mustsatisfyinordertobetakenintoac-
count under the ADP test. This require-
ment, designed to limit the use of targeted
QNECs, would generally treat a plan as
providingimpermissiblytargetedQNECs
if less than half of all NHCEs are receiv-
ing QNECs and would also treat a QNEC
as impermissibly targeted if the contribu-
tion is more than double the QNECs other
nonhighly compensated employees are re-
ceiving, when expressed as a percentage of
compensation. However, QNECs that do
not exceed 5% of compensation are never
treated as targeted and would always sat-
isfy the new requirement.
This restriction on targeting QNECs
would be implemented in the proposed
regulations by providing that a QNEC
that exceeds 5% of compensation could
be taken into account for the ADP test
only to the extent the contribution, when
expressed as a percentage of compen-
sation, does not exceed two times the
plan's representativecontribution rate.
The plan's representative contribution rate
would be defined as the lowest contribu-
tion rate among a group of NHCEs that is
half of all the eligible NHCEs under the
arrangement (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 made
no 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.438September 2, 2003

rate among all eligible NHCEs under the
arrangement who are employed on the last
day of the year, if greater). For purposes
of determining an NHCE's contribution
rate, the employee's qualified nonelective
contributions and thequalified matching
contributions taken into account under
the ADP test for the plan year are added
together and the sum is divided by the
employee's compensation for the same
period. The proposed regulations under
section 401(m) would provide parallel re-
strictions on QNECs taken into account in
ACP testing, and a QNEC cannot be taken
into account under both the ADP and ACP
test (including for purposes of determining
the representative contribution rate). As
discussed more fully below, the proposed
regulations would also have a limitation on
targeting matching contributions, which
would limit the extent to which QMACs
can be targeted as a means of avoiding the
restrictions on targeted QNECs.
The proposed regulations would also
implement a prohibition against double
counting of QNECs that was set forth in
Notice 98–1. Generally, QNECs used in
an ADP or ACP test, used to satisfy the
safe harbor under section 401(k), or under
a SIMPLE 401(k) plan can not be used
again to demonstrate compliance with
another test under section 401(k)(3) or
401(m)(2). For example, double count-
ing could arise when QNECs on behalf of
NHCEs 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 the
ADP of NHCEs. However, unlike Notice
98–1, these proposed regulations would
not contain the additional limitations on
double counting elective contributions or
matching contributions that were moved
between the ADP and ACP tests.
D. Correction
Section 401(k)(8)(C), as amended by
the SBJPA, provides that, for purposes
of correcting a plan's failure to meet the
nondiscrimination requirements of section
401(k)(3), distribution of excess contribu-
tions is made on the basis of the amount of
the contributions by, or on behalf of, each
HCE. The proposed regulations would
implement this correction procedure in the
same manner as set forth in Notice 97–2.
Thus, the total amount of excess contribu-
tions is determined using the rules under
the existing final regulations (i.e., based
on high percentages). Then that total
amount is apportioned among the HCEs
by assigning the excess to be distributed
first to those HCEs who have the greatest
dollar amount of contributions taken into
account under the ADP test (as opposed to
the highest deferral percentage). If these
amounts are distributed or recharacterized
in accordance with these regulations, the
plan complies with the ADP test for the
plan year with no obligation to recalculate
the ADP test.
The proposed regulations would pro-
vide a special rule for correcting through
distribution of excess contributions in the
case of an HCE who participates in mul-
tiple plans with CODAs. In that case,
the proposed regulations would provide
that, for purposes of determining which
HCE will be apportioned a share of the to-
tal excess contributions to be distributed
from a plan, all contributions in CODAs in
which 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 the
plan undergoing correction — rather than
all contributions taken into account in cal-
culating the employee's ADR — may be
distributed from a plan. If the high dollar
HCE's actual contributions under the plan
are insufficient to allow full correction,
then the HCE with the next highest dol-
lar amount of contributions is apportioned
the remaining excess contributions. If ad-
ditional correction is needed, this process
is repeated until the excess contributions
are completely apportioned. This correc-
tion mechanism is applied independently
to each CODA in which the HCE partici-
pates. If correction is needed in more than
one CODA, the ADRs of HCEs who have
received corrective distributions under the
other 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 income
attributable to excess contributions. The
existing regulations provide for a reason-
able determination of net income attrib-
utable to an excess contribution, but do
not specify which contribution within the
plan year is to be treated as the excess
contribution to be distributed. This pro-
vision would be retained in the proposed
regulations along with the existing alterna-
tive method of determining the net income,
which approximates the result that would
apply if the excess contribution is made
on the first day of the plan year. How-
ever, to the extent the employee is or will
be credited with allocable gain or loss on
those excess contributions for the period
after the end of the plan year (the gap pe-
riod), the proposed regulations would now
require that income be determined for that
period. As under the existing regulations,
the determination of the income for the gap
period could be based on the income de-
termined using the alternative method for
the aggregate of the plan year and the gap
period or using 10% of the income for the
plan year (determined under the alternative
method) for each month in the gap period.
The proposed regulations would permit
the recharacterization of excess contribu-
tions in a manner that generally follows
the existing regulations. However, the year
the employee must include the recharac-
terized contribution in current income has
been changed to match the year that the
employee would have had to include the
excess contribution in income, had it been
distributed. Thus, if the recharacterized
amount is less than $100, it is included in
gross income in the year that it is recharac-
terized, rather than the year of the earliest
elective contributions for the employee.
The proposed regulations would retain
the 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 year
testing
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 from
current year testing to prior year testing.
However, the proposed regulations would
provide that a plan is permitted to be in-
consistent between the choice of current
year testing method and prior year testing
method, as applied for ADP purposes and
ACP purposes. In such a case, any move-
ment of elective contributions or QMACs
September 2, 20034392003-35 I.R.B.

between the ADP and ACP tests (including
recharacterization) would be prohibited.
The proposed regulations would gen-
erally incorporate the rules set forth in
Notice 98–1 relating to plan coverage
changes in the case of a plan using prior
year testing. Thus, in the case of a plan
that uses prior year testing and experi-
ences a plan coverage change affecting
more than 10% of the NHCEs, the ADP
of the NHCEs would generally be de-
termined as the weighted average of the
ADP of the NHCEs of the plans in which
the NHCEs participated in the prior year.
The definition of plan coverage change
includes changes in the group of eligible
employees under a plan resulting from the
establishment or amendment of a plan,
a plan merger or spin-off or a change in
the way plans are combined or separated
under the section 410(b) rules. The defini-
tion under the proposed regulations would
also include a reclassification of a sub-
stantial group of employees that has the
same effect as amending the plan. These
proposed regulations retain the rule that
a plan that experiences coverage changes
affecting 10% or less of the NHCEs dis-
regards those changes in calculating the
ADP for the NHCEs. Similarly, a plan
that merely experiences a spin-off is not
required to recalculate the ADP for the
NHCEs.
5. Safe Harbor Section 401(k) Plans
Section 401(k)(12) provides a de-
sign-based safe harbor method under
which a CODA is treated as satisfying the
ADP 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 requirements
for these arrangements, generally follows
the rules set forth in Notice 98–52 and
Notice 2000–3. Thus, a plan satisfies
the section 401(k) safe harbor if it makes
specified QMACs for all eligible NHCEs.
The matching contributions can be under
a basic matching formula that provides
for QMACs equal to 100% of the first
3% of elective contributions and 50% of
the next 2% or an enhanced matching
formula that is at least as generous in the
aggregate, provided the rate of match-
ing contributions under the enhanced
matching formula does not increase as the
employee's rate of elective contributions
increases. In lieu of QMACs, the plan is
permitted to provide QNECs equal to 3%
of compensation for all eligible NHCEs.
In addition, notice must be provided to
each 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 method
must 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 the
part of any HCE cannot exceed the rate
of matching contribution that would apply
to any NHCE with the same rate of elec-
tive contribution. Notice 98–52 advised
that the general rules on aggregating con-
tributions for HCEs eligible under more
than 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 would
not require that elective or matching con-
tributions on behalf of an HCE who is
eligible to participate in more than one
plan of the same employer be aggregated
forpurposesoftherequirementofsection
401(k)(12)(B)(ii). Thus, the rate of match
for purposes of determining whether an
HCE has a higher matching rate is based
only on matching contributions with re-
spect to elective contributions under the
safe harbor plan. However, for an em-
ployer that uses the safe harbor method of
satisfying the ACP test, the rule in No-
tice 98–52 is retained for applying the ACP
safe harbor, with an exception for nonsi-
multaneous participation (as discussed in
connection with the ACP safe harbor be-
low).
These proposed regulations do not
provide any rules relating to suspension
of employee contributions under a plan
that provides that safe harbor matching
contributions are made with respect to
the sum of elective contributions and em-
ployee contributions. Although Notice
2000–3 specifically permitted suspension
of employee contributions in certain cir-
cumstances, the IRS and Treasury have
determined that there are no limits on sus-
pending employee contributions, provided
that safe harbor matching contributions
are made with respect to elective contribu-
tions. This is because the restrictions on
suspension of elective contributions are
sufficient to ensure an eligible NHCE can
get the full matching contribution.
The proposed regulations do not in-
clude any exception to the requirements
for safe harbor matching contributions
with respect to catch-up contributions.
Treasury and the IRS are aware that there
are questions concerning the extent to
which catch up contributions are required
to be matched under a plan that provides
for safe harbor matching contributions.
Treasury and the IRS are interested in
comments on the specific circumstances
under which elective contributions by a
NHCEtoasafeharborplanwouldbeless
than the amount required to be matched,
e.g., less than 5% of safe harbor compen-
sation, but would be treated by the plan as
catch-up contributions, and on the extent
to which a safe harbor plan should be
required to match catch-up contributions
under such circumstances.
Section 401(k)(12)(D) contains a re-
quirement that each eligible employee be
provided with a notice of the employee's
rights and obligations under the plan.
These proposed regulations do not ad-
dress the extent to which the notice can
be provided through electronic media. As
noted in the preamble to other regulations,
the IRS and the Treasury Department are
considering the extent to which the notice
described in section 401(k)(12)(D), as well
as other notices under the various Internal
Revenue Code requirements relating to
qualified retirement plans, can be pro-
vided electronically, taking into account
the effect of the Electronic Signatures
in Global and National Commerce Act
(E-SIGN), Public Law 106–229 (114 Stat.
464 (2000)). The IRS and the Treasury
Department anticipate issuing proposed
regulations regarding these issues, and in-
vite comments on these issues. Until those
proposed regulations are issued, plan ad-
ministrators and employers may continue
to rely on the interim guidance in Q&A–7
of Notice 2000–3 on use of electronic
media to satisfy the notice requirement in
section 401(k)(12)(D).
These proposed regulations would clar-
ify that a section 401(k) safe harbor plan
must generally be adopted before the be-
ginning of the plan year and be maintained
throughout a full 12-month plan year. This
requirement is consistent with the notion
that the statute specifies a certain contri-
bution level for nonhighly compensated
2003-35 I.R.B.440September 2, 2003

employees in order to be deemed to pass
the nondiscrimination requirements. If the
contribution level isnot maintained for
a full 12-month year, the employer con-
tributions made on behalf of nonhighly
compensated employees should not sup-
port what could be a full year's contribu-
tion by the highly compensated employ-
ees.
The proposed regulations would adopt
the 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 was
provided in Notice 2000–3. Under that op-
tion, an employer could adopt a section
401(k) safe harbor plan which has contin-
gent non-elective contributions, provided
the employer notifies employees of this
contingent arrangement before the start of
the year, amends the plan to provide the
nonelective contributions no less than 30
days before the end of the year, and pro-
vides employees with a follow-up notice if
the contribution will be made. Similarly,
the proposed regulations would adopt the
exception for a section 401(k) safe har-
bor plan that uses the matching contribu-
tion alternative. Under that exception, an
employer can amend the plan to eliminate
matching contributions with respect to fu-
ture elective deferrals, provided that the
matching contributions are made with re-
spect to pre-amendment elective deferrals,
employees are provided with notice of the
change and the opportunity to change their
elections, and the plan satisfies the ADP or
ACP test for the plan year using the current
year testing method.
The proposed regulations would recog-
nize the practical difficulty in a 12-month
requirement by following the rule in No-
tice 98–52 that allowed a short plan year in
the first plan year and would allow a short
plan year in certain other circumstances.
Specifically, a section 401(k) safe harbor
plan could have a short plan year in the
year the plan terminates, if the plan ter-
mination is in connection with a merger
or acquisition involving the employer, or
the employer incurs a substantial business
hardship comparable to a substantial busi-
ness hardship described in section 412(d).
In addition, a section 401(k) safe harbor
plan could have a short plan year if the plan
terminates, the employer makes the safe
harbor 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 short
plan year if it is preceded and followed by
12-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 made
to a plan other than the plan that contains
the CODA. These proposed regulations re-
flect that rule and provide that the plan
to which the safe harbor contributions are
made need not be a plan that can be aggre-
gated with the plan that contains the cash
or deferred arrangement.
Whether a contribution is taken into ac-
count for purposes of the safe harbor is
determined in accordance with the rules
regarding inclusion in ADP testing under
proposed §1.401(k)–2(a). Thus, for exam-
ple, a plan that provides for safe harbor
matching contributions in 2006 need not
provide for a matching contribution with
respect to an elective contribution made
during the first 2
1
/2months of 2007 and
attributable to service during 2006, unless
that 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 the
requirements of section 401(k)(3)(A)(ii)
if the contribution, vesting, notice and
exclusive plan requirements of sec-
tion 401(k)(11) are satisfied. Section
1.401(k)–4 of these proposed regula-
tions reflects the provisions of section
401(k)(11) in a manner that follows the
positions reflected in the model amend-
ments set forth in Rev. Proc. 97–9.
7. Matching Contributions and Employee
Contributions.
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 the
nondiscrimination test for elective contri-
butions set forth in section 401(k). Section
1.401(m)–1 of the proposed regulations
would set forth this test in a manner that
is consistent with the nondiscrimination
test set forth in proposed §1.401(k)–1(b).
Thus, satisfaction of the ACP test, the ACP
safe harbor or the SIMPLE 401(k) pro-
visions of the proposed regulations under
section 401(k) are the exclusive means that
matching 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 the
ability of an employer to make repeated
changes in plan provisions or testing pro-
cedures that have the effect of distorting
the ACP so as to increase significantly
the permitted ACP for HCEs, or otherwise
manipulate the nondiscrimination rules of
section 401(m), if a principal purpose of
the changes was to achieve such a result.
These proposed regulations also in-
clude provisions regarding plan aggrega-
tion and disaggregation that are similar to
those proposed for CODAs under section
401(k). For example, matching contri-
butions made under the portion of a plan
that is an ESOP and the portion of the
same plan that is not an ESOP would not
be disaggregated under these proposed
regulations.
The definitions of matching contri-
bution and employee contribution under
§1.401(m)–1 of the proposed regulations
would generally follow the definitions in
the existing regulations. Thus, whether an
employer contribution is on account of an
elective deferral or employee contribution
— and thus is a matching contribution
— is determined based on all the relevant
facts and circumstances. However, the
proposed regulations would provide that
a contribution would not be treated as a
matching contribution on account of an
elective deferral if it is contributed before
the employee's performance of services
with respect to which the elective deferral
is made (or when the cash that is subject
to the cash or deferred election would
be currently available, if earlier) and an
employer contribution is not a matching
contribution made on account of an em-
ployee contribution if it is contributed
before the employee contribution. Thus,
under these regulations, an employer
would not be able to prefund matching
contributions to accelerate the deduction
for those contributions and, as noted above
with respect to the timing of elective con-
tributions, employer contributions made
under the facts in Notice 2002–48 would
not be taken into account under the ACP
September 2, 20034412003-35 I.R.B.

test and would not satisfy any plan require-
ment to provide matching contributions.
8. ACP Test for Matching Contributions
and Employee Contributions
Section 1.401(m)–2 of the proposed
regulations would provide rules for the
ACP test that generally parallel the rules
applicable to the ADP test in proposed
§1.401(k)–2. Thus, for example, the ACP
test may be run by comparing the ACP for
eligible HCEs for the current year with
the ACP for eligible NHCEs for either
the current plan year or the prior plan
year. Similarly, the proposed regulations
reflect the special ACP testing rule in
section 401(m)(5)(C) for a plan that pro-
vides for early participation, comparable
to the special ADP testing rule in section
401(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 taken
into 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 under
all plans of the employer during the plan
year of the plan being tested, in a man-
ner comparable to that for determining the
ADR of an HCE who participates in two or
more CODAs.
The proposed regulations would re-
tain the rule from the existing regulations
under which a QMAC that is taken into ac-
count in the ADP test is excluded from the
ACP test. In addition, the proposed reg-
ulations would continue to allow QNECs
to be taken into account for ACP testing,
but would provide essentially the same
restrictions on targeting QNECs to a small
numberofNHCEsasisprovidedinpro-
posed §1.401(k)–2. The only difference
in the rules would be that the contribu-
tion percentages used to determine the
lowest contribution percentage would be
based on the sum of the QNECs and those
matching contributions taken into account
in the ACP test, rather than the sum of
the QNECs and the QMACs taken into
account under the ADP test. Because
QNECs that do not exceed 5% are not
subject to the limits on targeted QNECs
under either the ADP test or the ACP test,
an employer is permitted to take into ac-
count up to 10% in QNECs for an eligible
NHCE, 5% in ADP testing and 5% in
ACP testing, without regard to how many
NHCEs receive QNECs.
In addition, to prevent an employer
from using targeted matching contri-
butions to circumvent the limitation on
targeted QNECs, the proposed regulations
would provide that matching contributions
are not taken into account in the ACP test
to the extent the matching rate for the
contribution exceeds the greater of 100%
and 2 times the representative matching
rate. Paralleling the rule to limit targeted
QNECs, the representative plan matching
rate is the lowest matching rate for any
eligible employee in a group of NHCEs
that consists of half of all eligible NHCEs
in the plan for the plan year (or the lowest
matching rate for all eligible NHCEs in the
plan who are employed by the employer
on the last day of the plan year, if greater).
For this purpose, the matching rate is the
ratio of the matching contributions to the
contributions that are being matched, and
only NHCEs who make elective deferrals
or employee contributions for the plan
year are taken into account.
The proposed regulations would set
limits on the use of elective contributions
in the ACP test that are in addition to
the rules in the existing regulations under
which elective contributions may be taken
into account for the ACP test only to the
extent the plan satisfies the ADP test,
determined by including such elective
contributions in the ADP test. Under the
new rule, the proposed regulations would
provide that elective contributions under
a plan that is not subject to the ADP test,
such as a plan that uses the safe harbor
method of section 401(k)(12) or a contract
or arrangement subject to the requirements
of section 403(b)(12)(A)(ii), may not be
taken into account for the ACP test. In the
absence of this prohibition, contributions
that are not properly considered “excess”
could be taken into account under the ACP
test.
The provisions of these proposed reg-
ulations regarding correction of excess
aggregate contributions, including allo-
cation of excess aggregate contributions
and determination of allocable income,
would generally be consistent with the
provisions of the proposed regulations
under section 401(k). These proposed
regulations continue the provisions of the
current regulations regarding correction
through distribution of vested matching
contributions and forfeiture of unvested
matching contributions. Similarly, the
proposed regulations reflect the provisions
of section 411(a)(3)(G) which permit the
forfeiture of a matching contribution made
with respect to an excess deferral, excess
contribution, or excessaggregatecontribu-
tion. This provision is necessary to allow
forfeiture of matching contributions that
would 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 the
ACP test contained in section 401(m)(2).
Under section 401(m)(11), a defined con-
tribution plan is treated as satisfying the
ACP test with respect to matching contri-
butions if the plan satisfies the ADP safe
harbor of section 401(k)(12) and matching
contributions are not made with respect to
employee contributions or elective contri-
butions in excess of 6% of an employee's
compensation. For a plan that satisfies the
ADP safe harbor using a 3% nonelective
contribution, two additional requirements
that apply to a plan that satisfies the ADP
safe harbor using matching contributions
also apply: 1) the rate of an employer's
matching contribution does not increase as
the rate of employee contributions or elec-
tive deferrals increase; and 2) the match-
ing contribution with respect to any HCE at
any 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 of
an HCE to that HCE's elective deferrals
and employee contributions for a plan year
cannot be greater than the ratio of match-
ing contributions to elective deferrals or
employee contributions that would apply
with respect to any NHCE who contributes
(as an elective deferral or employee contri-
bution) the same percentage of safe harbor
compensation for that plan year.
Section 1.401(m)–3 of these proposed
regulations, which sets forth the require-
ments for these plans, would generally
follow the rules set forth in Notice 98–52
2003-35 I.R.B.442September 2, 2003

and Notice 2000–3. These proposed reg-
ulations would clarify that, for purposes
of determining whether an HCE has a
higher rate of matching contributions
than any NHCE, any NHCE who is an
eligible employee under the safe harbor
CODA must be taken into account, even
if the NHCE is not eligible for a match-
ing contribution. This means that a plan
with a provision which limits matching
contributions to employees who are em-
ployed on the last day of the plan year
will not be able to satisfy the ACP safe
harbor, since a NHCE who is not eligible
to receive a matching contribution on
account of the last day requirement will
nonetheless be taken into consideration
in determining whether the plan satisfies
section 401(m)(11)(B)(iii). The proposed
regulations also include the requirement
that matching contributions made at the
employer's discretion with respect to any
employee cannot exceed a dollar amount
equal to 4% of the employee's compen-
sation and that a safe harbor plan must
permit all eligible NHCEs to make suffi-
cient elective contributions (or employee
contributions, if applicable) to receive the
maximum matching contribution provided
under the plan.
The proposed regulations would pro-
vide a special rule for satisfying section
401(m)(11)(B)(iii) in the case of an HCE
who participates in two or more plans that
provide for matching contributions. Under
this rule, a plan will not fail to satisfy the
requirements of section 401(m)(11)(B)(iii)
merely because an HCE participates dur-
ing the plan year in more than one plan that
provides for matching contributions, pro-
vided that the HCE is not simultaneously
an eligible employee under two plans that
provide for matching contributions main-
tained by an employer for a plan year; and
the period used to determine compensa-
tion for purposes of determining match-
ing contributions under each such plan is
limited to periods when the HCE partici-
pated in the plan. In such a case, an HCE
can transfer from a plan with a more gen-
erous matching schedule to an otherwise
safe harbor section 401(m) plan (for exam-
ple, as a result of switching jobs within the
controlled group) without causing the safe
harbor plan to violate section 401(m)(11).
However, the plan which is not the safe
harbor plan will still have to aggregate
matching contributions for the HCE under
the 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 even
though the matching contributions satisfy
thesafeharborrequirements for section
401(m)(11). However, the proposed reg-
ulations would also adopt the position in
Notice 98–52 that the ACP test is permitted
to be applied by disregarding all matching
contributions with respect to all eligible
employees. If the ADP safe harbor using
matching contributions is satisfied but the
ACP safe harbor is not satisfied, the pro-
posed regulations would adopt the position
in Notice 98–52 that the ACP test is per-
mitted to be applied disregarding matching
contributions for any employee that do not
exceed 4% of compensation.
Proposed Effective Date
The regulations are proposed to apply
for plan years beginning no sooner than
12 months after publication of final regu-
lations in theFederal Register.However,
it is anticipated that the preamble for the
final regulations will permit plan sponsors
to implement the final regulations for the
first plan year beginning after publication
of final regulations in theFederal Regis-
ter.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a significant
regulatory action as defined in Executive
Order 12866. Therefore, a regulatory
assessment is not required. It is hereby
certified that the collection of informa-
tion in these regulations will not have a
significant economic impact on a sub-
stantial number of small entities. This
certification is based upon the conclu-
sion that few plans containing qualified
CODAs will correct excess contributions
through the recharacterization of these
amounts as employee contributions un-
der §1.401(k)–2(b)(3) of these proposed
regulations. The collections of informa-
tion contained in §§1.401(k)–3(d), (f) and
1.401(m)–3(e) are required by statutory
provisions. However, the IRS has con-
sidered alternatives that would lessen the
impact of these statutory requirements on
small entities and has requested comments
on the use of electronic media to satisfy
these notice requirements. Thus, the col-
lection of information in these regulations
will not have a significant economic im-
pact on a substantial number of small
entities. Therefore, an analysis under the
Regulatory Flexibility Act (5 U.S.C. chap-
ter 6) is not required. Pursuant to section
7805(f) of the Code, this notice of pro-
posed rulemaking will be submitted to the
Chief Counsel for Advocacy of the Small
Business Administration for comment on
its impact on small business.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration
will be given to any electronic or writ-
ten comments (preferably a signed origi-
nal and eight (8) copies) that are submitted
timely to the IRS. In addition to the other
requests for comments set forth in this doc-
ument, the IRS and Treasury also request
comments on the clarity of the proposed
rule and how it may be made easier to un-
derstand. All comments will be available
for public inspection and copying.
A public hearing has been scheduled for
November 12, 2003, at 10 a.m. in the IRS
Auditorium (7th Floor), Internal Revenue
Building, 1111 Constitution Avenue, NW,
Washington, DC. Due to building security
procedures, visitors must enter at the Con-
stitution Avenue, NW, entrance, located
between 10
th
and 12
th
Streets, NW. In ad-
dition, all visitors must present photo iden-
tification to enter the building. Because
of access restrictions, visitors will not be
admitted beyond the immediate entrance
area more than 30 minutes before the hear-
ing starts. For information about having
your name placed on the building access
list to attend the hearing, see the “FOR
FURTHER 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 written
comments and an outline of the topics to
be discussed and the time to be devoted
to each topic (signed original and eight (8)
copies) by October 22, 2003.
A period of 10 minutes will be allotted
to each person for making comments.
September 2, 20034432003-35 I.R.B.

An agenda showing the scheduling of
the speakers will be prepared after the
deadline for receiving outlines has passed.
Copies of the agenda will be available free
of 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 Exempt
and Government Entities). However, other
personnel from the IRS and Treasury par-
ticipated in their development.
*****
Proposed Amendments to The
Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805
26 U.S.C. 401(m)(9) * * *
Par. 2. Sections 1.401(k)–0 and
1.401(k)–1 are revised and §§1.401(k)–2
through 1.401(k)–6 are added to read as
follows:
§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)–1
through 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 deferred
arrangements.
(a) General rules.
(1) Certain plans permitted to include cash
or deferred arrangements.
(2) Rules applicable to cash or deferred
arrangements 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 as
plan assets.
(3) Rules applicable to cash or deferred
elections 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 treated
as cash or deferred elections.
(vi) Tax treatment of employees.
(vii) Examples.
(4) Rules applicable to qualified cash or
deferred arrangements.
(i) Definition of qualified cash or deferred
arrangement.
(ii) Treatment of elective contributions as
employer contributions.
(iii) Tax treatment of employees.
(iv) Application of nondiscrimination re-
quirements to plan that includes a qualified
cash or deferred arrangement.
(A) Exclusive means of amounts testing.
(B) Testing benefits, rights and features.
(C) Minimum coverage requirement.
(5) Rules applicable to nonqualified cash
or deferred arrangements.
(i) Definition of nonqualified cash or de-
ferred arrangement.
(ii) Treatment of elective contributions as
nonelective contributions.
(iii) Tax treatment of employees.
(iv) Qualification of plan that includes
a 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 contributions
made on behalf of self-employed individ-
uals.
(iii) Timing of self-employed individual's
cash 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 testing
methods.
(iv) Disaggregation of plans and separate
testing.
(A) In general.
(B) Restructuring prohibited.
(v) Modifications to section 410(b) rules.
(A) Certain disaggregation rules not appli-
cable.
(B) Permissive aggregation of collective
bargaining 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 upon
severance from employment.
(3) Rules applicable tohardship distribu-
tions.
(i) Distribution must be on account of hard-
ship.
(ii) Limit on maximum distributable
amount.
(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 maynot exceed amount of
need.
(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.444September 2, 2003

(4) Rules applicable to distributions upon
plan termination.
(i) No alternative defined contribution
plan.
(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 qualified
cash 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 Indian
tribal governments.
(iii) Adoption after May 6, 1986.
(iv) Adoption before May 7, 1986.
(5) One-year eligibility requirement.
(6) Other benefits not contingent upon
elective 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 under
current year and prioryear testing method.
(3) Determination of ADR.
(i) General rule.
(ii) ADR of HCEs eligible under more than
one 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 and
self-employed individuals.
(iii) Elective contributions for HCEs.
(5) Elective contributions not taken into
account under the ADP test.
(i) General rule.
(ii) Elective contributions for NHCEs.
(iii) Elective contributions treated as
catch-up contributions.
(iv) Elective contributions used to satisfy
the ACP test.
(6) Qualified nonelective contributions and
qualified matching contributions that may
be 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 not
takenintoaccount.
(A) General rule.
(B) Definition of representative contribu-
tion rate.
(C) Definition of applicable contribution
rate.
(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 or
qualified 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 excess
contributions for each HCE.
(B) Determination of the total amount of
excess contributions.
(C) Satisfaction of ADP.
(iii) Apportionment of total amount of ex-
cess contributions among the HCEs.
(A) Calculate the dollar amount of excess
contributions for each HCE.
(B) Limit on amount apportioned to any
individual.
(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 plan
year income.
(D) Safe harbor method of allocating gap
period income.
(E) Alternative method for allocating plan
year and gap period income.
(v) Distribution.
(vi) Tax treatment of corrective distribu-
tions.
(A) General rule.
(B) Rule forde minimisdistributions.
(vii) Other rules.
(A) No employee or spousal consent re-
quired.
(B) Treatment of corrective distributions as
elective contributions.
(C) No reduction of required minimum
distribution.
(D) Partial distributions.
(viii) Examples.
(3) Recharacterization of excess contribu-
tions.
(i) General rule.
(ii) Treatment of recharacterized excess
contributions.
(iii) Additional rules.
(A) Time of recharacterization.
(B) Employee contributions must be per-
mitted under plan.
(C) Treatment of recharacterized excess
contributions.
(4) Rules applicable to all corrections.
(i) Coordination with distribution of excess
deferrals.
(A) Treatment of excess deferrals that re-
duce excess contributions.
(B) Treatment of excess contributions that
reduce 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 that
are catch-up contributions.
(5) Failure to timely correct.
(i) Failure to correct within 2
1
/2months
after end of plan year.
(ii) Failure to correct within 12 months af-
ter end of plan year.
(c) Additional rules for prior year testing
method.
September 2, 20034452003-35 I.R.B.

(1) Rules for change in testing method.
(i) General rule.
(ii) Situations permitting a change to the
prior year testing method.
(2) Calculation of ADP under the prior
year 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 methods
fortheADPandACPtest.
(4) Rules for plan coverage changes.
(i) In general.
(ii) Optional rule for minor plan coverage
changes.
(iii) Definitions.
(A) Plan coverage change.
(B) Prior year subgroup.
(C) Weighted average of the ADPs for the
prior year subgroups.
(iv) Examples.
§1.401(k)–3 Safe harbor requirements.
(a) ADP test safe harbor.
(b) Safe harbor nonelective contribution
requirement.
(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 precluded
by certain plan provisions.
(i) Safe harbor matching contributions on
employee contributions.
(ii) Periodic matching contributions.
(6) Permissible restrictions on elective
contributions by NHCEs.
(i) General rule.
(ii) Restrictions on election periods.
(iii) Restrictions on amount of elective
contributions.
(iv) Restrictions on types of compensation
that may be deferred.
(v) Restrictions due to limitations under
the 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)Changeofplanyear.
(4) Final plan year.
(f) Plan amendments adopting safe harbor
nonelective contributions.
(1) General rule.
(2) Contingent notice provided.
(3) Follow-up notice requirement.
(g) Permissible reduction or suspension of
safe 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 nondiscrimination
tests.
(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) plan
requirements.
(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 deferred
arrangements.
(a)General rules—(1)Certain plans
permitted to include cash or deferred
arrangements. A plan, other than a
profit-sharing, stock bonus, pre-ERISA
money purchase pension, or rural coopera-
tive plan, does not satisfy the requirements
of section 401(a) if the plan includes a cash
or deferred arrangement. A profit-sharing,
stock bonus, pre-ERISA money purchase
pension, or rural cooperative plan does
not fail to satisfy the requirements of
section 401(a) merely because the plan
includes a cash or deferred arrangement.
A cash or deferred arrangement is part of
a plan for purposes of this section if any
contributions to the plan, or accruals or
other benefits under the plan, are made or
provided pursuant to the cash or deferred
arrangement.
(2)Rules applicable to cash or deferred
arrangements generally—(i)Definition of
cash or deferred arrangement. Except as
provided 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 the
requirements of section 401(a) (including
a contract that is intended to satisfy the re-
quirements of section 403(a)).
(ii)Treatment of after-tax employee
contributions. A cash or deferred arrange-
ment does not include an arrangement
under which amounts contributed under a
plan at an employee's election are desig-
nated or treated at the time of contribution
as after-tax employee contributions (e.g.,
by treating the contributions as taxable
income subject to applicable withholding
requirements). See also section 414(h)(1).
This is the case even if the employee's
election to make after-tax employee con-
tributions is made before the amounts
subject 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.446September 2, 2003

does not include an arrangement under
an ESOP under which dividends are ei-
ther distributed or invested pursuant to
an election made by participants or their
beneficiaries in accordance with section
404(k)(2)(A)(iii).
(iv)Treatment of elective contributions
as plan assets.The extent to which elec-
tive contributions constitute plan assets
for purposes of the prohibited transaction
provisions of section 4975 and Title I of
the Employee Retirement Income Security
Act of 1974 is determined in accordance
with regulations and rulings issued by
the Department of Labor. See 29 CFR
2510.3–102.
(3)Rules applicable to cash or deferred
elections generally—(i)Definition of cash
or deferred election. A cash or deferred
election is any direct or indirect election
(or modification of an earlier election) by
an employee to have the employer either—
(A) Provide an amount to the employee
in the form of cash (or some other taxable
benefit) that is not currently available; or
(B) Contribute an amount to a trust, or
provide an accrual or other benefit, under a
plan deferring the receipt of compensation.
(ii)Automatic enrollment. For pur-
poses of determiningwhether an election
is a cash or deferred election, it is irrel-
evant whether the default that applies in
the absence of an affirmative election is
described in paragraph (a)(3)(i)(A) of
this section (i.e., the employee receives
an amount in cash or some other taxable
benefit) or in paragraph (a)(3)(i)(B) of this
section (i.e., the employer contributes an
amount to a trust or provides an accrual
or other benefit under a plan deferring the
receipt of compensation).
(iii)Rules related to timing—(A)Re-
quirement that amounts not be currently
available. A cash or deferred election can
only be made with respect to an amount
that is not currently available to the em-
ployee on the date of the election. Fur-
ther, a cash or deferred election can only be
made with respect to amounts that would
(but for the cash or deferred election) be-
come currently available after the later of
the date on which the employer adopts the
cash or deferred arrangement or the date
on 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 only
if 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 benefit
would be currently available, if earlier).
(iv)Current availability defined.Cash
or another taxable benefit is currently
available to the employee if it has been
paid to the employee or if the employee is
able currently to receive the cash or other
taxable benefit at the employee's discre-
tion. An amount is not currently available
to an employee if there is a significant
limitation or restriction on the employee's
right to receive the amount currently. Sim-
ilarly, an amount is not currently available
as of a date if the employee may under no
circumstances receive the amount before a
particular time in the future. The determi-
nation of whether an amount is currently
available to an employee does not depend
on whether it has been constructively re-
ceived by the employee for purposes of
section 451.
(v)Certain one-time elections not
treated as cash or deferred elections.A
cash or deferred election does not include a
one-time irrevocable election upon an em-
ployee's commencement of employment
with the employer, or upon the employee's
first becoming eligible under the plan or
any other plan of the employer (whether
or not such other plan has terminated),
to have contributions equal to a specified
amount or percentage of the employee's
compensation (including no amount of
compensation) made by the employer on
the employee's behalf to the plan and a
specified amount or percentage of the
employee's compensation (including no
amount of compensation) divided among
all other plans of the employer (including
plans not yet established) for the duration
of the employee's employment with the
employer, 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 contributions
made pursuant to a one-time irrevocable
election described inthis paragraph are
not treated as having been made pursuant
to a cash or deferred election and are not
includible in an employee's gross income
by reason of §1.402(a)–1(d). In the case of
an irrevocable election made on or before
December 23, 1994—
(A) The election does not fail to be
treated as a one-time irrevocable election
under 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 not
fail to be treated as a one-time irrevoca-
ble election under this paragraph (a)(3)(v)
merely because the election was made after
commencement of employment or after the
employee's first becoming eligible under
any plan of the employer, provided that the
election was made before the first day of
the first plan year beginning after Decem-
ber 31,1988, or, if later, March 31,1989.
(vi)Tax treatment of employees.An
amount generally is includible in an em-
ployee's gross income for the taxable
year in which the employee actually or
constructively receives the amount. But
for sections 402(e)(3) and 401(k), an
employee is treated as having received
an amount that is contributed to a plan
pursuant to the employee's cash or de-
ferred election. This is the case even if the
election to defer is made before the year
in which the amount is earned, or before
the 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 eac
h eligible employee has
an election to defer an annual bonus payable on Jan-
uary 30 each year. The bonus equals 10% of com-
pensation during the pre
vious calendar year. Deferred
amounts are not treated as after-tax employee contri-
butions. The bonus is currently available on January
30.
(ii) An election made prior to January 30 to defer
all 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 p
rovides for discretionary profit
sharing contributions and under which each eligible
employee may elect to reduce his compensation by
up to 10% and to have
the employer contribute such
amount to the plan. The employer pays each em-
ployee every two weeks for services during the imme-
diately precedi
ng two weeks. The employee's elec-
tion to defer compensation for a payroll period must
be made prior to the date the amount would other-
wise be paid. T
he employer contributes to the plan the
amount of compensation that each employee elected
to defer, at the time it would otherwise be paid to the
September 2, 20034472003-35 I.R.B.

employee, and does not treat the contribution as an
after-tax employee contribution.
(ii) The election is a cash or deferred election and
the contributions are elective contributions.
Example 3. (i) The facts are the same as inExam-
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's
obligation to make contributions with respect to cash
or 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 contributed
January 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 obligation
to contribute an amount to the plan pursuant to Em-
ployee A's election. The $10,000 contribution can be
allocated under the plan terms providing for discre-
tionary profit sharing contributions.
Example 4. (i) The facts are the same as inEx-
ample 3, except that Employee A had an outstand-
ing election to defer $500 from each payroll per
iod's
compensation.
(ii) None of the additional $10,000 contributed
January 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 perform
ance of ser-
vices to which the contribution is attributable or when
the compensation would be currently available. Ac-
cordingly, the employer must make an ad
ditional con-
tribution of $500 per payroll period in order to satisfy
its 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 establi
shes a money
purchase pension plan in 1986. This is the first qual-
ified plan established by Employer B. All salaried
employees are eligible to part
icipate under the plan.
Hourly-paid employees are not eligible to participate
under the plan. In 2000, Employer B establishes a
profit-sharing plan under
which all employees (both
salaried and hourly) are eligible. Employer B permits
all employees on the effective date of the profit-shar-
ingplantomakeaone-tim
e irrevocable election to
have Employer B contribute 5% of compensation on
their behalf to the plan and make no other contribu-
tion to any other plan of
Employer B (including plans
not yet established) for the duration of the employee's
employment with Employer B, and have their salaries
reducedby5%.
(ii) The election provided under the profit-shar-
ing plan is not a one-time irrevocable election within
the meaning of parag
raph (a)(3)(v) of this section
with respect to the salaried employees of Employer
B who, before becoming eligible to participate under
the profit-shar
ing plan, became eligible to participate
under the money purchase pension plan. The election
under the profit-sharing plan is a one-time irrevocable
election withi
n the meaning of paragraph (a)(3)(v) of
this section with respect tothe hourly employees, be-
cause they were not previously eligible to participate
under another
plan of the employer.
(4)Rules applicable to qualified cash
or deferred arrangements—(i)Definition
of qualified cash or deferred arrangement.
A qualified cash or deferred arrangement
is a cash or deferred arrangement that sat-
isfies the requirements of paragraphs (b),
(c), (d), and (e) of this section.
(ii)Treatment of elective contributions
as employer contributions. Except as
otherwise provided in §1.401(k)–2(b)(3),
elective contributions under a qualified
cash or deferred arrangement are treated
as employer contributions. Thus, for ex-
ample, elective contributions are treated
as employer contributions for purposes of
sections 401(a) and 401(k), 402, 404, 409,
411, 412, 415, 416, and 417.
(iii)Tax treatment of employees. Except
as 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 or
deferred arrangement are neither includi-
ble in an employee's gross income at the
time the cash would have been includible
in the employee's gross income (but for the
cash or deferred election), nor at the time
the elective contributions are contributed
to the plan. See §1.402(a)–1(d)(2)(i).
(iv)Application of nondiscrimination
requirements to plan that includes a qual-
ified cash or deferred arrangement—(A)
Exclusive means of amounts testing. Elec-
tive contributions under a qualified cash or
deferred arrangement satisfy the require-
ments of section 401(a)(4) with respect
to amounts if and only if the amount of
elective contributions satisfies the nondis-
crimination test of section 401(k) under
paragraph (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 qualified
cash 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 requirements
regardingamountsdescribedinparagraph
(a)(4)(iv)(A) of this section. For example,
the right to make each level of elective
contributions under a cash or deferred
arrangement is a benefit, right or feature
subject to the requirements of section
401(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 level
of elective contributions under a cash or
deferred 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 wage
base, the arrangement will generally favor
HCEs with respect to the availability of
elective contributions and thus will gener-
ally not satisfy the requirements of section
401(a)(4).
(C)Minimum coverage requirement.
A qualified cash or deferred arrangement
is treated as a separate plan that must
satisfy the requirements of section 410(b).
See §1.410(b)–7(c)(1) for special rules.
The determination of whether a cash or
deferred arrangement satisfies the require-
ments of section 410(b) must be made
without regard to the modifications to
the 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 to
corrective amendments that may be made
to satisfy the minimum coverage require-
ments of section 410(b).
(5)Rules applicable to nonqualified
cash or deferred arrangements—(i)Def-
inition of nonqualified cash or deferred
arrangement. A nonqualified cash or de-
ferred arrangement is a cash or deferred
arrangement that fails to satisfy one or
more of the requirements in paragraph (b),
(c), (d) or (e) of this section.
(ii)Treatment of elective contributions
as nonelective contributions. Except as
specifically providedotherwise, elective
contributions under a nonqualified cash
or deferred arrangement are treated as
nonelective employer contributions. Thus,
for example, the elective contributions
are 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 417
and are not subject to the requirements of
section 401(m).
(iii)Tax treatment of employees. Elec-
tive contributions under a nonqualified
cash or deferred arrangement are includi-
ble in an employee's gross income at the
time the cash or other taxable amount that
the employee would have received (but for
the cash or deferred election) would have
been includible in the employee's gross
income. See §1.402(a)–1(d)(1).
(iv)Qualification of plan that includes
a nonqualified cash or deferred arrange-
ment—(A)In general. A profit-sharing,
stock bonus, pre-ERISA money purchase
pension, or rural cooperative plan does
2003-35 I.R.B.448September 2, 2003

not fail to satisfy the requirements of
section 401(a) merely because the plan
includes a nonqualified cash or deferred
arrangement. In determining whether
the plan satisfies the requirements of
section 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) and
1.410(b)–9 (definition of section 401(k)
plan).
(B)Application of section 401(a)(4) to
certain plans. The amount of employer
contributions under a nonqualified cash or
deferred arrangement is treated as satisfy-
ing section 401(a)(4) if the arrangement is
part of a collectively bargained plan that
automatically satisfies the requirements of
section 410(b). See §§1.401(a)(4)–1(c)(5)
and 1.410(b)–2(b)(7). Additionally, the
requirements of sections 401(a)(4) and
410(b) do not apply to a governmen-
tal plan (within the meaning of section
414(d)) maintained by a state or local gov-
ernment or political subdivision thereof
(or agency or instrumentality thereof). See
sections 401(a)(5) and 410(c)(1)(A).
(v)Example. The following example
illustrates the application of this paragraph
(a)(5):
Example. (i) For the 2006 plan year, Employer A
maintains a collectively bargai
ned plan that includes
a cash or deferred arrangement. Employer contribu-
tions under the cash or deferred arrangement do not
satisfy the nondiscriminat
ion test of section 401(k)
and paragraph (b) of this section.
(ii) The arrangement is a nonqualified cash or de-
ferred arrangement. The emp
loyer contributions un-
der the cash or deferred arrangement are considered
to be nondiscriminatory under section 401(a)(4), and
the elective contribut
ions are generally treated as em-
ployer contributions under paragraph (a)(5)(ii) of this
section. Under paragraph (a)(5)(iii) of this section
and under §1.402(a)–1
(d)(1), however, the elective
contributions are includible in each employee's gross
income.
(6)Rules applicable to cash or deferred
arrangements of self-employed individuals
—(i)Application of general rules. Gener-
ally, a partnership or sole proprietorship is
permitted to maintain a cash or deferred
arrangement, and individual partners or
owners are permitted to make cash or de-
ferred elections with respect to compensa-
tion attributable to services rendered to the
entity, under the same rules that apply to
other 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 arrangement
of a partnership or soleproprietorship are
elective contributions unless they are des-
ignated or treated as after-tax employee
contributions. 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 vary
the amount of contributions made on their
behalf. Consistent with §1.402(a)–1(d),
the elective contributions under such an ar-
rangement are includible in income and are
not deductible under section 404(a) unless
the arrangement is a qualified cash or de-
ferred arrangement (i.e., the requirements
of section 401(k) and this section are sat-
isfied). Also, even if the arrangement is
a qualified cash or deferred arrangement,
the elective contributions are includible in
gross income and are not deductible under
section 404(a) to the extent they exceed the
applicable limit under section 402(g). See
also §1.401(a)–30.
(ii)Treatment of matching contribu-
tions made on behalf of self-employed
individuals. Under section 402(g)(8),
matching contributions made on behalf of
a self-employed individual are not treated
as elective contributions made pursuant to
a cash or deferred election, without regard
to whether such matching contributions
indirectly permit individual partners to
vary the amount of contributions made on
their behalf.
(iii)Timing of self-employed individ-
ual's cash or deferred election.Forpur-
poses of paragraph (a)(3)(iv) of this sec-
tion, a partner's compensation is deemed
currentlyavailableonthelastdayofthe
partnership taxable year and a sole pro-
prietor's compensation is deemed currently
available on the last day of the individ-
ual's taxable year. Accordingly, a self-em-
ployed individual may not make a cash
or deferred election with respect to com-
pensation for a partnership or sole propri-
etorship taxable year after the last day of
that year. See §1.401(k)–2(a)(4)(ii) for the
rules regarding when these contributions
are 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 account
for purposes of section 410(b) pursuant
to §1.401(a)(4)–11(g)(3)(vii)(A)) satisfies
the requirements of section 410(b) (includ-
ing the average benefit percentage test, if
applicable); and
(ii) The cash or deferred arrangement
satisfies—
(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) described
in §1.401(k)–3; or
(C) The SIMPLE 401(k) provi-
sions of section 401(k)(11) described
in §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 government
or political subdivision thereof (or agency
or instrumentality thereof) shall be treated
as meeting the requirements of this para-
graph (b).
(3)Anti-abuse provisions. Sections
1.401(k)–1 through 1.401(k)–6 are
designed to provide simple, practical
rules that accommodate legitimate plan
changes. At the same time, the rules are
intended to be applied by employers in a
manner that does not make use of changes
in plan testing procedures or other plan
provisions to inflate inappropriately the
ADPforNHCEs(whichisusedasa
benchmark for testing the ADP for HCEs)
or to otherwise manipulate the nondis-
crimination testing requirements of this
paragraph (b). Further, this paragraph (b)
is part of the overall requirement that ben-
efits or contributions not discriminate in
favor of HCEs. Therefore, a plan will not
be treated as satisfying the requirements
of this paragraph (b) if there are repeated
changes to plan testing procedures or plan
provisions that have the effect of distorting
the ADP so as to increase significantly the
permitted ADP for HCEs, or otherwise
manipulate the nondiscrimination rules of
this paragraph, if a principal purpose of
the changes was to achieve such a result.
(4)Aggregation and restructuring—(i)
In general. This paragraph (b)(4) contains
September 2, 20034492003-35 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 a
single cash or deferred arrangement and a
plan must apply a single test under para-
graph (b)(1)(ii) of this section with re-
spect to all such arrangements within the
plan. Thus, for example, if two groups
of employees are eligible for separate cash
or deferred arrangements under the same
plan, all contributions under both cash or
deferred arrangements must be treated as
made under a single cash or deferred ar-
rangement subject to a single test, even if
they have significantly different features,
such as different limits on elective contri-
butions.
(iii)Aggregation of plans—(A)In
general. For purposes of this section
and §§1.401(k)–2 through 1.401(k)–6, the
term plan means a plan within the meaning
of §1.410(b)–7(a) and (b), after applica-
tion of the mandatory disaggregation 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 example, two plans
(within the meaning of §1.410(b)–7(b))
that are treated as a single plan pursuant
to the permissive aggregation rules of
§1.410(b)–7(d) are treated as a single plan
for purposes of section 401(k) and section
401(m).
(B)Plans with inconsistent ADP test-
ing methods. Pursuant to paragraph
(b)(4)(ii) of this section, a single testing
method must apply with respect to all
cash or deferred arrangements under a
plan. Thus, in applying the permissive
aggregation rules of §1.410(b)–7(d), an
employer may not aggregate plans (within
the meaning of §1.410(b)–7(b)) that ap-
ply inconsistent testing methods. For
example, a plan (within the meaning of
§1.410(b)–7(b)) that applies the current
year testing method may not be aggre-
gated with another plan that applies the
prior year testing method. Similarly, an
employer may not aggregate a plan (within
the meaning of §1.410(b)–7(b)) using the
ADP safe harbor provisions of section
401(k)(12) and another plan that is using
the ADP test of section 401(k)(3).
(iv)Disaggregation of plans and sepa-
rate testing—(A)In general. If a cash or
deferred arrangement is included in a plan
(within the meaning of §1.410(b)–7(b))
that is mandatorily disaggregated under
the rules of section 410(b) (as modi-
fied by this paragraph (b)(4)), the cash
or deferred arrangement must be dis-
aggregated in a consistent manner. For
example, in the case of an employer that
is treated as operating qualified separate
lines of business under section 414(r), if
the eligible employees under a cash or
deferred arrangement are in more than
one qualified separate line of business,
only those employees within each qual-
ified separate line of business may be
taken into account in determining whether
each disaggregated portion of the plan
complies with the requirements of section
401(k), unless the employer is applying
the special rule for employer-wide plans
in §1.414(r)–1(c)(2)(ii) with respect to
the plan. Similarly, if a cash or deferred
arrangement under which employees are
permitted to participate before they have
completed the minimum age and service
requirements of section 410(a)(1) ap-
plies section 410(b)(4)(B) for determining
whether the plan complies with section
410(b)(1), then the arrangement must be
treated as two separate arrangements, one
comprising all eligible employees who
have met the age and service requirements
of section 410(a)(1) and one comprising
all eligible employees who have not met
the age and service requirements under
section 410(a)(1), unless the plan is using
the rule in §1.401(k)–2(a)(1)(iii)(A).
(B)Restructuring prohibited.Restruc-
turing under §1.401(a)(4)–9(c) may not
be used to demonstrate compliance with
the requirements of section 401(k). See
§1.401(a)(4)–9(c)(3)(ii).
(v)Modifications to section 410(b)
rules—(A)Certain disaggregation rules
not applicable. The mandatory disag-
gregation rules relating to section 401(k)
plans and section 401(m) plans set forth
in §1.410(b)–7(c)(1) and ESOP and
non-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)–2
through 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. Notwithstanding
the general rule under section 410(b) and
§1.410(b)–7(c) that a plan that benefits
employees who are included in a unit of
employees covered by a collective bar-
gaining agreement and employees who
are not included in the collective bargain-
ing unit is treated as comprising separate
plans, an employer can treat two or more
separate collective bargaining units as
a single collective bargaining unit for
purposes of this section and §1.401(k)–2
through §1.401(k)–6, provided that the
combinations of units are determined on
a basis that is reasonable and reasonably
consistent from year to year. Thus, for
example, if a plan benefits employees in
three categories (e.g., employees included
in collective bargaining unit A, employees
included in collectivebargainingunitB,
and employees who are not included in
any collective bargaining unit), the plan
can be treated as comprising three sep-
arate plans, each of which benefits only
one category of employees. However, if
collective bargaining units A and B are
treated as a single collective bargaining
unit, the plan will be treated as comprising
only two separate plans, one benefit-
ting all employeeswho are included in
a collective bargaining unit and another
benefitting all other employees. Similarly,
if a plan benefits only employees who are
included in collective bargaining unit A
and employees who are included in col-
lective bargaining unit B, the plan can be
treated as comprising two separate plans.
However, if collective bargaining units A
and B are treated as a single collective
bargaining unit, the plan will be treated as
a single plan. An employee is treated as
included in a unit of employees covered
by a collective bargaining agreement if
and only if the employee is a collectively
bargained employee within the meaning
of §1.410(b)–6(d)(2).
(C)Multiemployer plans.Notwith-
standing §1.410(b)–7(c)(4)(ii)(C), the
portion of the plan that is maintained pur-
suant to a collective bargaining agreement
(within the meaning of §1.413–1(a)(2)) is
treated as a single plan maintained by a
2003-35 I.R.B.450September 2, 2003

single employer that employs all the em-
ployees benefitting under the same benefit
computation formulaandcoveredpursuant
to that collective bargaining agreement.
The rules of paragraph (b)(4)(v)(B) of
this section (including the permissive ag-
gregation of collective bargaining units)
apply to the resulting deemed single plan
in the same manner as they would to
a single employer plan, except that the
plan administrator is substituted for the
employer where appropriate and appro-
priate fiduciary obligations are taken into
account. The noncollectively bargained
portion of the plan is treated as maintained
by one or more employers, depending on
whether the noncollectively bargaining
unit employees who benefit under the plan
are employed by one or more employers.
(vi)Examples. The following examples
illustrate the application of this paragraph
(b)(4):
Example 1. (i) Employer A maintains Plan V, a
profit-sharing plan that includes a cash o
r deferred
arrangement in which all of the employees of Em-
ployer A are eligible to participate. For purposes of
applying section 410(b), Employer A is t
reated 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 speci
al 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 elective
contributions under the cash or d
eferred 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 throug
h 1.401(k)–6 must be
applied on an employer-wide rather than a qualified
separate line of business basis.
Example 2. (i) Employer B main
tains Plan W, a
profit-sharing plan that includes a cash or deferred ar-
rangement in which all of the employees of Employer
B are eligible to participa
te. For purposes of apply-
ing section 410(b), the plan treats the cash or deferred
arrangement as two separate plans, one for the em-
ployees who have comple
ted the minimum age and
service eligibility conditions under section 410(a)(1)
and the other for employees who have not completed
the conditions. The p
lan provides that it will sat-
isfy the section 401(k) safe harbor requirement of
§1.401(k)–3 with respect to the employees who have
met the minimum age a
nd service conditions and that
it will meet the ADP test requirements of §1.401(k)–2
with respect to the employees who have not met the
minimum age and s
ervice conditions.
(ii) Under these facts, the cash or deferred ar-
rangement must be disaggregated on a consistent ba-
sis with the disa
ggregation 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 min
imum age and service conditions with
the ADP for eligible NHCEs for the applicable year
who have not completed the minimum age and ser-
vice condit
ions.
Example 3. (i) Employer C maintains Plan X, a
stock-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 this
section the ESOP and non-ESOP portions of the
stock-bonus plan are a single cash or deferred
arrangement for purposes of this section and
§§1.401(k)–2 through 1.401(k)–6. However, as
provided in paragraph (a)(4)(iv)(C) of this section,
the ESOP and non-ESOP portions of the plan are still
treated as separate plans for purposes of satisfying
the requirements of section 410(b).
(c)Nonforfeitability requirements—(1)
General rule. A cash or deferred arrange-
mentsatisfiesthisparagraph(c)onlyif
the amount attributable to an employee's
elective contributions are immediately
nonforfeitable, within the meaning of
paragraph (c)(2) of this section, are dis-
regarded for purposes of applying section
411(a) to other contributions or benefits,
and the contributions remain nonfor-
feitable even if the employee makes no
additional elective contributions under a
cash or deferred arrangement.
(2)Definition of immediately non-
forfeitable. An amount is immediately
nonforfeitable if it is immediately non-
forfeitable within the meaning of section
411, and would be nonforfeitable under
the plan regardless of the age and service
of the employee or whether the employee
is employed on a specific date. An amount
that is subject to forfeitures or suspensions
permitted by section 411(a)(3) does not
satisfy the requirements of this paragraph
(c).
(3)Example. The following example
illustrates the application of this paragraph
(c):
Example. (i) Employees B and C
are covered by
Employer Y's stock bonus plan, which includes a cash
or deferred arrangement. All employees participating
in the plan have a nonforf
eitable right to a percent-
age of their account balance derived from all contri-
butions (including elective contributions) as shown in
the following table:
Years of serviceNonforfeitable
percentage
Less than 10%
120%
240%
360%
480%
5ormore100%
(
ii) The cash or deferred arrangement does not
satisfy paragraph (c) of this section because elective
contributions 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 arrangement
satisfies this paragraph (d) only if amounts
attributable to elective contributions may
not be distributed before one of the fol-
lowing events, and any distributions so
permitted 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, or
severance from employment;
(ii) In the case of a profit-sharing, stock
bonus or rural cooperative plan, the em-
ployee's attainment of age 59
1
/2,ortheem-
ployee's hardship; or
(iii) The termination of the plan.
(2)Rules applicable to distributions
upon severance from employment.An
employee has a severance from employ-
ment when the employee ceases to be an
employee of the employer maintaining
the plan. An employee does not have a
severance from employment if, in con-
nection with a change of employment, the
employee's new employer maintains such
plan with respect to the employee. For
example, a new employer maintains a plan
with respect to an employee by continuing
or assuming sponsorship of the plan or
by accepting a transfer of plan assets and
liabilities (within the meaning of section
414(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 treated
as made after an employee's hardship for
purposes of paragraph (d)(1)(ii) of this sec-
tion if and only if it is made on account
of the hardship. For purposes of this rule,
a distribution is made on account of hard-
ship only if the distribution both is made
on 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 the
amount necessary to meet the need must
be made in accordance with nondiscrimi-
natory and objective standards set forth in
the plan.
(ii)Limit on maximum distributable
amount—(A)General rule. A distribution
on account of hardship must be limited
to the maximum distributable amount.
The maximum distributable amount is
September 2, 20034512003-35 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 does
not include earnings, QNECs or QMACs,
unless grandfathered under paragraph
(d)(3)(ii)(B) of this section.
(B)Grandfathered amounts.Ifthe
plan provides, the maximum distributable
amount may be increased for amounts
credited to the employee's account as of a
date specified in the plan that is no later
than December 31, 1988, or if later, the
end of the last plan year ending before July
1, 1989 (or in the case of a collectively
bargained plan, the earlier of—
(1) the later of January 1, 1989, or the
date 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 heavy
financial need is to be determined based
on all the relevant facts and circumstances.
Generally, for example, the need to pay
the funeral expenses of a family member
would constitute an immediate and heavy
financial need. A distribution made to
an employee for the purchase of a boat
or television would generally not consti-
tute a distribution made on account of an
immediate and heavy financial need. A fi-
nancial need may be immediate and heavy
even if it was reasonably foreseeable or
voluntarily incurred by the employee.
(B)Deemed immediate and heavy fi-
nancial need. A distribution is deemed to
be on account of an immediate and heavy
financial need of the employee if the dis-
tribution is for—
(1) Expenses for medical care described
in section 213(d) previously incurred by
the employee, the employee's spouse, or
any dependents of the employee (as de-
fined in section 152) or necessary for these
persons to obtain medical care described in
section 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 the
employee's spouse, children, or depen-
dents (as defined in section 152); or
(4) Payments necessary to prevent the
eviction of the employee from the em-
ployee's principal residence or foreclosure
on the mortgage on that residence.
(iv)Distribution necessary to satisfy fi-
nancial need—(A)Distribution may not
exceed amount of need. A distribution
is treated as necessary to satisfy an im-
mediate and heavy financial need of an
employee only to the extent the amount
of the distribution is not in excess of the
amount required to satisfy the financial
need. For this purpose, the amount re-
quired to satisfy the financial need may in-
clude any amounts necessary to pay any
federal, state, or local income taxes or
penalties reasonably anticipated to result
from the distribution.
(B)No alternative means available.A
distribution is not treated as necessary to
satisfy an immediate and heavy financial
need of an employee to the extent the
need may be relieved from other resources
that are reasonably available to the em-
ployee. This determination generally is to
be made on the basis of all the relevant
facts and circumstances. For purposes of
this paragraph (d)(3)(iv), the employee's
resources are deemed to include those
assets of the employee's spouse and mi-
nor children that are reasonably available
to the employee. Thus, for example, a
vacation home owned by the employee
and the employee's spouse, whether as
community property, joint tenants, tenants
by the entirety, or tenants in common,
generally will be deemed a resource of the
employee. However, property held for the
employee's child under an irrevocable trust
or under the Uniform Gifts to Minors Act
(or comparable State law) is not treated as
a resource of the employee.
(C)Employer reliance on employee
representation. For purposes of paragraph
(d)(3)(iv)(B) of this section, an immediate
and heavy financial need generally may
be treated as not capable of being relieved
from other resources that are reasonably
available to the employee, if the employer
relies upon the employee's written repre-
sentation, unless the employer has actual
knowledge to the contrary, that the need
cannot 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 the
plan;
(4) By other distributions or nontax-
able (at the time of the loan) loans from
plans maintained by the employer or by
any other employer; or
(5) By borrowing from commercial
sources on reasonable commercial terms
in an amount sufficient to satisfy the need.
(D)Employee need not take counter-
productive actions. For purposes of this
paragraph (d)(3)(iv), a need cannot reason-
ably be relieved by one of the actions de-
scribed in paragraph (d)(3)(iv)(C) of this
section if the effect would be to increase
the amount of the need. For example, the
need for funds to purchase a principal res-
idence cannot reasonably be relieved by a
plan loan if the loan would disqualify the
employee from obtaining other necessary
financing.
(E)Distribution deemed necessary to
satisfy immediate and heavy financial
need. A distribution is deemed necessary
to satisfy an immediate and heavy finan-
cial need of an employee if each of the
following requirements are satisfied—
(1) The employee has obtained all
distributions, other than hardship distribu-
tions, and all nontaxable (at the time of
the loan) loans currently available under
the plan and all other plans maintained by
the employer; and
(2) The employee is prohibited, un-
der the terms of the plan or an otherwise
legally enforceable agreement, from mak-
ing elective contributions and employee
contributions to theplan and all other
plans maintained by the employer for at
least 6 months after receipt of the hardship
distribution.
(F)Definition of other plans.Forpur-
poses of paragraph (d)(3)(iv)(C)(4)and
(E)(1) of this section, the phrase “plans
maintained by the employer” means all
qualified and nonqualified plans of de-
ferred compensation maintained by the
employer, including a cash or deferred
arrangement that is part of a cafeteria
2003-35 I.R.B.452September 2, 2003

plan within the meaning of section 125.
However, it does not include the manda-
tory employee contribution portion of a
defined benefit plan or a health or welfare
benefit plan (including one that is part of
a cafeteria plan). In addition, for purposes
of paragraph (d)(3)(iv)(E)(2)ofthissec-
tion, the phrase “plans maintained by the
employer” also includes a stock option,
stock purchase, or similar plan maintained
by the employer. See §1.401(k)–6 for the
continued treatment of suspended employ-
ees as eligible employees.
(v)Commissioner may expand stan-
dards. The Commissioner may prescribe
additional 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 immediate
and heavy financial needs and prescribing
additional methods for distributions to be
deemed necessary to satisfy an immediate
and heavy financial need.
(4)Rules applicable to distributions
upon plan termination—(i)No alternative
defined contribution plan.Adistribu-
tion may not be made under paragraph
(d)(1)(iii) of this section if the employer
establishes or maintains an alternative
defined contribution plan. For purposes
of the preceding sentence, the defini-
tion of the term “employer” contained in
§1.401(k)–6 is applied as of the date of
plan termination, and a plan is an alterna-
tive defined contribution plan only if it is
a defined contribution plan that exists at
any time during the period beginning on
the date of plan termination and ending
12 months after distribution of all assets
from the terminated plan. However, if at
all times during the 24-month period be-
ginning 12 months before the termination,
fewer than 2% of the employees who were
eligible under the defined contribution
plan that includes the cash or deferred
arrangement as of the date of plan termi-
nation are eligible under the other defined
contribution plan, the other plan is not
an alternative defined contribution plan.
In addition, a defined contribution plan
is not treated as an alternative defined
contribution plan if it is an employee
stock ownership plan as defined in sec-
tion 4975(e)(7) or 409(a), a simplified
employee pension as defined in section
408(k), a SIMPLE IRA plan as defined in
section 408(p), a plan or contract that sat-
isfies the requirements of section 403(b),
or a plan that satisfies the requirements of
section 457.
(ii)Lump sum requirement for cer-
tain distributions. A distribution may be
made under paragraph (d)(1)(iii) of this
section only if it is a lump sum distri-
bution. The term lump sum distribution
has the meaning provided in section
402(e)(4)(D) (without regard to section
402(e)(4)(D)(i)(I), (II), (III) and (IV)). In
addition, a lump sum distribution includes
a distribution of an annuity contract from
a trust that is part of a plan described in
section 401(a) and which is exempt from
tax under section 501(a) or an annuity plan
described 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 of
any event not described in this paragraph
(d), such as completion of a stated period
of plan participation or the lapse of a fixed
number of years. For example, if excess
deferrals (and income) for an employee's
taxable year are not distributed within
the time prescribed in §1.402(g)–1(e)(2)
or (3), the amounts may be distributed
only on account of an event described in
this paragraph (d). Pursuant to section
401(k)(8), the prohibition on distributions
set forth in this section does not apply
to a distribution of excess contributions
under §1.401(k)–2(b). In addition, the
prohibition on distributions set forth in
this paragraph (d) does not apply to a
distribution of excess annual additions
pursuant to §1.415–6(b)(6)(iv).
(ii)Deemed distributions.Thecostof
life insurance (determined under section
72) 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 not
treated as a distribution, even if the loan
is secured by the employee's accrued ben-
efit attributable to elective contributions or
is 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.A
plan does not fail to satisfy the require-
ments of this paragraph (d) merely by rea-
son of a dividend distribution described in
section 404(k)(2).
(iv)Limitations apply after transfer.
The limitations of this paragraph (d)
generally continue to apply to amounts
attributable to elective contributions (in-
cluding QNECs and qualified matching
contributions taken into account for the
ADP test under §1.401(k)–2(a)(6)) that
are transferred to another qualified plan of
the same or another employer. Thus, the
transferee plan will generally fail to sat-
isfy the requirements of section 401(a) and
this section if transferred amounts may
be distributed before the times specified
in this paragraph (d). In addition, a cash
or deferred arrangement fails to satisfy
the limitations of this paragraph (d) if it
transfers amounts to a plan that does not
provide that the transferred amounts may
not be distributed before the times speci-
fied in this paragraph (d). The transferor
plan does not fail to comply with the pre-
ceding sentence if it reasonably concludes
that the transferee plan provides that
the transferred amounts may not be dis-
tributed before the times specified in this
paragraph (d). What constitutes a basis for
a reasonable conclusion is comparable to
the rules related to acceptance of rollover
distributions. See §1.401(a)(31)–1, A–14.
The limitations of this paragraph (d) cease
to apply after the transfer, however, if
the amounts could have been distributed
at the time of the transfer (other than
on 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 not
apply to amounts that have been paid in
a direct rollover to the plan after being
distributed by another plan.
(6)Examples. The following examples
illustrate the application of this paragraph
(d):
Example 1. Employer M maintains Plan V, a
profit-sharing p
lan that includes a cash or deferred
arrangement. Elective contributions under the ar-
rangement may be withdrawn for any reason after
two years follo
wing the end of the plan year in which
the contributions were made. Because the plan
permits distributions of elective contributions before
the occurren
ce of one of the events specified in
section 401(k)(2)(B) and this paragraph (d), the cash
or deferred arrangement is a nonqualified cash or
deferred ar
rangement and the elective contributions
are currently includible in income under section 402.
Example 2. (i) Employer N maintains Plan W, a
profit-sh
aring plan that includes a cash or deferred
arrangement. Plan W provides for distributions upon
a participant's severance from employment, death
or disabi
lity. All employees of Employer N and its
wholly owned subsidiary, Employer O, are eligible to
September 2, 20034532003-35 I.R.B.

participate in Plan W. Employer N agrees to sell all
issued and outstanding shares of Employer O to an
unrelated entity, Employer T, effective on December
31, 2006. Following the transaction, Employer O
will be a wholly owned subsidiary of Employer
T. Additionally, individuals who are employed by
Employer O on the effective date of the sale con-
tinue to be employed by Employer O following the
sale. Following the transaction, all employees of
Employer O will cease to participate in Plan W and
will become eligible to participate in the cash or
deferred arrangement maintained by Employer T,
Plan X. No assets will be transferred from Plan W to
Plan X, except in the case of a direct rollover within
the 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 from
Plan W.
Example 3. (i) Employer Q maintains Plan Y, a
profit-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, Plan
Y provides that elective contributions under the ar-
rangement may be distributed to an eligible
employee
on account of hardship using the deemed immedi-
ate and heavy financial need provisions of paragraph
(d)(3)(iii)(B) of this section and provi
sions regard-
ing distributions necessary to satisfy financial need of
paragraphs (d)(3)(iv)(A) through (D) of this section.
Employee A is an eligible employee i
n Plan Y with
an account balance of $50,000 attributable to elective
contributions made by Employee A. The total amount
of elective contributions made b
yEmployeeA,who
has not previously received a distribution from Plan
Y, is $20,000. Employee A requests a $15,000 hard-
ship distribution of his elect
ive contributions to pay
6 months of college tuition and room and board ex-
penses for his dependent child. At the time of the dis-
tribution request, the sol
e asset of Employee A (that is
reasonably available to Employee A within the mean-
ing of paragraph (d)(3)(iv)(B) of this section) is a sav-
ings account with an avai
lable balance of $10,000.
(ii) A distribution is made on account of hardship
only if the distribution both is made on account of an
immediate and heavy fi
nancial need of the employee
and is necessary to satisfy the financial need. Under
paragraph (d)(3)(iii)(B) of this section, a distribution
for payment of up to th
e next 12 months of post-sec-
ondary education and room and board expenses for
Employee A's dependant child is deemed to be on ac-
count of an immedia
te and heavy financial need of
Employee A.
(iii) A distribution is treated as necessary to
satisfy Employee
A's immediate and heavy financial
need to the extent the need may not be relieved from
other resources reasonably available to Employee
A. Under paragr
aph (d)(3)(iv)(B) of this section,
Employee A's $10,000 savings account is a resource
that is reasonably available to the employee and must
be taken into
account in determining the amount
necessary to satisfy Employee A's immediate and
heavy financial need. Thus, Employee A may re-
ceive a dist
ribution of only $5,000 of his elective
contributions on account of this hardship, plus an
amount necessary to pay any federal, state, or local
income taxes or penalties reasonably anticipated to
result from the distribution.
Example 4. (i)ThefactsarethesameasinEx-
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. The
total 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 requests
a $10,000 distribution of his elective contributions to
pay 6 months of college tuition and room and board
expenses for his dependent child. Employee B makes
a written representation (with respect to which Em-
ployer Q has no actual knowledge to the contrary) that
the 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) by
cessation of elective contributions or employee con-
tributions under the plan; 4) by other distributions
or nontaxable (at the time of the loan) loans from
plans maintained by the employer or by any other em-
ployer; or 5) by borrowing from commercial sources
on 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 months
of post-secondary education and room and bo
ard ex-
penses for Employee B's dependant child is deemed
to be on account of an Employee B's immediate and
heavy financial need. In addition, becau
se Employer
Q can rely on Employee B's written representation,
the distribution is considered necessary to satisfy
Employee B's immediate and heavy fi
nancial need.
Therefore, Employee B may receive a $10,000
distribution of his elective contributions on account
of hardship plus an amount necess
ary to pay any
federal, state, or local income taxes or penalties
reasonably anticipated to result from the distribution.
Example 5. (i) The facts are the sa
me as in
Example 3, except Plan Y provides for hardship
distributions using the safe harbor rule of paragraph
(d)(3)(iv)(E) of this secti
on. Accordingly, Plan Y
provides for a 6 month suspension of an eligible
employee's elective contributions and employee con-
tributions to the plan aft
er the receipt of a hardship
distribution by such eligible employee.
(ii) Under paragraph (d)(3)(iii)(B) of this section,
a distribution for paym
ent of up to the next 12 months
of post-secondary education and room and board ex-
penses for Employee A's dependant child is deemed
to be on account of an Em
ployee A's immediate and
heavy financial need. In addition, because Employee
A is not eligible for any other distribution or loan from
Plan Y and Plan Y susp
ends Employee A's elective
contributions and employee contributions following
receipt of the hardship distribution, the distribution
will be deemed nec
essary to satisfy Employee A's im-
mediate and heavy financial need (and Employee A
is not required to first liquidate his savings account).
Therefore, Emp
loyee A may receive a $15,000 dis-
tribution of his elective contributions on account of
hardship 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-ERISA
money purcha
se pension plan that includes a cash
or 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 a
profit-sharing, stock bonus or rural cooperative plan.
Since elective contributions under the arrangement
may be distributed before a permissible distribution
event occurs, the cash or deferred arrangement does
not satisfy this paragraph (d), and is not a qualified
cash or deferred arrangement. Moreover, the plan is
not a qualified plan because a money purchase pen-
sion plan may not provide for payment of benefits
upon 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 is
a profit-sharing, stock bonus, pre-ERISA
money purchase or rural cooperative plan
that otherwise satisfies the requirements
of section 401(a) (taking into account the
cash or deferred arrangement). A plan that
includes a cash or deferred arrangement
may provide for other contributions, in-
cluding employer contributions (other than
elective 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), elective
contributions and matching contributions
taken into account under §1.401(k)–2(a)
may not be taken into account for purposes
of determining whether any other contribu-
tions under any plan (including the plan to
which the contributions are made) satisfy
the requirements of section 401(a).
(2)Election requirements—(i)Cash
must be available. A cash or deferred
arrangement satisfies this paragraph (e)
only if the arrangement provides that
the amount that each eligible employee
may defer as an elective contribution is
available to the employee in cash. Thus,
for example, if an eligible employee is
provided the option to receive a taxable
benefit (other than cash) or to have the
employer contribute on the employee's
behalf to a profit-sharing plan an amount
equal to the value of the taxable benefit,
the arrangement is not a qualified cash or
deferred arrangement. Similarly, if an em-
ployee has the option to receive a specified
amount in cash or to have the employer
contribute an amount in excess of the spec-
ified cash amount to a profit-sharing plan
on the employee's behalf, any contribution
made by the employer on the employee's
behalf in excess of the specified cash
amount is not treated as made pursuant to
a qualified cash or deferred arrangement.
2003-35 I.R.B.454September 2, 2003

This cash availability requirement applies
even if the cash or deferred arrangement is
part of a cafeteria plan within the meaning
of section 125.
(ii)Frequency of elections. A cash or
deferred arrangement satisfies this para-
graph (e) only if the arrangement provides
an employee with an effective opportunity
to make (or change) a cash or deferred
election at least once during each plan year.
Whether an employee has an effective op-
portunity is determined based on all the
relevant facts and circumstances, includ-
ing notice of the availability of the election,
the period of time during which an election
may be made, and any other conditions on
elections.
(3)Separate accounting require-
ment—(i)General rule. A cash or deferred
arrangement satisfies this paragraph (e)
only if the portion of an employee's benefit
subject to the requirements of paragraphs
(c) and (d) of this section is determined
by an acceptable separate accounting be-
tween that portion and any other benefits.
Separate accounting is not acceptable un-
less gains, losses, withdrawals, and other
credits or charges are separately allocated
on a reasonable and consistent basis to
the accounts subject to the requirements
of paragraphs (c) and (d) of this section
and to other accounts.Subject to section
401(a)(4), forfeitures are not required to
be allocated to the accounts in which ben-
efits are subject to paragraphs (c) and (d)
of this section.
(ii)Satisfaction of separate accounting
requirement. The requirements of para-
graph (e)(3)(i) of this section are treated
as satisfied if all amounts held under a
plan that includes a cash or deferred ar-
rangement (and, if applicable, under an-
other plan to which QNECs and QMACs
are made) are subject to the requirements
of paragraphs (c) and (d) of this section.
(4)Limitations on cash or deferred
arrangements of state and local gov-
ernments—(i)General rule. A cash or
deferred arrangement does not satisfy the
requirements of this paragraph (e) if the
arrangement is adopted after May 6, 1986,
by a state or local government or politi-
cal subdivision thereof, or any agency or
instrumentality thereof (a governmental
unit). For purposes of this paragraph
(e)(4), an employer that has made a legally
binding commitment to adopt a cash or
deferred arrangement is treated as having
adopted the arrangement on that date.
(ii)Rural cooperative plans and Indian
tribal governments. This paragraph (e)(4)
does not apply to a rural cooperative plan
or 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 agency
or instrumentality of an Indian tribal gov-
ernment or subdivision thereof, or a cor-
poration chartered under federal, state or
tribal law which is owned in whole or in
part by any of the entities in this paragraph
(e)(4)(ii).
(iii)Adoption after May 6, 1986.A
cash or deferred arrangement is treated as
adopted after May 6, 1986, with respect to
all employees of any employer that adopts
the arrangement after such date.
(iv)Adoption before May 7, 1986.If
a governmental unit adopted a cash or
deferred arrangement before May 7, 1986,
then any cash or deferred arrangement
adopted by the unit at any time is treated
as adopted before that date. If an em-
ployer adopted an arrangement prior to
such date, all employees of the employer
may participate in the arrangement.
(5)One-year eligibility requirement.A
cash or deferred arrangement satisfies this
paragraph (e) only if no employee is re-
quired to complete a period of service with
the employer maintaining the plan extend-
ing beyond the period permitted under sec-
tion 410(a)(1) (determined without regard
to section 410(a)(1)(B)(i)) to be eligible to
make a cash or deferred election under the
arrangement.
(6)Other benefits not contingent upon
elective contributions—(i)General rule.
A cash or deferred arrangement satisfies
this paragraph (e) only if no other benefit
is conditioned (directly or indirectly) upon
the employee's electing to make or not to
make elective contributions under the ar-
rangement. The preceding sentence does
notapplyto—
(A) Any matching contribution (as de-
fined in §1.401(m)–1(a)(2)) made by rea-
sonofsuchanelection;
(B) Any benefit, right or feature (such
as a plan loan) that requires, or results
in,anamounttobewithheldfroman
employee's pay (e.g.to pay for the benefit
or to repay the loan), to the extent the cash
or deferred arrangement restricts elective
contributions to amounts available after
such withholding from the employee's pay
(after deduction of all applicable income
and employment taxes);
(C) Any reduction in the employer's
top-heavy contributions under section
416(c)(2) because of matching contri-
butions that resulted from the elective
contributions; or
(D) Any benefit that is provided at the
employee's election under a plan described
in section 125(d) in lieu of an elective con-
tribution under a qualified cash or deferred
arrangement.
(ii)Definition of other benefits.For
purposes of this paragraph (e)(6), other
benefits include, but are not limited to,
benefits under a defined benefit plan;
nonelective contributions under a defined
contribution plan; theavailability, cost,
or amount of health benefits; vacations
or vacation pay; life insurance; dental
plans; legal services plans; loans (in-
cluding plan loans); financial planning
services; subsidizedretirement benefits;
stock options; property subject to section
83; and dependent care assistance. Also,
increases in salary and bonuses (other than
those actually subject to the cash or de-
ferred election) are benefits for purposes
of this paragraph (e)(6). The ability to
make after-tax employee contributions
is a benefit, but that benefit is not con-
tingent upon an employee's electing to
make or not make elective contributions
under the arrangement merely because the
amount of elective contributions reduces
dollar-for-dollar the amount of after-tax
employee contributions that may be made.
Additionally, benefits under any other plan
or arrangement (whether or not qualified)
are not contingent upon an employee's
electing to make or not to make elective
contributions under a cash or deferred
arrangement merely because the elective
contributions are or are not taken into
account as compensation under the other
plan or arrangement for purposes of deter-
mining benefits.
(iii)Effect of certain statutory limits.
Any benefit under an excess benefit plan
described in section 3(36) of the Employee
Retirement Income Security Act of 1974
that 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, 20034552003-35 I.R.B.

deferred compensation plan is treated as
contingent for purposes of this paragraph
(e)(6) only to the extent that an employee
may receive additional deferred compen-
sation under the nonqualified plan to the
extent the employee makes or does not
make elective contributions. Deferred
compensation under a nonqualified plan
of deferred compensation that is depen-
dent on an employee's having made the
maximum elective deferrals under section
402(g) or the maximum elective contribu-
tions permitted under the terms of the plan
also is not treated as contingent.
(v)Plan loans and distributions.Aloan
or distribution of elective contributions is
not a benefit conditioned on an employee's
electing to make or not make elective con-
tributions under the arrangement merely
because the amount of the loan or distri-
bution is based on the amount of the em-
ployee's account balance.
(vi)Examples. The following examples
illustrate the application of this paragraph
(e)(6):
Example 1. Employer T maintains a cash or de-
ferred arrangement for all of its employe
es. Employer
T also maintains a nonqualified deferred compensa-
tion plan for two highly paid executives, Employees
R and C. Under the terms of the nonqua
lified deferred
compensation plan, R and C are eligible to participate
only if they do not make elective contributions under
the cash or deferred arrangement.
Participation in the
nonqualified plan is a contingent benefit for purposes
of this paragraph (e)(6), because R's and C's partic-
ipation is conditioned on the
ir electing not to make
elective contributions under the cash or deferred ar-
rangement.
Example 2. Employer T mainta
ins a cash or de-
ferred arrangement for all its employees. Employer
T also maintains a nonqualified deferred compensa-
tion plan for two highly pai
d executives, Employees
R and C. Under the terms of the arrangements, Em-
ployees R and C may defer a maximum of 10% of
their compensation, a
nd may allocate their deferral
between the cash or deferred arrangement and the
nonqualified deferred compensation plan in any way
they choose (subject
to the overall 10% maximum).
Because the maximum deferral available under the
nonqualified deferred compensation plan depends on
the elective defe
rrals made under the cash or deferred
arrangement, the right to participate in the nonquali-
fied plan is a contingent benefit for purposes of para-
graph (e)(6).
(7)Plan provisi
on requirement.Aplan
that includes a c
ash or deferred arrange-
ment satisfies
this paragraph (e) only if
it provides th
at the nondiscrimination re-
quirements o
f 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 of
the 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 specify
whether it is using the current year testing
method or prior year testing method. Ad-
ditionally, a plan that uses the prior year
testing method must specify whether the
ADP for eligible NHCEs for the first plan
year is 3% or the ADP for the eligible
NHCEs for the first plan year. Similarly,
a plan that uses the safe harbor method of
section 401(k)(12), as described in para-
graph (b)(1)(ii)(B) of this section, must
specify whether the safe harbor contribu-
tion will be the nonelective safe harbor
contribution or the matching safe harbor
contribution and is not permitted to pro-
vide that ADP testing will be used if the
requirements for the safe harbor are not
satisfied. 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 through
1.401(k)–6 apply to plan years that begin
on or after the date that is 12 months after
the issuance of these regulations in final
form, except as otherwise provided in this
paragraph (f).
(2)Collectively bargained plans.In
the case of a plan maintained pursuant to
one or more collective bargaining agree-
ments between employee representatives
and one or more employers in effect on the
date described in paragraph (f)(1) of this
section, the provisions of this section and
§§1.401(k)–2 through 1.401(k)–6 apply to
the 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 arrangement
satisfies the ADP test for a plan year only
if—
(A) The ADP for the eligible HCEs for
the plan year is not more than the ADP for
the eligible NHCEs for the applicable year
multiplied by 1.25; or
(B) The excess of the ADP for the eli-
gible HCEs for the plan year over the ADP
for the eligible NHCEs for the applicable
year is not more than 2 percentage points,
and the ADP for the eligible HCEs for the
plan year is not more than the ADP for
the eligible NHCEs for the applicable year
multiplied by 2.
(ii)HCEs as sole eligible employees.
If, for the applicable year for determining
the ADP of the NHCEs for a plan year,
there are no eligible NHCEs (i.e., all of the
eligible employees under the cash or de-
ferred arrangement for the applicable year
are HCEs), the arrangement is deemed to
satisfy the ADP test for the plan year.
(iii)Special rule for early participation.
If a cash or deferred arrangement provides
that employees are eligible to participate
before they have completed the minimum
age and service requirements of section
410(a)(1)(A), and if the plan applies sec-
tion 410(b)(4)(B) in determining whether
the cash or deferred arrangement meets
the requirements of section 410(b)(1), then
in determining whether the arrangement
meets 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 the
ADP for all eligible HCEs for the plan year
and the ADP of eligible NHCEs for the ap-
plicable year, disregarding all NHCEs who
have not met the minimum age and service
requirements of section 410(a)(1)(A); or
(B) Pursuant to §1.401(k)–1(b)(4), the
plan is disaggregated into separate plans
and the ADP test is performed separately
for all eligible employees who have com-
pleted the minimum age and service re-
quirements of section 410(a)(1)(A) and for
all 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)General
rule. The ADP for a group of eligible em-
ployees (either eligible HCEs or eligible
NHCEs) for a plan year or applicable year
is the average of the ADRs of the eligi-
ble employees in that group for that year.
2003-35 I.R.B.456September 2, 2003

The ADP for a group of eligible employ-
ees is calculated to the nearest hundredth
of a percentage point.
(ii)Determination of applicable year
under current year and prior year testing
method. The ADP test is applied using
the prior year testing method or the current
year testing method. Under the prior year
testing method, the applicable year for de-
termining the ADP for the eligible NHCEs
is the plan year immediately preceding the
plan year for which the ADP test is being
performed. Under the prior year testing
method, the ADP for the eligible NHCEs
is determined using the ADRs for the eli-
gible employees who were NHCEs in that
preceding plan year, regardless of whether
those NHCEs are eligible employees or
NHCEs in the plan year for which the ADP
test is being calculated. Under the cur-
rent year testing method, the applicable
year for determining the ADP for the eli-
gible NHCEs is the same plan year as the
plan year for which the ADP test is be-
ing performed. Under either method, the
ADP for eligible HCEs is the average of
the ADRs of the eligible HCEs for the plan
year for which the ADP test is being per-
formed. See paragraph (c) of this section
for additional rules for the prior year test-
ing method.
(3)Determination of ADR—(i)General
rule. The ADR of an eligible employee for
a plan year or applicable year is the sum of
the employee's elective contributions taken
into account with respect to such employee
for the year, determined under the rules of
paragraphs (a)(4) and (5) of this section,
and the qualified nonelective contributions
and qualified matching contributions taken
into account with respect to such employee
under paragraph (a)(6) of this section for
the 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 elective
contributions, qualified nonelective con-
tributions, or qualified matching contribu-
tions are taken into account under this sec-
tion with respect to an eligible employee
for the year, the ADR of the employee is
zero.
(ii)ADR of HCEs eligible under more
than one arrangement—(A)General rule.
Pursuant to section 401(k)(3)(A), the ADR
of an HCE who is an eligible employee in
more than one cash or deferred arrange-
ment of the same employer is calculated
by treating all contributions with respect
to such HCE under any such arrangement
as being made under the cash or deferred
arrangement being tested. Thus, the ADR
for such an HCE is calculated by accu-
mulating all contributions under any cash
or deferred arrangement (other than a
cash or deferred arrangement described
in paragraph (a)(3)(ii)(B) of this section)
that would be taken into account under
this section for the plan year, if the cash
or deferred arrangement under which the
contribution was made applied this section
and had the same plan year. For example,
in the case of a plan with a 12-month
plan year, the ADR for the plan year of
that plan for an HCE who participates in
multiple cash or deferred arrangements of
the same employer is the sum of all contri-
butions during such 12-month period that
would be taken into account with respect
to the HCE under all such arrangements in
which the HCE is an eligible employee, di-
vided by the HCE's compensation for that
12-month period (determined using the
compensation definition for the plan being
tested), without regard to the plan year of
the other plans and whether those plans
are 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 to
be 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 different
plan years set forth in §1.410(b)–7(d)(5))
are not aggregated under this paragraph
(a)(3)(ii).
(iii)Examples. The following examples
illustrate the application of this paragraph
(a)(3):
Example 1. (i) Employee A, an HCE with com-
pensation of $120,000, is eligible to make elective
contributions 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 or
deferred arrangement. During the current plan year,
Employee A makes elective contributions of $6,000
to Plan S and $4,000 to Plan T.
(ii) Under each plan, the ADR for Employee A is
determined by dividing Employee A's total elective
contributions under both arrangements by Emp
loyee
A's compensation taken into account under the plan
for the year. Therefore, Employee A's ADR under
each plan is 8.33% ($10,000/$120,000).
Example 2. (i) The facts are the same as inExam-
ple 1, except that Plan T defines compensation (for
deferral and testing purposes) to excl
ude all bonuses
paid to an employee. Plan S defines compensation
(for deferral and testing purposes) to include bonuses
paid to an employee. During the curren
t year, Em-
ployee A's compensation included a $10,000 bonus.
Therefore, Employee A's compensation under Plan T
is $110,000 and Employee A's compen
sation under
Plan S is $120,000.
(ii) Employee A's ADR under Plan T is 9.09%
($10,000/$110,000) and under P
lanS,EmployeeA's
ADR 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 plan
year begins on July 1 and ends on June 30. Plan V
has a calendar year plan year.
Compensation under
both plans is limited to the participant's compensa-
tion during the period of participation. Employee B
is an HCE who participates
in both plans. Employee
B's monthly compensation and elective contributions
to each plan for the 2005 and 2006 calendar years are
as follows:
Calendar yearMonthly CompensationMonthly Elective Contribution
to Plan U
Monthly Elective Contribution
to Plan V
2005
$10,000$500$400
2006
$11,500$700$550
(ii) Under Plan U, Employee B's ADR for the plan
year ended June 30, 2006, isequal to Employee B's
total elective contributions under Plan U and Plan V
for the plan year ending June 30, 2006, divided by
Employee 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 x
6)) / (($10,000 x 6) + ($11,500 x 6)), or 10%.
(iii) Under Plan V, Employee B's ADR for the
plan 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 year
ending December 31, 2005,is ($10,800/$120,000),
or 9%.
September 2, 20034572003-35 I.R.B.

Example 4. (i) The facts are the same asExample
3, except that Employee B first becomes eligible to
participate in Plan U on January 1, 2006.
(ii) Under Plan U, Employee B's ADR for the plan
year ended June 30, 2006, isequal to Employee B's
total elective contributions under Plan U and V for
the 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 year
ending 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 into
account under the ADP test—(i)General
rule. An elective contribution is taken into
account in determining the ADR for an
eligible employee for a plan year or ap-
plicable year only ifeach of the following
requirements is satisfied:
(A) The elective contribution is allo-
cated to the eligible employee's account
under the plan as of a date within that year.
Forpurposesofthisrule, an elective contri-
bution is considered allocated as of a date
within a year only if—
(1) The allocation is not contingent on
the employee's participation in the plan or
performance of services on any date sub-
sequent to that date; and
(2) The elective contribution is actually
paid to the trust no later than the end of
the 12-month period immediately follow-
ing the year to which the contribution re-
lates.
(B) The elective contribution relates to
compensation that either—
(1) Would have been received by the
employee in the year but for the employee's
election to defer under the arrangement; or
(2) Is attributable to services performed
by the employee in the year and, but for the
employee's election to defer, would have
been received by the employee within 2
1
/2
months after the close of the year, but only
if the plan so provides for elective con-
tributions that relate to compensation that
would have been received after the close
of a year to be allocated to such prior year
rather than the year in which the compen-
sation would have been received.
(ii)Elective contributions for partners
and self-employed individuals. For pur-
poses of this paragraph (a)(4), a partner's
distributive share of partnership income is
treated as received on the last day of the
partnership taxable year and a sole propri-
etor's compensation is treated as received
on the last day of the individual's taxable
year. Thus, an elective contribution made
on behalf of a partner or sole proprietor is
treated as allocated to the partner's account
for the plan year that includes the last day
of the partnership taxable year, provided
the requirements of paragraph (a)(4)(i) of
this section are met.
(iii)Elective contributions for HCEs.
Elective contributions of an HCE must
include any excess deferrals, as described
in §1.402(g)–1(a), even if those excess
deferrals are distributed, pursuant to
§1.402(g)–1(e).
(5)Elective contributions not taken into
account under the ADP test—(i)General
rule. 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 the
contributions were made, or for any other
plan year. Instead, the amount of the elec-
tive contributions must satisfy the require-
ments of section 401(a)(4) (without regard
to the ADP test) for the plan year for which
they are allocated under the plan as if they
were nonelective contributions and were
the only nonelective contributions for that
year. See §§1.401(a)(4)–1(b)(2)(ii)(B) and
1.410(b)–7(c)(1).
(ii)Elective contributions for NHCEs.
Elective contributions of an NHCE shall
not include any excess deferrals, as de-
scribed in §1.402(g)–1(a), to the extent the
excess deferrals are prohibited under sec-
tion 401(a)(30). However, to the extent
that the excess deferrals are not prohibited
under section 401(a)(30), they are included
in elective contributions even if distributed
pursuant to §1.402(g)–1(e).
(iii)Elective contributions treated as
catch-up contributions. Elective con-
tributions that are treated as catch-up
contributions under section 414(v) be-
cause they exceed a statutory limit or em-
ployer-provided limit (within the meaning
of §1.414(v)–1(b)(1)) are not taken into
account under paragraph (a)(4) of this
section for the plan year for which the
contributions were made, or for any other
plan year.
(iv)Elective contributions used to sat-
isfy the ACP test. Except to the extent
necessary to demonstrate satisfaction of
the requirement of §1.401(m)–2(a)(6)(ii),
elective contributions taken into account
for 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 contributions
and qualified matching contributions that
may be taken into account under the ADP
test. Qualified nonelective contributions
and qualified matching contributions may
be taken into account in determining the
ADR for an eligible employee for a plan
year or applicable year but only to the ex-
tent the contributions satisfy the following
requirements.
(i)Timing of allocation. The quali-
fied nonelective contribution or qualified
matching contribution is allocated to the
employee's account as of a date within
that 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 for
the applicable year, a qualified nonelective
contribution or qualified matching contri-
bution must be contributed no later than
the end of the 12-month period immedi-
ately following the applicable year even
though the applicable year is different than
the plan year being tested.
(ii)Requirement that amount satisfy
section 401(a)(4). The amount of nonelec-
tive contributions, including those quali-
fied nonelective contributions taken into
account under this paragraph (a)(6) and
those qualified nonelective contributions
taken into account for the ACP test of sec-
tion 401(m)(2) under §1.401(m)–2(a)(6),
satisfies the requirements of section
401(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 this
paragraph (a)(6) and those qualified non-
elective contributions taken into account
for the ACP test of section 401(m)(2)
under §1.401(m)–2(a)(6), satisfies the
requirements of section 401(a)(4). See
§1.401(a)(4)–1(b)(2). In the case of
an employer that is applying the spe-
cial rule for employer-wide plans in
§1.414(r)–1(c)(2)(ii) with respect to the
cash or deferred arrangement, the determi-
nation of whether the qualified nonelective
contributions satisfy the requirements of
this paragraph (a)(6)(ii) must be made
on an employer-wide basis regardless of
whether the plans to which the qualified
nonelective contributions are made are
satisfying the requirements of section
410(b) on an employer-wide basis. Con-
versely, in the case of an employer that
2003-35 I.R.B.458September 2, 2003

is treated as operating qualified separate
lines of business, and does not apply the
special rule for employer-wide plans in
§1.414(r)–1(c)(2)(ii) with respect to the
cash or deferred arrangement, then the
determination of whether the qualified
nonelective 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 whether
the plans to which the qualified nonelec-
tive contributions are made are satisfying
the requirements of section 410(b) on that
basis.
(iii)Aggregation must be permitted.
The plan that contains the cash or deferred
arrangement and the plan or plans to which
the qualified nonelective contributions or
qualified matching contributions are
made, are plans that would be permitted
to be aggregated under §1.401(k)–1(b)(4).
If the plan year of the plan that con-
tains the cash or deferred arrangement is
changed to satisfy the requirement under
§1.410(b)–7(d)(5) that aggregated plans
have the same plan year, qualified nonelec-
tive contributions and qualified matching
contributions may be taken into account in
the resulting short plan year only if such
qualified nonelective contributions and
qualified matching contributions could
have been taken into account under an
ADP test for a plan with the same short
plan year.
(iv)Disproportionate contributions not
taken into account—(A)General rule.
Qualified nonelective contributions cannot
be taken into account for a plan year for
an NHCE to the extent such contribu-
tions exceed the product of that NHCE's
compensation and the greater of 5% or
two times the plan's representative con-
tribution rate. Any qualified nonelective
contribution taken into account under
an 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 purposes
of this paragraph (a)(6) (including the
determination 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 among
a group of eligible NHCEs that consists of
half of all eligible NHCEs for the plan year
(or, if greater, the lowest applicable con-
tribution rate of any eligible NHCE in the
group of all eligible NHCEs for the plan
year and who is employed by the employer
on 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 rate
for an eligible NHCE is the sum of the
qualified matching contributions taken
into account under thisparagraph (a)(6)
for the eligible NHCE for the plan year
and the qualified nonelective contributions
made for that eligible NHCE for the plan
year, divided by that eligible NHCE's
compensation for the same period.
(v)Qualified matching contributions.
Qualified matching contributions satisfy
this paragraph (a)(6) only to the extent that
such qualified matching contributions are
matching contributions that are not pre-
cluded from being taken into account un-
der the ACP test for the plan year under the
rules of §1.401(m)–2(a)(5)(ii).
(vi)Contributions only used once.
Qualified nonelective contributions and
qualified matching contributions can not
be taken into account under this paragraph
(a)(6) to the extent such contributions
are taken into account for purposes of
satisfying any other ADP test, any ACP
test, or the requirements of §1.401(k)–3,
1.401(m)–3 or 1.401(k)–4. Thus, for ex-
ample, matching contributions that are
made pursuant to §1.401(k)–3(c) cannot
be taken into account under the ADP test.
Similarly, if a plan switches from the cur-
rent year testing method to the prior year
testing method pursuant to §1.401(k)–2(c),
qualified nonelective contributions that are
taken into account under the current year
testing method for a year may not be taken
into account under the prior year testing
method for the next year.
(7)Examples. The following examples
illustrate the application of this paragraph
(a):
Example 1. (i) Employer X has three employees,
A, B, and C. Employer X sponsors a profit-sha
ring
plan (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 ca
sh or deferred
arrangement, each eligible employee may elect to re-
ceive none, all or any part of the bonus in cash. X
contributes the remainder to Plan Z
. The portion of
the bonus paid in cash, if any, is paid 2 months af-
ter the end of the plan year and thus is included in
compensation for the following p
lan year. Employee
A 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 contributions
and bonuses paid during each plan year. In Febru-
ary of 2005, Employer X determined that no bonuses
will be paid for 2004. In Feb
ruaryof2006,Employer
X provided a bonus for each employee equal to 10%
of regular compensation for 2005. For the 2005 plan
year, A, B, and C have the f
ollowing compensation
and make the following elections:
EmployeeCompensationElective Contributio
n
A
$100,000$4,340
B60,0002,860
C45,0001,250
September 2, 20034592003-35 I.R.B.

(ii) For each employee, the ratio of elective contributions to the employee's compensat
ion for the plan year is:
EmployeeRatio of Elective Contribution to CompensationADR
A
$4,340/$100,000
4.34%
B2,860/60,0004.77
C1,250/45,0002.78
(iii) The ADP for the HCEs (Employee A) is
4.34%. 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 the
ADP test under paragraph (a)(1)(i) of this section.
Example 2.(i)ThefactsarethesameasinExam-
ple 1, except that elective contributions are made pur-
suant to a salary reduction agreement throughout the
plan 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 C
defer the same amount as inExample 1, but A defers
$5,770. Thus, the compensation and elective contri-
butions for A, B, and C are:
EmployeeGross CompensationElective ContributionsADR
A
$100,000$5,770
5.77%
B60,0002,8604.77
C45,0001,2502.78
(ii) The ADP for the HCEs (Employee A) is
5.77%. 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 under
paragraph (a)(1)(i) of thissection. However, because
the ADP for the HCEs does not exceed the ADP for
the NHCEs by more than 2 percentage points and the
ADP for the HCEs does not exceed the ADP for the
NHCEs multiplied by 2 (3.78% x 2 = 7.56%), the
plan 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 that
contains a cash or deferred arrangement. The plan is
a calendar year plan that uses the prior year testing
method. Plan T provides that elective contributions
are included in compensation (as provided under sec-
tion 414(s)(2)). Each eligible employee may elect to
defer up to 6% of compensation under the cash or de-
ferred arrangement. Employees D and E are HCEs.
The compensation, elective contributions, and ADRs
of Employees D and E for the 2006 plan year are
shown below:
EmployeeCompensation for
2006 Plan Year
Elective Contributions for
2006 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 F
through L were eligible NHCEs. The compensation,
elective contributions and ADRs of Employees F
through L for the 2005 plan year are shown in the
following table:
EmployeeCompensation for 2005 Plan YearElective Contributions for
2005PlanYear
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 ADP
is 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.460September 2, 2003

are eligible under the plan during the plan year). The
ADP for the NHCEs is 3.71% (the sum of the individ-
ual ADRs, 26%, divided by 7 employees). Because
7.5% exceeds 4.64% (3.71% x 1.25), Plan T does not
satisfy the ADP test under paragraph (a)(1)(i) of this
section. In addition, because the ADP for the HCEs
exceedstheADPfortheNHCEsbymorethan2per-
centage points, Plan T does not satisfy the ADP test
under 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 failure
is 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. Plan
U provides that elective contributions are included in
compensation (as provided under section 414(s)(2)).
The following amounts are contributed under Plan
Uforthe2006planyear: (A)QNECsequalto2%
of each employee's compensation; (B) Contributions
equal to 6% of each employee's compensation that are
not 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 contributions
are made for the HCEs (employees M and N) and the
NHCEs (employees O through S) for the plan year
and are contributed after the end of the plan year and
before the end of the following plan year. In addi-
tion, neither type of nonelective contributions is used
for any other ADP or ACP test.
(ii) For the 2006 plan year, the compensation,
elective contributions, and actual deferral ratios of
employees M through S are shown in the following
table:
EmployeeCompensationElective ContributionsActual Deferral Ratio
M
$100,000$3,000
3%
N
$100,000$2,000
2%
O
$60,000$1,800
3%
P
$40,000
00
Q
$30,000
00
R
$5,000
00
S
$20,000
00
(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 the
ADP 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 is
paid within 12-month after the plan year for which al-
located. All nonelective contributions also satisfy the
requirements relating to section 401(a)(4) set forth in
paragraph (a)(6)(ii) of this section (because all em-
ployees receive an 8% nonelective contribution and
the nonelective contributions excluding the QNECs
is 6% for all employees). In addition, the QNECs are
not disproportionate under paragraph (a)(6)(iv) of this
section because no QNEC for an NHCE exceeds the
product of the plan's applicable contribution rate (2%)
and that NHCE's compensation.
(v) Because the rules of paragraph (a)(6) of this
section are satisfied, the 2% QNECs may be taken
into account in applying the ADP test of section
401(k)(3) and paragraph (a)(1) of this section. The
6% nonelective contributions, however, may not be
taken into account because they are not QNECs.
(vi) If the 2% QNECs are taken into account, the
ADP for the HCEs is 4.5%, and the actual deferral
percentage for the NHCEs is 2.6%. Because 4.5% is
not more than two percentage points greater than 2.6
percent, and not more than two times 2.6, the cash or
deferred arrangement satisfies the ADP test of section
401(k)(3) under paragraph (a)(1)(ii) of this section.
Example 5. (i) The facts are the same asExample
4, 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 the
2005 ADP for the eligible NHCEs is 0.8%. An addi-
tional QNEC of 2% of compensation is made for each
eligible 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 section
for the applicable year for the 2005 plan year because
they were not contributed before the last day of the
2006 plan year. Accordingly, the 2% QNECs do not
satisfy the rules of paragraph (a)(6) of this section and
may not be taken into account in applying the ADP
test of section 401(k)(3) and paragraph (a)(1) of this
section for the 2006 plan year. The cash or deferred
arrangement fails to be a qualified cash or deferred
arrangement unless the ADP failure is corrected un-
derparagraph(b)ofthissection.
Example 6. (i) The facts are the same asExam-
ple 4, except that the ADP for the HCEs is 4.6%
and there is no 6% nonelective contribution under
the plan. The employer would like to take into ac-
count the 2% QNEC in determining the ADP for the
NHCEs 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) of
this section because the HCE ADP for the plan year
(4.6%) exceeds 0.75% (0.6% x 1.25) and 1.2% (0.6%
x2).
(iii) The 2% QNECs may not be taken into ac-
count in determining the ADP of the NHCEs because
they fail to satisfy the requirements relating to sec-
tion 401(a)(4) set forth in paragraph (a)(6)(ii) of this
section. This is because the amount of nonelective
contributions, excluding those QNECs that would
be taken into account under the ADP test, would be
2% of compensation for the HCEs and 0% for the
NHCEs. Therefore, the cash or deferred arrangement
fails to be a qualified cash or deferred arrangement
unless the ADP failure is corrected under paragraph
(b)ofthissection.
Example 7. (i) The facts are the same asExample
6, except that Employee R receives a QNEC in an
amount of $500 and no QNECs are made on behalf
of the other employees.
(ii) If the QNEC could be taken into account un-
der paragraph (a)(6) of this section, the ADP for the
NHCEs would be 2.6% and the plan would satisfy the
ADP test. The QNEC is disproportionate under para-
graph (a)(6)(iv) of this section, and cannot be taken
into account under paragraph (a)(6) of this section, to
the extent it exceeds the greater of 5% and two times
the plan's representative contribution rate (0%), mul-
tiplied by Employee R's compensation. The plan's
representative contribution rate is 0% because it is the
lowest applicable contribution rate among a group of
NHCEs that is at least half of all NHCEs, or all the
NHCEs who are employed on the last day of the plan
year. Therefore, the QNEC may be taken into account
under 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 satisfy
the ADP test and must correct under paragraph (b) of
this section.
Example 8. (i) The facts are the same as inEx-
ample 4except that the plan changes from the current
year testing method to the prior year testing method
for the following plan year (2006 plan year). The
ADP for the HCEs for the 2006 plan year is 3.5%.
(ii) The 2% QNECs may not be taken into account
in determining the ADP for the NHCEs for the appli-
cable year (2005 plan year) in satisfying the ADP test
for the 2006 plan year because they were taken into
account in satisfying the ADP test for the 2005 plan
year. Accordingly, the NHCE ADP for the applicable
year is 0.6%. The elective contributions for the plan
year fail the requirements of section 401(k) and para-
graph (a)(1) of this section because the HCE ADP for
September 2, 20034612003-35 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% x
2)), determined using the applicable year ADP for the
NHCEs. Therefore, the cashordeferredarrangement
fails to be a qualified cash or deferred arrangement
unless the ADP failure is corrected under paragraph
(b) of this section.
Example 9. (i)(A) Employer N maintains Plan
X, a profit sharing plan that contains a cash or de-
ferred arrangement and thatuses the current year test-
ing method. Plan X provides for employee contribu-
tions, elective contributions, and matching contribu-
tions. Matching contributions on behalf of nonhighly
compensated employees are qualified matching con-
tributions (QMACs) and are contributed during the
2005 plan year. Matching contributions on behalf of
highly compensated employees are not QMACs, be-
cause they fail to satisfy the nonforfeitability require-
ment of §1.401(k)–1(c). The elective contributions
and matching contributions with respect to HCEs for
the 2005 plan year are shown in the following table:
Elective
Contributions
Total Matching
Contributions
Matching
contributions
that are
not QMACs
QMACs
Highly compensated employees15%5%5%0%
(B) The elective contributions and matching contributions with respect to the NHCEs for the 2005 plan year are shown in the
following table:
Elective
Contributions
Total Matching
Contributions
Matching
contributions
that are
not QMACs
QMACs
Nonhighly compensated employees11%4%0%4%
(ii) The plan fails to satisfy the ADP test of section
401(k)(3)(A) and paragraph (a)(1) of this section be-
cause the ADP for HCEs (15%) is more than 125% of
the 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 they
are not used for any other ADP or ACP test. QMACs
equal to 1% of compensation are taken into account
for each NHCE in applying the ADP test. After this
adjustment, the applicable ADP and ACP (taking into
account the provisions of §1.401(m)–2(a)(5)(ii)) for
the plan year are as follows:
Actual Deferral PercentageActual Contribution Percentage
HCEs15%5%
Nonhighly compensated employees12%3%
(iii) The elective contributions and QMACs
taken into account for purposes of the ADP test of
section 401(k)(3) satisfy the requirements of section
401(k)(3)(A)(ii) under paragraph (a)(1)(ii) of this
section because the ADP for HCEs (15%) is not
more 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 deferred
arrangement does not fail to satisfy the
requirements of section 401(k)(3) and
paragraph (a)(1) of this section if the em-
ployer, in accordance with the terms of
the plan that includes the cash or deferred
arrangement, uses any of the following
correction methods—
(A)Qualified nonelective contribu-
tions or qualified matching contributions.
The employer makes qualified nonelec-
tive contributions or qualified matching
contributions that are taken into account
under this section and, in combination
with other amounts taken into account
under paragraph (a) of this section, allow
the cash or deferred arrangement to satisfy
the requirements of paragraph (a)(1) of
this section.
(B)Excess contributions distributed.
Excess contributions are distributed in
accordance with paragraph (b)(2) of this
section.
(C)Excess contributions recharacter-
ized. Excess contributions are recharacter-
ized in accordance withparagraph (b)(3)
of this section.
(ii)Combination of correction meth-
ods. A plan may provide for the use of
any of the correction methods described
in paragraph (b)(1)(i) of this section, may
limit elective contributions in a manner
designed to prevent excess contributions
from being made, or may use a combina-
tion of these methods, to avoid or correct
excess contributions. A plan may require
or permit an HCE to elect whether any
excess contributions are to be recharac-
terized or distributed. If the plan uses
a combination of correction methods,
any contribution made under paragraph
(b)(1)(i)(A) of this section must be taken
into 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 of
paragraph (a)(1) of this section may not
be corrected using any method other than
the ones described in paragraphs (b)(1)(i)
and (ii) of this section. Thus, excess
contributions for a plan year may not
remain unallocated or be allocated to a
suspense account for allocation to one or
2003-35 I.R.B.462September 2, 2003

more employees in any future year. In
addition, excess contributions may not
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)Corrections through distribu-
tion—(i)General rule. This paragraph
(b)(2) contains the rules for correction of
excess contributions through a distribu-
tion from the plan. Correction through
a distribution generally involves a 4 step
process. 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 distributed
under the plan. Second, the plan must
apportion the total amount of excess con-
tributions among HCEs in accordance
with paragraph (b)(2)(iii) of this section.
Third, the plan must determine the income
allocable to excess contributions in ac-
cordance with paragraph (b)(2)(iv) of this
section. Finally, the plan must distribute
the apportioned excess contributions and
allocable income in accordance with para-
graph (b)(2)(v) of this section. Paragraph
(b)(2)(vi) of this section provides rules
relating to the tax treatment of these dis-
tributions. Paragraph (b)(2)(vii) provides
other rules relating to these distributions.
(ii)Calculation of total amount to
be distributed. The following proce-
dures must be used to determine the total
amount of the excess contributions to be
distributed—
(A)Calculate the dollar amount of
excess contributions for each HCE.The
amount of excess contributions attribut-
able to a given HCE for a plan year is
theamount(ifany)bywhichtheHCE's
contributions taken into account under this
section must be reduced for the HCE's
ADR to equal the highest permitted ADR
under the plan. To calculate the highest
permitted ADR under a plan, the ADR
of the HCE with the highest ADR is re-
duced by the amount required to cause that
HCE's ADR to equal the ADR of the HCE
with the next highest ADR. If a lesser
reduction would enable the arrangement
to satisfy the requirements of paragraph
(b)(2)(ii)(C) of this section, only this
lesser reduction is used in determining the
highest permitted ADR.
(B)Determination of the total amount
of 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 of
paragraph (b)(2)(ii)(C) of this section. The
sum of all reductions for all HCEs deter-
mined under paragraph (b)(2)(ii)(A) of this
section is the total amount of excess con-
tributions for the plan year.
(C)Satisfaction of ADP. A cash or
deferred arrangement satisfies this para-
graph (b)(2)(ii)(C) if the arrangement
would satisfy the requirements of para-
graph (a)(1)(ii) of this section if the ADR
for each HCE were determined after
the reductions described in paragraph
(b)(2)(ii)(A) of this section.
(iii)Apportionment of total amount of
excess contributions among the HCEs.
The following procedures must be used in
apportioning the total amount of excess
contributions 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 the
amount required to cause that HCE's con-
tributions to equal the dollar amount of the
contributions taken into account under this
section for the HCE with the next highest
dollar amount of contributions taken ac-
count under this section. If a lesser ap-
portionment to the HCE would enable the
plan to apportion the total amount of ex-
cess contributions, only the lesser appor-
tionment would apply.
(B)Limit on amount apportioned to
any individual. For purposes of this
paragraph (b)(2)(iii), the amount of con-
tributions taken into account under this
section with respect to an HCE who is an
eligible employee in more than one plan
of an employer is determined by taking
into account all contributions otherwise
taken into account with respect to such
HCE under any plan of the employer
during the plan year of the plan being
tested as being made under the plan being
tested. However, the amount of excess
contributions apportioned for a plan year
with respect to any HCE must not exceed
the amount of contributions actually con-
tributed to the plan for the HCE for the
plan year. Thus, in the case of an HCE
who is an eligible employee in more than
one plan of the same employer to which
elective contributions are made and whose
ADR is calculated in accordance with
paragraph (a)(3)(ii) of this section, the
amount required to be distributed under
this paragraph (b)(2)(iii) shall not exceed
the contributions actually contributed to
the plan and taken into account under this
section for the plan year.
(C)Apportionment to additional HCEs.
The procedure in paragraph (b)(2)(iii)(A)
of this section must be repeated until the
total amount of excess contributions de-
termined under paragraph (b)(2)(ii) of this
section have been apportioned.
(iv)Income allocable to excess contri-
butions—(A)General rule.Theincome
allocable to excess contributions is equal
to the sum of the allocable gain or loss for
the plan year and, to the extent the excess
contributions are or will be credited with
allocable gain or loss for the period after
the close of the plan year (gap period), the
allocable gain or loss for the gap period.
(B)Method of allocating income.A
plan may use any reasonable method for
computing the income allocable to excess
contributions, provided that the method
does not violate section 401(a)(4), is used
consistently for all participants and for all
corrective distributions under the plan for
the 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 allocating
plan year income. A plan may allocate
income to excess contributions for the
plan year by multiplying the income for
the plan year allocable to the elective
contributions and other amounts taken
into account under this section (including
contributions made for the plan year),
by a fraction, the numerator of which is
the excess contributions for the employee
for the plan year, and the denominator of
which is the account balance attributable
to elective contributions and other con-
tributions taken into account under this
section as of the beginning of the plan year
(including any additional amount of such
contributions made for the plan year).
(D)Safe harbor method of allocat-
ing gap period income.Aplanmayuse
the safe harbor methodin this paragraph
(b)(2)(iv)(D) to determine income on
excess contributions for the gap period.
Under this safe harbor method, income
on excess contributions for the gap period
is equal to 10% of the income allocable
to excess contributions for the plan year
that would be determined under paragraph
September 2, 20034632003-35 I.R.B.

(b)(2)(iv)(C) of this section, multiplied by
the number of calendar months that have
elapsed since the end of the plan year.
For purposes of calculating the number
of calendar months that have elapsed un-
der the safe harbor method, a corrective
distribution that is made on or before the
fifteenth day of a month is treated as made
on the last day of the preceding month and
a distribution made after the fifteenth day
of a month is treated as made on the last
day of the month.
(E)Alternative method for allocating
plan year and gap period income.A
plan may determine the allocable gain
or loss for the aggregate of the plan year
andthegapperiodbyapplyingtheal-
ternative method provided by paragraph
(b)(2)(iv)(C) of this section to this ag-
gregate period. This is accomplished by
substituting the income for the plan year
and the gap period for the income for the
plan year and by substituting the contribu-
tions taken into account under this section
for the plan year and the gap period for
the contributions taken account under this
section for the plan year in determining the
fraction that is multiplied by that income.
(v)Distribution.Within12monthsaf-
ter the close of the plan year in which the
excess contribution arose, the plan must
distribute 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 a
corrective distribution by the employer. In
the event of a complete termination of the
plan 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 than
12 months after the date of termination. If
the entire account balance of an HCE is
distributed prior to when the plan makes a
distribution of excess contributions in ac-
cordance with this paragraph (b)(2), the
distribution is deemed to have been a cor-
rective distribution of excess contributions
(and income) to the extent that a corrective
distribution 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 this
section, a corrective distribution of excess
contributions (and income) that is made
within 2
1
/2months after the end of the plan
year for which the excess contributions
were made is includible in the employee's
gross income on the earliest date any elec-
tive contributions by the employee during
the plan year would have been received by
theemployeehadtheemployeeoriginally
elected to receive the amounts in cash. A
corrective distribution of excess contribu-
tions (and income) that is made more than
2
1
/2months after the end of the plan year
for which the contributions were made is
includible in the employee's gross income
in the employee's taxable year in which
distributed. Regardless of when the cor-
rective distribution is made, it is not subject
to 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 than
2
1
/2months after the end of the plan year.
See also §1.402(c)–2, A–4 for restrictions
on rolling over distributions that are excess
contributions.
(B)Rule for de minimis distributions.
If the total amount of excess contribu-
tions, determined under this paragraph
(b)(2), and excess aggregate contributions
determined under §1.401(m)–2(b)(2) dis-
tributed to a recipient under a plan for any
plan year is less than $100 (excluding in-
come), a corrective distribution of excess
contributions (and income) is includible
in the gross income of the recipient in the
taxable year of the recipient in which the
corrective distribution is made.
(vii)Other rules—(A)No employee or
spousal consent required. A corrective
distribution of excess contributions (and
income) may be made under the terms of
the plan without regard to any notice or
consent otherwise required under sections
411(a)(11) and 417.
(B)Treatment of corrective distribu-
tions as elective contributions. Excess
contributions are treated as employer con-
tributions for purposes of sections 404 and
415 even if distributed from the plan.
(C)No reduction of required minimum
distribution. A distribution of excess
contributions (and income) is not treated
as a distribution for purposes of deter-
mining whether the plan satisfies the
minimum distribution requirements of
section 401(a)(9). See §1.401(a)(9)–5,
Q&A–9(b).
(D)Partial distributions.Anydistribu-
tion of less than the entire amount of excess
contributions (and allocable income) with
respect to any HCE is treated as apro rata
distribution of excess contributions and al-
locable income.
(viii)Examples.Thefollowingexam-
ples illustrate the application of this para-
graph (b)(2). For purposes of these exam-
ples, none of the plans provide for catch-up
contributions under section 414(v). The
examples 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 the
ADP 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 comp
ensa-
tion of $128,000, for an ADR of 7%. The ADP for
the NHCEs is 3%. Under the ADP test, the ADP of
the two HCEs under the plan may not exceed 5% (
i.e.,
2 percentage points more than the ADP of the NHCEs
under the plan). The ADP for the 2 HCEs under the
plan is 6.5%. Therefore, there must be a co
rrection of
excess contributions.
(ii) The total amount of excess contributions for
the HCEs is determined under paragrap
h (b)(2)(ii) of
this section as follows: the elective contributions of
Employee B (the HCE with the highest ADR) are re-
duced by $1,280 in order to reduce hi
s ADR to 6%
($7,680/$128,000), which is the ADR of Employee
A.
(iii) Because the ADP of the HCEs
determined af-
ter the $1,280 reduction to Employee B still exceeds
5%, further reductions in elective contributions are
necessary in order to reduce th
eADPoftheHCEs
to 5%. The elective contributions of Employee A and
Employee B are each reduced by 1% of compensa-
tion ($2,000 and $1,280 resp
ectively). Because the
ADP of the HCEs determined after the reductions
equals 5%, the plan would satisfy the requirements
of (a)(1)(ii) of this sec
tion.
(iv) The total amount of excess contributions
($4,560 = $1,280+$2,000+$1,280) is apportioned
among the HCEs under par
agraph (b)(2)(iii) of this
section first to the HCE with the highest amount of
elective contributions. Therefore, Employee A is
apportioned $3,040
(the amount required to cause
Employee A's elective contributions to equal the next
highest dollar amount of elective contributions).
(v) Because the tota
l amount of excess contribu-
tions has not been apportioned, further apportionment
is necessary. The balance ($1,520) of the total amount
of excess contribu
tions is apportioned equally among
Employee A and Employee B ($760 to each).
(vi) Therefore, the cash or deferred arrangement
will satisfy the
requirements of paragraph (a)(1) of
this section if, by the end of the 12 month period fol-
lowing the end of the 2006 plan year, Employee A
receives a corr
ective distribution of excess contribu-
tions equal to $3,800 ($3,040 + $760) and allocable
2003-35 I.R.B.464September 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 inExam-
ple 1, except Employee A's ADR is based on $3,000
of elective contributions to this plan and $9,000 of
elective contributions to another plan of the employer.
(ii) The total amount of excess contributions
($4,560 = $1,280+$2,000+$1,280) is apportioned
among the HCEs under paragraph (b)(2)(iii) of this
section first to the HCE with the highest amount
of elective contributions. The amount of elective
contributions for Employee A is $12,000. Therefore,
Employee A is apportioned $3,040 (the amount re-
quired to cause Employee A's elective contributions
to 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 amount
actually contributed to the plan may be apportioned
to an HCE. Accordingly, no more than $3,000 may
be apportioned to Employee A. Therefore, the re-
maining $1,560 must be apportioned to Employee B.
(ii) The cash or deferred arrangement will satisfy
the requirements of paragraph (a)(1) of this section if,
by the end of the 12 month period following the end of
the 2006 plan year, Employee A receives a corrective
distribution of excess contributions equal to $3,000
(total amount of elective contributions actu
ally con-
tributed to the plan for Employee A) and allocable
income and Employee B receives a corrective distri-
bution of $1,560 and allocable income.
Example 3. (i) The facts are the same as inExam-
ple 1. The plan allocates income on a daily basis. The
corrective distributions are made in F
ebruary 2007.
The excess contribution that must be distributed to
Employee A as a corrective distribution is $3,800.
This amount must be increased (or dec
reased) to re-
flect gains (or losses) allocable to that amount dur-
ing the 2006 plan year. The plan uses a reasonable
method that satisfies paragraph (
b)(2)(iv)(B) of this
section to determine the gain during the 2006 plan
year allocable to the $3,800 as $145. Therefore, as of
the end of the 2006 plan year, t
he amount of correc-
tive distribution that is required would be $3,945.
(ii) Because the plan allocates income on a daily
basis, excess contributions
are credited with gain or
loss during the gap period. Therefore, the corrective
distribution must include income allocable to $3,945
through the date of distri
bution. For the period from
January 1 through the date of distribution, the income
allocable to $3,945 is $105. Therefore, the plan will
satisfy the requiremen
ts of paragraph (a)(1) of this
section if Employee A receives a corrective distribu-
tion of $4,050.
Example 4. (i) The facts
are the same as inExam-
ple 1. The plan determines plan year income using the
alternative method for calculating income provided
in paragraph (b)(2)
(iv)(C) of this section and using
the portion of the participant's account attributable
to elective contributions, including elective contribu-
tions made for the
plan year. The plan uses the safe
harbor method provided in paragraph (b)(2)(iv)(D) of
this section for allocating gap period income. The
corrective dis
tribution is made during the last week
of February 2007. At the beginning of the 2006 plan
year, $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 elective
contributions for the 2006 plan year is $8,000.
(ii) Therefore, the plan year income allocable to
the $3,800 corrective distribution for Employee A
is $266.65 ($8,000 multiplied by $3,800 divided by
$110,000). Therefore, as of the end of the 2006 plan
year, the amount of corrective distribution that is re-
quired is $4,066.65. This amount must be increased
by the gap period income of $53.32 (10% multiplied
by $266.65 (2006 plan year income attributable to the
excess 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 a
corrective distribution of $4,119.97.
Example 5. (i)ThefactsarethesameasinEx-
ample 4, except that the plan provides for quarterly
valuations based on the account balance at the end of
the 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 be
credited with an allocation of income with respect to
the amount distributed. Accordingly, Plan P need not
plan adjust the distribution of excess contri
bution for
income during the gap period and thus satisfies para-
graph (a)(1) of this section if Employee A receives a
corrective distribution of $4,066.65.
(3)Recharacterization of excess contri-
butions—(i)General rule. Excess cont
ri-
butions are recharacterized in accord
ance
with this paragraph (b)(3) only if the
ex-
cess contributions that would have t
obe
distributed under (b)(2) of this se
ction if
the plan was correcting through dis
tribu-
tion of excess contributions are r
echarac-
terized as described in paragr
aph (b)(3)(ii)
of this section, and all of the
conditions set
forth in paragraph (b)(3)(ii
i) of this section
are satisfied.
(ii)Treatment of recharacte
rized excess
contributions. Recharacte
rized excess
contributions are includ
ible in the em-
ployee's gross income as
if such amounts
were distributed under
paragraph (b)(2) of
this section. The recha
racterized excess
contributions must be
treated as employee
contributions for pu
rposes of section 72,
sections 401(a)(4) a
nd 401(m). This re-
quirement is not tr
eated as satisfied unless
the payor or plan a
dministrator reports
the recharacteri
zed excess contributions
as employee cont
ributions to the Internal
Revenue Service
and the employee by
timely providi
ng such federal tax forms
and accompany
ing instructions and timely
taking such o
ther action as prescribed
by the Commis
sioner in revenue rulings,
notices and
other guidance published
in the Inter
nal Revenue Bulletin (see
601.601(d
)(2) of this chapter) as well as
the applicable federal tax forms and ac-
companying instructions.
(iii)Additional rules—(A)Time of
recharacterization. Excess contributions
may not be recharacterized under this
paragraph (b)(3) after 2
1
/2months after
the close of the plan year to which the
recharacterization relates. Recharacteri-
zation is deemed to have occurred on the
date on which the last of those HCEs with
excess contributionsto be recharacterized
is notified in accordance with paragraph
(b)(3)(ii) of this section.
(B)Employee contributions must be
permitted under plan. The amount of
recharacterized excess contributions, in
combination with the employee contribu-
tions actually made by the HCE, may not
exceed the maximum amount of employee
contributions (determined without regard
to the ACP test of section 401(m)(2)) per-
mitted under the provisions of the plan as
in effect on the first day of the plan year.
(C)Treatment of recharacterized ex-
cess contributions. Recharacterized ex-
cess contributions continue to be treated as
employer 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, for
example, recharacterized excess contribu-
tions remain subject to the requirements of
§1.401(k)–1(c) and (d); must be deducted
under section 404; and are treated as em-
ployer contributions described in section
415(c)(2)(A) and §1.415–6(b).
(4)Rules applicable to all correc-
tions—(i)Coordination with distribution
of excess deferrals—(A)Treatment of ex-
cess deferrals that reduce excess contribu-
tions. The amount of excess contributions
(and allocable income) to be distributed
under paragraph (b)(2) of this section or
the amount of excess contributions rechar-
acterized under paragraph (b)(3) of this
section with respect to an employee for
a plan year, is reduced by any amounts
previously distributed to the employee
from the plan to correct excess deferrals
for the employee's taxable year ending
with or within the plan year in accordance
with section 402(g)(2).
(B)Treatment of excess contributions
that reduce excess deferrals. Under
§1.402(g)–1(e), the amount required to be
distributed to correct an excess deferral to
an employee for a taxable year is reduced
September 2, 20034652003-35 I.R.B.

by any excess contributions (and allocable
income) previously distributed or excess
contributions recharacterized with respect
to the employee for the plan year begin-
ning with or within the taxable year. The
amount of excess contributions includible
in the gross income of the employee, and
the amount of excess contributions re-
ported by the payer or plan administrator
as includible in the gross income of the
employee, does not include the amount of
any reduction under §1.402(g)–1(e)(6).
(ii)Forfeiture of match on distributed
excess contributions. A matching contri-
bution is taken into account under section
401(a)(4)evenifthematchiswithre-
spect to an elective contribution that is
distributed or recharacterized under this
paragraph (b). This requires that, after
correction of excess contributions, each
level of matching contributions be cur-
rently and effectively available to a group
of employees that satisfies section 410(b).
See §1.401(a)(4)–4(e)(3)(iii)(G). Thus, a
plan that provides the same rate of match-
ing contributions to all employees will not
meet the requirements of section 401(a)(4)
if elective contributions are distributed
under this paragraph (b) to HCEs to the
extent needed to meet the requirements of
section 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 attributable
to excess contributions, excess aggregate
contributions or excess deferrals to avoid
a violation of section 401(a)(4). See
also §1.401(a)(4)–11(g)(vii)(B) regarding
the use of additional allocations to the
accounts of NHCEs for the purpose of
correcting a discriminatory rate of match-
ing contributions.
(iii)Permitted forfeiture of QMAC.Pur-
suant to section 401(k)(8)(E), a qualified
matching contribution is not treated as for-
feitable under §1.401(k)–1(c) merely be-
cause under the plan itis forfeited in ac-
cordance with paragraph (b)(4)(ii) of this
section.
(iv)No requirement for recalculation.
If excess contributions are distributed or
recharacterized in accordance with para-
graphs (b)(2) and (3) of this section, the
cash or deferred arrangement is treated as
meeting the nondiscrimination test of sec-
tion 401(k)(3) regardless of whether the
ADP for the HCEs, if recalculated after the
distributions or recharacterizations, would
satisfy section 401(k)(3).
(v)Treatment of excess contribu-
tions that are catch-up contributions.A
cash or deferred arrangement does not
fail to meet the requirements of section
401(k)(3) and paragraph (a)(1) of this sec-
tion merely because excess contributions
that are catch-up contributions because
they exceed the ADP limit, as described in
§1.414(v)–1(b)(1)(iii), are not corrected in
accordance with this paragraph (b).
(5)Failure to timely correct—(i)Fail-
ure to correct within 2
1
/2months after end
of plan year. If a plan does not correct ex-
cess contributions within 2
1
/2months af-
ter the close of the plan year for which
the excess contributions are made, the em-
ployer will be liable for a 10% excise tax
on the amount of the excess contributions.
See section 4979 and §54.4979–1 of this
chapter. Qualified nonelective contribu-
tions and qualified matching contributions
properly taken into account under para-
graph (a)(6) of this section for a plan year
mayenableaplantoavoidhavingexcess
contributions, even if the contributions are
made after the close of the 2
1
/2month pe-
riod.
(ii)Failure to correct within 12 months
after end of plan year. If excess contribu-
tions are not corrected within 12 months
after the close of the plan year for which
they were made, the cash or deferred ar-
rangement will fail to satisfy the require-
ments of section 401(k)(3) for the plan
year for which the excess contributions are
made and all subsequent plan years during
which the excess contributions remain in
the trust.
(c)Additional rules for prior year test-
ing method—(1)Rules for change in test-
ing method—(i)General rule.Aplanis
permitted to change from the prior year
testing method to the current year test-
ing method for any plan year. A plan
is permitted to change from the current
year testing method to the prior year test-
ing method only in situations described in
paragraph (c)(1)(ii) of this section. For
purposes of this paragraph (c)(1), a plan
that uses the safe harbor method described
in §1.401(k)–3 or a SIMPLE 401(k) plan
is treated as using the current year testing
method for that plan year.
(ii)Situations permitting a change to
the prior year testing method.Thesitua-
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 the
current year testing method was used under
the 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 been
in existence, including years in which the
plan was a portion of another plan).
(B) The plan is the result of the aggre-
gation of two or more plans, and for each
of the plans that are being aggregated (the
aggregating plans), the current year test-
ing method was used for each of the 5
plan years preceding the plan year of the
change(oriflesser,thenumberofplan
years since that aggregating plan has been
in existence, including years in which the
aggregating plan was a portion of another
plan).
(C) A transaction described in section
410(b)(6)(C)(i) and §1.410(b)–2(f) occurs
and—
(1) As a result of the transaction, the
employer maintains both a plan using the
prior year testing method and a plan using
the current year testing method; and
(2) The change from the current year
testing method to the prior year testing
method occurs within the transition period
described in section 410(b)(6)(C)(ii).
(2)Calculation of ADP under the prior
year testing method for the first plan
year—(i)Plans that are not successor
plans. If, for the first plan year of any plan
(other than a successor plan), the plan uses
the prior year testing method, the plan is
permitted to use either that first plan year
as the applicable year for determining the
ADP for eligible NHCEs, or use 3% as
the ADP for eligible NHCEs, for applying
the ADP test for that first plan year. A
plan (other than a successor plan) that
uses the prior year testing method but has
elected for its first plan year to use that
year as the applicable year is not treated as
changing its testing method in the second
plan year and is not subject to the limita-
tions on double counting on QNECs under
paragraph (a)(6)(vi) of this section for the
second plan year.
(ii)First plan year defined.Forpur-
poses of this paragraph (c)(2), the first
plan year of any plan is the first year in
2003-35 I.R.B.466September 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 (within
the meaning of §1.410(b)–7(b)) for a plan
year if for such plan year the plan is ag-
gregated under §1.401(k)–1(b)(4) with any
other 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 were
eligible employees under a qualified cash
or deferred arrangement maintained by the
employer in the prior year. If a plan that
is a successor plan uses the prior year test-
ing method for its first plan year, the ADP
for the group of NHCEs for the applicable
year must be determined under paragraph
(c)(4) of this section.
(3)Plans using different testing meth-
ods for the ADP and ACP test. Except
as otherwise provided in this paragraph
(c)(3), a plan may use the current year test-
ing method or prior year testing method for
the ADP test for a plan year without regard
to whether the current year testing method
or prior year testing method is used for the
ACP test for that year. For example, a plan
may use the prior year testing method for
the ADP test and the current year testing
method for its ACP test for the plan year.
However, plans that use different testing
methods under this paragraph (c)(3) can-
not use—
(i) The recharacterization method of
paragraph (b)(3) of this section to correct
excess contributions for a plan year;
(ii) The rules of §1.401(m)–2(a)(6)(ii)
to take elective contributions into account
under the ACP test (rather than the ADP
test); or
(iii) The rules of paragraph (a)(6)(v) of
this section to take qualified matching con-
tributions into account under the ADP test
(rather than the ACP test).
(4)Rules for plan coverage
changes—(i)In general. A plan that
uses the prior year testing method and ex-
periences a plan coverage change during
a plan year satisfies the requirements of
this section for that year only if the plan
provides that the ADP for the NHCEs for
the plan year is the weighted average of
the 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 weighted
averages described in paragraph (c)(4)(i)
of this section, the plan may provide that
the ADP for the group of eligible NHCEs
for the prior year under the plan is the
ADP of the NHCEs for the prior year of
the plan under which that single prior year
subgroup was eligible.
(iii)Definitions. The following defini-
tions apply for purposes of this paragraph
(c)(4):
(A)Plan coverage change.Theterm
plan coverage change means a change in
the group or groups of eligible employees
under a plan on account of—
(1) The establishment or amendment of
aplan;
(2) A plan merger or spinoff under sec-
tion 414(l);
(3) A change in the way plans (within
the meaning of §1.410(b)–7(b)) are
combined or separated for purposes of
§1.401(k)–1(b)(4) (e.g., permissively
aggregating plans not previously aggre-
gated under §1.410(b)–7(d), or ceasing
to permissively aggregate plans under
§1.410(b)–7(d));
(4) A reclassification of a substantial
group of employees that has the same ef-
fect as amending the plan (e.g., a transfer
of a substantial group of employees from
one 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.Theterm
prior year subgroup means all NHCEs
for the prior plan year who, in the prior
year, were eligible employees under a
specific plan maintained by the employer
that included a qualified cash or deferred
arrangement and who would have been
eligible employees in the prior year under
the plan being tested if the plan coverage
change had first been effective as of the
first day of the prior plan year instead of
first being effective during the plan year.
The determination of whether an NHCE
is a member of a prior year subgroup is
made without regard to whether the NHCE
terminated employment during the prior
year.
(C)Weighted average of the ADPs
for the prior year subgroups.Theterm
weighted average of the ADPs for the
prior year subgroups means the sum, for
all prior year subgroups, of the adjusted
ADPs for the plan year. The term adjusted
ADP with respect to a prior year subgroup
means the ADP for the prior plan year of
the specific plan under which the members
of the prior year subgroup were eligible
employees on the first day of the prior plan
year, multiplied by a fraction, the numer-
ator of which is the number of NHCEs in
the prior year subgroup and denominator
of which is the total number of NHCEs in
all prior year subgroups.
(iv)Examples. The following examples
illustrate the application of this paragraph
(c)(4):
Example 1. (i) Employer B maintains two
calendar year plans, Plan O and Plan P, each of
which includes a cash or deferred arrangement.
The plans were not permissively aggregated under
§1.410(b)–7(d) for the 2005 plan year. Both plans
use the prior year testing method. Plan O had 300
eligible employees who were NHCEs for the 2005
plan year, and their ADP for that year was 6%.
Sixty of the eligible employees who were NHCEs
for the 2005 plan year under Plan O, terminated
their employment during that year. Plan P h
ad 100
eligible employees who were NHCEs for 2005, and
the ADP for those NHCEs for that plan was 4%.
Plan O and Plan P are permissively aggreg
ated under
§1.410(b)–7(d) for the 2006 plan year.
(ii) The permissive aggregation of Plan O and
Plan P for the 2006 plan year under § 1
.410(b)–7(d)
is a plan coverage change that results in treating
the plans as one plan (Plan OP) for purposes of
§1.401(k)–1(b)(4). Therefore, t
he prior year ADP
for the NHCEs under Plan OP for the 2006 plan year
is the weighted average of the ADPs for the prior
year subgroups: the Plan O pri
or year subgroup and
the Plan P prior year subgroup.
(iii) The Plan O prior year subgroup consists of
the 300 employees who, in the
2005 plan year, were
eligible NHCEs under Plan O and who would have
been eligible under Plan OP for the 2005 plan year if
Plan O and Plan P had been per
missively aggregated
for that plan year. The Plan P prior year subgroup
consists of the 100 employees who, in the 2005 plan
year, were eligible NH
CEs under Plan P and would
have been eligible under Plan OP for the 2005 plan
year if Plan O and Plan P had been permissively ag-
gregated for that pla
n year.
(iv) The weighted average of the ADPs for the
prior year subgroups is the sum of the adjusted ADP
for the Plan O prior
year subgroup and the adjusted
ADP for the Plan P prior year subgroup. The adjusted
ADP for the Plan O prior year subgroup is 4.5%, cal-
culated as follow
s: 6% (the ADP for the NHCEs un-
der Plan O for the 2005 plan year) x 300/400 (the
number of NHCEs in the Plan O prior year subgroup
divided by the t
otal number of NHCEs in all prior year
subgroups). The adjusted ADP for the Plan P prior
year subgroup is 1%, calculated as follows: 4% (the
ADP for the NH
CEs under Plan P for the 2005 plan
year) x 100/400 (the number of NHCEs in the Plan
P prior year subgroup divided by the total number of
NHCEs in all
prior year subgroups). Thus, the prior
year ADP for NHCEs under Plan OP for the 2006
September 2, 20034672003-35 I.R.B.

plan year is 5.5% (the sum of adjusted ADPs for the
prior year subgroups, 4.5% plus 1%).
(v) As provided in paragraph (c)(4)(iii)(B) of this
section, the determination of whether an NHCE is
a member of a prior year subgroup is made without
regard to whether that NHCE terminated employed
during the prior year. Thus, the prior ADP for the
NHCEs under Plan OP for the 2006 plan year is un-
affected by the termination of the 60 NHCEs covered
by Plan O during the 2005 plan year.
Example 2. (i) The facts are the same asExample
1, except that the 60 employees who terminated em-
ployment during the 2005 plan are instead spun-off to
another plan.
(ii) The permissive aggregation of Plan O and
Plan P for the 2006 plan year under §1.410(b)–7(d)
is a plan coverage change that results in treating
the 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 prior
year ADP for the NHCEs under Plan OP for the 2006
plan year is the weighted average of the ADPs for the
prior year subgroups: the Plan O prior year subgroup
and the Plan P prior year subgroup.
(iii) For purposes of determining the prior year
subgroups, 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 coverage
changes had first been effective as of the first day
of the prior plan year. The Plan O prior year su
b-
group consists of the 240 employees who, in the 2005
plan year, were eligible NHCEs under Plan O and
would have been eligible under Plan OP f
or the 2005
plan year if the spin-off had occurred at the begin-
ningofthe2005planyearandPlanOandPlanPhad
been permissively aggregated under
§1.410(b)–7(d)
for that plan year. The Plan P prior year subgroup
consists of the 100 employees who, in the 2005 plan
year, were eligible NHCEs under Pl
an P and would
have been eligible under Plan OP for the 2005 plan
year 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 the
prior year subgroups is the sum of the adjusted ADP
with respect to the prior year
subgroup consisting of
eligible NHCEs from Plan O and the adjusted ADP
with respect to the prior year subgroup consisting of
eligible NHCEs from Plan P
. The adjusted ADP for
the prior year subgroup consisting of eligible NHCEs
under Plan O is 4.23%, calculated as follows: 6% (the
ADP for the NHCEs under P
lan O for the 2005 plan
year) x 240/340 (the number of NHCEs in that prior
year subgroup divided by the total number of NHCEs
in all prior year subg
roups). The adjusted ADP for the
prior year subgroup consisting of the eligible NHCEs
from Plan P is 1.18%, calculated as follows: 4% (the
ADP for the NHCEs un
der Plan P for the 2005 plan
year) x 100/340 (the number of NHCEs in that prior
year subgroup divided by the total number of NHCEs
in all prior year
subgroups). Thus, the prior year ADP
for NHCEs under Plan OP for the 2006 plan year is
5.41% (the sum of adjusted ADPs for the prior year
subgroups, 4.
23% plus 1.18%).
Example 3. (i) The facts are the same as inExam-
ple 1, except that instead of Plan O and Plan P being
permissively
aggregated for the 2006 plan year, 200
of the employees eligible under Plan O were spun-off
from Plan O and merged into Plan P.
(ii) The spin-off from Plan O and merger to Plan P
for the 2006 plan year are plan coverage changes for
Plan P. Therefore, the prior year ADP for the NHCEs
under Plan P for the 2006 plan year is the weighted
average of the ADPs for the prior year subgroups un-
der Plan P. There are 2 subgroups under Plan P for
the 2006 plan year. The Plan O prior year subgroup
consists of the 200 employees who, in the 2005 plan
year, were eligible NHCEs under Plan O and who
would have been eligible under Plan P for the 2005
plan year if the spin-off and merger had occurred on
the first day of the 2005 plan year. The Plan P prior
year subgroup consists of the 100 employees who, in
the 2005 plan year, were eligible NHCEs under Plan
P for the 2005 plan year.
(iii) The weighted average of the ADPs for the
prior year subgroups is the sum of the adjusted ADP
for the Plan O prior year subgroup and the adjusted
ADP for the Plan P prior year subgroup. The adjusted
ADP 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 (the
number of NHCEs in the Plan O prior year subgroup
divided by the total number of NHCEs in all prior ye
ar
subgroups). The adjusted ADP for the Plan P prior
year subgroup is 1.33%, calculated as follows: 4%
(the ADP for the NHCEs under Plan P for the 2
005
plan year) x 100/300 (the number of NHCEs in the
Plan P prior year subgroup divided by the total num-
ber of NHCEs in all prior year subgroups
). Thus, the
prior year ADP for NHCEs under Plan P for the 2006
plan year is 5.33% (the sum of adjusted ADPs for the
2 prior year subgroups, 4.0% plus 1
.33%).
(iv) The spin-off from Plan O for the 2006 plan
year is a plan coverage change for Plan O. There-
fore, the prior year ADP for the NH
CEs under Plan
O for the 2006 plan year is the weighted average of
the ADPs for the prior year subgroups under Plan O.
In this case, there is only one p
rior 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. Because
there is only one prior year subgroup under Plan O,
the weighted average of the ADPs for the prior year
subgroup under Plan O is e
qual to the NHCE ADP for
the prior year (2005 plan year) under Plan O, or 6%.
Example 4. (i) Employer C maintains a calendar
year plan, Plan Q, whic
h includes a cash or deferred
arrangement 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 employees
who were NHCEs, and the ADP for those NHCEs for
2005 was 2%. Effective January 1, 2006, Employer
C amends the eligib
ility provisions under Plan Q to
exclude employees of Division B effective January 1,
2006. In addition, effective on that same date, Em-
ployer C establ
ishes a new calendar year plan, Plan
R, which includes a cash or deferred arrangement that
uses the prior year testing method. The only eligible
employees und
er 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 meaning
of paragraph
(c)(2)(iii) of this section (because all of
the employees were eligible employees under Plan Q
in the prior year). Therefore, Plan R cannot use the
first plan y
ear rule set forth in paragraph (c)(2)(i) of
this section.
(iii) The amendment to the eligibility provisions
of Plan Q an
d 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 NHCE
ADP for the 2006 plan year under the rules set forth
in paragraph (c)(4) of this section.
(iv) The prior year ADP for NHCEs under Plan Q
is the weighted average of the ADPs for the prior year
subgroups. Plan Q has only one prior year subgroup
(becausetheonlyNHCEswhowouldhavebeeneli-
gible employees under Plan Q for the 2005 plan year
if the amendment to the Plan Q eligibility provisions
had occurred as of the first day of that plan year were
eligible employees under Plan Q). Therefore, for pur-
poses of the 2006 plan year under Plan Q, the ADP
for NHCEs for the prior year is the weighted average
of the ADPs for the prior year subgroups, or 2%, the
same 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 have
been eligible employees under Plan R for the 2005
plan year if the plan were established as of the first
day of that plan year were eligible employees under
Plan Q). Therefore, for purposes of the 2006 testing
year under Plan R, the ADP for NHCEs for the prior
year is the weighted average of the ADPs for the prior
year subgroups, or 2%, the same as that of Plan Q.
Example 5. (i) The facts are the same as inExam-
ple 4, except that the provisions of Plan R extend eli-
gibility to 50 hourly employees who previously were
not eligible employees under any qualified
cash or de-
ferred arrangement maintained by Employer C.
(ii) Plan R is a successor plan (because 100 of
Plan R's 150 eligible employees were el
igible em-
ployees under another qualified cash or deferred ar-
rangement maintained by Employer C in the prior
year). Therefore,Plan R cannot use t
he first plan year
rule 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. Becau
se the 50 hourly
employees were not eligible employees under any
qualified cash or deferred arrangement of Employer
C for the prior plan year, they do
not comprise a prior
year subgroup. Accordingly, Plan R still has only one
prior year subgroup. Therefore, for purposes of the
2006 testing year under Plan R
, the ADP for NHCEs
for the prior year is the weighted average of the ADPs
for the prior year subgroups, or 2%, the same as that
of Plan Q.
§1.401(k)–3 Safe harbor r
equirements.
(a)ADP test safe harbor.A
cash or de-
ferred arrangement sati
sfies the ADP safe
harbor provision of sect
ion 401(k)(12) for
a plan year if the arran
gement satisfies
thesafeharborcontr
ibution requirement of
paragraph (b) or (c)
of this section for the
plan year, the notic
e requirement of para-
graph (d) of this se
ction, the plan year re-
quirements of para
graph (e) of this sec-
tion, and the add
itional rules of paragraphs
(f), (g) and (h) o
f this section, as applica-
ble. Pursuant t
o section 401(k)(12)(E)(ii),
thesafeharbor
contribution requirement of
paragraph (b)
or (c) of this section must be
satisfied wit
hout regard to section 401(l).
2003-35 I.R.B.468September 2, 2003

The contributions made under paragraphs
(b)and(c)ofthissectionarereferredto
as safe harbor nonelective contributions
and safe harbor matching contributions, re-
spectively.
(b)Safe harbor nonelective contribu-
tion requirement—(1)General rule.The
safe harbor nonelective contribution re-
quirement of this paragraph is satisfied if,
under the terms of the plan, the employer
is required to make a qualified nonelective
contribution on behalf of each eligible
NHCE equal to at least 3% of the em-
ployee's safe harbor compensation.
(2)Safe harbor compensation de-
fined. For purposes of this section, safe
harbor compensation means compensa-
tion as defined in §1.401(k)–6 (which
incorporates 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 generally
permits a definition of compensation to
exclude all compensation in excess of a
specified dollar amount) does not apply in
determining the safe harbor compensation
of NHCEs. Thus, for example, the plan
may limit the period used to determine
safe harbor compensation to the eligible
employee's period of participation.
(c)Safe harbor matching contribution
requirement—(1)In general.Thesafe
harbor matching contribution requirement
of 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 in
paragraph (c)(2) of this section, or under
an enhanced matching formula of section
401(k)(12)(B)(i)(II), as described in para-
graph (c)(3) of this section.
(2)Basic matching formula.Under
the basic matching formula, each eligible
NHCE receives qualified matching con-
tributions in an amount equal to the sum
of—
(i) 100% of the amount of the em-
ployee's elective contributions that do not
exceed 3% of the employee's safe harbor
compensation; and
(ii) 50% of the amount of the em-
ployee's elective contributions that exceed
3% of the employee's safe harbor com-
pensation but that do not exceed 5% of the
employee's safe harbor compensation.
(3)Enhanced matching formula.Un-
der an enhanced matching formula, each
eligible NHCE receives a matching con-
tribution under a formula that, at any rate
of elective contributions by the employee,
provides an aggregate amount of qualified
matching contributions at least equal to the
aggregate amount of qualified matching
contributions that would have been pro-
vided under the basic matching formula of
paragraph (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 a
plan year to the employee's elective con-
tributions may not increase as the amount
of 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) is
not satisfied if the ratio of matching con-
tributions made on account of an HCE's
elective contributions under the cash or
deferred arrangement for a plan year to
those elective contributions is greater than
the ratio of matching contributions to elec-
tive contributions that would apply with
respect to any eligible NHCE with elec-
tive contributions at the same percentage
of safe harbor compensation.
(5)Use of safe harbor match not pre-
cluded by certain plan provisions—(i)
Safe harbor matching contributions on
employee contributions. The safe harbor
matching contribution requirement of this
paragraph (c) will not fail to be satisfied
merely because safe harbor matching
contributions are made on both elective
contributions and employee contributions
if safe harbor matching contributions are
made with respect to the sum of elective
contributions and employee contributions
on the same terms as safe harbor matching
contributions are made with respect to
elective contributions. Alternatively, the
safe harbor matching contribution require-
ment of this paragraph (c) will not fail
to be satisfied merely because safe har-
bor matching contributions are made on
both elective contributions and employee
contributions if safe harbor matching con-
tributions on elective contributions are
not affected by the amount of employee
contributions.
(ii)Periodic matching contributions.
The safe harbor matching contribution
requirement of this paragraph (c) will not
fail to be satisfied merely because the
plan provides that safe harbor matching
contributions will be made separately with
respect to each payroll period (or with
respect to all payroll periods ending with
or within each month or quarter of a plan
year) taken into account under the plan for
the plan year, provided that safe harbor
matching contributions with respect to any
elective contributions made during a plan
year quarter are contributed to the plan by
the last day of the immediately following
plan year quarter.
(6)Permissible restrictions on elective
contributions by NHCEs—(i)General
rule. The safe harbor matching contri-
bution requirement of this paragraph (c)
is not satisfied if elective contributions
by NHCEs are restricted, unless the re-
strictions are permitted by this paragraph
(c)(6).
(ii)Restrictions on election periods.A
plan may limit the frequency and dura-
tion of periods in which eligible employ-
ees may make or change cash or deferred
elections under a plan. However, an em-
ployee must have a reasonable opportunity
(including a reasonable period after receipt
of the notice described in paragraph (d) of
this section) to make or change a cash or
deferred election for the plan year. For pur-
poses of this paragraph (c)(6)(ii), a 30-day
period is deemed to be a reasonable period
to make or change a cash or deferred elec-
tion.
(iii)Restrictions on amount of elective
contributions. A plan is permitted to limit
the amount of elective contributions that
maybemadebyaneligibleemployee
under a plan, provided that each NHCE
whoisaneligibleemployeeispermitted
(unless the employee is restricted under
paragraph (c)(6)(v) of this section) to
make elective contributions in an amount
that is at least sufficient to receive the max-
imum amount of matching contributions
available under the plan for the plan year,
and the employee is permitted to elect any
lesser amount of elective contributions.
However, a plan may require eligible em-
ployees to make cash or deferred elections
in whole percentages of compensation or
whole dollar amounts.
(iv)Restrictions on types of compen-
sationthatmaybedeferred.Aplanmay
limit the types of compensation that may
be deferred by an eligible employee under
a plan, provided that each eligible NHCE
September 2, 20034692003-35 I.R.B.

is permitted to make elective contribu-
tions under a definition of compensation
that would be a reasonable definition
of compensation within the meaning of
§1.414(s)–1(d)(2). Thus, the definition of
compensation from which elective con-
tributions may be made is not required to
satisfy the nondiscrimination requirement
of §1.414(s)–1(d)(3).
(v)Restrictions due to limitations un-
der the Internal Revenue Code.Aplan
may limit the amount of elective contribu-
tions made by an eligible employee under
aplan—
(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 ability
to make elective contributions has been
suspended for 6 months in accordance
with §1.401(k)–1(d)(3)(iv)(E).
(7)Examples. The following examples
illustrate the safe harbor contribution re-
quirement of this paragraph (c):
Example 1. (i) Beginning January 1, 2006,
Employer A maintains Plan L covering employee
s
(including HCEs and NHCEs) in Divisions D and E.
Plan L contains a cash or deferred arrangement and
provides qualified matching contribut
ions equal to
100% of each eligible employee's elective contribu-
tions up to 3% of compensation and 50% of the next
2% of compensation. For purposes of th
e matching
contribution formula, safe harbor compensation is
defined as all compensation within the meaning of
section 415(c)(3) (a definition th
at satisfies section
414(s)). Also, each employee is permitted to make
elective contributions from all safe harbor com-
pensation within the meaning o
f section 415(c)(3)
and may change a cash or deferred election at any
time. Plan L limits the amount of an employee's
elective contributions for p
urposes of section 402(g)
and section 415, and, in the case of a hardship
distribution, suspends an employee's ability to make
elective contributions
for 6 months in accordance
with §1.401(k)–1(d)(3)(iv)(E). All contributions
under Plan L are nonforfeitable and are subject to the
withdrawal restrictio
ns of section 401(k)(2)(B). Plan
L provides for no other contributions and Employer
A maintains no other plans. Plan L is maintained on
a calendar-year basi
s and all contributions for a plan
year are made within 12 months after the end of the
plan year.
(ii) Based on these f
acts, matching contributions
under Plan L are safe harbor matching contributions
because they are qualified matching contributions
equal to the basic
matching formula. Accordingly,
Plan L satisfies the safe harbor contribution require-
ment of this paragraph (c).
Example 2.(i)Th
e facts are the same as inExam-
ple 1, except that instead of providing a basic match-
ing contribution, Plan L provides a qualified match-
ing contributi
on equal to 100% of each eligible em-
ployee's elective contributions up to 4% of safe harbor
compensation.
(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 of
elective contributions, provides an aggregate amount
of qualified matching contributions at least equal to
the aggregate amount of qualified matching contribu-
tions that would have been received under the basic
safe harbor matching formula, and the rate of match-
ing contributions does not increase as the rate of an
employee's elective contributions increases. Accord-
ingly, Plan L satisfies the safe harbor contribution re-
quirement of this paragraph (c).
Example 3.(i)ThefactsarethesameasinExam-
ple 1, except that instead of permitting each employee
to make elective contributions from all compensation
within 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 under
Plan L is a reasonable definition of compensation
within the meaning of §1.414(s)–1(d)(2).
(iii) Plan L will not fail to satisfy the safe harbor
contribution requirement of this paragraph (c) merely
because Plan L limits the amount of elective co
ntri-
butions and the types of compensation that may be
deferred by eligible employees, provided that each el-
igible NHCE may make elective contribution
sequal
to at least 4% of the employee's safe harbor compen-
sation.
Example 4.(i)Thefactsarethesameasi
nExam-
ple 1, except that Plan L provides that only employees
employed on the last day of the plan year will receive
a safe harbor matching contribution
.
(ii) Even if the plan that provides for employee
contributions and matching contributions satisfies the
minimum coverage requirements of se
ction 410(b)(1)
taking into account this last-day requirement, Plan L
would not satisfy the safe harbor contribution require-
ment of this paragraph (c) becau
se safe harbor match-
ing contributions are not made on behalf of all eligible
NHCEs who make elective contributions.
(iii) The result would be the sa
me if, instead of
providing safe harbor matching contributions under
an enhanced formula, Plan L provides for a 3% safe
harbor nonelective contri
bution that is restricted to el-
igible employees under the cash or deferred arrange-
ment who are employed on the last day of the plan
year.
Example 5. (i)ThefactsarethesameasinEx-
ample 1, except that instead of providing qualified
matching 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 un
der the basic matching formula,
while safe harbor matching contributions continue to
be provided to employees in Division D under the en-
hanced matching for
mula described inExample 2.
(ii) Even if Plan L satisfies §1.401(a)(4)–4 with
respect to each rate of matching contributions avail-
able to employees
under the plan, the plan would fail
to satisfy the safe harbor contribution requirement of
this paragraph (c) because the rate of matching con-
tributions with
respect to HCEs in Division D at a rate
of elective contributions between 3% and 5% would
be greater than that with respect to NHCEs in Divi-
sion E at the sam
e rate of elective contributions. For
example, an HCE in Division D who would have a
4% rate of elective contributions would have a rate
of matching contributions of 100% while an NHCE
in 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)General
rule. The notice requirement of this para-
graph (d) is satisfied for a plan year if each
eligible employee is given written notice
of the employee's rights and obligations
under the plan and the notice satisfies the
content requirement of paragraph (d)(2) of
this section and the timing requirement of
paragraph (d)(3) of this section.
(2)Content requirement—(i)General
rule. 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 the
plan; and
(B) Written in a manner calculated to be
understood 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 n
ot
considered sufficiently accurate and c
om-
prehensive unless the notice accurate
ly
describes—
(A) The safe harbor matching contribu-
tion or safe harbor nonelective contri
bu-
tion formula used under the plan (incl
ud-
ing a description of the levels of s
afe har-
bor matching contributions, if a
ny, avail-
able under the plan);
(B) Any other contributions unde
rthe
plan or matching contributions
to another
plan on account of elective cont
ributions
or employee contributions u
nder the plan
(including the potential f
or discretionary
matching contributions) a
nd the conditions
under which such contribu
tions are made;
(C) The plan to which safe ha
rbor con-
tributions will be made (i
fdifferentthan
the plan containing the ca
sh or deferred ar-
rangement);
(D) The type and amount o
f compensa-
tion that may be deferr
ed under the plan;
(E)Howtomakecashorde
ferred
elections, including
any administrative
requirements that app
ly to such elections;
(F) The periods avail
able under the plan
for making cash or def
erred elections;
(G) Withdrawal and ve
sting provisions
applicable to contri
butions under the plan;
and
2003-35 I.R.B.470September 2, 2003

(H) Information that makes it easy
to obtain additional information about
the plan (including an additional copy
of the summary plan description) such
as telephone numbers, addresses and, if
applicable, electronic addresses, of indi-
viduals or offices from whom employees
can obtain such plan information.
(iii)References to SPD.Aplanwillnot
fail to satisfy the content requirements of
this paragraph (d)(2) merely because, in
the case of information described in para-
graph (d)(2)(ii)(B) of this section (relat-
ing to any other contributions under the
plan), 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 (relating
to the type and amount of compensation
that may be deferred under the plan), the
notice cross-references the relevant por-
tions of a summary plan description that
provides the same information that would
be provided in accordance with such para-
graphs and that has been provided (or is
concurrently provided) to employees.
(3)Timing requirement—(i)General
rule. The timing requirement of this
paragraph (d)(3) is satisfied if the notice
is provided within a reasonable period
before the beginning of the plan year (or,
in the year an employee becomes eligi-
ble, within a reasonable period before
the employee becomes eligible). The de-
termination of whether a notice satisfies
the timing requirement of this paragraph
(d)(3) is based on all of the relevant facts
and circumstances.
(ii)Deemed satisfaction of timing re-
quirement. The timing requirement of this
paragraph (d)(3) is deemed to be satisfied
if at least 30 days (and no more than 90
days) before the beginning of each plan
year, the notice is given to each eligible
employee for the plan year. In the case of
an 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 before
the beginning of the plan year, the tim-
ing requirement is deemed to be satisfied
if the notice is provided no more than 90
days 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 the
first plan year in which an employee be-
comes eligible under an existing plan that
provides 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 requirements
of section 401(k)(12) and this section un-
less plan provisions that satisfy the rules of
this section are adopted before the first day
of the plan year and remain in effect for
an entire 12-month plan year. Moreover,
if, as described under paragraph (g)(4) of
this 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
be made in the other plan and providing
that the contributions will be QNECs or
QMACs must also be adopted before the
first day of that plan year.
(2)Initial plan year.Anewlyes-
tablished plan (other than a successor
plan within the meaning of §1.401(k)–
2(c)(2)(iii)) will notbe treated as violat-
ing the requirements of this paragraph
(e) merely because the plan year is less
than 12 months, provided that the plan
year is at least 3 months long (or, in the
case of a newly established employer that
establishes the plan as soon as administra-
tively feasible after the employer comes
into existence, a shorter period). Simi-
larly, a cash or deferred arrangement will
not fail to satisfy the requirement of this
paragraph (e) if it is added to an existing
profit sharing, stock bonus, or pre-ERISA
money purchase pension plan for the first
time 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 prior
to the end of the plan year.
(3)Change of plan year. A plan that
has a short plan year as a result of changing
its plan year will not fail to satisfy the re-
quirements of paragraph (e)(1) of this sec-
tion merely because the plan year has less
than 12 months, provided that—
(i) The plan satisfied the requirements
of this section for the immediately preced-
ing plan year; and
(ii) The plan satisfies the requirements
of 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 final
plan year is less than 12 months, provided
that—
(i) The plan would satisfy the require-
ments of paragraph (g) of this section,
treating the termination of the plan as a
reduction or suspension of safe harbor
matching contributions, other than the
requirement that employees have a rea-
sonable opportunity to change their cash
or deferred elections and, if applicable,
employee contribution elections; or
(ii) The plan termination is in connec-
tion with a transaction described in section
410(b)(6)(C) or the employer incurs a sub-
stantial business hardship comparable to a
substantial business hardship described in
section 412(d).
(f)Plan amendments adopting safe
harbor nonelective contributions—(1)
General rule. Notwithstanding paragraph
(e)(1) of this section, a plan that provides
for the use of the current year testing
method may be amended after the first
day of the plan year and no later than 30
days before the last day of the plan year to
adopt the safe harbor method of this sec-
tion using nonelective contributions under
paragraph (b) of this section, but only
if the plan provides the contingent and
follow-up notices described in this sec-
tion. A plan amendment made pursuant
to this paragraph (f)(1) for a plan year
may provide for the use of the safe harbor
method described in this section solely for
that plan year and a plan sponsor is not
limited in the number of years for which it
is permitted to adopt an amendment pro-
viding for the safe harbor method of this
section using nonelective contributions
under paragraph (b) of this section.
(2)Contingent notice provided.Aplan
satisfies the requirement to provide the
contingent notice under this paragraph
(f)(2) if it provides a notice that would sat-
isfy the requirements of paragraph (d) of
this section, except that, in lieu of setting
forth the safe harbor contributions used
under the plan as set forth in paragraph
(d)(2)(ii)(A) of this section, the notice
specifies that the plan may be amended
during the plan year to include the safe
harbor nonelective contribution and that,
if the plan is amended, a follow-up notice
will be provided.
September 2, 20034712003-35 I.R.B.

(3)Follow-up notice requirement.A
plan satisfies the requirement to provide
a follow-up notice under this paragraph
(f)(3) if, no later than 30 days before the
last day of the plan year, each eligible em-
ployee is given a notice that states that the
safe harbor nonelective contributions will
be made for the plan year. This notice
is 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 suspension
of safe harbor matching contributions—
(1)General rule. A plan that provides for
safe harbor matching contributions will not
fail to satisfy the requirements of section
401(k)(3) for a plan year merely because
the plan is amended during a plan year to
reduce or suspend safe harbor matching
contributions on future elective contribu-
tions (and, if applicable, employee contri-
butions) provided that—
(i) All eligible employees are provided
the supplemental notice in accordance
with paragraph (g)(2) of this section;
(ii) The reduction or suspension of safe
harbor matching contributions is effective
no earlier than the later of 30 days after
eligible employees are provided the no-
tice described in paragraph (g)(2) of this
section and the date the amendment is
adopted;
(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 contributions
to change their cash or deferred elections
and, if applicable, their employee contri-
bution elections;
(iv) The plan is amended to provide that
the ADP test will be satisfied for the entire
plan year in which the reduction or suspen-
sion occurs using the current year testing
method described in §1.401(k)–2(a)(2)(ii);
and
(v) The plan satisfies the requirements
of this section (other than this paragraph
(g)) with respect to amounts deferred
through the effective date of the amend-
ment.
(2)Notice of suspension requirement.
The notice of suspension requirement of
this paragraph (g)(2) is satisfied if each
eligible employee is given a written notice
that explains—
(i) The consequences of the amendment
which reduces or suspends matching con-
tributions on future elective contributions
and, if applicable, employee contributions;
(ii) The procedures for changing their
cash or deferred election and, if applicable,
their employee contribution elections; and
(iii) The effective date of the amend-
ment.
(h)Additional rules—(1)Contributions
taken into account. A contribution is taken
into account for purposes of this section
for a plan year if and only if the contribu-
tion would be taken into account for such
plan year under the rules of §1.401(k)–2(a)
or 1.401(m)–2(a). Thus, for example, a
safe harbor matching contribution must be
made within 12 months of the end of the
plan year. Similarly, an elective contribu-
tion that would be taken into account for a
plan year under §1.401(k)–2(a)(4)(i)(B)(2)
must be taken into account for such plan
year for purposes of this section, even if the
compensation would have been received
after the close of the plan year.
(2)Use of safe harbor nonelective
contributions to satisfy other nondiscrim-
ination tests. A safe harbor nonelective
contribution used to satisfy the non-
elective contribution requirement under
paragraph (b) of this section may also be
taken into account for purposes of deter-
mining whether a plan satisfies section
401(a)(4). Thus, these contributions are
not subject to the limitations on qual-
ified nonelective contributions under
§1.401(k)–2(a)(6)(ii), but are subject to
the 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), to
the extent they are needed to satisfy the
safe harbor contribution requirement of
paragraph (b) of this section, safe har-
bor nonelective contributions may not
be taken into account under any plan for
purposes of section 401(l) (including the
imputation of permitted disparity under
§1.401(a)(4)–7).
(3)Early participation rules. Section
401(k)(3)(F) and §1.401(k)–2(a)(1)(iii)(A),
which provide an alternative nondis-
crimination rule for certain plans that
provide for early participation, do not
apply for purposes of section 401(k)(12)
and this section. Thus, a plan is not
treated as satisfying this section with
respect to the eligible employees who
have not completed the minimum age
and service requirements of section
410(a)(1)(A) unless the plan satisfies the
requirements of this section with respect
to such eligible employees.
(4)Satisfying safe harbor contribution
requirement under another defined contri-
bution plan. Safe harbor matching or non-
elective contributions may be made to the
plan that contains the cash or deferred ar-
rangement or to another defined contribu-
tion plan that satisfies section 401(a) or
403(a). If safe harbor contributions are
made to another defined contribution plan,
the safe harbor plan must specify the plan
to which the safe harbors are made and
contribution requirement of paragraph (b)
or (c) of this section must be satisfied in
the other defined contribution plan in the
same manner as if the contributions were
made to the plan that contains the cash or
deferred arrangement. Consequently, the
plan to which the contributions are made
must have the same plan year as the plan
containing the cash and deferred arrange-
ment and each employee eligible under the
plan containing the cash or deferred ar-
rangement must be eligible under the same
conditions under the other defined contri-
bution plan. The plan to which the safe
harbor contributions are made need not be
a plan that can be aggregated with the plan
that contains the cash or deferred arrange-
ment.
(5)Contributions used only once.Safe
harbor matching or nonelective contribu-
tions cannot be used to satisfy the require-
ments of this section with respect to more
than one plan.
§1.401(k)–4 SIMPLE 401(k) plan
requirements.
(a)General rule. A cash or deferred
arrangement satisfies the SIMPLE 401(k)
plan provision of section 401(k)(11) for a
plan year if the arrangement satisfies the
requirements of paragraphs (b) through (i)
of this section for that year. A plan that
contains a cash or deferred arrangement
that satisfies this section is referred to as
a SIMPLE 401(k) plan. Pursuant to sec-
tion 401(k)(11), a SIMPLE 401(k) plan is
treated as satisfying the ADP test of sec-
tion 401(k)(3)(A)(ii) for that year.
(b)Eligible employer—(1)General
rule. A SIMPLE 401(k) plan must be
2003-35 I.R.B.472September 2, 2003

established by an eligible employer. Eligi-
ble employer for purposes of this section
means, with respect to any plan year,
an employer that had no more than 100
employees who received at least $5,000
of SIMPLE compensation, as defined in
paragraph (e)(5) of this section, from the
employer for the prior calendar year.
(2)Special rule. An eligible employer
that establishes a SIMPLE 401(k) plan for
a plan year and that fails to be an eligi-
ble employer for any subsequent plan year,
is treated as an eligible employer for the
2 plan years following the last plan year
the employer was an eligible employer. If
the failure is due to any acquisition, dispo-
sition, or similar transaction involving an
eligible employer, the preceding sentence
applies only if the provisions of section
410(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) plan
participant 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 of
any SIMPLE 401(k) plan participant un-
der any other qualified plan maintained by
the employer. Other qualified plan for pur-
poses of this section means any plan, con-
tract, pension, or trust described in section
219(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) merely
because any SIMPLE401(k) plan partic-
ipant receives an allocation of forfeitures
under another plan of the employer.
(d)Election and notice—(1)General
rule. An eligible employer establishing or
maintaining a SIMPLE 401(k) plan must
satisfy the election and notice require-
ments in paragraphs (d)(2) and (d)(3) of
this section.
(2)Employee elections—(i)Initial plan
year of participation. For the plan year in
which an employee first becomes eligible
under the SIMPLE 401(k) plan, the em-
ployee must be permitted to make a cash
or deferred election under the plan during
a 60-day period that includes either the day
the employee becomes eligible or the day
before.
(ii)Subsequent plan years. For each
subsequent plan year, each eligible em-
ployee must be permitted to make or mod-
ify his cash or deferredelectionduringthe
60-day period immediately preceding such
plan year.
(iii)Election to terminate.Aneligible
employee must be permitted to terminate
his cash or deferred election at any time.
If an employee does terminate his cash or
deferred election, the plan is permitted to
provide that such employee cannot have
elective contributions made under the plan
fortheremainderoftheplanyear.
(3)Employee notices. The employer
must notify each eligible employee within
a reasonable time prior to each 60-day
election period, or on the day the election
period starts, that he or she can make a cash
or deferred election, or modify a prior elec-
tion, if applicable, during that period. The
notice must state whether the eligible em-
ployer will make the matching contribu-
tions described in paragraph (e)(3) of this
section 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 contributions
may be made to the SIMPLE 401(k) plan
during such year, other than contributions
described in this paragraph (e) and rollover
contributions described in §1.402(c)–2,
Q&A–1(a).
(2)Elective contributions. Subject to
the limitations on annual additions un-
der section 415, each eligible employee
must be permitted to make an election
to have up to $10,000 of elective contri-
butions made on the employee's behalf
under the SIMPLE 401(k) plan for a plan
year. The $10,000 limit is increased be-
ginning in 2006 in the same manner as
the $160,000 amount is adjusted under
section 415(d), except that pursuant to
section 408(p)(2)(E)(ii) the base period
shall be the calendar quarter beginning
July 1, 2004, and any increase which is
not a multiple of $500 is rounded to the
next lower multiple of $500.
(3)Matching contributions. Each plan
year, the eligible employer must contribute
a matching contribution to the account of
each eligible employee on whose behalf
elective contributions were made for the
plan year. The amount of the matching
contribution must equal the lesser of the
eligible employee's elective contributions
for the plan year or 3% of the eligible em-
ployee's SIMPLE compensation for the en-
tire plan year.
(4)Nonelective contributions.Forany
plan year, in lieu of contributing matching
contributions described in paragraph (e)(3)
of this section, an eligible employer may,
in accordance with plan terms, contribute a
nonelective contribution to the account of
each eligible employee in an amount equal
to 2% of the eligible employee's SIMPLE
compensation for the entire plan year. The
eligible 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 for
the entire plan year.
(5)SIMPLE compensation. Except
as otherwise provided, the term SIMPLE
compensation for purposes of this section
means the sum of wages, tips, and other
compensation from the eligible employer
subject to federal income tax withholding
(as described in section 6051(a)(3)) and
the employee's elective contributions made
under 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 section
457 plan, required to be reported by the
employer on Form W–2 (as described in
section 6051(a)(8)). For self-employed in-
dividuals, SIMPLE compensation means
net earnings from self-employment de-
termined under section 1402(a) prior to
subtracting any contributions made under
the SIMPLE 401(k) plan on behalf of the
individual.
(f)Vesting. All benefits attributable to
contributions described in paragraph (e) of
this section must be nonforfeitable at all
times.
(g)Plan year. The plan year of a SIM-
PLE 401(k) plan must be the whole cal-
endar year. Thus, in general, a SIMPLE
401(k) plan can be established only on Jan-
uary 1 and can be terminated only on De-
cember 31. However, in the case of an
employer that did not previously maintain
a SIMPLE 401(k) plan, the establishment
date can be as late as October 1 (or later in
the case of an employer that comes into ex-
istence after October 1 and establishes the
SIMPLE 401(k) plan as soon as adminis-
tratively feasible after the employer comes
into existence).
(h)Other rules. A SIMPLE 401(k) plan
is not treated as a top-heavy plan under
section 416. See section 416(g)(4)(G).
September 2, 20034732003-35 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 of
section 401(k) and the regulations thereun-
der.
Actual contribution percentage (ACP)
test.Actual contribution percentage test
orACP testmeans the test described in
§1.401(m)–2(a)(1).
Actual deferral percentage (ADP).Ac-
tual deferral percentageorADPmeans the
ADP of the group of eligible employees as
defined in §1.401(k)–2(a)(2).
Actual deferral percentage (ADP)
test.Actual deferral percentage testor
ADP testmeans the test described in
§1.401(k)–2(a)(1).
Actual deferral ratio (ADR).Actual
deferral ratioorADRmeans the ADR
of an eligible employee as defined in
§1.401(k)–2(a)(3).
Cash or deferred arrangement.Cash
or deferred arrangementis defined in
§1.401(k)–1(a)(2).
Cash or deferred election.Cash
or deferred electionis defined in
§1.401(k)–1(a)(3).
Compensation. Compensationmeans
compensation as defined in section 414(s)
and §1.414(s)–1. The period used to de-
termine an employee's compensation for
a plan year must be either the plan year
or the calendar year ending within the
plan year. Whichever period is selected
must be applied uniformly to determine
the compensation of every eligible em-
ployee under the plan for that plan year.
A plan may, however, limit the period
taken into account under either method
to that portion of the plan year or cal-
endar year in which the employee was
an eligible employee, provided that this
limit is applied uniformly to all eligible
employees under the plan for the plan
year. In the case of an HCE whose ADR
is 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 section
401(a)(17) and §1.401(a)(17)–1(c)(1).
Current year testing method.Current
year testing methodmeans the testing
method described in §1.401(k)–2(a)(2)(ii)
or §1.401(m)–2(a)(2)(ii) under which the
applicable year is the current plan year.
Elective contributions.Elective con-
tributionsmeans employer contributions
made to a plan pursuant to a cash or de-
ferred election under a cash or deferred
arrangement (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 employeemeans an employee who
is directly or indirectly eligible to make a
cash or deferred election under the plan for
all or a portion of the plan year. For exam-
ple, if an employee must perform purely
ministerial or mechanical acts (e.g.,formal
application for participation or consent to
payroll withholding) in order to be eligible
to make a cash or deferred election for a
plan year, the employee is an eligible em-
ployee for the plan year without regard to
whether the employee performs the acts.
(2)Conditions on eligibility.Anem-
ployee who is unable to make a cash or
deferred election because the employee
has not contributed to another plan is
also an eligible employee. By contrast,
if an employee must perform additional
service (e.g., satisfy a minimum period
of service requirement) in order to be eli-
gible to make a cash or deferred election
for a plan year, the employee is not an
eligible employee for the plan year unless
the service is actually performed. See
§1.401(k)–1(e)(5), however, for certain
limits on the use of minimum service re-
quirements. An employee who would be
eligible to make elective contributions but
for a suspension due to a distribution, a
loan, or an election not to participate in the
plan, is treated as an eligible employee for
purposes of section 401(k)(3) for a plan
year even though the employee may not
make a cash or deferred election by reason
of the suspension. Finally, an employee
does not fail to be treated as an eligible
employee merely because the employee
may receive no additional annual additions
because of section 415(c)(1).
(3)Certain one-time elections.Anem-
ployee is not an eligible employee merely
because the employee, upon commencing
employment with the employer or upon the
employee's first becoming eligible to make
a 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 maintained
by the employer (including plans not yet
established) for the duration of the em-
ployee's employment with the employer.
This rule applies in addition to the rules
in §1.401(k)–1(a)(3)(v) relating to the def-
inition of a cash or deferred election. In
no event is an election made after De-
cember 23, 1994, treated as a one-time ir-
revocable election under this paragraph if
theelectionismadebyanemployeewho
previously became eligible under another
plan (whether or not terminated) of the em-
ployer.
Eligible HCE. Eligible HCEmeans an
eligible employee who is an HCE.
Eligible NHCE. Eligible NHCEmeans
an eligible employee who is not an HCE.
Employee. Employeemeans an em-
ployee within the meaning of §1.410(b)–9.
Employee stock ownership plan
(ESOP). Employee stock ownership plan
orESOPmeans the portion of a plan
that is an ESOP within the meaning of
§1.410(b)–7(c)(2).
Employer. Employermeans an em-
ployer within the meaning of §1.410(b)–9.
Excess contributions. Excess contri-
butionsmeans, with respect to a plan
year, the amount of total excess contri-
butions apportioned to an HCE under
§1.401(k)–2(b)(2)(iii).
Excess deferrals. Excess deferrals
means excess deferrals as defined in
§1.402(g)–1(e)(3).
Highly compensated employee (HCE).
Highly compensated employeeorHCEhas
the meaning provided in section 414(q).
Matching contributions. Matching con-
tributionsmeans matching contributions
as defined in §1.401(m)–1(a)(2).
Nonelective contributions. Nonelective
contributionsmeans employer contribu-
tions (other than matching contributions)
with respect to which the employee may
not elect to have the contributions paid
to the employee in cash or other benefits
instead of being contributed to the plan.
Non-employee stock ownership plan
(non-ESOP). Non-employee stock owner-
ship planornon-ESOPmeans the portion
of a plan that is not an ESOP within the
meaning of §1.410(b)–7(c)(2).
2003-35 I.R.B.474September 2, 2003

Non-highly compensated employee
(NHCE). Non-highly compensated em-
ployeeorNHCEmeans an employee who
is not an HCE.
Plan.Planis defined in
§1.401(k)–1(b)(4).
Pre-ERISA money purchase pension
plan.(1)Pre-ERISA money purchase
pension planis 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, included
a salary reduction agreement; and
(iii) Under which neither the employee
contributions nor the employer contri-
butions, including elective contributions,
may exceed the levels (as a percentage of
compensation) 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 or
before that date, even if no funds had yet
been paid to the trust associated with the
plan.
Prior year testing method. Prior
year testing methodmeans the test-
ing method under which the appli-
cable year is the prior plan year, as
described in §1.401(k)–2(a)(2)(ii) or
§1.401(m)–2(a)(2)(ii).
Qualified matching contributions
(QMACs). Qualified matching con-
tributionsorQMACsmeans matching
contributions that, except as provided
otherwise in §1.401(k)–1(c) and (d), sat-
isfy the requirements of §1.401(k)–1(c)
and (d) as though the contributions were
elective contributions, without regard
to whether the contributions are actu-
ally taken into account under the ADP
test under §1.401(k)–2(a)(6) or the ACP
test under §1.401(m)–2(a)(6). Thus, the
matching contributions must satisfy the
vesting requirements of §1.401(k)–1(c)
and be subject to the distribution re-
quirements of §1.401(k)–1(d) when they
are contributed to the plan. See also
§1.401(k)–2(b)(4)(iii) for a rule providing
that a matching contribution does not fail
to qualify as a QMAC solely because it
is forfeitable under section 411(a)(3)(G)
because it is a matching contribution with
respect to an excess deferral, excess con-
tribution, or excess aggregate contribution.
Qualified nonelective contributions
(QNECs). Qualified nonelective con-
tributionsorQNECsmeans 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 to
whether the contributions are actually
taken into account under the ADP test
under §1.401(k)–2(a)(6) or the ACP test
under §1.401(m)–2(a)(6). Thus, the non-
elective contributions must satisfy the
vesting requirements of §1.401(k)–1(c)
and be subject to the distribution require-
ments of §1.401(k)–1(d) when they are
contributedtotheplan.
Rural cooperative plans. Rural cooper-
ative planmeans a plan described in sec-
tion 401(k)(7).
Par. 3. Sections 1.401(m)–0 through
1.401(m)–2 are revised and sections
1.401(m)–3 through 1.401(m)–5 are
added 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)–1
through 1.401(m)–5.
LIST OF SECTIONS
§1.401(m)–1 Employee contributions and
matching 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 and
matching 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 or
elective 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 for
amount of contributions.
(1) Matching contributions and employee
contributions.
(2) Automatic satisfaction by certain plans.
(3) Anti-abuse provisions.
(4) Aggregation and restructuring.
(i) In general.
(ii) Aggregation of employee contributions
and matching contributions within a plan.
(iii) Aggregation of plans.
(A) In general.
(B) Arrangements with inconsistent ACP
testing methods.
(iv) Disaggregation of plans and separate
testing.
(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 under
current year and prior year testing method.
(3) Determination of ACR.
(i) General rule.
(ii) ACR of HCEs eligible under more than
one plan.
(A) General rule.
(B) Plans not permitted to be aggregated.
(iii) Example.
(4) Employee contributions and matching
contributions taken into account under the
ACP test.
(i) Employee contributions.
(ii) Recharacterized elective contributions.
(iii) Matching contributions.
(5) Matching contributions not taken into
account under the ACP test.
September 2, 20034752003-35 I.R.B.

(i) General rule.
(ii) Disproportionate matching contribu-
tions.
(A) Matching contributions in excess of
100%.
(B) Representative matching rate.
(C) Definition of matching rate.
(iii) Qualified matching contributions used
to 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 and
elective contributions that may be taken
into 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 not
taken into account.
(A) General rule.
(B) Definition of representative contribu-
tion rate.
(C) Definition of applicable contribution
rate.
(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 excess
aggregate contributions for each HCE.
(B) Determination of the total amount of
excess aggregate contributions.
(C) Satisfaction of ACP.
(iii) Apportionment of total amount of
excess aggregate contributions among the
HCEs.
(A) Calculate the dollar amount of excess
aggregate contributions for each HCE.
(B) Limit on amount apportioned to any
HCE.
(C) Apportionment to additional HCEs.
(iv) Income allocable to excess aggregate
contributions.
(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 gap
period income.
(E) Alternative method of allocating plan
year and gap period income.
(F) Allocable income for recharacterized
elective contributions.
(v) Distribution and forfeiture.
(vi) Tax treatment of corrective distribu-
tions.
(A) General rule.
(B) Rule forde minimisdistributions.
(3) Other rules.
(i) No employee or spousal consent re-
quired.
(ii) Treatment of corrective distributions
and forfeited contributions as employer
contributions.
(iii) No reduction of required minimum
distribution.
(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 2
1
/2months
after 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 testing
method.
(1) Rules for change in testing method.
(2) Calculation of ACP under the prior year
testing 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 methods
for the ACP and ADP test.
(4) Rules for plan coverage change.
(i) In general.
(ii) Optional rule for minor plan coverage
changes.
(iii) Definitions.
(A) Plan coverage change.
(B) Prior year subgroup.
(C) Weighted average of the ACPs for the
prior year subgroups.
(iv) Examples.
§1.401(m)–3 Safe harbor requirements.
(a) ACP test safe harbor.
(b) Safe harbor nonelective contribution
requirement.
(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 compensation
that may be deferred.
(v) Restrictions due to limitations under
the 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 nonelective
safe harbor contributions.
(h) Permissible reduction or suspension of
safe 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 nondiscrimination
tests.
(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 to
employee 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 and
matching contributions.
(a)Generalnondiscrimination
rules—(1)Nondiscriminatory amount
of contributions—(i)Exclusive means of
2003-35 I.R.B.476September 2, 2003

amounts testing. A defined contribution
plan does not satisfy section 401(a) for a
plan year unless the amount of employee
contributions and matching contributions
to the plan for the plan year satisfies sec-
tion 401(a)(4). The amount of employee
contributions and matching contributions
under a plan satisfies the requirements of
section 401(a)(4) with respect to amounts
if and only if the amount of employee
contributions and matching contributions
satisfies the nondiscrimination test of sec-
tion 401(m) under paragraph (b) of this
section and the plan satisfies the additional
requirements 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 employee
contributions or matching contributions
must satisfy the requirements of section
401(a)(4) relating to benefits, rights and
features in addition to the requirement
regarding amounts described in paragraph
(a)(1)(i) of this section. For example,
the right to make each level of employee
contributions and the right to each level
of matching contributions under the plan
are benefits, rights or features subject to
the requirements of section 401(a)(4).
See §1.401(a)(4)–4(e)(3)(i) and (iii)(F)
through (G).
(2)Matching contributions—(i)In
general. For purposes of section 401(m),
this section and §§1.401(m)–2 through
1.401(m)–5, matching contributions are—
(A) Any employer contribution (includ-
ing a contribution made at the employer's
discretion) to a defined contribution plan
on account of an employee contribution to
a plan maintained by the employer;
(B) Any employer contribution (includ-
ing a contribution made at the employer's
discretion) to a defined contribution plan
on account of an elective deferral; and
(C) Any forfeiture allocated on the basis
of employee contributions, matching con-
tributions, or elective deferrals.
(ii)Employer contributions made on
account of an employee contribution or
elective deferral.Whether an employer
contribution is made on account of an
employee contribution or an elective de-
ferral is determined on the basis of all the
relevant facts and circumstances, includ-
ing the relationship between the employer
contribution and employee actions outside
the plan. An employer contribution made
to a defined contribution plan on account
of contributions made by an employee
under an employer-sponsored savings
arrangement that are not held in a plan
that is intended to be a qualified plan or a
plan described in §1.402(g)–1(b) is not a
matching contribution.
(iii)Employer contributions not on ac-
count of an employee contribution or elec-
tive deferral. An employer contribution is
not 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 which
the elective deferral is made (or when the
cash that is subject to the cash or deferred
election would be currently available, if
earlier). In addition, an employer contri-
bution is not a matching contribution made
on account of an employee contribution if
it is contributed before the employee con-
tribution.
(3)Employee contributions—(i)In
general. For purposes of section 401(m),
this section and §§1.401(m)–2 through
1.401(m)–5, employee contributions are
contributions to a plan that are designated
or treated at the time of contribution as
after-tax employee contributions (e.g.,
by treating the contributions as taxable
income subject to applicable withholding
requirements) and are allocated to an indi-
vidual account for each eligible employee
to which attributable earnings and losses
are allocated. See §1.401(k)–1(a)(2)(ii).
The termemployee contributionsin-
cludes—
(A) Employee contributions to the de-
fined contribution portion of a plan de-
scribedinsection414(k);
(B) Employee contributions applied to
the purchase of whole life insurance pro-
tection or survivor benefit protection under
a defined contribution plan;
(C) Amounts attributable to excess
contributions within the meaning of
section 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 or
contract that satisfies the requirements of
section 403(b).
(ii)Certain contributions not treated as
employee contributions.Thetermem-
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 transferred
to the plan from another plan.
(iii)Qualified cost-of-living arrange-
ments. Employee contributions to a
qualified cost-of-living arrangement de-
scribed in section 415(k)(2)(B) are treated
as employee contributions to a defined
contribution plan, without regard to the
requirement that the employee contribu-
tions be allocated to an individual account
to which attributable earnings and losses
are allocated.
(b)Nondiscrimination requirements for
amount of contributions—(1)Matching
contributions and employee contributions.
The matching contributions and employee
contributions under a plan satisfy this
paragraph (b) for a plan year only if the
plan satisfies—
(i)The ACP test of section 401(m)(2)
described in §1.401(m)–2;
(ii) The ACP safe harbor provisions
of section 401(m)(11) described in
§1.401(m)–3; or
(iii) The SIMPLE 401(k) provisions of
sections 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 of
this section are treated as satisfied with
respect to employee contributions and
matching contributions under a collec-
tively bargained plan (or the portion of
a plan) that automatically satisfies sec-
tion 410(b). See §§1.401(a)(4)–1(c)(5)
and 1.410(b)–2(b)(7). Additionally, the
requirements of sections 401(a)(4) and
410(b) do not apply to a governmen-
tal plan (within the meaning of section
414(d)) maintained by a state or local gov-
ernment or political subdivision thereof
(or agency or instrumentality thereof). See
sections 401(a)(5)(G), 403(b)(12)(C) and
410(c)(1)(A).
(3)Anti-abuse provisions. Sections
1.401(m)–1 through 1.401(m)–5 are
designed to provide simple, practical
rules that accommodate legitimate plan
changes. At the same time, the rules are
intended to be applied by employers in a
manner that does not make use of changes
in plan testing procedures or other plan
provisions to inflate inappropriately the
ACPforNHCEs(whichisusedasa
benchmark for testing the ACP for HCEs)
or to otherwise manipulate the nondis-
crimination testing requirements of this
September 2, 20034772003-35 I.R.B.

paragraph (b). Further, this paragraph (b)
is part of the overall requirement that ben-
efits or contributions not discriminate in
favor of HCEs. Therefore, a plan will not
be treated as satisfying the requirements
of this paragraph (b) if there are repeated
changes to plan testing procedures or plan
provisions that have the effect of distorting
the ACP so as to increase significantly the
permitted ACP for HCEs, or otherwise
manipulate the nondiscrimination rules of
this paragraph, if a principal purpose of
the changes was to achieve such a result.
(4)Aggregation and restructuring—(i)
In general. This paragraph (b)(4) con-
tains the exclusive rules for aggregating
and disaggregating plans that provide for
employee 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 within
aplan. Except as otherwise specifically
provided in this paragraph (b)(4) and
§1.401(m)–3(f)(1), a plan must be subject
to a single test under paragraph (b)(1) of
this section with respect to all employee
contributions and matching contributions
and all eligible employees under the
plan. Thus, for example, if two groups
of employees are eligible for matching
contributions under a plan, all employee
contributions and matching contributions
under the plan must be subject to a single
test, even if they have significantly dif-
ferent features, such as different rates of
match.
(iii)Aggregation of plans—(A)In
general.Thetermplanmeans a plan
within the meaning of §1.410(b)–7(a) and
(b), after application of the mandatory
disaggregation 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 single
plan pursuant to the permissive aggrega-
tion rules of §1.410(b)–7(d) are treated
as a single plan for purposes of sections
401(k) and 401(m).
(B)Arrangements with inconsistent
ACP testing methods. Pursuant to para-
graph (b)(4)(ii) of this section, a single
testing method must apply with respect to
all employee contributions and matching
contributions 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 meaning
of §1.410(b)–7) that applies the current
year testing method may not be aggre-
gated with another plan that applies the
prior year testing method. Similarly, an
employer may not aggregate a plan (within
the meaning of §1.410(b)–7) that is using
the ACP safe harbor provisions of section
401(m)(11) and another plan that is using
the ACP test of section 401(m)(2).
(iv)Disaggregation of plans and sepa-
rate testing—(A)In general.Ifemployee
contributions or matching contributions
are included in a plan (within the meaning
of §1.410(b)–7(b)) that is mandatorily
disaggregated under the rules of section
410(b) (as modified by this paragraph
(b)(4)), the matching contributions and
employee contributions under that plan
must be disaggregated in a consistent
manner. For example, in the case of
an employer that is treated as operating
qualified separate lines of business under
section 414(r), if the eligible employees
under a plan which provides for employee
contributions or matching contributions
are in more than one qualified separate line
of business, only those employees within
each qualified separate line of business
may be taken into account in determining
whether each disaggregated portion of the
plan complies with the requirements of
section 401(m), unless the employer is ap-
plying the special rule for employer-wide
plans in §1.414(r)–1(c)(2)(ii) with re-
spect to the plan. Similarly, if a plan that
provides for employee contributions or
matching contributions under which em-
ployees are permitted to participate before
they have completed the minimum age and
service requirements of section 410(a)(1)
applies section 410(b)(4)(B) for determin-
ing whether the plan complies with section
410(b)(1), then the plan must be treated
as two separate plans, one comprising
all eligible employees who have met the
minimum age and service requirements of
section 410(a)(1) and one comprising all
eligible employees who have not met the
minimum age and service requirements of
section 410(a)(1), unless the plan is using
the rule in §1.401(m)–2(a)(1)(iii)(A).
(B)Restructuring prohibited.Restruc-
turing under §1.401(a)(4)–9(c) may not
be used to demonstrate compliance with
the requirements of section 401(m). See
§1.401(a)(4)–9(c)(3)(ii).
(v)Certain disaggregation rules not
applicable. The mandatory disaggre-
gation rules relating to section 401(k)
plans and section 401(m) plans set forth
in §1.410(b)–7(c)(1) and to ESOP and
non-ESOP portions of a plan set forth
in §1.410(b)–7(c)(2) shall not apply for
purposes of this section and §§1.401(m)–2
through 1.401(m)–5.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.
(c)Additional requirements—(1)Sepa-
rate testing for employee contributions
and 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 receive
matching contributions must satisfy the
requirements of section 410(b) as if those
employees were covered under a separate
plan. The determination of whether the
separate plan satisfies the requirements
of section 410(b) must be made without
regard 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 section
401(k), 410(b)(2)(A)(ii), or 416(c)(2)(A),
employee contributions, matching contri-
butions and elective contributions taken
into account under §1.401(m)–2(a)(6) may
not be taken into account for purposes of
determining whether any other contribu-
tions under any plan (including the plan
to which the employee contributions or
matching contributions are made) satisfy
the requirements of section 401(a). See
also §1.401(a)(4)–11(g)(3)(vii) for special
rules relating to corrections of violations
of the minimum coverage requirements or
discriminatory rates of matching contribu-
tions.
(2)Plan provision requirement.A
plan that provides for employee contribu-
tions or matching contributions satisfies
this section only if it provides that the
nondiscrimination requirements of section
401(m) will be met. Thus, the plan must
provide for satisfaction of one of the spe-
cific alternatives described in paragraph
2003-35 I.R.B.478September 2, 2003

(b)(1) of this section and, if with respect to
that alternative there are optional choices,
which of the optional choices will apply.
For example, a plan that uses the ACP
test of section 401(m)(2), as described in
paragraph (b)(1)(i) of this section, must
specify whether it is using the current
year testing method or prior year testing
method. Additionally, a plan that uses
the prior year testing method must spec-
ify whether the ACP for eligible NHCEs
for the first plan year is 3% or the ACP
for the eligible NHCEs for the first plan
year. Similarly, a plan that uses the safe
harbor method of section 401(m)(11), as
described in paragraph (b)(1)(ii) of this
section, must specify whether the safe
harbor contribution will be the nonelective
safe harbor contribution or the matching
safe harbor contribution and is not per-
mitted to provide that ACP testing will
be used if the requirements for the safe
harbor are not satisfied. For purposes of
this paragraph (c)(2), a plan may incorpo-
rate by reference the provisions of section
401(m)(2) and §1.401(m)–2 if that is the
nondiscrimination test being applied.
(d)Effective date. This section and
§§1.401(m)–2 through 1.401(m)–5 apply
to plan years that begin on or after the date
that is 12 months after the issuance of these
regulations in final form.
§1.401(m)–2 ACP test.
(a)Actual contribution percentage
(ACP) test—(1)In general—(i)ACP test
formula. A plan satisfies the ACP test for
a plan year only if—
(A) The ACP for the eligible HCEs for
the plan year is not more than the ACP for
the eligible NHCEs for the applicable year
multiplied by 1.25; or
(B) The excess of the ACP for the eli-
gible HCEs for the plan year over the ACP
for the eligible NHCEs for the applicable
year is not more than 2 percentage points,
and the ACP for the eligible HCEs for the
plan year is not more than the ACP for
the eligible NHCEs for the applicable year
multiplied by 2.
(ii)HCEs as sole eligible employees.If,
for the applicable year there are no eligible
NHCEs (i.e., all of the eligible employees
under the plan for theapplicable year are
HCEs), the plan is deemed to satisfy the
ACP test.
(iii)Special rule for early participation.
If a plan providing for employee contribu-
tions or matching contributions provides
that employees are eligible to participate
before they have completed the minimum
age and service requirements of section
410(a)(1)(A), and if the plan applies sec-
tion 410(b)(4)(B) in determining whether
the plan meets the requirements of section
410(b)(1), then in determining whether the
plan 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 the
ACP for all eligible HCEs for the plan year
and the ACP of eligible NHCEs for the ap-
plicable year, disregarding all NHCEs who
have not met the minimum age and service
requirements of section 410(a)(1)(A); or
(B) Pursuant to §1.401(m)–1(b)(4), the
plan is disaggregated into separate plans
and the ACP test is performed separately
for all eligible employees who have com-
pleted the minimum age and service re-
quirements of section 410(a)(1)(A) and for
all 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)General
rule. The ACP for a group of eligible em-
ployees (either eligible HCEs or eligible
NHCEs) for a plan year or applicable year
is the average of the ACRs of eligible em-
ployees in the group for that year. The
ACP for a group of eligible employees is
calculated to the nearest hundredth of a
percentage point.
(ii)Determination of applicable year
under current year and prior year testing
method. The ACP test is applied using
the prior year testing method or the cur-
rent year testing method. Under the prior
year testing method, the applicable year
for determining the ACP for the eligible
NHCEs is the plan year immediately pre-
ceding the plan year for which the ACP test
is being calculated. Under the prior year
testing method, the ACP for the eligible
NHCEs is determined using the ACRs for
the eligible employees who were NHCEs
in that preceding plan year, regardless of
whether those NHCEs are eligible employ-
ees or NHCEs in the plan year for which
the 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 the
plan year for which the ACP test is being
calculated. Under either method, the ACP
for the eligible HCEs is determined using
the ACRs of eligible employees who are
HCEs for the plan year for which the ACP
test is being performed. See paragraph (c)
of this section for additional rules for the
prior year testing method.
(3)Determination of ACR—(i)General
rule. The ACR of an eligible employee for
the plan year or applicable year is the sum
of the employee contributions and match-
ing contributions taken into account with
respect 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 into
account under paragraph (a)(6) of this sec-
tion for the year, divided by the employee's
compensation taken into account for the
year. The ACR is calculated to the near-
est hundredth of a percentage point. If no
employee contributions, matching contri-
butions, elective contributions, or qualified
nonelective contributions are taken into ac-
count under this section with respect to an
eligible employee for the year, the ACR of
the employee is zero.
(ii)ACR of HCEs eligible under more
than one plan—(A)General rule.Pur-
suant to section 401(m)(2)(B), the ACR
of an HCE who is an eligible employee
in more than one plan of an employer to
which matching contributions or employee
contributions are made is calculated by
treating all contributions with respect to
such HCE under any such plan as being
made under the plan being tested. Thus,
the ACR for such an HCE is calculated by
accumulating all matching contributions
and employee contributions under any plan
(other than a plan described in paragraph
(a)(3)(ii)(B) of this section) that would be
taken into account under this section for
the plan year, if the plan under which the
contribution was made applied this section
and had the same plan year. For example,
in the case of a plan with a 12-month plan
year, the ACR for the plan year of that plan
foranHCEwhoparticipatesinmultiple
plans of the same employer that provide for
matching contributions or employee con-
tributions is the sum of all such contri-
butions during such 12-month period that
would be taken into account with respect
September 2, 20034792003-35 I.R.B.

to the HCE under all plans in which the
HCE is an eligible employee, divided by
the HCE's compensation for that 12-month
period (determined using the compensa-
tion definition for the plan being tested),
without regard to the plan year of the other
plans 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 that
are not permitted to be aggregated under
§1.401(m)–1(b)(4) (determined without
regard to the prohibition on aggregating
plans with inconsistent testing methods
set forth in §1.401(m)–1(b)(4)(iii)(B)
and the prohibition on aggregating plans
with different plan years set forth in
§1.410(b)–7(d)(5)) are not aggregated
under 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 parallel
rule under section 401(k)(3)(A). The ex-
ampleisasfollows:
Example. Employee A, an HCE with compen-
sation of $120,000, is eligible to mak
eemployee
contributions under Plan S and Plan T, two calen-
dar-year profit-sharing plans of Employer H. Plan
S and Plan T use the same definition o
f compensa-
tion. Plan S provides a match equal to 50% of each
employee's contributions and Plan T has no match.
During the current plan year, Emp
loyee A elects to
contribute $4,000 in employee contributions to Plan
T and $4,000 in employee contributions to Plan S.
There are no other contribut
ions made on behalf of
Employee A. Each plan must calculate Employee A's
ACR by dividing the total employee contributions
by Employee A and matching
contributions under
both plans by $120,000. Therefore, Employee A's
ACR under each plan is 8.33% ($4,000+ $4,000+
$2,000/$120,000).
(4)Employee contribut
ions and match-
ing contributions tak
en into account under
the ACP test—(i)Empl
oyee contributions.
An employee contribu
tion is taken into ac-
count in determinin
g the ACR for an eligi-
ble employee for the
plan year or applica-
ble year in which t
he contribution is made.
For purposes of t
he preceding sentence, an
amount withheld
from an employee's pay
(or a payment by
the employee to an agent
of the plan) is t
reated as contributed at the
time of such wi
thholding (or payment) if
the funds pai
d are transmitted to the trust
within a rea
sonable period after the with-
holding (or
payment).
(ii)Rechar
acterized elective contribu-
tions.Exce
ss contributions recharacter-
ized in acc
ordance with §1.401(k)–2(b)(3)
are taken into account as employee con-
tributions for the plan year that includes
the time at which the excess contribution
is includible in the gross income of the em-
ployee under §1.401(k)–2(b)(3)(ii)(A).
(iii)Matching contributions.Amatch-
ing contribution is taken into account in
determining the ACR for an eligible em-
ployee for a plan year or applicable year
only if each of the following requirements
is satisfied—
(A) The matching contribution is allo-
cated to the employee's account under the
terms of the plan as of a date within that
year;
(B) The matching contribution is made
on account of (or the matching contri-
bution is allocated on the basis of) the
employee's elective deferrals or employee
contributions for that year; and
(C) The matching contribution is actu-
ally paid to the trust no later than the end of
the 12-month period immediately follow-
ing the year that contains that date.
(5)Matching contributions not taken
into account under the ACP test—(i)Gen-
eral rule. Matching contributions that do
not satisfy the requirements of paragraph
(a)(4)(iii) of this section may not be taken
into account in the ACP test for the plan
year with respect to which the contribu-
tions were made, or for any other plan
year. Instead, the amount of the match-
ing contributions must satisfy the require-
ments of section 401(a)(4) (without regard
to the ACP test) for the plan year for which
they are allocated under the plan as if they
were nonelective contributions and were
the only nonelective contributions for that
year. See §§1.401(a)(4)–1(b)(2)(ii)(B) and
1.410(b)–7(c)(1).
(ii)Disproportionate matching contri-
butions—(A)Matching contributions in
excess of 100%. A matching contribution
with respect to any employee contribution
or elective deferral for an NHCE is not
taken into account under the ACP test to
the extent the matching rate with respect
to the employee contribution or elective
deferral exceeds the greater of 100% and
2 times the plan's representative matching
rate.
(B)Representative matching rate.For
purposes of this paragraph (a)(5)(ii), the
plan's representative matching rate is the
lowest matching rate for any eligible
NHCE among a group of NHCEs that
consists of half of all eligible NHCEs in
the plan for the plan year who make elec-
tive deferrals or employee contributions
for the plan year (or, if greater, the lowest
matching rate for all eligible NHCEs in
theplanwhoareemployedbytheem-
ployer on the last day of the plan year and
who make elective deferrals or employee
contributions for the plan year).
(C)Definition of matching rate.For
purposes of this paragraph (a)(5)(ii), the
matching rate for an employee is the
matching contributions made for such
employee divided by the elective deferrals
or employee contributions that are being
matched.
(iii)Qualified matching contributions
used to satisfy the ADP test.Qualified
matching contributions that are taken
into account for the ADP test of section
401(k)(3) under §1.401(k)–2(a)(6) are
not taken into account in determining an
eligible employee's ACR.
(iv)Matching contributions taken into
account under safe harbor provisions.A
plan that satisfies the ACP safe harbor
requirements of section 401(m)(11) for
a plan year but nonetheless must satisfy
the requirements of this section because
it provides for employee contributions
for such plan year is permitted to apply
this section disregarding all matching
contributions with respect to all eligible
employees. 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 not
satisfy the ACP safe harbor requirements
of section 401(m)(11) for such plan year is
permitted to apply this section by exclud-
ing matching contributions with respect to
all eligible employees that do not exceed
4% of each employee's compensation. If
a plan disregards matching contributions
pursuant to this paragraph (a)(5)(iv), the
disregard must apply with respect to all
eligible employees.
(v)Treatment of forfeited matching con-
tributions. A matching contribution that is
forfeited because the contribution to which
it relates is treated as an excess contribu-
tion, excess deferral, or excess aggregate
contribution is not taken into account for
purposes of this section.
(6)Qualified nonelective contributions
and elective contributions that may be
taken into account under the ACP test.
Qualified nonelective contributions and
elective contributions may be taken into
2003-35 I.R.B.480September 2, 2003

account in determining the ACR for an
eligible employee for a plan year or ap-
plicable year, but only to the extent the
contributions satisfy the following re-
quirements—
(i)Timing of allocation. The quali-
fied nonelective contribution is allocated
to the employee's account as of a date
within that year (within the meaning of
§1.401(k)–2(a)(4)(i)(A)) and the elective
contribution 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 group
of eligible NHCEs for the applicable year,
a qualified nonelective contribution must
be contributed no later than the end of the
12-month period following the applicable
year even though the applicable year is dif-
ferent than the plan year being tested.
(ii)Elective contributions taken into
account under the ACP test. Elective con-
tributions may be taken into account for
the ACP test only if the cash or deferred
arrangement under which the elective con-
tributions are made is required to satisfy
the ADP test in §1.401(k)–2(a)(1) and,
then only to the extent that the cash or
deferred arrangement would satisfy that
test, including such elective contributions
in the ADP for the plan year or applicable
year. Thus, for example, elective deferrals
made pursuant to a salary reduction agree-
ment under an annuity described in section
403(b) are not permitted to be taken into
account in an ACP test. Similarly, elective
contributions under a cash or deferred ar-
rangement that is using the section 401(k)
safe harbor described in §1.401(k)–3 can
not be taken into account in an ACP test.
(iii)Requirement that amount satisfy
section 401(a)(4). The amount of non-
elective contributions, including those
qualified nonelective contributions taken
into account under this paragraph (a)(6)
and those qualified nonelective contribu-
tions taken into account for the ADP test
under paragraph §1.401(k)–2(a)(6), and
the amount of nonelective contributions,
excluding those qualified nonelective
contributions taken into account under
this paragraph (a)(6) for the ACP test
and those qualified nonelective contri-
butions taken into account for the ADP
test under paragraph §1.401(k)–2(a)(6),
satisfies the requirements of section
401(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-wide
plans in §1.414(r)–1(c)(2)(ii) with re-
spect to the plan, the determination of
whether the qualified nonelective contri-
butions satisfy the requirements of this
paragraph (a)(6)(iii) must be made on an
employer-wide basis regardless of whether
the plans to which the qualified nonelec-
tive contributions are made are satisfying
the requirements of section 410(b) on an
employer-wide basis. Conversely, in the
case 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 nonelective
contributions satisfy the requirements of
this paragraph (a)(6)(iii) is not permitted
to be made on an employer-wide basis
regardless of whether the plans to which
the qualified nonelective contributions are
made are satisfying the requirements of
section 410(b) on that basis.
(iv)Aggregation must be permitted.
The plan that provides for employee or
matching contributions and the plan or
plans to which the qualified nonelective
contributions or elective contributions are
made are plans that would be permitted to
be aggregated under §1.401(m)–1(b)(4).
If the plan year of the plan that provides
for employee or matching contributions
is changed to satisfy the requirement
under §1.410(b)–7(d)(5) that aggregated
plans have the same plan year, qualified
nonelective contributions and elective
contributions may be taken into account
in the resulting short plan year only if
such qualified nonelective and elective
contributions could have been taken into
account under an ADP test for a plan with
that same short plan year.
(v)Disproportionate contributions not
taken into account—(A)General rule.
Qualified nonelective contributions cannot
be taken into accountfor an applicable
year for an NHCE to the extent such
contributions exceed the product that
NHCE's compensation and the greater of
5% and 2 times the plan's representative
contribution rate. Any qualified non-
elective contribution taken into account
in 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 permitted
to be taken into account for purposes of
this paragraph (a)(6) (including the deter-
mination of the representative contribution
rate 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 among
a group of eligible NHCEs that consists
of half of all eligible NHCEs for the plan
year (or, if greater, the lowest applicable
contribution rate of any eligible NHCE in
the group of all eligible NHCEs for the ap-
plicable year and who is employed by the
employer on the last day of the applicable
year).
(C)Definition of applicable contribu-
tion rate. For purposes of this paragraph
(a)(6)(v), the applicable contribution rate
for an eligible NHCE is the sum of the
matching contributions taken into account
under this section for the employee for
the plan year and the qualified nonelective
contributions made for that employee for
the plan year, divided by that employee's
compensation for the same period.
(vi)Contribution only used once.Qual-
ified nonelective contributions can not be
taken into account under this paragraph
(a)(6) to the extent such contributions
are taken into account for purposes of
satisfying any other ACP test, any ADP
test, or the requirements of §1.401(k)–3,
1.401(m)–3 or 1.401(k)–4. Thus, for ex-
ample, qualified nonelective contributions
that are made pursuant to §1.401(k)–3(b)
cannot be taken into account under the
ACP test. Similarly, if a plan switches
from the current year testing method to
the prior year testing method pursuant to
§1.401(m)–2(c)(1), qualified nonelective
contributions that are taken into account
under the current year testing method for
a plan year may not be taken into account
under the prior year testing method for the
next plan year.
(7)Examples. The following examples
illustrate the application of this paragraph
(a). See §1.401(k)–2(a)(6) for additional
examples 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-sh
aring plan under which $.50 matching
contributions are made for each dollar of employee
September 2, 20034812003-35 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 percentage
of compensation) for Plan U's highly compensated
employees and nonhighly compensated employees
for the 2006 plan year:
Employee
Contributions
Matching
Contributions
Actual Contribution Percentage
Highly compensated employees4%2%6%
Nonhighly compensated employees3%1.5%4.5%
(ii) The matching rate for all NHCEs is 50% and
thus the matching contributions are not disproportion-
ate under paragraph (a)(5)(ii) of this section. Accord-
ingly, they are taken into account in determining the
ACR 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 satisfy
the 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 2
percentage points and the ACP for the HCEs does not
exceed 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 arrangement
and permits employee contributions. Under Plan V,
a$.50matchingcontributionismadeforeachdollar
of elective contributions and employee contributions.
Plan V uses the current year testing method and does
not provide for elective contributions to be taken into
account in determining an eligible employee's ACR.
For the 2006 plan year, Employees A and B are HCEs
and the remaining employees are NHCEs. The com-
pensation, elective contributions, employee contribu-
tions, and matching contributions for the 2006 plan
year are shown in the following table:
EmployeeCompensationElective ContributionsEmployee
Contributions
Matching Contributions
A
$190,000$15,000$3,500$9,250
B100,000
$5,000$10,000$7,500
C85,000
$12,000$0$6,000
D70,000
$9,500$0$4,750
E40,000
$10,000$0$5,000
F10,000
$0$0$0
(ii) The matching rate for all NHCEs is 50% and
thus the matching contributions are not disproportion-
ate under paragraph (a)(5)(ii) of this section. Accord-
ingly, they are taken into account in determining the
ACR of eligible employees, as shown in the follow-
ing table:
EmployeeCompensationEmployee
Contributions
Matching ContributionsACR %
A
$190,000$3,500$9,250
6.71
B100,000
$10,000$7,500
17.50
C85,000
$0$6,000
7.06
D70,000
$0$4,750
6.79
E40,000
$0$5,000
12.50
F10,000
$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 fails
to 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 the
nonhighly compensated employees (6.59% x 1.25 =
8.24%). In addition, Plan V fails to satisfy the ACP
test 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 fails
to satisfy the requirements of section 401(m)(2) and
paragraph (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 asExample
2, except that the plan provides that the nonhighly
compensated employees' elective contributions may
be 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 determining
the ACP rather than the ADP to the extent that the
plan 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 the
NHCEs, the ADP for the highly compensated em-
ployees is 6.45% (7.89% + 5.00%)/2 and the ADP
for the nonhighly compensated employees would be
2003-35 I.R.B.482September 2, 2003

6.92% (14.12% + 13.57% + 0% +0%)/4) and the plan
would satisfy the requirements of §1.401(k)–2(a)(1)
excluding from the ADP the elective contributions
for NHCEs that are taken into account under section
401(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 ACP
for the HCEs (12.11%) is less than 1.25 times the
ACP for the nonhighly compensated employees.
Example 4. (i) The facts are the same asExam-
ple 2, except that Plan V provides for a higher than
50% 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 ACP
test, 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, elective
contributions, employee contributions, matching con-
tributions at a 74% match rate of the eligible NHCEs
(employees C through F) are shown in the following
table:
EmployeeCompensationElective ContributionsEmployee
Contributions
Matching Contributions
C
$85,000$12,000$0$8,880
D70,000
$9,500$0$7,030
E40,000
$10,000$0$7,400
F10,000
$0$0$0
(ii) The matching rate for all NHCEs is 74% and
thus 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 for
the HCEs (12.11%) is less than 1.25 times the ACP
for the NHCEs, the plan satisfies the requirements of
section 401(m).
Example 5. (i) The facts are the same asExam-
ple 4, except that: Employee E's elective contribu-
tions are $2,000 (rather than $10,000) and pursuant
to paragraph (a)(6)(ii) of this section, the $2,000 of
elective contributions for Employee E are taken into
account in determining the ACP rather than the ADP.
In addition, Plan V provides that the higher match
rate is not limited to 100% and applies only for a
specified group of nonhighly compensated employ-
ees. The only member of that group is Employee E.
Under the plan provision, the higher match rate is a
400% 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 following
table:
EmployeeCompensationElective ContributionsEmployee
Contributions
Matching Contributions
C
$85,000$12,000$0$6,000
D70,000
$9,500$0$4,750
E40,000
$2,000$0$8,000
F10,000
$0$0$0
(ii) If the entire matching contribution made on
behalf of Employee E were taken into account under
the ACP test, Plan V would satisfy the test, because
the ACP for the NHCEs would be 9.71% (7.06% +
6.79% + 25.00% + 0%)/4. Because the ACP for the
HCEs (12.11%) is less than 1.25 times what the ACP
for the NHCEs would be, the plan would satisfy the
requirements of section 401(m).
(iii) Pursuant to paragraph (a)(5)(ii) of this sec-
tion, however, matching contributions for an eligible
NHCE that are based on a matching rate in excess
of the greater of 100% and twice the plan's repre-
sentative matching rate cannot be taken into account
in applying the ACP test. The plan's representative
matching rate is the lowest matching rate for any el-
igible employee in a group of NHCEs that is at least
half of all eligible employees who are NHCEs in the
plan for the plan year who make elective contribu-
tions or employee contributions for the plan year. For
Plan 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% and
400% respectively. The lowest matching rate for a
group of NHCEs that is at least
1
/2of all the NHCEs
who make elective contributions or employee con-
tributions (or 2 NHCEs) is 50%. Because 400% is
more than twice the plan's representative matching
rate, only the matching contributions made on behalf
of Employee E that do not exceed 100% (or in this
case $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 for
the NHCEs is 5.96% (7.06% + 6.79% + 10% + 0%)/4
and the plan fails to satisfy the requirements of sec-
tion 401(m)(2) and paragraph (a)(1) of this section
unless the ACP failure is corrected under paragraph
(b) of this section.
Example 6. (i) The facts are the same asExam-
ple 2, except that Plan V provides a QNEC equal to
13% of pay for Employee F that will be taken into
account under the ACP test to the extent the contribu-
tions satisfy the requirements of paragraph (a)(6) of
this section.
(ii) Pursuant to paragraph (a)(6)(v) of this section,
a QNEC cannot be taken into account in determining
an NHCE's ACR to the extent it exceeds the greater of
5% and the product of the employee's compensation
and the plan's representative contribution rate. The
plan's representative contribution rate is two times the
lowest applicable contribution rate for any eligible
employee in a group of NHCEs that is at least half of
all eligible employees who are NHCEs in the plan for
the plan year. For Plan V, the applicable contribution
rates for Employees C, D, E and F are 7.06%, 6.79%,
12.5% and 13% respectively. The lowest applicable
rate for a group of NHCEs that is at least
1
/2of all the
NHCEs is 12.50% (the lowest applicable rate for the
group 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 times
12.50% or 25.00%. Accordingly, the QNECs for Em-
ployee F can be taken into account under the ACP test
only 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 ACP
test.
(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, 20034832003-35 I.R.B.

the HCEs (12.11%) is less than 1.25 times the ACP
for the NHCEs, the plan satisfies the requirements of
section 401(m)(2) and paragraph (a)(1) of this sec-
tion.
(b)Correction of excess aggregate
contributions—(1)Permissible correc-
tion methods—(i)In general.Aplan
that provides for employee contributions
or matching contributions does not fail
to satisfy the requirements of section
401(m)(2) and paragraph (a)(1) of this
section if the employer, in accordance
with the terms of the plan, uses either of
the following correction methods—
(A)Additional contributions.Theem-
ployer makes additional contributions that
are taken into account for the ACP test un-
der this section that, in combination with
the other contributions taken into account
under this section, allow the plan to satisfy
the requirements of paragraph (a)(1) of this
section.
(B)Excess aggregate contributions dis-
tributed or forfeited.Excess aggregate
contributions are distributed or forfeited in
accordance with paragraph (b)(2) of this
section.
(ii)Combination of correction methods.
A plan may provide for the use of either of
the correction methods described in para-
graph (b)(1)(i) of this section, may limit
employee contributions or matching con-
tributions in a manner that prevents excess
aggregate contributions from being made,
or may use a combination of these meth-
ods, to avoid or correct excess aggregate
contributions. If a plan uses a combina-
tion of correction methods, any contribu-
tions made under paragraph (b)(1)(i)(A) of
this section must be taken into account be-
fore application of the correction method
in paragraph (b)(1)(i)(B) of this section.
(iii)Exclusive means of correction.A
failure to satisfy the requirements of para-
graph (a)(1) of this section may not be cor-
rected using any method other than one
described in paragraph (b)(1)(i) or (ii) of
this 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 terms
of the plan. Similarly, excess aggregate
contributions 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 may
not 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 of
excess aggregate contributions through
a distribution from the plan. Correction
through a distribution generally involves
a four step process. First, the plan must
determine, in accordance with paragraph
(b)(2)(ii) of this section, the total amount
of excess aggregate contributions that
must be distributed under the plan. Sec-
ond, the plan must apportion the total
amount of excess aggregate contributions
among 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 contributions
in accordance with paragraph (b)(2)(iv)
of this section. Finally, the plan must
distribute the apportioned contributions,
together with allocable income (or forfeit
the apportioned matching contributions,
if forfeitable) in accordance with para-
graph (b)(2)(v) of this section. Paragraph
(b)(2)(vi) of this section provides rules
relating to the tax treatment of these dis-
tributions.
(ii)Calculation of total amount to
be distributed. The following procedures
must be used to determine the total amount
of the excess aggregate contributions to be
distributed—
(A)Calculate the dollar amount of
excess aggregate contributions for each
HCE. The amount of excess aggregate
contributions attributable to an HCE for a
plan year is the amount (if any) by which
the HCE's contributions taken into account
under this section must be reduced for the
HCE's ACR to equal the highest permitted
ACR under the plan. To calculate the
highest permitted ACR under a plan, the
ACR of the HCE with the highest ACR is
reduced by the amount required to cause
that HCE's ACR to equal the ACR of
the HCE with the next highest ACR. If
a lesser reduction would enable the plan
to satisfy the requirements of paragraph
(b)(2)(ii)(C) of this section, only this lesser
reduction applies.
(B)Determination of the total amount
of excess aggregate contributions.
The process described in paragraph
(b)(2)(ii)(A) of this section must be
repeated until the plan would satisfy the
requirements of paragraph (b)(2)(ii)(C)
of this section. The sum of all reductions
for all HCEs determined under paragraph
(b)(2)(ii)(A) of this section is the total
amount of excess aggregate contributions
for the plan year.
(C)Satisfaction of ACP.Aplansat-
isfies this paragraph (b)(2)(ii)(C) if the
plan would satisfy the requirements of
paragraph (a)(1)(i) of this section if the
ACR for each HCE were determined af-
ter the reductions described in paragraph
(b)(2)(ii)(A) of this section.
(iii)Apportionment of total amount of
excess aggregate contributions among the
HCEs. The following procedures must be
used in apportioning the total amount of
excess aggregate contributions determined
under paragraph (b)(2)(ii) of this section
among the HCEs—
(A)Calculate the dollar amount of
excess aggregate contributions for each
HCE. The contributions with respect to
the HCE with the highest dollar amount
of contributions taken account under this
section are reduced by the amount re-
quired to cause that HCE's contributions
to equal the dollar amount of contribu-
tions taken into account under this section
for the HCE with the next highest dollar
amount of such contributions. If a lesser
apportionment to the HCE would enable
the plan to apportion the total amount of
excess aggregate contributions, only the
lesser apportionment would apply.
(B)Limit on amount apportioned to
any HCE. For purposes of this paragraph
(b)(2)(iii), the contributions for an HCE
who is an eligible employee in more than
oneplanofanemployertowhichmatching
contributions and employee contributions
are made is determined by adding together
all contributions otherwise taken into ac-
count in determining the ACR of the HCE
under the rules of paragraph (a)(3)(ii)
of this section. However, the amount of
contributions apportioned with respect to
an HCE must not exceed the amount of
contributions taken into account under this
section that were actually made on behalf
of the HCE to the plan for the plan year.
Thus,inthecaseofanHCEwhoisan
eligible employee in more than one plan
of the same employer to which employee
contributions or matching contributions
are made and whose ACR is calculated
2003-35 I.R.B.484September 2, 2003

in accordance with paragraph (a)(3)(ii) of
this section, the amount distributed under
this paragraph (b)(2)(iii) will not exceed
such contributions actually contributed to
the plan for the plan year that are taken
into account under this section for the plan
year.
(C)Apportionment to additional HCEs.
The procedure in paragraph (b)(2)(iii)(A)
of this section must be repeated until the
total 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 aggregate
contributions is equal to the sum of the
allocable gain or loss for the plan year
and, to the extent the excess aggregate
contributions are or will be credited with
allocable gain or loss for the period after
the close of the plan year (the gap period),
the allocable gain or loss for the gap pe-
riod.
(B)Method of allocating income.A
plan may use any reasonable method for
computing the incomeallocable to excess
aggregate contributions, provided that the
method does not violate section 401(a)(4),
is used consistently for all participants and
for all corrective distributions under the
plan for the plan year, and is used by the
plan 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 the
income for the plan year allocable to em-
ployee contributions, matching contribu-
tions and other amounts taken into account
under this section (including the contribu-
tions for the year), by a fraction, the nu-
merator of which is the excess aggregate
contributions for the employee for the plan
year, and the denominator of which is the
account balance attributable to employee
contributions and matching contributions
and other amounts taken into account un-
der this section as of the beginning of the
plan year (including any additional such
contributions for the plan year).
(D)Safe harbor method of allocat-
ing gap period income.Aplanmayuse
the safe harbor method in this paragraph
(b)(2)(iv)(D) to determine income on ex-
cess aggregate contributions for the gap
period. Under this safe harbor method,
income on excess aggregate contributions
for the gap period is equal to 10% of the
income allocable to excess aggregate con-
tributions for the plan year that would be
determined under paragraph (b)(2)(iv)(C)
of this section, multiplied by the number
of calendar months that have elapsed since
the end of the plan year. For purposes of
calculating the number of calendar months
that have elapsed under the safe harbor
method, a corrective distribution that is
made on or before the fifteenth day of a
month is treated as made on the last day
of the preceding month and a distribution
made after the fifteenth day of a month
is treated as made on the last day of the
month.
(E)Alternative method of allocating
plan year and gap period income.A
plan may determine the allocable gain
or loss for the aggregate of the plan year
and 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 by
substituting the income for the plan year
and the gap period for the income for the
plan year and by substituting the contribu-
tions taken into account under this section
for the plan year and the gap period for the
contributions taken into account for the
plan year in determining the fraction that
is multiplied by that income.
(F)Allocable income for recharacter-
ized elective contributions. If recharacter-
ized elective contributions are distributed
as excess aggregate contributions, the
income allocable to the excess aggregate
contributions is determined as if rechar-
acterized elective contributions had been
distributed as excess contributions. Thus,
income must be allocated to the rechar-
acterized amounts distributed using the
methods in §1.401(k)–2(b)(2)(iv).
(v)Distribution and forfeiture.Within
12 months after the close of the plan year
in which the excess aggregate contribution
arose, the plan must distribute to each HCE
the contributions apportioned to such HCE
under paragraph (b)(2)(iii) of this section
(and the allocable income) to the extent
they are vested or forfeit such amounts, if
forfeitable. Except as otherwise provided
in this paragraph (b)(2)(v), a distribution
of excess aggregate contributions must be
in addition to any other distributions made
during the year and must be designated as a
corrective distribution by the employer. In
the 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 soon
as administratively feasible after the date
of termination of the plan, but in no event
later than 12 months after the date of termi-
nation. If the entire account balance of an
HCE is distributed prior to when the plan
makes a distribution of excess aggregate
contributions in accordance with this para-
graph (b)(2), the distribution is deemed to
have been a corrective distribution of ex-
cess aggregate contributions (and income)
to the extent that a corrective distribution
would 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 distribution
of excess aggregate contributions (and in-
come) that is made within 2
1
/2months af-
ter the end of the plan year for which the
excess aggregate contributions were made
is includible in the employee's gross in-
come for the taxable year of the employee
ending with or within the plan year for
which the excess aggregate contributions
were made. A corrective distribution of ex-
cess aggregate contributions (and income)
that is made more than 2
1
/2months after
the plan year for which the excess aggre-
gate contributions were made is includible
in the employee's gross income in the tax-
able year of the employee in which dis-
tributed. The portion of the distribution
that is treated as an investment in the con-
tract under section 72 is determined with-
out regard to any plan contributions other
than those distributed as excess aggregate
contributions. Regardless of when the cor-
rective distribution is made, it is not sub-
ject to the early distribution tax of section
72(t). See paragraph (b)(4) of this sec-
tion for additional rules relating to the em-
ployer excise tax on amounts distributed
more than 2
1
/2months after the end of the
plan year. See also §1.402(c)–2, A–4 pro-
hibiting rollover of distributions that are
excess aggregate contributions.
(B)Rule for de minimis distributions.
If the total amount of excess aggregate
contributions determined under this para-
graph (b)(2), and excess contributions
determined under §1.401(k)–2(b)(2) dis-
tributed to a recipient under a plan for any
plan year is less than $100 (excluding in-
come), a corrective distribution of excess
aggregate contributions (and income) is
September 2, 20034852003-35 I.R.B.

includible in gross income in the recipi-
ent's taxable year in which the corrective
distribution is made.
(3)Other rules—(i)No employee or
spousal consent required. A distribution
of excess aggregate contributions (and in-
come) may be made under the terms of
the plan without regard to any notice or
consent otherwise required under sections
411(a)(11) and 417.
(ii)Treatment of corrective distri-
butions and forfeited contributions as
employer contributions. Excess aggregate
contributions (other than amounts attribut-
able to employee contributions), including
forfeited matching contributions, are
treated as employercontributions for
purposes of sections 404 and 415 even
if distributed from the plan. Forfeited
matching contributions that are reallo-
cated to the accounts of other participants
for the plan year in which the forfeiture
occurs are treated under section 415 as
annual additions for the participants to
whose accounts they are reallocated and
for the participants from whose accounts
they are forfeited.
(iii)No reduction of required minimum
distribution. A distribution of excess
aggregate contributions (and income) is
not treated as a distribution for purposes
of determining whether the plan satisfies
the minimum distribution requirements
of section 401(a)(9). See §1.401(a)(9)–5,
A–9(b).
(iv)Partial correction. Any distribution
of less than the entire amount of excess
aggregate contributions (and allocable in-
come) is treated as apro ratadistribution
of excess aggregate contributions and allo-
cable income.
(v)Matching contributions on excess
contributions, excess deferrals and excess
aggregate contributions—(A)Corrective
distributions not permitted. A matching
contribution may not be distributed merely
because the contribution to which it relates
is treated as an excess contribution, excess
deferral, or excess aggregate contribution.
(B)Coordination with section
401(a)(4). A matching contribution is
taken into account under section 401(a)(4)
even if the match is distributed, unless the
distributed contribution is an excess aggre-
gate contribution. This requires that, after
correction of excess aggregate contribu-
tions, each level of matching contributions
be currently and effectively available to a
group of employees that satisfies section
410(b). See §1.401(a)(4)–4(e)(3)(iii)(G).
Thus, a plan that provides the same rate of
matching contributions to all employees
will not meet the requirements of sec-
tion 401(a)(4) if employee contributions
are distributed under this paragraph (b)
to HCEs to the extent needed to meet
the requirements of section 401(m)(2),
while matching contributions attribut-
able to employee contributions remain
allocated to the HCEs' accounts. This
is because the level of matching con-
tributions will be higher for a group
of employees that consists entirely of
HCEs. Under section 411(a)(3)(G) and
§1.411(a)–4(b)(7), a plan may forfeit
matching contributions attributable to
excess contributions, excess aggregate
contributions and excess deferrals to avoid
a violation of section 401(a)(4). See also
§1.401(a)(4)–11(g)(3)(vii)(B) regarding
the use of additional allocations to the
accounts of NHCEs for the purpose of
correcting a discriminatory rate of match-
ing contributions. A plan is permitted to
provide for which contributions are to be
distributed to satisfy the ACP test so as to
avoid discriminatory matching rates that
would otherwise violate section 401(a)(4).
For example, the plan may provide that
unmatched employee contributions will
be distributed before matched employee
contributions.
(vi)No requirement for recalculation.
If the distributions and forfeitures de-
scribed in paragraph (b)(2) of this section
are made, the employee contributions
and matching contributions are treated as
meeting the nondiscrimination test of sec-
tion 401(m)(2) regardless of whether the
ACP for the HCEs, if recalculated after the
distributions and forfeitures, would satisfy
section 401(m)(2).
(4)Failure to timely correct—(i)Fail-
ure to correct within 2
1
/2months after end
of plan year. If a plan does not correct
excess aggregate contributions within 2
1
/2
months after the close of the plan year for
which the excess aggregate contributions
are made, the employer will be liable for
a 10% excise tax on the amount of the
excess 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 may
enable a plan to avoid having excess ag-
gregate contributions, even if the contribu-
tions are made after the close of the 2
1
/2
month period.
(ii)Failure to correct within 12 months
after end of plan year. If excess aggregate
contributions are not corrected within 12
months after the close of the plan year for
which they were made, the plan will fail to
meet the requirements of section 401(a)(4)
for the plan year for which the excess ag-
gregate contributions were made and all
subsequent plan years in which the excess
aggregate contributions remain in the trust.
(5)Examples. The following examples
illustrate 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 of
the plans provide for catch-up contribu-
tions under section 414(v). The examples
are as follows:
Example 1. (i) Employer L maintains a plan that
provides for employee con
tributions and fully vested
matching contributions. The plan provides that fail-
ures of the ACP test are corrected by distribution. In
2006, the ACP for the el
igible NHCEs is 6%. Thus,
the ACP for the eligible HCEs may not exceed 8%.
The three HCEs who participate have the following
compensation, contr
ibutions, and ACRs:
2003-35 I.R.B.486September 2, 2003

EmployeeCompensationEmployee contributions and
matching contributions
Actual Contribution Ratio
A200,00014,0007%
B150,00013,5009
C100,00012,00012
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 matching
and employee contributions of Employee C (the HCE
with the highest ACR) is reduced by 3% of compen-
sation (or $3,000) in order to reduce the ACR of that
HCEto9%,whichistheACRofEmployeeB.
(iii) Because the ACP of the HCEs determined
after the $3,000 reduction still exceeds 8%, further
reductions in matching contributions and employee
contributions are necessary in order to reduce the
ACP of the HCEs to 8%. The employee contributions
and matching contributions for Employees B and C
are reduced by an additional .5% of compensation or
$1,250 ($750 and $500 respectively). Because the
ACP of the HCEs determined after the reductions
now 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 HCEs
under paragraph (b)(2)(iii) of this section first to the
HCE 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 of
matching contributions and employee contributions).
(v) Because the total amount of excess aggregate
contributions has not been apportioned, further ap-
portionment is necessary. The balance ($3,750) of the
total amount of excess aggregate contributions is ap-
portioned equally among Employees A and B ($1,500
to each, the amount required to cause their contri-
butions to equal the next highest dollar amount of
matching contributions and employee contributions).
(vi) Because the total amount of excess aggre-
gate contributions has not been apportioned, further
apportionment is necessary. The balance ($750) of
the total amount of excess aggregate contributions is
apportioned equally among Employees A, B and C
($250 to each, the amount required to allocate the to-
tal amount of excess aggregate contributions for the
plan).
(vii) Therefore, the plan will satisfy the require-
ments of paragraph (a)(1) of this section if, by the
end of the 12 month period following the end of the
2006 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 $250
and 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 who
is eligible to participate in a cash or deferred arrange-
ment maintained by Employer M. The plan that in-
cludes the arrangement, Plan X, permits employee
contributions and provides a fully vested matching
contribution equal to 50% of elective contributions.
Plan X is a calendar year plan. Plan X corrects ex-
cess contributions by recharacterization and provides
that 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 PercentageActual Contribution Percentage
Employee D7.5%3.75%
NHCEs4%2%
(ii) In February 2007, Employer M determines
that 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 increases
D's actual contribution ratio to 5.25% ($7,500 in
matching contributions plus $3,000 recharacterized
as employee contributions, divided by $200,000 in
compensation). Since D's actual contribution ratio
must be limited to 4% for Plan X to satisfy the actual
contribution percentage test, Plan X must distribute
1.25% or $2,500 of D's employee contributions
and matching contributions together with allocable
income. If $2,500 in matching contributions and
allocable income is distributed, this will correct the
excess aggregate contributions and will not result in
a discriminatory rate of matching contributions. See
Example 8.
Example 3. (i) The facts are the same as inEx-
ample 2, except that Employee D also had elective
contributions under Plan Y, maintained by an em-
ployer unrelated to M. In January 2007, D requests
and receives a distribution of $1,200 in excess defer-
ralsfromPlanX.PursuanttothetermsofPlanX,D
forfeits the $600 match on the excess deferrals to cor-
rect a discriminatory rate of match.
(ii) The $3,000 that would otherwise have been
recharacterized 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 $1,800
to be recharacterized. See §1.401(k)–2(b)(4)(i)(A).
D's actual contribution ratio is now 4.35% ($7,500
in matching contributions plus $1,800 in recharacter-
ized contributions less $600 forfeited matching con-
tributions attributable to the excess deferrals, divided
by $200,000 in compensation).
(iii) The matching and employee contributions for
Employee D must be reduced by .35% of compen-
sation in order to reduce the ACP of the HCEs to
4%. The plan must provide for forfeiture of addi-
tional matching contributions to prevent a discrimi-
natory rate of matching contributions. SeeExample
8.
Example 4.(i)ThefactsarethesameasinExam-
ple 3, except that D does not request a distribution of
excess deferrals until March 2007. Employer X has
already recharacterized $3,000 as employee contribu-
tions.
(ii) Under §1.402(g)–1(e)(6), the amount of
excess deferrals is reduced by the amount of excess
contributions that are recharacterized. Because the
amount recharacterized is greater than the excess
deferrals, Plan X is neither required nor permitted
to make a distribution of excess deferrals, and the
recharacterization has corrected the excess deferrals.
Example 5. (i) For the 2006 plan year, Employee
F defers $10,000 under Plan M and $6,000 under Plan
N. Plans M and N, which have calendar plan years are
maintained by unrelated employers. Plan M provides
a fully vested, 100% matching contribution, does not
take elective contributions into account under section
401(m) or take matching contributions into account
under section 401(k) and provides that excess contri-
butions and excess aggregate contributions are cor-
rected by distribution. Under Plan M, Employee F is
allocated excess contributions of $600 and excess ag-
gregate contributions of $1,600. Employee F timely
requests and receives a distribution of the $1,000 ex-
cess deferral from Plan M and, pursuant to the terms
of Plan M, forfeits the corresponding $1,000 match-
ing contribution.
(ii) No distribution is required or permitted to
correct the excess contributions because $1,000 has
been distributed by Plan M as excess deferrals. The
distribution required to correct the excess aggregate
September 2, 20034872003-35 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 Plan
N, Plan M would have had to correct the $600 excess
contributions in Plan M by distributing $600. Since
Employee F then would have forfeited $600 (instead
of $1,000) in matching contributions, Employee F
would have had $1,000 ($1,600 in excess aggregate
contributions minus $600 in forfeited matching con-
tributions) remaining of excess aggregate contribu-
tionsinPlanM.Thesewouldhavebeencorrectedby
distributing an additional $1,000 from Plan M.
Example 6. (i) Employee G is the sole highly
compensated employee in a profit sharing plan un-
der which the employer matches 100% of employee
contributions up to 2% of compensation, and 50% of
employee contributions up to the next 4% of com-
pensation. For the 2008 plan year, Employee G has
compensation of $100,000 and makes a 7% employee
contribution of $7,000. Employee G receives a 4%
matching contribution or $4,000. Thus, Employee
G'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 reduce
dto7%
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 unm
atched
employee contributions of $1,000, and $2,000 of
matched employee contributions with their related
matches of $1,000. This would leave
Employee G
with 4% employee contributions, and 3% matching
contributions, for an ACR of 7%. Alternatively,
the plan could distribute all mat
ching contributions
and satisfy this section. However, the plan could
not distribute $4,000 of Employee G's employee
contributions without forfei
ting the related matching
contributions because this would result in a discrim-
inatory rate of matching contributions. See also
Example 7.
Example 7. (i) Employee H is an HCE in Em-
ployer X's profit sharing plan, which matches 100%
of employee contribution
supto5%ofcompensation.
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 the
matching contributions at the end of the 2006 plan
year. In February 200
7, Employer X determines that
Employee H has excess aggregate contributions of
$1,000. The plan provides that only matching contri-
butions will be dis
tributed as excess aggregate contri-
butions.
(ii) Employer X has two options available in dis-
tributing Employ
ee H's excess contributions. The
first option is to distribute $600 of vested matching
contributions and forfeit $400 of nonvested match-
ing contributi
ons. These amounts are in proportion
to Employee H's vested and nonvested interests in all
matching contributions. The second option is to dis-
tribute $1,0
00 of vested matching contributions, leav-
ing the nonvested matching contributions in the plan.
(iii) If the second option is chosen, the plan must
also provide
a separate vesting schedule for vesting
these 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 of
the next 2 years.
(iv) The plan will not satisfy the nondiscrimina-
tory availability requirement of section 401(a)(4) if
only nonvested matching contributions are distributed
because the effect is that matching contributions for
HCEs 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 or
deferred arrangement. Elective contributions are
matched at the rate of 100%. After-tax employee
contributions are permitted under the plan only for
nonhighly compensated employees and are matched
at the same rate. No employees make excess defer-
rals. Employee J, a highly compensated employee,
makes an $8,000 elective contribution and receives
an $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 ACP
tests, the plan distributes to A $1,000 of excess contri-
butions and $500 of excess aggregate contributions.
After the distributions, Employee J's contributions
for 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) under
section 411(a)(3)(G), if the plan so provides. The
plan could instead correct the di
scriminatory rate of
matching 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 change
from the prior year testing method to the
current year testing method for any plan
year. A plan is permitted to change from
thecurrentyeartestingmethodtotheprior
year 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 that
uses the safe harbor method described in
§1.401(m)–3 or a SIMPLE 401(k) plan is
treated as using the current year testing
method for that plan year
(2)Calculation of ACP under the prior
year testing method for the first plan
year—(i)Plans that are not successor
plans. If, for the first plan year of any plan
(other than a successor plan), a plan uses
the prior year testing method, the plan is
permitted to use either that first plan year
as the applicable year for determining the
ACP for the eligible NHCEs, or 3% as the
ACP for eligible NHCEs, for applying the
ACP test for that first plan year. A plan
(other than a successor plan) that uses the
prior year testing method but has elected
for its first plan year to use that year as the
applicable year for determining the ACP
for the eligible NHCEs is not treated as
changing its testing method in the second
plan year and is not subject to the limita-
tions on double counting under paragraph
(a)(6)(vi) of this section for the second
plan year.
(ii)First plan year defined.Forpur-
poses of this paragraph (c)(2), the first
plan year of any plan is the first year in
which the plan provides for employee
contributions or matching contributions.
Thus, the rules of this paragraph (c)(2) do
not apply to a plan (within the meaning
of §1.410(b)–7) for a plan year if for such
plan year the plan is aggregated under
§1.401(m)–1(b)(4) with any other plan
that provides for employee or matching
contributions in the prior year.
(iii)Plans that are successor plans.A
plan is a successor plan if 50% or more
of the eligible employees for the first plan
year were eligible employees under an-
other plan maintained by the employer in
the prior year that provides for employee
contributions or matching contributions. If
a plan that is a successor plan uses the prior
year testing method for its first plan year,
the ACP for the group of NHCEs for the
applicable year must be determined under
paragraph (c)(4) of this section.
(3)Plans using different testing meth-
ods for the ACP and ADP test. Except
as otherwise provided in this paragraph
(c)(3), a plan may use the current year test-
ing method or prior year testing method for
the ACP test for a plan year without regard
to whether the current year testing method
orprioryeartestingmethodisusedforthe
ADP test for that year. For example, a plan
may use the prior year testing method for
the ACP test and the current year testing
method for its ADP test for the plan year.
However, plans that use different testing
methods 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) of
this section to take elective contributions
2003-35 I.R.B.488September 2, 2003

into account under the ACP test (rather
than 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 year
testing method that experiences a plan cov-
erage change during a plan year satisfies
the requirements of this section for that
year only if the plan provides that the ACP
for the NHCEs for the plan year is the
weighted average of the ACPs 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 weighted
averages described in paragraph (c)(4)(i)
of this section, the plan may provide that
the ACP for the group of eligible NHCEs
for the prior year under the plan is the
ACP of the NHCEs for the prior year of
the plan under which that single prior year
subgroup was eligible.
(iii)Definitions. The following defini-
tions apply for purposes of this paragraph
(c)(4)—
(A)Plan coverage change.Theterm
plan coverage changemeans a change in
the group or groups of eligible employees
under a plan on account of—
(1) The establishment or amendment of
aplan;
(2) A plan merger or spinoff under sec-
tion 414(l);
(3) A change in the way plans (within
the meaning of §1.410(b)–7) are com-
bined or separated for purposes of
§1.401(m)–1(b)(4) (e.g., permissively
aggregating plans not previously aggre-
gated under §1.410(b)–7(d), or ceasing
to permissively aggregate plans under
§1.410(b)–7(d));
(4) A reclassification of a substantial
group of employees that has the same ef-
fect as amending the plan (e.g., a transfer
of a substantial group of employees from
one 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.Theterm
prior year subgroupmeansallNHCEsfor
the prior plan year who, in the prior year,
were eligible employees under a specific
plan that provides for employee contribu-
tions or matching contributions maintained
by the employer and who would have been
eligible employees in the prior year under
the plan being tested if the plan coverage
change had first been effective as of the
first day of the prior plan year instead of
first being effective during the plan year.
The determination of whether an NHCE is
a member of a prior year subgroup is made
without regard to whether the NHCE ter-
minated employment during the prior year.
(C)Weighted average of the ACPs
for the prior year subgroups.Theterm
weighted average of the ACPs for the
prior year subgroupsmeans the sum, for
all prior year subgroups, of the adjusted
ACPs for the plan year. The termadjusted
ACP with respect to a prior year subgroup
means the ACP for the prior plan year of
the specific plan under which the members
of the prior year subgroup were eligible
employees on the first day of the prior plan
year, multiplied by a fraction, the numer-
ator of which is the number of NHCEs in
the prior year subgroup and denominator
of which is the total number of NHCEs in
all prior year subgroups.
(iv)Example. The following example
illustrate the application of this paragraph
(c)(4). See also §1.401(k)–2(c)(4) for ex-
amples of the parallel rules applicable to
the ADP test. The example is as follows:
Example. (i) Employer B maintains two plans,
Plan N and Plan P, each of whic
h provides for
employee contributions or matching contributions.
The plans were not permissively aggregated under
§ 1.410(b)–7(d) for the 200
5 testing year. Both plans
use the prior year testing method. Plan N had 300
eligible employees who were NHCEs for 2005, and
theirACPforthatyearwa
s 6%. Plan P had 100
eligible employees who were NHCEs for 2005, and
the ACP for those NHCEs for that plan was 4%.
Plan N and Plan P are pe
rmissively aggregated under
§ 1.410(b)–7(d) for the 2006 plan year.
(ii) The permissive aggregation of Plan N and
Plan P for the 2006 tes
ting year under § 1.410(b)–7(d)
is a plan coverage change that results in treating the
plans as one plan (Plan NP). Therefore, the prior year
ACP for the NHCEs u
nder Plan NP for the 2006 test-
ing year is the weighted average of the ACPs for the
prior year subgroups.
(iii) The first st
ep in determining the weighted av-
erage of the ACPs for the prior year subgroups is to
identify the prior year subgroups. With respect to
the 2006 testin
g year, an employee is a member of
a prior year subgroup if the employee was an NHCE
of Employer B for the 2005 plan year, was an eligible
employee for
the 2005 plan year under any section
401(k) plan maintained by Employer B, and would
have been an eligible employee in the 2005 plan year
under Plan N
PifPlanNandPlanPhadbeenpermis-
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 comprise
separate prior year subgroups. Thus, there are two
prior 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 100
NHCEs who were eligible employees under Plan P
for the 2005 plan year.
(iv) The weighted average of the ACPs for the
prior year subgroups is the sum of the adjusted ACP
with respect to the prior year subgroup that consists of
the NHCEs who were eligible employees under Plan
N, and the adjusted ACP with respect to the prior year
subgroup that consists of the NHCEs who were eligi-
ble employees under Plan P. The adjusted ACP for the
prior year subgroup that consists of the NHCEs who
were 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 number
of NHCEs in that prior year subgroup divided by the
total number of NHCEs in all prior year subgroups),
which equals 4.5%. The adjusted ACP for the prior
year subgroup that consists of the NHCEs who were
eligible employees under Plan P is 1%, calculated
as
follows: 4% (the ACP for the NHCEs under Plan P
for the prior year) x 100/400 (the number of NHCEs
in that prior year subgroup divided by the
total num-
ber of NHCEs in all prior year subgroups), which
equals 1%. Thus, the prior year ACP for NHCEs un-
der Plan NP for the 2006 testing year is 5
.5% (the sum
of adjusted ACPs for the prior year subgroups, 4.5%
plus 1%).
§1.401(m)–3 Safe harbor requirements.
(a)ACP test safe harbor. Matching
contributions under a plan satisfy the
ACP safe harbor provisions of section
401(m)(11) for a plan year if the plan
satisfies the safe harbor contribution re-
quirement of paragraphs (b) or (c) of this
section for the plan year, the limitations on
matching contributions of paragraph (d)
of this section, the notice requirement of
paragraph (e) of this section, the plan year
requirements 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 requirement
of paragraphs (b) and (c) of this section
must be satisfied without regard to section
401(l). The contributions made under
paragraphs (b) and (c) of this section are
referred to as safe harbor nonelective
contributions and safe harbor matching
contributions, respectively.
(b)Safe harbor nonelective contribu-
tion requirement. A plan satisfies the safe
harbor nonelective contribution require-
ment of this paragraph (b) if it satisfies
the safe harbor nonelective contribution
requirement of §1.401(k)–3(b).
September 2, 20034892003-35 I.R.B.

(c)Safe harbor matching contribution
requirement. A plan satisfies the safe har-
bor matching contribution requirement of
this 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 for
matching contributions meets the require-
ments of this section only if it satisfies the
limitations on contributions set forth in
this paragraph (d).
(2)Matching rate must not increase.A
plan 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 under
the plan for a plan year to the employee's
elective deferrals and employee contribu-
tions, does not increase as the amount of
an employee's elective deferrals and em-
ployee contributions increases.
(3)Limit on matching contributions.A
plan that provides for matching contribu-
tions satisfies the requirements of this sec-
tion only if—
(i) Matching contributions are not
made with respect to elective defer-
rals or employee contributions that ex-
ceed 6% of the employee's safe harbor
compensation (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.A
plan meets the requirements of this sec-
tion only if the ratio of matching contribu-
tions on behalf of an HCE to that HCE's
elective deferrals or employee contribu-
tions (or the sum of elective deferrals and
employee contributions) for that plan year
is no greater than the ratio of matching
contributions to elective deferrals or em-
ployee contributions (or the sum of elective
deferrals and employeecontributions) that
would apply with respect to any NHCE for
whom the elective deferrals or employee
contributions (or the sum of elective de-
ferrals and employee contributions) are the
same percentage of safe harbor compensa-
tion. An employee is taken into account
for purposes of this paragraph (d)(4) if the
employee is an eligible employee under
the cash or deferred arrangement with re-
spect to which the contributions required
by paragraph (b) or (c) of this section are
being made for a plan year. A plan will not
fail to satisfy this paragraph (d)(4) merely
because the plan provides that matching
contributions will be made separately with
respect to each payroll period (or with re-
spect to all payroll periods ending with
or within each month or quarter of a plan
year) taken into account under the plan
for the plan year, provided that matching
contributions with respect to any elective
deferrals or employee contributions made
during a plan year quarter are contributed
to the plan by the last day of the immedi-
ately following plan year quarter.
(5)HCEs participating in multiple
plans. 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 matching
contributions under paragraph (d)(4) of
this section. However, a plan will not
fail to satisfy the safe harbor matching
contribution requirements of this section
merely because an HCE participates dur-
ing the plan year in more than one plan
that provides for matching contributions,
provided that —
(i) The HCE is not simultaneously an
eligible employee under two plans that
provide for matching contributions main-
tained by an employer for a plan year; and
(ii) The period used to determine com-
pensation for purposes of determining
matching contributions under each such
plan is limited to periods when the HCE
participated in the plan.
(6)Permissible restrictions on elective
deferrals by NHCEs—(i)General rule.
A plan does not satisfy the safe harbor
requirements of this section, if elective
deferrals or employee contributions by
NHCEs are restricted, unless the restric-
tions are permitted by this paragraph
(d)(6).
(ii)Restrictions on election periods.A
plan 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 employee
must have a reasonable opportunity (in-
cluding a reasonable period after receipt of
the notice described in paragraph (e) of this
section) to make or change a contribution
election for the plan year. For purposes of
this section, a 30-day period is deemed to
be a reasonable period to make or change
a contribution election.
(iii)Restrictions on amount of con-
tributions. A plan is permitted to limit
the amount of contributions that may be
made by an eligible employee under a
plan, provided that each NHCE who is
an eligible employee is permitted (unless
the employee is restricted under para-
graph (d)(6)(v) of this section) to make
contributions in an amount that is at least
sufficient to receive the maximum amount
of matching contributions available un-
der the plan for the plan year, and the
employee is permitted to elect any lesser
amount of contributions. However, a plan
may require eligible employees to make
contribution elections in whole percent-
ages of compensation or whole dollar
amounts.
(iv)Restrictions on types of compensa-
tion that may be deferred.Aplanmay
limit the types of compensation that may
be deferred or contributed by an eligible
employee under a plan, provided that each
eligible NHCE is permitted to make con-
tributions under a definition of compen-
sation that would be a reasonable defini-
tion of compensation within the meaning
of §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 under
the Internal Revenue Code.Aplanmay
limit the amount of contributions made by
an 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 ability
to 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 satisfies
the 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 requirements
of section 401(m)(11) and this section un-
less plan provisions that satisfy the rules
of this section are adopted before the first
day of that plan year and remain in effect
for an entire 12-month plan year. More-
over, if, as described in paragraph (j)(4) of
this 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.490September 2, 2003

be made in the other plan and providing
that the contributions will be QNECs or
QMACs must be also be adopted before
the first day of that plan year.
(2)Initial plan year.Anewlyes-
tablished plan (other than a successor
plan within the meaning of §1.401(m)–2
(c)(2)(iii)) will not be treated as violating
the requirements of this paragraph (f)
merely because the plan year is less than
12 months, provided that the plan year is
at least 3 months long (or, in the case of
a newly established employer that estab-
lishes the plan as soon as administratively
feasible after the employer comes into ex-
istence, a shorter period). Similarly, a plan
will not fail to satisfy the requirements of
this paragraph (f) for the first plan year
in 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 effective
at the same time as the adoption of a cash
or deferred arrangement that satisfies the
requirements of §1.401(k)–3, taking into
account the rules of §1.401(k)–3(e)(2).
(3)Change of plan year. A plan that
has a short plan year as a result of changing
its plan year will not fail to satisfy the re-
quirements of paragraph (f)(1) of this sec-
tion merely because the plan year has less
than 12 months, provided that—
(i) The plan satisfied the requirements
of this section for the immediately preced-
ing plan year; and
(ii) The plan satisfies the requirements
of this section for the immediately follow-
ingplanyear.
(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 final
plan year is less than 12 months, provided
that—
(i) The plan would satisfy the require-
ments of paragraph (h) of this section,
treating the termination of the plan as a
reduction or suspension of safe harbor
matching contributions, other than the
requirement that employees have a rea-
sonable opportunity to change their cash
or deferred elections and, if applicable,
employee contribution elections; or
(ii) The plan termination is in connec-
tion with a transaction described in section
410(b)(6)(C) or the employer incurs a sub-
stantial business hardship, comparable to a
substantial business hardship described in
section 412(d).
(g)Plan amendments adopting non-
elective safe harbor contributions.
Notwithstanding paragraph (f)(1) of this
section, a plan that provides for the use
of the current year testing method may
be amended after the first day of the plan
year and no later than 30 days before
the last day of the plan year to adopt the
safe harbor method of this section using
nonelective contributions under paragraph
(b) of this section if the plan satisfies the
requirements of §1.401(k)–3(f).
(h)Permissible reduction or suspen-
sion of safe harbor matching contribu-
tions—(1)General rule. A plan that
provides for safe harbor matching con-
tributions will not fail to satisfy the re-
quirements of section 401(m)(2) for a plan
year merely because the plan is amended
during a plan year to reduce or suspend
safe harbor matching contributions on
future elective deferrals and, if applicable,
employee contributions provided—
(i) All eligible employees are provided
the supplemental notice in accordance
with paragraph (h)(2) of this section;
(ii) The reduction or suspension of safe
harbor matching contributions is effective
no earlier than the later of 30 days after
eligible employees are provided the no-
tice described in paragraph (h)(2) of this
section and the date the amendment is
adopted;
(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 contributions
to change their cash or deferred elections
and, if applicable, their employee contri-
bution elections;
(iv) The plan is amended to provide
that the ACP test will be satisfied for
the entire plan year in which the re-
duction or suspension occurs using the
current year testing method described in
§1.401(m)–2(a)(1)(ii); and
(v) The plan satisfies the requirements
of this section (other than this paragraph
(h)) with respect to amounts deferred
through the effective date of the amend-
ment.
(2)Notice of suspension requirement.
The notice of suspension requirement of
this paragraph (h)(2) is satisfied if each
eligible 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 is
taken into account for purposes of this
section for a plan year under the same
rules as §1.401(k)–3(h)(1).
(2)Use of safe harbor nonelective
contributions to satisfy other nondiscrim-
ination tests. A safe harbor nonelective
contribution used to satisfy the nonelective
contribution requirement under paragraph
(b) of this section may also be taken
into account for purposes of determining
whether 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 certain
plans that provide for early participation,
does not apply for purposes of section
401(m)(11) and this section. Thus, a plan
is not treated as satisfying this section
with respect to the eligible employees
who have not completed the minimum
age and service requirements of section
410(a)(1)(A) unless the plan satisfies the
requirements of this section with respect
to such eligible employees.
(4)Satisfying safe harbor contribution
requirement under another defined contri-
bution plan. Safe harbor matching or non-
elective contributions may be made to an-
other defined contribution plan under the
same rules as §1.401(k)–3(h)(4). Conse-
quently, each NHCE under the plan pro-
viding for matching contributions must be
eligible under the same conditions under
the other defined contribution plan and the
plan to which the contributions are made
must have the same plan year as the plan
providing for matching contributions.
(5)Contributions used only once.Safe
harbor matching or nonelective contribu-
tions cannot be used to satisfy the require-
ments of this section with respect to more
than one plan.
(6)Plan must satisfy ACP with respect
to employee contributions. If the plan pro-
vides for employee contributions, in addi-
tion to satisfying the requirements of this
section, 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 ACP
test is permitted to be run taking into ac-
count only employee contributions when
September 2, 20034912003-35 I.R.B.

this section is satisfied with respect to the
matching 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 of
section 401(m) and the regulations there-
under.
Actual contribution percentage
(ACP). Actual contribution percentage
orACPmeans the ACP of the group
of eligible employees as defined in
§1.401(m)–2(a)(2)(i).
Actual contribution percentage (ACP)
test. Actual contribution percentage test
orACP testmeans the test described in
§1.401(m)–2(a)(1).
Actual contribution ratio (ACR). Ac-
tual contribution ratioorACRmeans the
ACR of an eligible employee as defined in
§1.401(m)–2(a)(3).
Actual deferral percentage (ADP)
test. Actual deferral percentage testor
ADP testmeans the test described in
§1.401(k)–2(a)(1).
Compensation. Compensationmeans
compensation as defined in section 414(s)
and §1.414(s)–1. The period used to de-
termine an employee's compensation for a
plan year must be either the plan year or the
calendar 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 the
plan for that plan year. A plan may, how-
ever, limit the period taken into account
under either method to that portion of the
plan year or calendar year in which the em-
ployee was an eligible employee, provided
that this limit is applied uniformly to all
eligible employees under the plan for the
plan 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), period
of 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 methodmeans the
testing method under which the appli-
cable year is the current plan year, as
described in §1.401(m)–2(a)(2)(ii) or
1.401(k)–2(a)(2)(ii).
Elective contributions. Elective contri-
butionsmeans elective contributions as de-
fined in §1.401(k)–6.
Elective deferrals. Elective deferrals
means elective deferrals described in sec-
tion 402(g)(3).
Eligible employee—(1)General rule.
Eligible employeemeans an employee who
is directly or indirectly eligible to make an
employee contribution or to receive an al-
location of matching contributions (includ-
ingmatchingcontributionsderivedfrom
forfeitures) under the plan for all or a por-
tion of the plan year. For example, if an
employee must perform purely ministerial
or mechanical acts (e.g., formal applica-
tion for participation or consent to pay-
roll withholding) in order to be eligible to
make an employee contribution for a plan
year, the employee is an eligible employee
for the plan year without regard to whether
the employee performs these acts.
(2)Conditions on eligibility.Anem-
ployee who is unable to make employee
contributions or to receive an allocation
of matching contributions because the em-
ployee has not contributed to another plan
is also an eligible employee. By contrast, if
an employee must perform additional ser-
vice (e.g., satisfy a minimum period of ser-
vice requirement) in order to be eligible to
make an employee contribution or to re-
ceive an allocation of matching contribu-
tions for a plan year, the employee is not an
eligible employee for the plan year unless
the service is actually performed. An em-
ployee who would be eligible to make em-
ployee contributions but for a suspension
due to a distribution, a loan, or an election
not to participate in the plan, is treated as
an eligible employee for purposes of sec-
tion 401(m) for a plan year even though the
employee 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 to
be treated as an eligible employee merely
because the employee may receive no ad-
ditional annual additions because of sec-
tion 415(c)(1).
(3)Certain one-time elections.Anem-
ployee is not an eligible employee merely
because the employee, upon commencing
employment with the employer or upon the
employee's first becoming eligible under
any plan of the employer providing for em-
ployee or matching contributions, is given
a one-time opportunity to elect, and the
employee in fact does elect, not to be eli-
gible to make employee contributions or to
receive allocations ofmatching contribu-
tions under the plan or any other plan main-
tained by the employer (including plans
not yet established) for the duration of
the employee's employment with the em-
ployer. In no event is an election made af-
ter December 23, 1994, treated as one-time
irrevocable election under this paragraph if
theelectionismadebyanemployeewho
previously became eligible under another
plan (whether or not terminated) of the em-
ployer.
Eligible HCE. Eligible HCEmeans an
eligible employee who is an HCE.
Eligible NHCE. Eligible NHCEmeans
an eligible employee who is not an HCE.
Employee. Employeemeans an em-
ployee within the meaning of §1.410(b)–9.
Employee contributions. Employee
contributionsmeans employee contribu-
tions as defined in 1.401(m)–1(a)(3).
Employee stock ownership plan
(ESOP). Employee stock ownership plan
orESOPmeans the portion of a plan
that is an ESOP within the meaning of
§1.410(b)–7(c)(2).
Employer. Employermeans an em-
ployer within the meaning of §1.410(b)–9.
Excess aggregate contributions. Excess
aggregate contributionsmeans, with re-
spect to a plan year, the amount of excess
aggregate contributions apportioned to an
HCE under §1.401(m)–2(b)(2)(iii).
Excess contributions. Excess contribu-
tionmeans with respect to a plan year, the
amount of excess contribution apportioned
to an HCE under §1.401(k)–2(b)(2)(iii).
Excess deferrals. Excess deferrals
means excess deferrals as defined in
§1.402(g)–1(e)(3).
Highly compensated employee (HCE).
Highly compensated employeeorHCEhas
the meaning provided in section 414(q).
Matching contributions. Matching con-
tributionis defined in §1.401(m)–1(a)(2).
Nonelective contributions. Nonelective
contributionsmeans employer contribu-
tions (other than matching contributions)
with respect to which the employee may
not elect to have the contributions paid
to the employee in cash or other benefits
instead of being contributed to the plan.
2003-35 I.R.B.492September 2, 2003

Non-employee stock ownership plan
(non-ESOP). Non-employee stock owner-
ship planornon-ESOPmeans the portion
of a plan that is not an ESOP within the
meaning of §1.410(b)–7(c)(2).
Non-highly compensated employee
(NHCE). Non-highly compensated em-
ployeeorNHCEmeans an employee who
is not an HCE.
Plan. Planmeans plan as defined in
§1.401(m)–1(b)(4).
Prior year testing method. Prior
year testing methodmeans the test-
ing method under which the appli-
cable year is the prior plan year, as
described in §1.401(m)–2(a)(2)(ii) or
§1.401(k)–2(a)(2)(ii).
Qualified matching contributions
(QMAC). Qualified matching contri-
butionsorQMACmeans matching con-
tributions that satisfy the requirements
of §1.401(k)–1(c) and (d) at the time the
contribution is made, without regard to
whether the contributions are actually
taken 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 providing
that a matching contribution does not fail
to qualify as a QMAC solely because it
is forfeitable under section 411(a)(3)(G)
because it is a matching contribution with
respect to an excess deferral, excess con-
tribution, or excess aggregate contribution.
Qualified nonelective contributions
(QNEC). Qualified nonelective contribu-
tionsorQNECmeans employer contri-
butions, other than elective contributions
or matching contributions, that satisfy the
requirements of §1.401(k)–1(c) and (d) at
the time the contribution is made, without
regard to whether the contributions are
actually taken into account under the ADP
test under §1.401(k)–2(a)(6) or the ADP
test 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 Register
for July 17, 2003, 68 F.R. 42475)
Notice of Proposed Rulemaking;
Notice of Public Hearing;
and Withdrawal of Previously
Proposed Regulations
Credit for Increasing Research
Activities
REG–133791–02 and
REG–105606–99
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking;
notice of public hearing; and withdrawal of
previously proposed regulations.
SUMMARY: This document contains
proposed regulations relating to the com-
putation and allocation of the credit for
increasing research activities for members
of a controlled group of corporations or a
group of trades or businesses under com-
mon control. These proposed regulations
reflect changes made to section 41 by the
Revenue Reconciliation Act of 1989 and
the Small Business Job Protection Act of
1996, which introduced the alternative
incremental research credit. This doc-
ument also provides notice of a public
hearing on these proposed regulations
and withdraws the proposed regulations
(REG–105606–99, 2000–1 C.B. 421 [65
FR 258]) published in the Federal Register
on January 4, 2000.
DATES: Written or electronic comments
must be received by October 23, 2003. Re-
quests to speak and outlines of the topics to
be 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), room
5226, Internal Revenue Service, POB
7604, Ben Franklin Station, Washington,
DC 20044. Submissions may also be
hand delivered Monday through Friday
between the hours of 8 a.m. and 4 p.m. to:
CC:PA:RU (REG–133791–02), Courier's
Desk, Internal Revenue Service, 1111
Constitution Avenue, NW, Washington,
DC 20224. Alternatively, taxpayers may
submit comments electronically via the In-
ternet by submitting comments directly to
the IRS Internet site at:www.irs.gov/regs.
The public hearing will be held in room
4718, Internal Revenue Building, 1111
Constitution Avenue, NW, Washington,
DC 20224.
FOR FURTHER INFORMATION
CONTACT: Concerning these proposed
regulations, Jolene J. Shiraishi at (202)
622–3120 (not a toll-free call); concerning
submissions of comments, the hearing,
and to be placed on the building access
list to attend the hearing, Guy Traynor at
(202) 622–7180 (not a toll-free call).
SUPPLEMENTARY INFORMATION:
Background
On January 4, 2000, Treasury and the
IRS published in theFederal Register
(REG–105606–99, 2000–1 C.B. 421 [65
FR 258]) proposed amendments to the
regulations under section 41(f) (2000
proposed regulations) relating to the com-
putation and allocation of the credit for
increasing research activities (research
credit) for members of a controlled group
of corporations or a group of trades or busi-
nesses under common control (controlled
group). The 2000 proposed regulations
reflected changes made to section 41 by
the Revenue Reconciliation Act of 1989
(the 1989 Act) and the Small Business Job
Protection Act of 1996. Treasury and the
IRS received written comments from two
commentators. A public hearing was held
on April 26, 2000. After considering the
written comments and the statements at
the public hearing, Treasury and the IRS
are withdrawing the 2000 proposed regu-
lations and are proposing new regulations.
Summary of Comments and
Explanation of Provisions
Overview
These new proposed regulations for
members of a controlled group under
section 41(f) follow the research credit
computation rule contained in the 2000
proposed regulations. The computation of
the research credit for a controlled group
(group credit) under these new proposed
regulations is done by treating all of the
members of a controlled group as a single
taxpayer. Unlike the 2000 proposed reg-
ulations, these new proposed regulations
then allocate the group credit among the
September 2, 20034932003-35 I.R.B.

members of the controlled group based
on the relative amounts of each individual
member's stand-alone entity credit — the
credit, if any, that a member of a controlled
group would be entitled to claim if it were
not a member of a controlled group. These
new proposed regulations generally will
apply to taxable years beginning on or
after the date that final regulations are
published in theFederal Register.
Computation of the Group Credit
Section 41(f)(1)(A)(i) provides that in
determining the amount of the research
credit under section 41, “all members of
the same controlled group of corporations
shall be treated as a single taxpayer.” Sec-
tion 41(f)(1)(B)(i) provides a similar rule
for a group of trades or businesses under
common control. Accordingly, for pur-
poses of determining the amount of the
group credit, the 2000 proposed regula-
tions applied all of the section 41 comp
u-
tational rules on an aggregate basis.
The
commentators agreed that with respe
ct to
the computation of the group credit,
the
2000 proposed regulations are c
onsistent
with the provisions of section
41(f). These
new proposed regulations, the
refore, do
not change the method for comp
uting the
group credit. These new prop
osed reg-
ulations, however, clarify
the application
of the start-up company r
ules under sec-
tion 41(c)(3)(B) to a co
ntrolled group with
respect to the computat
ion of the group
credit.
Allocation of the Group Credit Among
Members 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 such
member shall be its proportionate shares
of the qualified research expenses and
basic research payments giving rise to the
credit.” Section 41(f)(1)(B)(ii) provides a
similar rule for a group of trades or busi-
nesses under common control. These new
proposed regulations apply these provi-
sions by allocating the group credit based
on the relative amounts of each individual
member's stand-alone entity credit.
2000 P
roposed 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, for
purposes of allocating the group credit
under the 2000 proposed regulations, was
determined by applying the controlled
group's fixed-base percentage to the mem-
ber's average annual gross receipts for the
four taxable years preceding the credit
year. The group credit was allocated to
a member having an excess amount of
QREs by multiplying the group credit
by a fraction having the individual mem-
ber's excess amount as the numerator and
the aggregate excess amount of all the
members of the controlled group as the
denominator. A similar allocation method
was provided for the credit for basic re-
search payments and for the alternative
incremental research credit.
The preamble to the 2000 proposed
regulations stated that the purpose of this
method was to allocate the group credit to
“those members whose share of current
year qualified research expenses exceeds
their share of the [controlled group's] base
amount.” In particular, the preamble noted
that in providing a rule that reflects the
incremental nature of the research credit,
Treasury and the IRS declined to follow
comments noting that amendments to
section 41 made by the 1989 Act required
that the allocation of the group credit be
based on the relative amounts of total
QREs incurred separately by members of
the controlled group:
In proposing rules for the allocation
of the credit, Treasury and the IRS
considered, but were not persuaded
by, certain taxpayers' argument that
the elimination of the word “increase”
from the allocation rule in the statute
requires that the credit be allocated
on the basis of the gross amount of
qualified research expenses incurred by
the various members of the controlled
group. Treasury and the IRS believe
that elimination of the word “increase”
was necessitated by the 1989 statu-
tory amendments to the computation
of the research credit, which afford a
credit in certain circumstances even
where the taxpayer (or each member
of a controlled group) is decreasing
its gross amount of qualified research
expenses (e.g., because the taxpayer's
gross receipts also are decreasing).
However, there is no indication that
the elimination of the word “increase”
was intended to suggest that the credit
be allocated without regard to its in-
cremental nature. To the contrary, the
statutory prescription that the credit be
allocated according to each member's
proportionate share of the qualified
research expenses “giving rise to” the
credit supports a rulethat allocates the
credit to those members whose share
of current year qualified research ex-
penses exceeds their share of the base
amount.
Comments on the 2000 Proposed
Regulations
Two commentators submitted a series
of comments in response to the 2000 pro-
posed regulations. As noted above, both
commentators agreed that the method for
computing the group credit contained in
the 2000 proposed regulations is consistent
with the provisions of section 41(f). The
commentators diverged significantly, how-
ever, with respect to the method for allocat-
ing the group credit. The first commenta-
tor supported the allocation rule contained
in the 2000 proposed regulations. The
second commentator reiterated the earlier
expressed view that the allocation of the
group credit should be done on the basis
of each member's total QREs (gross QREs
method).
The second commentator set out a
number of reasons why a gross QREs
method should be adopted instead of the
method contained in the 2000 proposed
regulations. In particular, the commen-
tator stated that a gross QREs method is
the only method consistent with the plain
meaning of section 41(f). As a related
point, the commentator claimed that a
statutory amendment made by the 1989
Act supports its plain meaning argument.
The commentator also noted that the al-
location method contained in the 2000
proposed regulations, by incorporating
both individual member and controlled
group elements, was at odds with the com-
putation method provided by the statute
and failed to allocate rationally the group
credit.
Treasury and the IRS continue to be-
lieve that, compared to a gross QREs
method, an allocation method based on
a group member's QREs in excess of a
2003-35 I.R.B.494September 2, 2003

base amount more fully carries out the
purposes of section 41 in general and
the section 41(f) controlled group credit
rules. The research credit is not, and
has never been, a credit computed as a
percentage of total qualifying expenses.
Rather, the research credit generally is
allowed only when a taxpayer's QREs
exceed a base amount. Prior to the 1989
Act, the research credit was computed by
multiplying the credit rate by the excess of
the taxpayer's current year QREs over the
taxpayer's average QREs for the preceding
three years. The 1989 Act significantly
modified the computation of the research
credit while retaining the incremental
approach of the pre-1989 Act credit. In
general, the research credit computation is
based on whether and the extent to which
a taxpayer increases the proportion of its
QREs relative to its recent gross receipts,
compared to a historical base period. Ul-
timately, this computation measures the
extent to which a taxpayer's current year
QREs exceed a base amount.
Treasury and the IRS conclude that
the controlled group allocation rules set
out in section 41(f) were not intended to
result in the allocation of the group credit
to individual members of the group in a
manner wholly at odds with the incre-
mental nature of the research credit. The
legislative history to the research credit,
as originally enacted in 1981, indicates
that the group credit rules were enacted to
ensure that the research credit would be al-
lowed only for actual increases in research
expenditures. These rules were intended
to prevent taxpayers from creating artifi-
cial increases in research expenditures by
shifting expenditures among commonly
controlled 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 credit
computation rule serves as a cap on the
maximum amount of credit that the mem-
bers of the group, in the aggregate, may
claim. A rule that then allocates the group
credit based solely on the total amount
of QREs incurred by each individual
member, however, would be inconsistent
with the incremental nature of the credit
and would not further the purpose of the
section 41(f) group credit rules.
As during the consideration of the 2000
proposed regulations, Treasury and the
IRS do not find persuasive the second
commentator's argument that a plain read-
ing of the statute, following the deletion
of the phrase “increase in” in sections
41(f)(1)(A)(ii) and 41(f)(1)(B)(ii) by the
1989 Act, mandates a gross QREs method
for allocating the group credit. Prior
to the 1989 Act, for example, section
41(f)(1)(A)(ii) provided that the research
credit, if any, allowable to each member
of a controlled group was the member's
“proportionate share of the increase in
qualified research expenses giving rise to
the credit.” The phrase “increase in” was
deleted by the 1989 Act. The commenta-
tor maintained that a gross QREs method
gives effect to the phrase “giving rise to
the credit” as well as to the deletion of the
phrase “increase in” from the statute by
the 1989 Act because “each dollar of the
group's QREs gives rise to [the] excess
over the group's base amount” or “(s)tated
otherwise, if you eliminate a dollar of
qualified research expenses from any
member of the group, the group's credit
will be reduced proportionately.”
The reason for the deletion of the
phrase “increase in” is not addressed in
the legislative history to the 1989 Act.
The changes to the computation of the
research credit made by the 1989 Act,
however, made a taxpayer's QREs for
prior years, other than taxable years be-
ginning after December 31, 1983, and
before January 1, 1989 (base years), ir-
relevant to the computation of the credit.
Instead, the amount of the research credit
now depends on whether and the extent to
which a taxpayer increases the proportion
(compared to that of the base years) of its
QREs relative to its average annual gross
receipts from the prior four years. Ac-
cordingly, althoughthe research credit is
still based on the amount by which current
year QREs exceed a base amount, that
base amount, unlike the general research
credit computation prior to the 1989 Act,
is not a rolling average of QREs incurred
in the three years prior to the credit year.
Treasury and the IRS, therefore, conclude
that the deletion of the phrase “increase
in” was intended to reflect this change,
and not to indicate that the allocation of
the group credit was to be made using a
gross QREs method.
The second commentator noted, in
arguing that the allocation method in the
2000 proposed regulations impermissibly
mixed controlled group and individual
member calculations, that the allocation
method favors those members whose cur-
rent ratio of QREs to recent gross receipts
exceeds the controlled group's fixed-base
percentage, regardless of whether that
member's ratio, in fact, was increasing or
decreasing. As stated by the commentator,
“[t]he group's fixed-base percentage can
be wildly different from the fixed-base
percentage for an individual member
depending on the individual member's
separate QREs and separate gross receipts
during the [base years]. In other words,
the amount of group credit that would be
allocated to an individual member under
the 2000 proposed regulations may bear
little or no relationship to what the indi-
vidual member would be entitled to on
a stand-alone basis, depending on how
similar the individual member's separate
fixed-base percentage was to the group's
fixed-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 determined
that the allocation method contained in the
2000 proposed regulations does not fully
carry out the purpose of the research credit
statute and, in particular, the amendments
made by the 1989 Act. Treasury and the
IRS continue to believe that the method
for allocating the group credit must take
into account the incremental nature of the
credit. In considering the consequences
of the allocation method contained in the
2000 proposed regulations, as highlighted
by the commentators, Treasury and the
IRS believe that the method may not, in
certain cases, appropriately balance the
purpose of the group credit computation
and allocation rules contained in section
41(f) with the general purpose of the
research credit, which is to encourage
research activities.
Accordingly, these new proposed reg-
ulations allocate the group credit among
the members of the controlled group by
first computing each individual member's
stand-alone entity credit and then multi-
plying the group creditby the ratio that the
member's stand-alone entity credit bears to
the sum of the stand-alone entity credits of
all the members of the controlled group.
This new allocation method ensures that
September 2, 20034952003-35 I.R.B.

the amount of group credit allocated to
each individual member will be propor-
tionate to the amount of research credit that
the individual member would have been
entitled to claim had it not been part of
a controlled group. This new allocation
method therefore addresses the concerns
expressed 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 research
credit — or, conversely, a disproportion-
ately greater amount of research credit —
compared to what they would have been
entitled to on a stand-alone basis, solely as
a result of being part of a controlled group.
Special Allocation Rule for Consolidated
Groups
In the preamble to the 2000 pro-
posed regulations, Treasury and the IRS
requested comments with respect to a spe-
cial rule that would treat all members of
a consolidated group within a controlled
group as a single member for purposes
of allocating the group credit among the
members of a controlled group. After con-
sidering the comments received, Treasury
and the IRS have decided not to propose
a special allocation rule for consolidated
groups.
Effective Date
The 2000 proposed regulations pro-
vided that they would be effective, when
finalized, for taxable years ending on or
after the date the proposed regulations
were filed with theFederal Register(i.e.,
December 29, 1999). The 2000 proposed
regulations, however, were proposed to be
retroactive in certain instances to prevent
abuse:
To prevent taxpayers that are members
of a controlled group from together
claiming in excess of 100% of the
credit with respect to prior taxable
years, the rules for allocating the group
credit would apply to any taxable year
beginning after December 31, 1989,
in which, as a result of inconsistent
methods of allocation, the members of
a controlled group as a whole claimed
more than 100% of the allowable group
credit. In the case of a group whose
members have different taxable years
and whose members used inconsistent
methods of allocation, the members of
the group as a whole shall be deemed
to have claimed more than 100% of the
allowable 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 containing
the allocation method set out in the 2000
proposed regulations to be applied retroac-
tively. The second commentator therefore
proposed that final regulations be applied
prospectively and that for prior years, tax-
payersbepermittedtorelyonfinalreg-
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 inconsistent
methods of allocation for past years. The
fact that members of the same controlled
groupmay,intheaggregate, claim more
than 100% of the group's Research Credit
should not make any difference.”
The group credit rules in section 41(f)
provide for a total group credit. There is
nothing in the statute or the legislative his-
tory that suggests that it then should be
permissible for the members of the con-
trolled group to claim, in the aggregate,
an amount of research credit exceeding the
group 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 controlled
group applied different allocation meth-
ods to claim more than 100 percent of the
group credit. The preamble to the 2000
proposed regulations and those proposed
regulations themselves eliminated any am-
biguity that may have existed with respect
to the Treasury and IRS position on this
point.
Accordingly, Treasury and the IRS pro-
pose that final regulations be effective for
taxable years beginning on or after the
date that these regulations are published in
theFederal Registeras final regulations.
Treasury and the IRS further propose that
the final regulations be retroactive in lim-
ited circumstances to prevent abuse. Gen-
erally, a taxpayer may use any reasonable
method of computing and allocating the
credit for taxable years beginning before
the date these regulations are published
in theFederal Registeras final regula-
tions. However, paragraph (b) relating to
the computation of the group credit and
paragraph (c), relating to the allocation of
the group credit, will apply to taxable years
ending on or after December 29, 1999, if
the members of a controlled group, as a
whole, claimed more than 100 percent of
the amount that would be allowable under
paragraph (b). In the case of a controlled
group whose members have different tax-
able years and whose members use incon-
sistent methods of allocation, the members
of the controlled group shall be deemed to
have, as a whole, claimed more than 100
percent 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 a
significant regulatory action as defined
in Executive Order 12866. Therefore,
a regulatory assessment is not required.
It also has been determined that section
553(b) of the Administrative Procedure
Act (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 Internal
Revenue Code, these proposed regulations
will be submitted to the Administrator
of the Small Business Administration for
comment on their impact on small busi-
ness.
*****
Withdrawal of Propose
d Amendments
to the Regulations
Accordingly, under the authority of 26
U.S.C. 7805, the notice of proposed rule-
making (REG–105606–99, 2000–1 C.B.
421 [65 FR 258]) published in theFederal
Registeron January 4, 2000, is withdrawn.
Proposed Amendments to the
Regulations
Accordingly
, 26 CFR part 1 is proposed
to be amende
dasfollows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 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.496September 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 research
is manipulated.
(g) Membership during taxable year in
more 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) are
added.
6. Newly designated paragraph (f)(1) is
revised.
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 determine
the amount of research credit (if any) al-
lowable to a trade or business that at the
end of its taxable year is a member of a
controlled group of corporations or a group
of 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 the
members of the group in the manner de-
scribed in paragraph (c) of this section.
*****
(4)Definition of group credit.Forpur-
poses of this section, the termgroup credit
means the research credit (if any) allow-
able to a controlled group of corporations
or a group of trades or businesses under
common control.
(b)Computation of the group credit—
(1)In general. All members of a controlled
group of corporations or a group of trades
or businesses under common control are
treated as a single taxpayer for purposes of
computing the research credit. The group
credit is computed by applying all of the
section 41 computational rules on an ag-
gregate basis.
(2)Start-up companies. A controlled
group of corporations or a group of trades
or businesses under common control is
treated as a start-up company for purposes
of determining the group's fixed-base
percentage under section 41(c)(3)(B)(ii)
only if each member of the group quali-
fies as a start-up company under section
41(c)(3)(B)(i).
(c)Allocation of the group credit—(1)
In general. To determine the amount of the
group credit (if any) computed under para-
graph (b) of this section that is allocated to
a member of the group, a taxpayer must —
(i) Compute the member's stand-alone
entity credit; and
(ii) Multiply the group credit by the ra-
tio that the member's stand-alone entity
credit bears to the sum of the stand-alone
entity credits of all the members of the
group:
member’s stand-alone entity credit
group credit×
sum of all the members’ stand-alone entity credits
(2)Stand-alone entity credit. For pur-
poses of this section, the termstand-alone
entity creditmeans the research credit (if
any) that would be allowable to a mem-
ber of a group if the credit were computed
without regard to section 41(f). In comput-
ing a member's stand-alone entity credit, a
taxpayer must use the same method (i.e.,
the computation method provided in sec-
tion 41(a) or the elective method provided
in section 41(c)(4)) that was used to com-
pute the group credit. Therefore, if the
research credit determined under section
41(a) is not allowable to the group and the
group credit is computed using the alter-
native incremental research credit (AIRC)
rules of section 41(c)(4), each member's
stand-alone entity credit also must be com-
puted using the AIRC rules, even if the
research credit determined under section
41(a) would be allowable to a member if
that member were not a part of the group.
(d)Examples. The following examples
illustrate the provisions of this section:
Example 1.Research credit—(i)Facts.A,B,
andC,allofwhicharecalend
ar-year taxpayers, are
members of a controlled group of corporations. Nei-
ther A, B, nor C made any basic research payments
for their taxable year end
ing December 31, 2003. For
purposes of computing the group credit for the 2003
taxable year (the credit year), A, B, and C had the fol-
lowing:
September 2, 20034972003-35 I.R.B.

ABC
Group
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 the
Credit Year
$1,200x$200x$300x$1,700x
(ii)Computation of the gr
oup credit—(A)In gen-
eral. The research credit allowable to the group is
computed as if the three corporations were one tax-
payer. The group cred
it is equal to 20 percent of
the excess of the group's aggregate credit year QREs
($330x) over the group's base amount ($170x). The
group credit is 0.2
0 × ($330x−$170x), which equals
$32x.
(B)Group's base amount—(1)Computation.
The group's base a
mount equals the greater of: the
group's fixed-base percentage (10 percent) multi-
plied by the group's aggregate average annual gross
receipts for t
he 4 taxable years preceding the credit
year ($1,700x), or the gro
up'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, o
r $165x.
(2)Group's minimum base amount. The group's
minimum base amount is 50 percent of the group's
aggregate credit ye
ar QREs. The group's minimum
base amount is 0.50 × $330x, which equals $165x.
(3)Group's fixed-base percentage. The group's
fixed-base percent
age is the lesser of: the ratio that
the group's aggregate QREs for the taxable years be-
ginning after December 31,1983, and before January
1, 1989, bears t
o the group's aggregate gross receipts
for the same period, or 16 p
ercent (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 perce
nt,or16percent.
(iii)Allocation of the group credit. The group
credit of $32x is allocated among the members of the
group based on the ra
tio that each member's stand-
alone entity credit bears to the sum of the stand-alone
entity credits of all the members of the controlled
group. The $32x gr
oup credit is allocated as follows:
ABCTotal
Stand-Alone Entity Credit
$20x$2x$11x$33x
Allocation Rat
io (Stand-Alone Entity Credit/Sum
of Stand-Alone
Entity Credits)
20/332/3311/33
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, nor
F made any basic research payments during the 2003
taxable year. For purposes of computing the group
credit for the 2003 taxableyear (the credit year), D,
E, and F had the following:
DEF
Group
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 the
Credit Year
$1,200x$200x$0x$1,400x
(ii)Computation of the group credit—(A)In gen-
eral. The research credit allowable to the group is
computed as if the three corporations were one tax-
payer. The group credit is equal to 20 percent of
the excess of the group's aggregate credit year QREs
($270x) over the group's base amount ($135x). The
group 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: the
group's fixed-base percentage (5 percent) multiplied
by the group's aggregate average annual gross re-
ceipts for the 4 taxable years preceding the credit
year ($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's
minimum base amount is 50 percent of the group's
aggregate credit year QREs. The group's minimum
base amount is 0.50 × $270x, which equals $135x.
2003-35 I.R.B.498September 2, 2003

(3)Group's fixed-base percentage. Because
only one member of the group, F, is a start-up
company under section 41(c)(3)(B)(i), the group
is not a start-up company under paragraph (b)(2)
of this section. Therefore, the group's fixed-base
percentage is the lesser of: the ratio that the group's
aggregate QREs for the taxable years beginning after
December 31, 1983, and before January 1, 1989,
bears to the group's aggregate gross receipts for the
same period, or 16 percent (the statutory minimum).
The group's fixed-base percentage, therefore, is 5
percent, which is the lesser of: $70x/$1,400x, which
equals 5 percent, or 16 percent.
(iii)Allocation of the group credit. The group
credit of $27x is allocated among the members of the
group 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:
DEFTotal
Stand-Alone Entity Credit
$20x$2x$5x$27x
Allocation Ratio (Stand-Alone Entity Credit/Sum
of Stand-Alone Entity Credits)
20/272/275/27
Multiplied by: Group Credit
$27x$27x$27x
Equals: Credit Allocated to Member
$20x$2x$5x$27x
Example 3.Grou
p 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 o
f G, H, and I qualifies as a start-up com-
pany under section 41(c)(3)(B)(i). The 2003 taxable
year is the fifth taxable year beginning after Decem-
ber 31, 19
93,forwhicheachofG,H,andIhasQREs.
Because each of
G, H, and I qualifies as a start-up
company under section 41(c)(3)(B)(i), the group is
treated as a start-up company under paragraph (b)(2)
of this secti
on. The 2003 taxable year is the fifth
taxable year beginning after December 31, 1993, for
which the group has QREs. Neither G, H, nor I made
any basic
research payments during the 2003 taxable
year. For purpo
ses of computing the group credit for
the 2003 taxable year (thecredit year), G, H, and I
had the following:
GHI
Group
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 the
Credit Year
$1,600x$340x$300x
2,240x
(ii)Computation of the group credit—(A)In gen-
eral. The research credit allowable to the group is
computed as if the three corporations were one tax-
payer. The group credit is equal to 20 percent of
the excess of the group's aggregate credit year QREs
($380x) over the group's base amount ($190x). The
group 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: the
group's fixed-base percentage (3 percent) multiplied
by 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's
minimum base amount is 50 percent of the group's
aggregate credit year QREs. The group's minimum
base 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-up
company 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 the
group has QREs, under section 41(c)(3)(B)(ii)(I), the
group's fixed-base percentage is 3 percent.
(iii)Allocation of the group credit. The group
credit of $38x is allocated among the members of the
group 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:
GHITotal
Stand-Alone Entity Credit
$25.5x$2.5x$10x$38x
Allocation Ratio (Stand-Alone Entity Credit/Sum
of Stand-Alone Entity Credits)
25.5/382.5/3810/38
Multiplied by: Group Credit
$38x$38x$38x
Equals: Credit Allocated to Member
$25.5x$2.5x$10x$38x
September 2, 20034992003-35 I.R.B.

Example 4.Group alternative incremental
research credit—(i)Facts. J,K,andL,allof
which are calendar-year taxpayers, are members of
a controlled group of corporations. The research
credit under section 41(a) is not allowable to the
group for the 2003 taxable year because the group's
aggregate QREs for the 2003 taxable year are less
than 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 the
2003 taxable year (the credit year), J, K, and L had
the following:
JKL
Group
Aggregate
Credit Year QREs
$0x$20x$110x$130x
Average Annual Gross Receipts for 4 Years Preceding the
Credit Year
$1,200x$200x$300x$1,700x
(ii)Computation of the group credit.There-
search credit allowable to the group is computed as if
the three corporations were one taxpayer. The group
credit is equal to the sum of: 2.65 percent of so much
of the group's aggregate QREs for the taxable year
as exceeds 1 percent of the group's aggregate average
annual 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's
aggregate 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 exceeds
2 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 group
credit is allocated to each member of the group by
multiplying the group credit by the ratio that each
member's stand-alone entity credit bears to the sum
of the stand-alone entity credits of all the members
of the group. The $4.10x group credit is allocated as
follows:
JKLTotal
Stand-Alone Entity Credit
$0x$.66x$3.99x$4.65x
Allocation Ratio (Stand-Alone Entity Credit/Sum
of Stand-Alone Entity Credits)
0/4.650.66/4.653.99/4.65
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 before
January 1, 1990. For taxable years begin-
ning before January 1, 1990, see §1.41–6
as contained in 26 CFR part 1, revised
April 1, 2003.
(f)Tax accounting periods used—(1)
In general. The credit allowable to a mem-
ber of a controlled group of corporations
or a group of trades or businesses under
common control is that member's share of
the group credit computed as of the end of
that member's taxable year. In computing
the group credit for a group whose mem-
bers have different taxable years, a mem-
ber generally should treat the taxable year
of another member that ends with or within
the credit year of the computing member
as the credit year of that other member.
For example, M, N, and O are members
of a controlled group of corporations. M
and N file a calendar year consolidated re-
turn. O files a separate return using a fis-
cal year ending June 30. For purposes of
computing the group credit at the end of
the M's and N's (the computing members')
calendar year on December 31, O's fiscal
year ending June 30, which ends within the
M's and N's calendar year, is treated as O's
credit year.
*****
(i)Effective date. Paragraphs (a)(1),
(a)(4),(b),(c),(d),and(f)(1)ofthis
section 1.41–6 are applicable for taxable
years beginning on or after the date these
regulations are published in theFederal
Registeras final regulations. Generally, a
taxpayer may use any reasonable method
of computing and allocating the credit
for taxable years beginning before the
date these regulations are published in
theFederal Registeras final regulations.
However, paragraph (b) relating to the
computation of the group credit and para-
graph (c), relating to the allocation of the
group credit, will apply to taxable years
ending on or after December 29, 1999, if
the members of a controlled group, as a
whole, claimed more than 100 percent of
the amount that would be allowable under
paragraph (b). In the case of a controlled
group whose members have different
taxable years and whose members use
inconsistent methods of allocation, the
members of the controlled group shall be
deemed to have, as a whole, claimed more
than 100 percent of theamount that would
be 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 Register
for July 29, 2003, 68 F.R. 44499)
Notice of Proposed Rulemaking
and Notice of Public Hearing
Real Estate Mortgage
Investment Conduits;
Application of Section 446
With Respect to Inducement
Fees
REG–162625–02
AGENCY: Internal Revenue Service
(IRS), Treasury.
2003-35 I.R.B.500September 2, 2003

ACTION: Notice of proposed rulemaking
and notice of public hearing.
SUMMARY: This document contains
proposed regulations relating to the proper
timing and source of income from fees
received to induce the acquisition of
noneconomic residual interests in Real
Estate Mortgage Investment Conduits
(REMICs). The proposed regulations
would apply to taxpayers who receive
inducement fees in connection with be-
coming the holder of a noneconomic
REMIC residual interest. This document
also provides notice of a public hearing on
the proposed regulations.
DATES: Written or electronic comments
must be received by October 20, 2003.
Outlines of topics to be discussed at the
public hearing scheduled for November
18, 2003, at 10:00 a.m. must be received
by October 28, 2003.
ADDRESSES: Send submissions to
CC:PA:RU (REG–162625–02), room
5226, Internal Revenue Service, POB
7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand
delivered Monday through Friday be-
tween the hours of 8 a.m. and 4 p.m. to:
CC:PA:RU (REG–162625–02), Courier's
Desk, Internal Revenue Service, 1111
Constitution Avenue, NW, Washington,
DC. Alternatively, taxpayers may submit
electronic comments via the IRS Internet
site at:www.irs.gov/regs. The public hear-
ingwillbeheldintheIRSAuditorium,
1111 Constitution Avenue, NW, Washing-
ton, DC.
FOR FURTHER INFORMATION
CONTACT: Concerning the proposed
regulations, John W. Rogers III at (202)
622–3950; concerning submissions of
comments, the hearing, and/or to be
placed 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 proposed
amendments to the Income Tax Regu-
lations (26 CFR part 1) under sections
446(b) (relating to general rules for meth-
ods of accounting), 860C (relating to other
definitions and special rules applicable
to REMICs), and 863(a) (relating to spe-
cial rules for determining source) of the
Internal Revenue Code of 1986 (Code).
The proposed regulations prescribe certain
accounting rules for taking an inducement
fee into income over a period that is related
to the period during which the applicable
REMIC is expected to generate taxable
income or net loss allocable to the holder
of the noneconomic residual interest. The
proposed regulations set forth two safe
harbor methods of accounting for induce-
ment fees. The proposed regulations also
contain a rule clarifying that an induce-
ment fee is income from sources within
the United States.
Explanation of Provisions
Final regulations governing REMICs,
issued in 1992, contain rules governing the
transfer of noneconomicresidual interests.
Those regulations do not, however, contain
rules that address the transferee's treatment
of the fee received to induce the acquisition
of a REMIC noneconomic residual inter-
est.
An inducement fee is paid to a trans-
feree of a noneconomic residual interest
because, under sections 860C(a)(1) and
860E(a)(1) of the Code, the holder of a
REMIC residual interest must take into ac-
count the REMIC's taxable income or net
loss. The holder of a noneconomic resid-
ual interest will receiveinsufficient distri-
butions to cover the resulting tax liabilities,
and a transferee will, therefore, require an
inducement fee to become the holder of the
noneconomic residual interest.
In its earlier years, a REMIC typically
accrues more taxable interest income than
deductible interest expense. As a result, in
its earliest years, the REMIC will have net
income (generally referred to as phantom
income) taxable to the residual holder.
This phenomenon generally will reverse,
resulting in REMIC net loss (phantom
loss) in later years.
Following release of the final REMIC
regulations, the IRS and the Treasury De-
partment received requests for guidance on
the proper method of accounting to be used
by taxpayers for inducement fee income.
The proposed regulations provide rules re-
lating to the proper timing and source of
income from an inducement fee received
in connection with becoming the holder
of a noneconomic residual interest in a
REMIC.
The proposed regulations provide that,
to clearly reflect income, an inducement
fee must be included in income over a pe-
riod that is reasonably related to the period
during which the applicable REMIC is ex-
pected to generate taxable income or net
loss allocable to the holder of the noneco-
nomic residual interest. The proposed reg-
ulations provide that an inducement fee
generally may not be taken into account in
a single tax year.
The proposed regulations set forth two
safe harbor methods of accounting for in-
ducement fees. These safe harbor methods
are:
(1) A book method, under which an
inducement fee is recognized for federal
income tax purposes in the same amounts
and over the same period in which that in-
ducement fee is included in income by the
taxpayer for financial reporting purposes,
provided that the period is not shorter
than the period over which the applicable
REMIC is expected to generate taxable
income; and
(2) A method under which the induce-
ment fee is recognized for federal income
tax purposes ratably over the remaining
anticipated weighted average life of the
REMIC determined as of the time the
noneconomic residual interest is trans-
ferred to the taxpayer. This method is
based on rules in the final REMIC regu-
lations for taking into account a REMIC
sponsor's unrecognized gain or loss on a
REMIC residual interest upon the forma-
tion of a REMIC.
Additionally, the proposed regulations
contain a rule that applies if a holder of
a residual interest sells or otherwise dis-
poses of the residual interest. Under this
rule, the holder must take into account, at
the 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) applies
are excluded from this rule because section
381 and the regulations thereunder pro-
vide for the carryover of tax attributes, in-
cluding methods of accounting. The IRS
and the Treasury Department considered
excluding other non-recognition transac-
tions, such as contributions under sections
351 or 721. These other transactions, how-
ever, do not provide for the carryover of
tax attributes. The proposed regulations,
September 2, 20035012003-35 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 contain
a rule clarifying that an inducement fee
is income from sources within the United
States.
The IRS and the Treasury Department
request comments on other possible safe
harbor methods of accounting for these in-
ducement fees. In particular, comments
are requested on whether a safe harbor
method that recognizes inducement fees
proportionally to the anticipated future fi-
nancing costs for funding the net tax liabil-
ities of the noneconomic residual interest
would be of general use to taxpayers and, if
so, what factors should be used under that
safe harbor method for determining a tax-
payer's anticipated future financing costs.
The proposed regulations state that the
treatment of inducement fees is a method
of accounting that must be applied con-
sistently to all inducement fees received
in connection with noneconomic REMIC
residual interests. Thus, if a taxpayer uses
a safe harbor method, the taxpayer must
usethatsamesafeharbormethodforallin-
ducement fees received in connection with
any noneconomic REMIC residual inter-
ests held by the taxpayer.
The proposed regulations regarding the
timing for inclusion of inducement fees in
income, if finalized as proposed, would ap-
ply for taxable years ending on or after
publication of the final regulations in the
Federal Register. The IRS and the Trea-
sury Department request comments with
respect to whether the applicability of the
regulations should be limited to transac-
tions arising on or after the effective date
of these regulations and whether some de-
lay in the effective date of these regulations
is warranted.
The proposed regulations clarifying the
source of inducement fees, if finalized as
proposed, would apply for taxable years
ending on or after publication of the final
regulations in theFederal Register.
A taxpayer may not change its method
of accounting for inducement fees with-
out securing the prior consent of the Com-
missioner. The Commissioner may pre-
scribe terms and conditions necessary to
obtain the Commissioner's consent to ef-
fect a change in method of accounting and
to prevent amounts from being duplicated
or omitted. See sections 446 and 481;
§1.446–1(e)(3). The terms and conditions
thatmaybeprescribedbytheCommis-
sioner may include terms and conditions
that require the change in method of ac-
counting to be effected on a cut-off basis or
with an adjustment under section 481(a).
The IRS and the Treasury Department re-
quest comments on how best to effect any
change in method of accounting necessi-
tatedbytheseregulations.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a significant
regulatory action as defined in Executive
Order 12866. Therefore, a regulatory as-
sessment is not required. It has also been
determined 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 small
entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply. Pursuant
to section 7805(f) of the Code, the notice
of proposed rulemaking will be submitted
to the Chief Counsel for Advocacy of the
Small Business Administration for com-
ment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration
will be given to any electronic or written
comments (a signed original and eight (8)
copies) that are submitted timely to the
IRS. The IRS and the Treasury Department
specifically request comments on the clar-
ity of the proposed rules and how they may
be made easier to understand. The IRS
and the Treasury Department also specifi-
cally request comments on the safe harbor
methods provided in the regulations and
suggestions for other possible safe harbor
methods of accounting for these induce-
ment fees. All comments will be available
for public inspection and copying.
A public hearing has been scheduled for
November 18, 2003, beginning at 10:00
a.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 visitors
must present photo identification to enter
the building. Because of access restric-
tions, visitors will not be admitted beyond
the immediate entrance area more than 30
minutes before the hearing starts. For in-
formation about having your name placed
on the building access list to attend the
hearing, 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 to
present oral comments at the hearing must
submit electronic or written comments and
an outline of the topics to be discussed
and the time to be devoted to each topic
(a signed original and eight (8) copies) by
October 28, 2003. A period of 10 minutes
will be allotted to each person for making
comments. An agenda showing the sched-
uling of the speakers will be prepared af-
ter the deadline for receiving outlines has
passed. 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 of
Associate 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 the
Treasury Department participated in their
development.
*****
Proposed Amendments t
othe
Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The
authority citation for
part 1 is amende
dbyaddinganentryin
numerical ord
er 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 of
income from an inducement fee received
2003-35 I.R.B.502September 2, 2003

in connection with becoming the holder
of a noneconomic REMIC residual inter-
est. An inducement fee must be included
in income over a period reasonably related
to the period during which the applicable
REMIC is expected to generate taxable in-
come or net loss allocable to the holder of
the noneconomic residual interest.
(b)Definitions. For purposes of this
section—(1)Applicable REMIC.Theap-
plicable REMIC is the REMIC that issued
the noneconomic residual interest with re-
spect to which the inducement fee is paid.
(2)Inducement fee. An inducement fee
is the amount paid to induce a person to be-
come the holder of a noneconomic residual
interest in an applicable REMIC.
(3)Noneconomic residual interest.A
REMIC residual interest is a noneconomic
residual interest if it is a noneconomic
residual interest within the meaning of
§1.860E–1(c)(2).
(4)Remaining anticipated weighted
average 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 date
of acquisition of the noneconomic residual
interest.
(5)REMIC.ThetermREMIChasthe
same 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 the
remaining expected life of the applicable
REMIC in a manner that reasonably re-
flects, without regard to this paragraph, the
after-tax costs and benefits of holding that
noneconomic residual interest.
(d)Special rule on disposition of a
residual interest. If any portion of an
inducement fee received with respect to
the acquisition of a noneconomic resid-
ual interest in an applicable REMIC has
not been recognized in full by the holder
as of the time the holder sells, or other-
wise disposes of, that residual interest in
the applicable REMIC (in a transaction
other than a transaction to which section
381(c)(4) applies), then the holder must
include the unrecognized portion of the
inducement fee in income at that time.
(e)Safe harbors. If inducement fees
are 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 book
method, an inducement fee is recognized
in accordance with the method of account-
ing, and over the same period, that is used
by the taxpayer for financial reporting
purposes (including consolidated financial
statements to shareholders, partners, ben-
eficiaries, other proprietors and for credit
purposes), provided that the inducement
fee is included in income for financial
reporting purposes over a period that is not
shorter than the period during which the
applicable REMIC is expected to generate
taxable income.
(2)The modified REMIC regulatory
method. Under the modified REMIC
regulatory method, the inducement fee
is recognized ratably over the remaining
anticipated weighted average life of the ap-
plicable REMIC as if the inducement fee
were unrecognized gain being included in
gross income under §1.860F–2(b)(4)(iii).
(3)Additional safe harbor methods.
The Commissioner, by revenue ruling
or revenue procedure published in the
Internal Revenue Bulletin, may provide
additional safe harbor methods for recog-
nizing inducement fees on noneconomic
REMIC residual interests.
(f)Method of accounting. The treat-
ment of inducement fees is a method of
accounting to which the provisions of
sections 446 and 481 and the regulations
thereunder apply. A taxpayer is generally
permitted to adopt a method of account-
ing for inducement fees that satisfies the
requirements of paragraph (c) of this sec-
tion. Once a taxpayer adopts a method
of accounting for inducement fees, that
method must be applied consistently to all
inducement fees received in connection
with noneconomic REMIC residual inter-
ests and may be changed only with the
consent of the Commissioner, as provided
by section 446(e) and the regulations and
procedures thereunder.
(g)Effective date.Thissectionisappli-
cable for taxable yearsendingonorafter
the date this document is published as a fi-
nal regulation in theFederal Register.
Par. 3. Section 1.860A–0 is amended
by 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 residual
interests.
*****
(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 residual
interests.
*****
(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 United
States.
(f)Effective dates.The rules of para-
graphs (a), (b) and (c) of this section will
apply to taxable years beginning after De-
cember 30, 1996. However, taxpayers may
September 2, 20035032003-35 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 before
December 30, 1996. For years beginning
before December 30, 1996, see §1.863–1
(as contained in 26 CFR part 1 revised as
of April 1, 1996). See paragraph (d)(4) of
this section for rules regarding the applica-
bility date of paragraph (d) of this section.
Paragraph (e) of this section is applicable
for taxable years ending on or after the date
this document is published as a final regu-
lationintheFederal 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 Register
for July 21, 2003, 68 F.R. 43055)
Notice of Proposed Rulemaking
Elimination of Forms of
Distribution in Defined
Contribution 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 the
circumstances under which certain forms
of distribution previously available are per-
mitted to be eliminated from qualified de-
fined contribution plans. These proposed
regulations affect qualified retirement plan
sponsors, administrators, and participants.
DATES: Written and electronic comments
and request for a public hearing must be
received by October 6, 2003.
ADDRESSES: Send submissions to:
CC:PA:RU (REG–112039–03), room
5226, Internal Revenue Service, POB
7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand
delivered Monday through Friday be-
tween the hours of 8 a.m. and 5 p.m. to:
CC:PA:RU (REG–112039–03), Courier's
Desk, Internal Revenue Service, 1111
Constitution Avenue, NW, Washington,
DC. Alternatively, taxpayers may submit
comments electronically directly to the
IRS Internet site at:www.irs.gov/regs.
FOR FURTHER INFORMATION
CONTACT: Concerning the regulations,
Vernon S. Carter, 202–622–6060 (not a
toll-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 proposed
amendments to 26 CFR part 1 under sec-
tion 411(d)(6) of the Internal Revenue
Code of 1986 (Code) as amended by the
Economic Growth and Tax Relief Rec-
onciliation Act of 2001 (EGTRRA) (115
Stat. 117). Section 411(d)(6)(A) of the
Code generally provides that a plan will
not be treated as satisfying the require-
ments of section 411 if the accrued benefit
of a participant is decreased by a plan
amendment. Section411(d)(6)(B) prior
to amendment by EGTRRA provided that
an amendment is treated as reducing an
accrued benefit if, with respect to benefits
accrued before the amendment is adopted,
the amendment has the effect of either
eliminating 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, 2000–2
C.B. 279 [65 FR 53901], in theFed-
eral Registeron September 6, 2000. T.D.
8900, which amended section §1.411(d)–4
of the Income Tax Regulations, added
paragraph(e)ofQ&A–2toprovidefor
additional circumstances under which a
defined contribution plan can be amended
to eliminate or restrict a participant’s right
to receive payment of accrued benefits
under certain optional forms of benefit.
Section 1.411(d)–4, Q&A–2(e)(1) pro-
vides that a defined contribution plan may
be amended to eliminate or restrict a par-
ticipant’s right to receive payment of ac-
crued benefits under a particular optional
form of benefit without violating the sec-
tion 411(d)(6) anti-cutback rules if, once
the plan amendment takes effect for a par-
ticipant, the alternative forms of payment
that remain available to the participant in-
clude payment in a single-sum distribution
form that is “otherwise identical” to the
eliminated or restricted optional form of
benefit. The amendment cannot apply to
a participant for any distribution with an
annuity starting date before the earlier of
the 90
th
day after the participant receives a
summary that reflects the plan amendment
and that satisfies Department of Labor’s
requirements for a summary of material
modifications 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-sum
distribution form is “otherwise identical”
to the optional form of benefit that is being
eliminated or restricted only if it is iden-
tical in all respects (or would be identical
except that it provides greater rights to the
participant), except for the timing of pay-
ments after commencement. A single-sum
distribution 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 any
date on which the installment form
could have commenced;
•is not available in the same medium as
the installment form; or
•imposes any additional condition of el-
igibility.
Further, an otherwise identical distribution
form need not retain any rights or features
of the eliminated or restricted optional
form of benefit to the extent those rights or
features would not be protected from elim-
ination under the anti-cutback rules. The
single-sum distribution form would not,
however, be disqualified from being an
otherwise identical distribution form if the
single-sum form provides greater rights
to participants than did the eliminated or
restricted optional form of benefits.
Section 645(a)(1) of EGTRRA revised
section 411(d)(6) in a manner that is
similar to §1.411(d)–4, Q&A–2(e), but
without the advance notice condition.
Section 411(d)(6)(E) of the Code provides
that, except to the extent provided in reg-
ulations, a defined contribution plan is not
treated as reducing a participant’s accrued
benefit where a plan amendment elim-
inates a form of distribution previously
available under the plan if a single-sum
distribution is available to the participant
atthesametimeastheformofdistribution
eliminated by the amendment, and the
2003-35 I.R.B.504September 2, 2003

single-sum distribution is based on the
same or greater portion of the participant’s
account as the form of distribution elimi-
nated by the amendment.
To reflect the addition of section
411(d)(6)(E) by EGTRRA, these proposed
regulations would amend §1.411(d)–4,
Q&A–2(e). Under these amendments, the
regulations would retain the rules under
which a defined contribution plan may be
amended to eliminate or restrict a partici-
pant’s right to receive payment of accrued
benefits under a particular optional form
of benefit without violating the section
411(d)(6) anti-cutback rules if, once the
plan amendment takes effect for a partic-
ipant, the alternative forms of payment
that remain available to the participant
include payment in a single-sum distribu-
tion. However, these proposed regulations
would remove the 90-day notice condi-
tion previously applicable to these plan
amendments.
1
Under section 101 of Reorganization
Plan No. 4 of 1978 (43 FR 47713), the
Secretary of the Treasury has interpretive
jurisdiction over the subject matter ad-
dressed in these regulations for purposes
of the Employee Retirement Income Se-
curity Act of 1974 (ERISA), as well as
the Code. Section 204(g)(2) of ERISA, as
amended by EGTRRA, provides a parallel
rule to section 411(d)(6)(E) of the Code
that applies under Title I of ERISA, and
authorizes the Secretary of the Treasury to
provide exception to this parallel ERISA
requirement. Therefore, these regulations
apply for purposes of the parallel require-
ments of sections 204(g)(2) of ERISA,
as well as for section 411(d)(6)(E) of the
Code.
Effective Date and Applicability Date
The proposed regu
lations are proposed
toapplyontheda
te of publication of final
regulations in
theFederal Register.
Special Analyses
It has been determined that this Trea-
sury decision is not a significant regula-
tory action as defined in Executive Order
12866. Therefore, a regulatory assessment
is not required. It also has been determined
that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does
not apply to these regulations, and because
the regulation does not impose a collec-
tion of information on small entities, the
Regulatory Flexibility Act (5 U.S.C. chap-
ter 6) does not apply. Pursuant to section
7805(f) of the Code, this notice of pro-
posed rulemaking will be submitted to the
Chief Counsel for Advocacy of the Small
Business Administration for comment on
its impact on small business.
Drafting Information
The principal author of these regula-
tions is Vernon S. Carter of the Office
of the Division Counsel/Associate Chief
Counsel (Tax Exempt and Government En-
tities). However, other personnel from the
IRS and Treasury participated in their de-
velopment.
*****
Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
Paragraph 1.The authority citation for
part 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) protected
benefits.
*****
A–2: * * *
(e)Permitted plan amendments affect-
ing alternative forms of payment under
defined contribution plans—(1)General
rule. A defined contribution plan does
not violate the requirements of section
411(d)(6) merely because the plan is
amended to eliminate or restrict the ability
of a participant to receive payment of
accrued benefits under a particular op-
tional form of benefit if, after the plan
amendment is effective with respect to the
participant, the alternative forms of pay-
ment available to the participant include
payment in a single-sum distribution form
that is otherwise identical to the optional
form of benefit that is being eliminated or
restricted.
(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–2
only if the single-sum distribution form
is identical in all respects to the elimi-
nated or restricted optional form of ben-
efit (or would be identical except that it
provides 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 not
otherwise 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 installment
form would have been available for com-
mencement, is not available in the same
medium of distribution as the installment
form, or imposes any condition of eligi-
bility that did not apply to the installment
form. However, an otherwise identical dis-
tribution form need not retain rights or fea-
tures of the optional form of benefit that is
eliminated or restricted to the extent that
those 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 example
illustrates 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 that
is invested in mutual funds. The distribution forms
available to P under Plan M include a distribution of
P's vested account bal
ance under Plan M in the form
of distribution of various annuity contract forms (in-
cluding a single life annuity and a joint and survivor
annuity). The annuit
y payments under the annuity
contract forms begin as of the first day of the month
following P's severance from employment (or as of
the first day of any
subsequent month, subject to the
requirements of section 401(a)(9)). P has not pre-
viously elected payment of benefits in the form of
a life annuity,
and Plan M is not a direct or indirect
transferee of any plan that is a defined benefit plan or
a defined contribution plan that is subject to section
412. Distribu
tions on the death of a participant are
made in accordance with plan provisions that comply
with section 401(a)(11)(B)(iii)(I). On May 2, 2004,
Plan M is ame
nded so that, after the amendment is
effective, P is no longer entitled to any distribution
in 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 that
plan amendments be described in a timely summary of material modifications (SMM) or a revised summary plan description (SPD) to be distributed to planparticipants and beneficiaries in
accordance with applicable Department of Labor disclosure rules (see 29 CFR 2520.104b–3).
September 2, 20035052003-35 I.R.B.

However, after the amendment is effective, P is en-
titled to receive a single-sum cash distribution of P's
vested account balance under Plan M payable as of
the first day of the month following P's severance
from employment (or as of the first day of any sub-
sequent month, subject to the requirements of section
401(a)(9)). The amendment does not apply to P if P
elects to have annuity payments begin before July 1,
2004.
(ii) Plan M does not violate the requirements
of section 411(d)(6) (or section 401(a)(11)) merely
because, as of July 1, 2004, the plan amendment
has eliminated P's option to receive a distribution in
any of the various annuity contract forms previously
available.
(4)Effective date. This paragraph (e)
is applicable on the date of publication of
final regulations in theFederal 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 Register
for July 8, 2003, 68 F.R. 40581)
Notice of Proposed Rulemaking
by Cross-Reference to Temporary
Regulations and Notice of Public
Hearing
Prohibited Allocations of
Securities in an S Corporation
REG–129709–03
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking
by 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 the
definition of synthetic equity under sec-
tion 409(p)(5). These proposed regula-
tions would generallyaffect plan spon-
sors of, and participants in, ESOPs holding
stock of Subchapter S corporations. The
text of those temporary regulations also
serves 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 comments
must be received by October 17, 2003.
Requests to speak (with outlines of oral
comments to be discussed) at the public
hearing 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 be
hand delivered Monday through Friday
betweenthehoursof8a.m. and5p.m.
to: CC:PA:LPD:PR (REG–129709–03),
Courier's Desk, Internal Revenue Service,
1111 Constitution Avenue, NW, Wash-
ington, DC. Alternatively, taxpayers may
submit comments electronically directly to
the IRS Internet site atwww.irs.gov/regs.
The public hearing will be held in room
6718, Internal Revenue Building, 1111
Constitution Avenue, NW, Washington,
DC.
FOR FURTHER INFORMATION
CONTACT:Concerning the proposed
regulations, John Ricotta at 622–6060;
concerning submissions of comments,
Sonya Cruse, (202) 622–4693 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
Temporary regulations (T.D. 9081)
on page 420 of this issue of the Bulletin
amend the Income Tax Regulations (26
CFR part 1) relating to section 409(p).
The temporary regulations contain rules
relating to the identification of disqualified
persons and determination whether a plan
year is a nonallocation year under section
409(p) and the definition of synthetic eq-
uity under section 409(p)(5). The text of
those temporary regulations also serves
as the text of these proposed regulations.
The preamble to the temporary regulations
explains the temporary regulations.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a significant
regulatory action as defined in Executive
Order 12866. Therefore, a regulatory as-
sessment is not required. It also has been
determined 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, a
Regulatory Flexibility Analysis under the
Regulatory Flexibility Act (5 U.S.C. chap-
ter 6) is not required. Pursuant to section
7805(f) of the Internal Revenue Code, this
notice of proposed rulemaking will be sub-
mitted to the Chief Counsel for Advocacy
of the Small Business Administration for
comment on its impact on small business.
Comments and Requests for a Public
Hearing
Before these proposed regulations are
adopted as final regulations, consideration
will be given to any written comments (a
signed original and eight (8) copies) that
are submitted timely to the IRS. All com-
ments will be available for public inspec-
tion and copying.
Comments are requested with respect to
issues raised by S corporation ESOPs es-
tablished by March 14, 2001, that will need
to comply with the requirements of sec-
tion 409(p) beginning in 2005. For these
ESOPs, the inclusion of deferred compen-
sation as synthetic equity can be avoided
by distributing such deferred compensa-
tion before 2005. Some employers may
prefer other transition approaches. For
example, a preferable transition approach
maybetospinoffandterminatethepor-
tion of a plan benefitting disqualified per-
sons. Comments are requested on whether
guidance is needed to address these possi-
ble transition approaches.
Comments are also requested on issues
that are reserved in the regulations with re-
spect to whether certain interests in an S
corporation should be treated as synthetic
equity, including the extent to which rights
to acquire assets of the S corporation or
another person are established for reason-
able business purposes and should not be
treated as synthetic equity. While com-
ments can be filed as late as October 17,
2003, commentators are encouraged to file
comments as early as possible because the
IRS and Treasury intend to move forward
to address these issues as early as 2003.
2003-35 I.R.B.506September 2, 2003

Commentators may also wish to com-
ment on section 409(p)-related issues that
are not directly raised in the proposed reg-
ulations. For example, commentators may
wish to comment on the extent to which
administrative guidance may be needed on
an interim basis to deal with specific struc-
turesusedtoavoidorevadethepurposeof
section 409(p).
A public hearing has been scheduled for
November 17, 2003, at 10 a.m. in room
6718 of the Internal Revenue Building,
1111 Constitution Avenue, NW, Washing-
ton, DC. All visitors must present photo
identification to enter the building. Be-
cause of access restrictions, visitors will
not be admitted beyond the immediate en-
trance area more than 30 minutes before
the 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 "FOR
FURTHER 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 comments at the hearing must
submit written comments and an outline
of the topics to be discussed and the time
to be devoted to each topic (signed orig-
inal and eight (8) copies) by October 27,
2003. A period of 10 minutes will be
allotted to each person for making com-
ments. An agenda showing the scheduling
of the speakers will be prepared after the
deadline for receiving outlines has passed.
Copies of the agenda will be available free
of charge at the hearing.
Drafting Information
The principal author of these regula-
tions is John Ricotta of the Office of the
Division Counsel/Associate Chief Coun-
sel (Tax Exempt and Government Enti-
ties). However, other personnel from the
IRS and Treasury participated in their de-
velopment.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by an entry in numerical
order 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 of
securities in an S corporation.
[The text of proposed §1.409(p)–1 is
the 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, 2
003,
8:45 a.m., and published in the issue of the Federal Register
for July 21, 2003, 68 F.R. 43058)
September 2, 20035072003-35 I.R.B.

Definition of Terms
Revenue rulings and revenue procedures
(hereinafter referred to as “rulings”) that
have an effect on previous rulings use the
following defined terms to describe the ef-
fect:
Amplifieddescribes a situation where
no change is being made in a prior pub-
lished position, but the prior position is be-
ingextendedtoapplytoavariationofthe
fact situation set forth therein. Thus, if
an earlier ruling held that a principle ap-
plied to A, and the new ruling holds that the
same principle also applies to B, the earlier
ruling is amplified. (Compare withmodi-
fied,below).
Clarifiedis used in those instances
where the language in a prior ruling is
being made clear because the language
has caused, or may cause, some confusion.
It is not used where a position in a prior
ruling is being changed.
Distinguisheddescribes a situation
where a ruling mentions a previously pub-
lished ruling and points out an essential
difference between them.
Modifiedis used where the substance
of a previously published position is being
changed. Thus, if a prior ruling held that a
principle applied to A but not to B, and the
new ruling holds that it applies to both A
and B, the prior ruling is modified because
it corrects a published position. (Compare
withamplifiedandclarified,above).
Obsoleteddescribes a previously pub-
lished ruling that is not considered deter-
minative with respect to future transac-
tions. This term is most commonly used in
a ruling that lists previously published rul-
ings that are obsoleted because of changes
in laws or regulations. A ruling may also
be obsoleted because the substance has
been included in regulations subsequently
adopted.
Revokeddescribes situations where the
position in the previously published ruling
is not correct and the correct position is
beingstatedinanewruling.
Supersededdescribes a situation where
the 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 the
1986 Code and regulations the same po-
sition published under the 1939 Code and
regulations. The term is also used when
it is desired to republish in a single rul-
ing a series of situations, names, etc., that
were previously published over a period of
time in separate rulings. If the new rul-
ing does more than restate the substance
of a prior ruling, a combination of terms
is used. For example,modifiedandsu-
persededdescribes a situation where the
substance of a previously published ruling
is being changed in part and is continued
without change in part and it is desired to
restate the valid portion of the previously
published ruling in a new ruling that is self
contained. In this case, the previously pub-
lished ruling is first modified and then, as
modified, is superseded.
Supplementedis used in situations in
which a list, such as a list of the names of
countries, is published in a ruling and that
list is expanded by adding further names in
subsequent rulings. After the original rul-
ing has been supplemented several times, a
new ruling may be published that includes
the list in the original ruling and the ad-
ditions, and supersedes all prior rulings in
the series.
Suspendedis used in rare situations
to show that the previous published rul-
ings will not be applied pending some
future action such as the issuance of new
or amended regulations, the outcome of
cases in litigation, or the outcome of a
Service study.
Abbreviations
The following abbreviations in current use
and formerly used will appear in material
published 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.iSeptember 2, 2003

Numerical Finding List
1
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, 2003ii2003-35 I.R.B.

Findings List of Current Actions on
Previously Published Items
1
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,andsupersededby
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
Section4supersededby
Rev. Proc. 2003-55, 2003-31 I.R.B.242
Section5supersededby
Rev. Proc. 2003-56, 2003-31 I.R.B.249
Section6supersededby
Rev. Proc. 2003-57, 2003-31 I.R.B.257
Section7supersededby
Rev. Proc. 2003-59, 2003-31 I.R.B.268
Section8supersededby
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.iiiSeptember 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, 2003iv2003-35 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.vSeptember 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, 2003vi2003-35 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.viiSeptember 2, 2003

INDEX
Internal Revenue Bulletins
2003–27 through 2003–35
The abbreviation and number in parenthesis
following the index entry refer to the specific
item; numbers in roman and italic type follow-
ing the parentheses refer to the Internal Rev-
enue Bulletin in which the item may be found
and the page number on which it appears.
Key to Abbreviations:
AnnAnnouncement
CDCourt Decision
DODelegation Order
EOExecutive Order
PLPublic Law
PTEProhibited Transaction
Exemption
RPRevenue Procedure
RRRevenue Ruling
SPRStatement of Procedural
Rules
TCTax Convention
TDTreasury Decision
TDOTreasury Department Order
EMPLOYEE PLANS
Defined contribution plans, minimum
vesting standards (REG–112039–03)
35,504
ESOPs, prohibited allocations of s
ecuri-
ties in an S corporation (TD 9081) 35
,
420; (REG–129709–03) 35,506
Excise tax:
Reversion (RR 85) 32,291
Statute of limitations (RR 88) 32,
292
Full funding limitations, weight
ed aver-
age interest rate for:
July 2003 (Notice 48) 30,133
August 2003 (Notice 58) 35,429
Group health plan, COBRA, small em-
ployer plan exception (RR 70) 27,3
Minimum funding, entry age norma
l(RR
83) 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 defer
red
arrangements under section
401(k)
and matching contributions
or em-
ployee contributions unde
r section
401(m) (REG–108639–99) 35
,431
EMPLOYEE
PLANS—Cont.
26 CFR 1.409(p)–1, added; prohibited
allocations of securities in an S cor-
poration (REG–129709–03) 35,506
26 CFR 1.411(d)–4, amended; elim-
ination of forms of distribution
in defined contribution plans
(REG–112039–03) 35,504
Regulations:
26 CFR 1.409(p)–1T, added; prohib-
ited allocations of securities in an S
corporation (TD 9081) 35,420
Retirement plans, cash or deferred ar-
rangements under section 401(k) and
matching contributions or employee
contributions 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 extension
to file certain information returns and
exempt 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 time
to file certain information returns
and 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 file
certain information returns and ex-
empt organization returns (TD 9061)
27,5
ESTATE TAX
Charitable lead trusts, sa
mple forms (No-
tice 39) 27,10
Charitable remainder an
nuity trusts:
Inter vivos:
For a term of years (RP 54) 3
1,236
For one measuring life (RP 5
3) 31,
230
ESTATE TAX—Cont.
With concurrent and consecutive in-
terests for two measuring lives
(RP 56) 31,249
With consecutive interests for two
measuring lives (RP 55) 31,242
Testamentary:
For a term of years (RP 58) 31,262
For one measuring life (RP 57) 31,
257
With concurrent and consecutive in-
terests for two measuring lives
(RP 60) 31,274
With consecutive interests for two
measuring 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 of
golden parachute payments (RP 68) 34,
398
Tax on reversion of qualified plan assets
to employer (RR 85) 32,291
EXEMPT
ORGANIZATIONS
Coverdell education savings account re-
porting (Notice 53) 33,362
Declaratory judgment suits (Ann 53) 32,
345
Extension of time, automatic extension
to file certain information returns and
exempt 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 time
to file certain information return
s
and 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), amend
ed;
31.6081(a)–1, amended; 31.60
81
(a)–1T, added; 602.101, amen
ded;
September 2, 2003viii2003-35 I.R.B.

EXEMPT
ORGANIZATIONS—Cont.
automatic extension of time to file
certain 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) 31,236
For one measuring life (RP 53) 31,
230
With concurrent and consecutive in-
terests for two measuring lives
(RP 56) 31,249
With consecutive interests for two
measuring lives (RP 55) 31,242
Testamentary:
For a term of years (RP 58) 31,262
For one measuring life (RP 57) 31,
257
With concurrent and consecutive in-
terests for two measuring lives
(RP 60) 31,274
With consecutive interests for two
measuring lives (RP 59) 31,268
INCOME TAX
Accounting, changes in accounting peri-
ods, automatic approval for individuals
(RP 62) 32,299;(Ann49)32,339
Advance refunding bonds, tax-exempt
bonds (RR 78) 29,76
Annuity contracts:
Tax-free exchanges (Notice 51) 33,
361
Tax-free exchanges and basis alloca-
tion (RR 76) 33,355
Assumption of a partner’s liabilities
not accounted for under section
752(a) and (b) (TD 9062) 28,46;
(REG–106736–00) 28,60
Backup withholding rate, reduced f
or
amounts paid after December 31, 200
2
(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) 31,236
For one measuring life (RP 53) 31,
230
With concurrent and consecutive in-
terests for two measuring lives
(RP 56) 31,249
With consecutive interests for two
measuring lives (RP 55) 31,242
Testamentary:
For a term of years (RP 58) 31,262
For one measuring life (RP 57) 31,
257
With concurrent and consecutive in-
terests for two measuring lives
(RP 60) 31,274
With consecutive interests for two
measuring 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 aliens
and foreign corporations (Notice 38)
27,9
Controlled foreign corporations, insur-
ance business treated as a domestic
corporation (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 corporate
group:
To concentrate on one business
(RR 74) 29,77
To resolve capital allocation
problem (RR 75) 29,79
Treatment 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) 28,50
Increasing 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 housing
projects (REG–131997–02) 33,
366
Satisfactory bond, “bond factor”
amounts for the period:
July through September 2003
(RR 93) 33,346
New markets tax credit, qualified
equity investments under section
45D(b)(1)(C) (Notice 56) 34,396
Nonconventional source fuel credit,
qualified fuels under section
29(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 277
membership 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) 29,119
Depreciation and mid-quarter conven-
tion relief, automatic extension of
time to make election (Notice 45) 29,
86
Disciplinary actions involving attorneys,
certified public accountants, enrolled
agents, and enrolled actuaries (Ann 50)
30,222
Electronic and magnetic filing:
Requirements for submitting Form
8655 (RP 69) 34,403
Specifications for Forms 1098, 1099,
5498, and W-2G (RP 52) 30,134
Enhanced oil recovery credit, 2003 infla-
tion adjustment (Notice 43) 28,50
Entity classification for certain foreign el-
igible entities (Notice 46) 28,53
Equitable relief under section 66(c) or
section 6015(f) (RP 61) 32,296
Extension of time, automatic extension
to file certain information returns and
exempt organization returns (TD 9061)
27,5; (REG–107618–02) 27,13
2003-35 I.R.B.ixSeptember 2, 2003

INCOME TAX—Cont.
Extraterritorialincome 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 restricted
country (Notice 52) 32,296
Foreign trusts, Canadian retirement plan
trust 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) 28,49
Assignment deadline for private activ-
ity bond volume cap (Notice 42) 28,
49
Carryforward election of unused pri-
vate activity bond volume cap (RP
46) 28,54
Insurance companies:
Foreign insurance companies, mini-
mum effectively connected net in-
vestment income (RP 70) 34,406
Life insurance companies, variable
contracts (RR 91) 33,347
Life insurance contracts, change in
benefits (RR 95) 33,358
Interest:
Deductibility, note-forward contract
units (RR 97) 34,380
Investment:
Federal short-term, mid-term, and
long-term rates for:
July 2003 (RR 71) 27,1
August 2003 (RR 94) 33,357
Inventory:
LIFO, price indexes used by depart-
ment stores for:
May 2003 (RR 87) 29,82
June 2003 (RR 100) 34,385
Valuation, acquired in liquidation of
lump sum purchase (RP 51) 29,121
Lease strips:
Reallocation of income and deductions
among unrelated parties (RR 96) 34,
386
Tax consequences (Notice 55) 34,395
Marginal 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) 32,304
LIFO, automatic consent (RP 45) 27,
11
Uniform capitalization (Notice 59) 35,
429
New York Liberty Bonds, tax-exempt
bonds (Notice 40) 27,10
Nonconventional source fuel credit, qual-
ified fuels under section 29(c)(1)(C),
solid fuel from coal, suspended private
letter 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 waiver
of 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 carryover
and 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-exempt
bonds (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 1.421–1
and amended; 1.421–8 redesignated
as 1.421–2 and amended; 1.422–1,
–2, –4, –5, added; 1.422–4, re-
moved; 1.422–5 redesignated as
1.422–3; 1.423–1, –2, amended;
1.425–1 redesignated as 1.424–1
and amended; 1.6039–1, removed;
1.6039–2 redesignated as 1.6039–1
and 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 with
respect 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 time
to file certain information returns
and exempt organization returns
(REG–107618–02) 27,13
26 CFR 301.6724–1, amended; waiver
of information reporting penalties
(REG–141669–02) 34,408
Publications, 1220, Specifications for Fil-
ing Forms 1098, 1099, 5498, and W-2G
Electronically or Magnetically (RP 52)
30,134
Qualified census tracts, issuers of qual-
ified mortgage bonds and mortgage
credit certificates; correction (RP 49)
29,89
Qualified tertiary injectant expenses and
enhanced oil recovery credit (RR 82)
30,125
Real estate investment trusts (REITs):
Loans from (RP 65) 32,336
Taxable REIT subsidiaries (TRSs) and
independent contractors, rents (RR
86) 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 compensatory
options (TD 9067) 32,287
26 CFR 1.752–6T, added; assumption
of 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 file
certain information returns and ex-
empt organization returns (TD 9061)
27,5
REMICs, residual interests, inducement
fees (REG–162625–02) 35,500
Revocations, exempt organizations (Ann
48) 28,73; (Ann 52) 32,345
September 2, 2003x2003-35 I.R.B.

INCOME TAX—Cont.
Rulings, obsolete (RR 99) 34,388
Statute of limitations on assessment as af-
fected by bankruptcy (RR 80) 29,83
Stocks:
Deduction for compensatory stock op-
tion-related transactions following
certain corporate transactions (RR
98) 34,378
Option valuation for purposes of
golden parachute payments (RP
68) 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 options
to related persons (Notice 47) 30,
132
Tax-exempt bonds:
Advance refunding bonds (RR 78) 29,
76
New York Liberty Bonds (Notice 40)
27,10
Remedial action rules, application
(REG–132483–03) 34,410
Withholding foreign partnership (WP)
and withholding foreign trust (WT)
agreements (RP 64) 32,306
2003-35 I.R.B.xiSeptember 2, 2003
*U.S. G.P.O.: 2003—496–919/60098