(2) Qualified salary reduction arrangement (A) In general For purposes of this subsection, the term “qualified salary reduction arrangement” means a written arrangement of an eligible employer under which— (i) an employee eligible to participate in the arrangement may elect to have the employer make payments— (I) as elective employer contributions to a simple retirement account on behalf of the employee, or (II) to the employee directly in cash, (ii) the amount which an employee may elect under clause (i) for any year is required to be expressed as a percentage of compensation and may not exceed a total of the applicable dollar amount for any year, (iii) the employer is required to make a matching contribution to the simple retirement account for any year in an amount equal to so much of the amount the employee elects under clause (i)(I) as does not exceed the applicable percentage of compensation for the year, and (iv) no contributions may be made other than contributions described in clause (i) or (iii). (B) Employer may elect 2-percent nonelective contribution (i) In general An employer shall be treated as meeting the requirements of subparagraph (A)(iii) for any year if, in lieu of the contributions described in such clause, the employer elects to make nonelective contributions of 2 percent of compensation for each employee who is eligible to participate in the arrangement and who has at least $5,000 of compensation from the employer for the year. If an employer makes an election under this subparagraph for any year, the employer shall notify employees of such election within a reasonable period of time before the 60-day period for such year under paragraph (5)(C). (ii) Compensation limitation The compensation taken into account under clause (i) for any year shall not exceed the limitation in effect for such year under section 401(a)(17). (C) Definitions For purposes of this subsection— (i) Eligible employer (I) In general The term “eligible employer” means, with respect to any year, an employer which had no more than 100 employees who received at least $5,000 of compensation from the employer for the preceding year. (II) 2-year grace period An eligible employer who establishes and maintains a plan under this subsection for 1 or more years and who fails to be an eligible employer for any subsequent year shall be treated as an eligible employer for the 2 years following the last year the employer was an eligible employer. If such failure is due to any acquisition, disposition, or similar transaction involving an eligible employer, the preceding sentence shall not apply. (ii) Applicable percentage (I) In general The term “applicable percentage” means 3 percent. (II) Election of lower percentage An employer may elect to apply a lower percentage (not less than 1 percent) for any year for all employees eligible to participate in the plan for such year if the employer notifies the employees of such lower percentage within a reasonable period of time before the 60-day election period for such year under paragraph (5)(C). An employer may not elect a lower percentage under this subclause for any year if that election would result in the applicable percentage being lower than 3 percent in more than 2 of the years in the 5-year period ending with such year. (III) Special rule for years arrangement not in effect If any year in the 5-year period described in subclause (II) is a year prior to the first year for which any qualified salary reduction arrangement is in effect with respect to the employer (or any predecessor), the employer shall be treated as if the level of the employer matching contribution was at 3 percent of compensation for such prior year. (D) Arrangement may be only plan of employer (i) In general An arrangement shall not be treated as a qualified salary reduction arrangement for any year if the employer (or any predecessor employer) maintained a qualified plan with respect to which contributions were made, or benefits were accrued, for service in any year in the period beginning with the year such arrangement became effective and ending with the year for which the determination is being made. If only individuals other than employees described in subparagraph (A) of section 410(b)(3) are eligible to participate in such arrangement, then the preceding sentence shall be applied without regard to any qualified plan in which only employees so described are eligible to participate. (ii) Qualified plan For purposes of this subparagraph, the term “qualified plan” means a plan, contract, pension, or trust described in subparagraph (A) or (B) of section 219(g)(5). (E) Applicable dollar amount; cost-of-living adjustment (i) In general For purposes of subparagraph (A)(ii), the applicable amount is $10,000. (ii) Cost-of-living adjustment In the case of a year beginning after December 31, 2005 , the Secretary shall adjust the $10,000 amount under clause (i) at the same time and in the same manner as under section 415(d), except that the base period taken into account shall be the calendar quarter beginning July 1, 2004 , and any increase under this subparagraph which is not a multiple of $500 shall be rounded to the next lower multiple of $500.