Session 4: Cross-Testing in Special...

Session 4:Cross-Testing in Special Situations

S. Derrin Watson, J.D., APM

Pension Attorney and Educator

Law Offices of S. Derrin Watson

Thank You to Our Sponsors!

THE BASICSPlan

Employer

Employee

General test

3 plans

Deferrals

Match

Nonelect

Plans by Contribution Type401(k) 401(m) 401(a)(4) (non-elect)

Elective deferrals Matching contributions Profit sharing

Roth elective deferrals After-tax contributions Top-heavy

Forfeitures allocated as match Forfeitures allocated as nonelective

SH match SH nonelective

Minimum gateway

QMAC used in ADP test QNEC used in ADP/ACP test

• Must pass ACP with and without QMAC shifted to ADP

• Must pass 401(a)(4) with and without QNEC shifted to ADP or ACP

• Only average benefit percentage test (ABPT) adds all three contribution types

Ways to have related

employers

• Controlled group

– Parent-subsidiary

– Brother-sister

– Combined

• Common control

– Special tax-exempt rules

• Traditional affiliated service groups

– A-Org

– B-Org

• Management function groups

Consequences of related employer

status

• All employees of all related employers are deemed to be employed by a single employer for most retirement plan purposes

– Exclusive benefit rule

– Crediting service for eligibility, vesting, and benefit accrual

– Coverage

– Nondiscrimination

– 415 limits

– Top-heavy

Employee

• Includes:

– Common-law employees

– Leased employees

– Shared employees

– Self-employed individuals

– Certain full-time life insurance salespeople

• Of all related employers

Non-excludable Employee

• Employee counted in coverage test• Excludable employees:

– Employees who don’t satisfy minimum age and service conditions

– Employees in the “other” plan under OEE rule– Nonresident aliens without US source income– Union employees– Employees in another QSLOB– Certain terminated employees with <501 HOS– Certain governmental employees and employees of tax-

exempt organizations who participate in 403(b) plans

Performing the General TestBased on Allocations

• Determine each employee’s allocation rate

• Group employees into rate groups based on allocation rates

• Determine coverage fraction for each rate group

• If each rate group at least 70 percent, PASS; otherwise:

• Determine concentration percentage/midpoint percentage

• Plan passes if:

– Each rate group at least equal to midpoint percentage

– Plan satisfies average benefit percentage test (AB%T)

Performing the General TestBased on Benefits

• Provide NHCEs minimum gateway (or show it isn’t needed)


• Convert allocation rates into EBARS

• Group employees into rate groups based on EBARs




• Plan passes if:


– Plan satisfies AB%T based on EBARs

Fractions

• Concentration percentage = non-excludable NHCES/non-excludable EEs

• Coverage fraction = NHCE %/HCE %

NHCE % = benefiting NHCEs/non-excludable NHCEs

HCE % = benefiting HCEs/non-excludable HCEs

AB%T Notes

Consider all non-excludable

employees, whether they

benefit from this plan or not

Aggregate all plans employer maintains

• Including 401(k) and 401(m)

Poll Question #1: Can You Do It?Can you determine whether an XT plan passes just using spreadsheet, without using EBARs?

A. Heavens, no!

B. Yes, so long as I know the EBARs

C. Yes, I can do it all

XT WITH RELATED ENTITIES

A myth is as good as a mile

• Myth: So long as the plan passes coverage, we can ignore the controlled group

• Truth: You can’t ignore the controlled group if you must pass the general test

FractionsRelated Employer Differences

• Concentration percentage = non-excludable NHCES/non-excludable EEs

• Coverage fraction = NHCE %/HCE %

NHCE % = benefiting NHCEs/non-excludable NHCEs

HCE % = benefiting HCEs/non-excludable HCEs

Performing the General Test Based on BenefitsRelated Employer Differences

• Provide NHCEs minimum gateway (or show it isn’t needed)


• Convert allocation rates into EBARS

• Group employees into rate groups based on EBARs




• Plan passes if:


– Plan satisfies AB%T based on EBARs

Cross-testing Related Employers

Company A only

Name Allocation EBAR

Hilda 20% 3.78%

Nick 5% 2.14%

Nancy 5% 7.27%

Norman 5% 3.22%

Nadia 5% 16.45%

3.78% rate group covers 50% of NHCEs (30% midpoint)AB%T = 192.07%Plan passes

A and B together

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Name Allocation EBAR

Hilda 20% 3.78%

Harry 0% 0%

Nick 5% 2.14%

Nancy 5% 7.27%

Norman 5% 3.22%

Nadia 5% 16.45%

6 other NHCES 0% 0%

3.78% rate group covers 50% of HCEs and 20% of NHCEs = 40% (27.75% midpoint)

AB%T = 153.66%Plan passes

Poll Question #2Do we need to provide a minimum gateway contribution for the NHCEs at B?

A. Absolutely yes; they are in the AB%T

B. Nope, they aren’t benefiting from the XT plan

IMPUTING PERMITTED DISPARITY

What Do You DoWhen it Blows Up in Your Face?

• You can still test based on allocations

– Everyone in separate classification leaves lots of flexibility

– No need for minimum gateway

• General test gives leeway for some disparity

• You can even use permitted disparity

Permitted Disparity

Two ways to get there

• As part of a safe-harbor plan design

• No need for general test

• In performing nondiscrimination testing regardless of plan design

• Only available with general nondiscrimination test

• Imputing permitted disparity

Separate systems for

• Testing by contributions

• Testing by benefits

Standard Defined ContributionPermitted Disparity

CompExcess Comp

Combined Comp Integrated Balance Allocation

Harry 250,000 136,300 386,300 22,019 27,981 50,000 Hilda 200,000 86,300 286,300 16,319 22,385 38,704 Nancy 70,000 0 70,000 3,990 7,835 11,825 Nick 50,000 0 50,000 2,850 5,596 8,446 Neville 40,000 0 40,000 2,280 4,477 6,757 Nora 30,000 0 30,000 1,710 3,358 5,068

640,000 222,600 862,600 49,168 71,631 120,799

• Design below provides

– Excess comp based on taxable wage base

– Up to 5.7 percent allocation on combined compensation

– 11.19 percent allocation on comp

What if You Did the Same Design and Did the General Test (Without Imputed Disparity)?

CompExcess Comp

Combined Comp Integrated Balance Allocation

Harry 250,000 136,300 386,300 22,019 27,981 50,000 Hilda 200,000 86,300 286,300 16,319 22,385 38,704 Nancy 70,000 0 70,000 3,990 7,835 11,825 Nick 50,000 0 50,000 2,850 5,596 8,446 Neville 40,000 0 40,000 2,280 4,477 6,757 Nora 30,000 0 30,000 1,710 3,358 5,068

640,000 222,600 862,600 49,168 71,631 120,799

• Testing on a defined contribution basis– HCEs allocation rates = 20 percent, 19.35 percent– NHCE allocation rate = 16.89 percent

• Classic fail

Imputing Permitted Disparity When Testing Based on Contributions

Formula 1 Formula 2

Comp <= TWB 2 X UAR UAR + 5.7%

Comp > TWB Allocation/(Comp – TWB / 2) (Allocation + 5.7% X TWB)/Comp

• Run general test based on adjusted allocation rate

• Adjusted rate determined by formula below

– Use lesser of formula 1 or formula 2

• Allocation = dollar amount of allocations tested under 401(a)(4)

• TWB = taxable wage base

– No authority to use any different integration level

• UAR = unadjusted allocation rate = allocation/compensation

Straightforward Imputed Disparity

Comp Allocation Alloc Rate Formula 1 Formula 2 Lesser 1,2Harry 250,000 50,000 20.00% 25.89% 22.59% 22.59%Hilda 200,000 38,704 19.35% 27.04% 22.59% 22.59%Nancy 70,000 11,825 16.89% 33.78% 22.59% 22.59%Nick 50,000 8,446 16.89% 33.78% 22.59% 22.59%Neville 40,000 6,757 16.89% 33.78% 22.59% 22.59%Nora 30,000 5,068 16.89% 33.78% 22.59% 22.59%

640,000 120,799

• Start with giving everyone same allocation as in integrated plan– Use 100 percent of taxable wage base

• Compute allocation rate• Compute adjusted allocation rate• Run general test

– It’s built to pass

Several Adjustments

Comp Allocation Alloc Rate Formula 1 Formula 2 Lesser 1,2Harry 250,000 50,000 20.00% 25.89% 22.59% 22.59%Hilda 200,000 20,000 10.00% 13.97% 13.24% 13.24%Nancy 70,000 2,100 3.00% 6.00% 8.70% 6.00%Nick 50,000 1,500 3.00% 6.00% 8.70% 6.00%Neville 40,000 3,016 7.54% 15.08% 13.24% 13.24%Nora 30,000 5,770 19.23% 38.47% 24.93% 24.93%

640,000 82,386

• Drop the non-owner HCE to ten percent allocation• Drop the two best compensated NHCEs to top-heavy minimum• Give Neville enough to put him in Hilda’s rate group• Give Nora enough to pass the ABPT (and to be in Harry’s rate group)• Saves over $38,000 compared to integrated design

COMPONENT PLANSRestructuring

Principles of Restructuring

• Alternative approach to passing nondiscrimination

• Separate 401(a)(4) plan into separate component plans

– Each plan consists of allocations, accruals, benefits, rights, and features provided to a given set of employees

– You get to pick which employees are in each set

– Each participant is in one and only one set

• The plan as a whole passes nondiscrimination if:

– Each component plan separately passes coverage and

– Each component plan separately passes nondiscrimination

• Can use different testing methods for each

Limitations

• Must pass coverage for the plan as a whole

• Can’t use component plans for:

– Uniform points plan

– ADP test

– ACP test

– Top-heavy

– Gateways

– DB minimum participation

• If any component plan tested by reference to benefits, plan must provide minimum gateways to all NHCEs benefiting from any component unless an exception applies on the basis of the plan as whole:

– Broadly available allocation rates

– Graduated age/service schedule

– Uniform target benefit

Methodology

• The plan must first satisfy coverage without regard to restructuring

• No need for special plan document provisions; this is a testing option

• Divide plan participants into separate component plans

– On any basis you choose

• If the plan as a whole passes the AB%T, then each component plan does as well

Enjoy the flexibility

• You can do it some years and not others

• You choose how many component plans to test

• You choose who is in what plan

– Each participant must be in one and only one plan

• Each year you can make a different choice

– Whether you use restructuring at all

– How many component plans

– Who is in what plan

Passing Coverage in the Component Plan

• Each component plan must either:

– Pass ratio percentage test, or

– Pass average benefit test:

• Nondiscriminatory classification

• Reasonable, objective classification

– Tough when you’re picking and choosing people however you want

• Average benefit percentage test (for plan as a whole)

Simple Example

• Components: Chicago/Denver

• Chicago coverage = 40%/25% = 160%

• Denver coverage = 60%/75% = 80%

• Each component is safe harbor

PS % HCE NHCE

Chicago 5% 10 40

Denver 20% 30 60

Total 40 100

• Employer has a profit-sharing plan for all its employees

• The plan is not a safe-harbor design and the employer must run the general test

– It would pass

• Or use restructuring

NHCE4 is Part-time; SH 401(k)

• Put NHCE4 alone in a group:– No HCEs: This group passes automatically

• The 13.27 percentage group has 75 percent coverage fraction– Passes ratio percentage for safe harbor– Safe harbor

Employee Comp Deferrals SH 3% Regular PS TotalAllocation

rateHCE1 $275,000 $18,500 $8,250 $28,250 $36,500 13.27%HCE2 $200,000 $18,500 $6,000 $20,545 $26,545 13.27%NHCE1 $90,000 $7,200 $2,700 $9,245 $11,945 13.27%NHCE2 $60,000 $4,000 $1,800 $6,164 $7,964 13.27%NHCE3 $50,000 $2,500 $1,500 $5,136 $6,636 13.27%NHCE4 $30,000 $0 $900 $0 $900 3.00%Total $705,000 $50,700 $21,150 $69,341 $90,491 12.84%

Example 2

NHCE HCE Ratio

10.94% 0% 50% 0%

4.27% 50% 100% 50%

AB%T 5.19% 7.60% 68.32%

• HCE2 is an employee

• As it stands the plan fails

– Although it would pass if we gave NHCE 4 an extra $108

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Age PV Comp Alloc % Alloc EBAR

Owner 55 3.52 150,000 15% 22,500 4.27%

HCE 2 30 0.457 120,000 5% 6,000 10.94%

NHCE 1 45 1.555 45,000 5% 2,250 3.22%

NHCE 2 56 3.815 40,000 5% 2,000 1.31%

NHCE 3 37 0.810 35,000 5% 1,750 6.17%

NHCE 4 29 0.496 25,000 5% 1,250 10.08%

Example 2: Component Plan Approach

» Plan 2: HCE 2, NHCES 1 and 2» Tested by contributions» Coverage % = 50%/50% = 100%» Passes general test on

contribution basis

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Owner 55 3.52 150,000 15% 22,500 4.27%

NHCE 3 37 0.810 35,000 5% 1,750 6.17%

NHCE 4 29 0.496 25,000 5% 1,250 10.08%

HCE 2 30 0.457 120,000 5% 6,000 10.94%

NHCE 1 45 1.555 45,000 5% 2,250 3.22%

NHCE 2 56 3.815 40,000 5% 2,000 1.31%

» Plan 1: Owner, NHCEs 3 and 4» Tested by benefits» Coverage % = 50%/50% = 100%» Rate group = 50%/50% = 100%» Could increase owner to 21.7%

Example 2: Alternative Approach

NHCE HCE Ratio

4.27% 60% 100% 60%

AB%T 6.34% 4.27% 148.71%

• Use top 20 percent rule so HCE 2 becomes NHCE

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Owner 55 3.52 150,000 15% 22,500 4.27%

HCE 2 30 0.457 120,000 5% 6,000 10.94%

NHCE 1 45 1.555 45,000 5% 2,250 3.22%

NHCE 2 56 3.815 40,000 5% 2,000 1.31%

NHCE 3 37 0.810 35,000 5% 1,750 6.17%

NHCE 4 29 0.496 25,000 5% 1,250 10.08%

More Complex Example

• Midpoint percentage = 45 percent

• Tested as a whole, 12.61 percent and 6.26 percent rate groups fail nondiscriminatory classification

• Plan passes AB%T = 71.756 percent, but only because NHCEs defer39

EE Age PV Comp Defer Alloc% PS Alloc EBARAB%T EBAR

Dad 55 3.516 250,000 17,000 13% 33,000 3.75% 5.69%

Mom 49 2.155 200,000 17,000 5% 10,000 2.32% 6.26%

Kid1 22 0.238 15,000 0 3% 450 12.61% 12.61%

Kid2 20 0.202 10,000 0 3% 300 14.85% 14.85%

N1 63 6.752 60,000 3,000 5% 3,000 0.74% 1.48%

N2 57 4.139 50,000 2,000 5% 2,500 1.21% 2.17%

N3 50 2.338 25,000 0 5% 1,250 2.14% 2.14%

N4 35 0.688 30,000 600 5% 1,500 7.27% 10.17%

N5 23 0.258 20,000 0 5% 1,000 19.38% 19.38%

Try RestructuringEE Alloc% EBAR

Dad 13% 3.75%

Mom 5% 2.32%

Kid1 3% 12.61%

Kid2 3% 14.85%

N1 5% 0.74%

N2 5% 1.21%

N3 5% 2.14%

N4 5% 7.27%

N5 5% 19.38%

» Plan 2 has Mom, Kids, N1, N2, and N3

» Coverage percentage = 60%/75% = 80%

» Plan passes general test on contribution basis

40

» Plan 1 has Dad, N4, and N5

» Coverage percentage = 40%/25% = 160%

» Testing on benefits basis, 40% of NHCEs are in 3.75% rate group and 25% of HCEs (ignoring those not covered in component plan) = 160%

Neither component plan

needs AB%T

Gradual Age and Service Schedules

An Alternative to Gateways

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Gradual Age/Service Schedule

• Smoothly increasing allocation schedule

– Plan defines a series of bands based solely on age, years of service, or points equal to the sum of age and service

– Allocation rates for the bands smoothly increase at regular intervals

– Each band allocation greater than the prior band

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• Smoothly increasing

– Not greater than prior band by more than five percentage points nor twice the prior band

– Ratio of band to preceding band cannot exceed ratio of two immediately preceding bands

– Minimum allocations, e.g., top-heavy, generally permitted, as long as contribution to lowest band is at least one percent

• Regular intervals

– Each band, other than highest band, must be of same length

– If lowest band starts before age 25 it can be deemed to start at any age up to 25 to satisfy same length requirement

Gradual Age Schedule(a) Band (b) Ages (c) Alloc Rate (d) Increased (e) % Increase

1 Under 28 1.25%

2 28-35 2.50% 1.25% 200%

3 36-43 5.00% 2.50% 200%

4 44-51 10.00% 5.00% 200%

5 52-59 15.00% 5.00% 150%

6 Over 59 20.00% 5.00% 133.3%

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• Regular intervals– Bands 2, 3, 4, and 5 are each eight years

• Smoothly increasing– No entry in column (d) exceeds five percent– No entry in column (e) exceeds 200 percent– Column (e) goes down or stays the same

This schedule is in the

plan document

The same schedule

applies to everyone

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XT with GatewayEmployee Cost = $6,750

Name Age Comp PSP Alloc % PV Factor EBAR

Owner 55 250,000 50,000 20.00% 4.684 4.27%

NHCE 1 22 20,000 1,000 5.00% 0.238 20.99%

NHCE 2 24 25,000 1,250 5.00% 0.280 17.83%

NHCE 3 28 30,000 1,500 5.00% 0.389 12.87%

NHCE 4 25 25,000 1,250 5.00% 0.304 16.44%

NHCE 5 36 35,000 1,750 5.00% 0.746 6.70%

Totals 385,000 56,750

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Age Schedule (Top-Heavy)Employee Cost $4,750


Owner 55 250,000 50,000 20.00% 4.684 4.27%

NHCE 1 22 20,000 600 3.00% 0.238 12.59%

NHCE 2 24 25,000 750 3.00% 0.280 10.70%

NHCE 3 28 30,000 900 3.00% 0.389 7.72%

NHCE 4 25 25,000 750 3.00% 0.304 9.86%

NHCE 5 36 35,000 1,750 5.00% 0.746 6.70%

Totals 385,000 54,750

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Age Schedule (Not Top-Heavy)Employee Cost $3,375


Owner 55 250,000 50,000 20.00% 4.684 4.27%

NHCE 1 22 20,000 250 1.25% 0.238 5.25%

NHCE 2 24 25,000 312.5 1.25% 0.280 4.46%

NHCE 3 28 30,000 750 2.50% 0.389 6.44%

NHCE 4 25 25,000 312.5 1.25% 0.304 4.11%

NHCE 5 36 35,000 1,750 5.00% 0.746 6.70%

Totals 385,000 53,375

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• Gradual age/service schedules

– Work particularly well for transient populations and small groups

– Can reduce staff contribution to nearly three percent in top-heavy plans and below three percent in non-top-heavy plans

– Schedule must be in plan document

• Recommend last day allocation requirement and preliminary testing

• Prevents problems when employer unexpectedly hires (or rehires!) older staff member

59 Old County Road59 Old County Road

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Session 4: Cross-Testing in Special...

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