Presents
NONDISCRIMINATION TESTING
TRAPS FOR THE UNWARY
Felicia A. Finston
ffinston@wifilawgroup.com
Purpose of Nondiscrimination Testing
 Ensure plan does not discriminate in
favor of highly compensated employees
(“HCEs”) as to eligibility or benefits (i.e.,
same benefits must be provided to nonHCEs (“NHCEs”))
 Required as a condition of tax
qualification
Slide No. 2
ROAD MAP
Components of Nondiscrimination Testing
(“NDT”)
 Common NDT Gotchas
Safe Harbor Plan Designs
Prior Year v. Current Year Testing
Leased Employee Coverage Issues
Prototype v. Individually Designed Plans
Slide No. 3
Components of NDT
Code and
regulations
• Apply to all qualified
plans
• Different tests for
different purposes
Terms of the plan
document
• Employer specific
• Must comply with
regulations
Participant
contribution data
Slide No. 4
Basic Tests
Slide No. 5
Name
Code
Section
Description
Applies To
Failure
Rate
Coverage
410(b)
Ensures plan provides benefits to Plan
a
sufficient
percentage
of
employees
Rare
Contributions 401(a)(4)
Applies to defined benefit and Plan
defined contribution plans (other
than elective deferrals and
match) to ensure contributions
don’t discriminate in favor of
HCEs
Rare
Actual
Deferral
Percentage
(“ADP”)
401(k)
Ensure HCE
percent does
HCE deferral
than specific
2%)
elective deferral Plan
not exceed Nonpercent by more
amount (generally
Common
Actual
Contribution
Percentage
(“ACP”)
401(m)
Ensure HCE after-tax and Plan
matching contribution percent
does not exceed Non-HCE aftertax and matching contribution
percent by more than specific
amount (generally 2%)
Common
Deferrals
402(g)
Ensure participant deferrals do Participant
not exceed a stated limit
Rare
Additional Tests
Name
Code
Section
Description
Annual
Additions
415
Ensures contributions to a Participant
defined contribution plan don’t
exceed the lesser of 100% of
compensation or a specific dollar
amount
Rare
Annual
Benefits
415
Ensures benefits paid from a Participant
defined benefit plan do not
exceed a specific dollar amount
Rare
Minimum
Participation
401(a)(26)
Requires defined benefit plan to Plan
cover a minimum number of
participants
Common
Top Heavy
416
Ensure benefits provided to key Plan
employees do not exceed 60% of
contributions
and
benefits
provided to non-key employees
Rare
for
large plans;
common for
small
Ensure specific rights and Plan
features, such as contribution
levels, do not discriminate in
favor of HCEs
Not
Uncommon
Benefits,
401(a)(4)
Rights and
Features
Slide No. 6
Applies To
Failure
Rate
Common NDT Gotchas




Slide No. 7
Compensation
Frozen Benefits
Benefits, Rights or Features
Tiered Contribution Formulas
Compensation
Uses
Slide No. 8
Elements
Compensation Uses
Contributions
and Benefits
Determine
HCEs
415
Amounts
Testing
Slide No. 9
ADP/ACP
Testing
Compensation Uses
 Specific definitions of compensation
apply for determining HCEs and NDT
 Generally, sponsor has discretion in
determining compensation for
contribution purpose
 Multiple definitions of compensation
may be used, but increase complexity
of administering the plan
Slide No. 10
Compensation Elements
W-2
Gross
415
414(s)
404
Slide No. 11
Things to Consider
 Ability to track desired definition of
compensation (e.g., W-2 versus
something else)
 Cost – benefit of having multiple
definitions of compensation
 Imputed income items
Slide No. 12
Common Pitfalls
 Plan definitions of compensation may not
be implemented correctly
•
•
•
Payroll may not communicate with benefits
Pay codes may not clearly fall within or outside
plan definitions
Administrative burdens of tracking varying
definitions lead to errors
 Complicated vocabulary makes effective
communication with providers difficult
 Failure to implement 401(a)(17) limit
Slide No. 13
Impact
 Employer contribution allocations are
incorrect
•
•
Correction is time consuming and expensive
(e.g., VCP, audit penalties, additional funding)
Employee relations issues which can impact
future participation and testing
 Incorrect compensation is used for testing
•
•
•
Slide No. 14
Different required definitions may not be
followed
Compensation elements within definition are
incorrect
Requires retesting and could lead to penalties
Administrative Tips
 Limit number of compensation definitions
in plan document if possible
 Always track “gross” compensation, it’s
needed for testing
 Review ACP test for match $ or % above
the plan limits
 Review annual HCE determination and
compare it to last year
 Periodically review pay codes and
compare with plan definitions of
compensation
Slide No. 15
Frozen Benefits
 A frozen benefit situation occurs when the
benefits or contributions under the plan
are frozen (i.e., closed to new entrants)
•
•
Slide No. 16
Plan must continue to satisfy 410(b) (and
401(a)(26) if a defined benefit plan) and
applicable amounts NDT (e.g., ACP/ADP or
general test)
A plan that benefits no HCEs will automatically
satisfy NDT
Frozen Benefits, Rights and Features
 Sometimes plans freeze participants’
rights to certain benefit, rights or features
(“BRFs”) (e.g., a lump sum form of
distribution, death benefits, right to direct
investments, etc.)
•
•
•
Slide No. 17
Benefit must be currently available (i.e., satisfy
section 410(b))
Benefit must be effectively available (i.e.,under
facts and circumstances available to not just
HCEs)
Determined as of freeze date
Frozen BRFs Limited to Frozen Benefits
 When BRF is only available to active
employees whose benefits are frozen the
following tests must be met:
•
•
•
Slide No. 18
The BRF must satisfy the current and effective
availability tests with respect to the frozen
participants
There must not have been any change in the
availability of the BRF, or
Any change in the availability of the BRF is
made in a nondiscriminatory manner
Tiered Contribution Formulas
 Contributions may vary based on age,
years of service or facility
 Subject to multiple NDT
•
•
•
Slide No. 19
Amounts testing (e.g., ACP test)
BRF testing
Failures can only be corrected by expanding
tier to NHCEs
Administrative Tips
 Run preliminary test before the year to avoid
surprises
 Utilize transition period in a merger and
acquisition to determine going forward game plan
 Consider how population will evolve over time
 Consider plan designs to simplify administration
Slide No. 20
Safe Harbor Plans
 Formulaic method of satisfying ADP
and ACP test
 Three types
• 3% nonelective
• Non-automatic enrollment safe
harbor match
• Automatic enrollment safe harbor
match
Slide No. 21
Safe Harbor Requirements
 Must adopt before 12 month plan year
unless exception applies
 Notice requirements
 Limited ability to amend plan mid year
 Limited ability to suspend contributions
mid year
Slide No. 22
Safe Harbor Plan Pitfalls
Incorrect
compensation
used
Eligibility
provisions
misapplied
Discretionary
match provisions
gone wrong
Component plan
testing failures
Notice
requirements
Slide No. 23
Administrative Tips
 Remember the safe harbor ≠ a testing
exemption
 Beware of discretionary match - not
allowed with automatic enrollment safe
harbor
 For safe harbor match, check that every
participant who deferred got one
 Review definition of compensation
 Give timely notice and spring plan if
necessary
Slide No. 24
Prior Year vs. Current Year Testing




Slide No. 25
Method of ACP and ADP testing
Must be specified in document
Limits plan aggregation
Specific rules on changing methods
Prior Year Testing Method
What Is it
Why is it
used
Problem
Slide No. 26
• Method where last years NHCE ADP testing is
used for current year
• Belief it helped HCEs determine how much they
could defer each year
• Test results aren’t available soon enough for
planning
• Error in one year cascades to others
Potential Gotchas
 Limited ability to use QNECs or QMACs to
satisfy testing because they have to be
allocated before end of the plan year being
tested
 If different methods are used for ADP and
ACP then
•
•
•
Slide No. 27
Can’t recharacterize elective deferrals as aftertax contributions,
can’t use elective deferrals under ACP and
QMACs can’t be taken into account under ADP
Administrative Tips
 Ensure plan specifies testing method
being used
 If prior year is specified, ask why and if
a reason cannot be articulated consider
amending plan
Slide No. 28
Leased Employee Issues
 Individual who provides services to the
employer pursuant to an agreement on
a substantially full-time basis for at least
one year under the primary direction
and control of the employer
 Not required to cover, but count in
410(b) testing
 Code’s limited safe harbor for leasing
company that maintains a money
purchase plan rarely applies
Slide No. 29
Common Pitfalls
 Plan terms don’t exclude leased
employees
 Leased employees not considered in
NDT
 Hours worked as leased employee
count for eligibility and vesting
 Transfer from employee to leased
employee isn’t a separation from
service
Slide No. 30
Administrative Tips
 Be sure plan terms exclude leased
employees from participation
 Be sure you track leased employee
hours for eligibility and vesting
 Be sure you consider leased employees
in NDT
 Benefits provided to leased employees
may be counted under your NDT
Slide No. 31
Prototype Plans
 Consists of adoption agreement and
base plan document
 Employer selects design options in
adoption agreement
 Prototype sponsor obtains opinion letter
from the Internal Revenue Service
employer can rely on
 Prototype sponsor responsible for
document updates
Slide No. 32
Prototype Plan Amendment Pitfalls
 Custom amendments may negate
prototype status
 Plan will incur cost and inconvenience
of needing to obtain determination letter
 Future amendments will need to be
managed by plan sponsor
 Ancillary documents will need to be
managed by plan sponsor
Slide No. 33
Administrative Tips
 Run all amendments by prototype
sponsor to ensure desired change can
be accommodated
 If amendment will impact prototype
status, consider need and timing
Slide No. 34
Prototype NDT Pitfalls
 Prototype plan will outline certain NDT
provisions



HCE determination
ADP/ACP testing
Top Heavy
 Prototype plan will specify compensation
that may be used for contribution
purposes
Slide No. 35
Administrative Tips
 Make sure you review NDT provisions
of prototype plan before you adopt it to
ensure you can capture and administer
relevant compensation definitions
 If you change prototype plans make
sure provisions of the new document
are the same or you are aware and
want differences
Slide No. 36
Questions??
The information presented in this presentation is of a general nature and should not be
considered as legal or tax advice.
You are encouraged to seek direct counsel on legal matters. To ensure compliance with
requirements imposed by U.S. Treasury Regulations, we advise you that any U.S. tax
advice contained in this communication was not intended or written to be used, and cannot
be used, for the purpose of avoiding penalties under the Internal Revenue Code.
Slide No. 37