Overall Coverage Tests Professor Kathryn Kennedy Chapter 4/Week Four The Code permits a qualified retirement plan to use a third criteria (beyond a minimum age and/or waiting period) to restrict eligibility under the plan. However, a plan sponsor that decides to invoke this privilege subjects its plan to the annual nondiscrimination coverage tests set forth in the Code. TRA ‘86 sought to impose more objective nondiscrimination standards into the Code; thus that’s why we have mathematical tests for coverage testing and benefits/contribution testing. The first two coverage tests of IRC §410(b) result in a “head count” test – how many NHCEs are covered relative to HCEs that are covered? The presumption is that the percentage of HCE covered under the plan is greater than the percentage of NHCEs covered under the plan. The third test involves a “head count” test, but then also compares the average benefits that the HCEs receive as a group relative to the average benefits that the NHCEs receive as a group – thereby linking the “head count” with benefits provided.

Coverage and Benefits What employees can the employer exclude? Certain employees need not be covered Remaining coverage may be sufficient If coverage is not sufficient, plan will be disqualified Can different levels of allocations/accruals be granted to participants? Identification of the highly compensated employees (HCEs) versus nonhighly compensated employees (NHCEs) Both ERISA and the Code permit certain exclusions from eligibility under employee pension plans. If the plan further restricts eligibility beyond a service and/or age requirement (as well as not covering collectively bargained employees), the Code is concerned that eligibility will result in discrimination. Remember with higher marginal tax rates for the HCEs, they have more to gain by being covered under a qualified plan than the NHCEs. Thus, the Code’s coverage tests perform a “head count” analysis to ascertain if there are a sufficient number of NHCEs covered under the plan. Note the analysis isn’t simply how many employees are covered under the plan, as they could all be NHCEs and therefore be a nondiscriminatory plan. The Code is also concerned that, even if a sufficient number of NHCEs are covered under the plan, that the actual benefits paid to the HCEs do not discriminate to the detriment of the NHCEs. Thus, the nondiscrimination tests of IRC §401(a)(4) go beyond a “head count” analysis and examine the level of benefits actually paid to the HCEs versus the NHCEs. Hence, IRC §§401(a)(3) and 401(a)(4) are related to each other – a DC plan could cover all NHCEs and HCEs to pass coverage, but if it provided an allocation of 1% of pay to the NHCEs and 10% of pay to the HCEs, it would have a discriminatory allocation. Obviously which employees are HCEs and which are NHCEs is critical in doing this testing. IRC §414(q) defines an HCE as an employee: Who was a 5% owner (which really means has ownership in excess of 5%) for the current plan year or preceding plan year, or Who is paid over $110,000 (for 2010) in the preceding 2009 plan year. Using the numbers of the preceding plan year affords greater certainty for the employer in identifying HCEs and NHCEs at the beginning of the year. The regulations also permit the employer to limit the group of HCEs to the top 20% paid employees (as ranked by compensation).

Coverage Rules Permitted use of a third criteria to further reduce coverage under qualified plan, but required testing for discrimination IRC §410(b) Coverage Rules All EEs – Permissible Exclusions The Code’s coverage rules assumes that the plan sponsor is using a third criteria to restrict eligibility, possibly to exclude more NHCEs but not HCEs. To assure that the qualified plan does not disproportionately cover the HCEs to the exclusion of the NHCEs, there are a variety of tests under IRC §410(b). The first two tests include a “head count” as to how many NHCEs are counted relative to its test group and compare that to how many HCEs are counted relative to its test group. Hence, one begins the test by counting all employees employed by the employer. There are two exceptions whereby these rules can be applied separately to each line of business and where the rules are delayed in the event of a merger or acquisition. Start with total number of employees, here 1,000. If the plan uses a minimum age 21 requirement, we can exclude these 20 young employees from our test group. If the plan uses a minimum one-year wait, we can exclude these 80 new employees from our test group. If union employees are excluded from plan participation, we can exclude those 200 collective bargaining employees (CBA) from the test group. Hence, the test group has shrunk from 1,000 to 700 but to the three sets of exclusions (20 young employees, 80 new employees, and 200 CBA). We then take the 700 test group and split it into two subsets – those of the 700 who are NHCEs and those of the 700 who are HCEs. Since an employee can’t be both an HCE and a NHCE at the same time, each employee falls into only one camp.

Coverage Tests Plans that automatically meet coverage: collectively bargained plans plans benefiting only NHCEs plans by ERs that have only HCEs Test Group = 700 ees - split between NHCEs and HCEs - 600 NHCEs and 100 HCEs HCE determined as a 5% owner (this year or prior year) or paid over a certain dollar amount Step 1 is to identify all employees of the plan sponsor (including other employers in the controlled group). If the plan’s eligibility provisions exclude employees who are not yet age 21 and who have not met the one-year waiting period, the numbers of those ineligible employees are deducted from the “all employee” number. If the employer has collectively bargained employees (i.e., union employees) where benefits have been the subject of good faith bargaining, those employees can also be excluded. The resulting number is called the “test group,” (i.e., the maximum number of employees that could have been covered under this plan). If the plan doesn’t have a a third criteria for eligibility, then the plan covers 100% of the test group and meets the Percentage Test which asks if 70% of all NHCEs are covered under the plan. According to the Treasury regulations, there are certain plans that automatically meet the coverage tests and therefore do not have to be tested: plans covering collectively bargained employees where benefits have been the subject of good faith bargaining; plans that cover only NHCEs; and plans maintained by an employer with only HCEs and no NHCEs Step 2 is to split the test group into NHCEs and HCEs. For example, if our test group = 700 ees, we ascertain how many of these 700 ees are HCEs for the plan year (say 100) and then the NHCEs = 700 – 100 = 600 ees. When we do the coverage tests, the denominators will be 600 for the NHCE group and 100 for the HCE group. Who is an HCE can change year to year, as it incorporates any 5% owner (this year or for the prior year) and anyone with compensation in excess of a given dollar threshold. There are also attribution rules such that one can’t avoid becoming a 5% owner by having one’s spouse be a 5% owner.

Coverage Tests Who benefits under plan? 3rd criteria of eligiblity – what % of the NHCE benefit under the plan and what % of the HCE benefit under the plan? Test 1: Do 70% of NHCEs benefit? Test 2: Coverage of NHCE is not 70%, what is the ratio of coverage for NHCEs relative to ratio of coverage for HCEs? Is it at least 70%? Ability to aggregate plans for purposes of coverage Step 3 involves determining the group of employees “benefiting” under the plan for a given plan year. An employee benefits under a plan only if he/she receives an allocation of contributions or forfeitures (for DC plans) or he/she accrues a benefit (for DB plans). For example, a participant may be covered under the plan but fails to attain the minimum 1,000 hours of service to be eligible to receive an allocation or accrual doesn’t benefit under the plan for that plan year. The Code’s first coverage test assumes that 100% of the HCE group is eligible to participate under the plan. If this is the case, then 70% of the NHCE group must be eligible to participate. Hence, in our example, with 700 in the test group, if 100 HCEs were eligible under the plan (100% coverage of the 100 HCE test group), then 70% of the 600 NHCEs (or 420 NHCEs) would have to be eligible under the plan. If there are at least 420 NHCEs benefiting under the plan, it satisfies this test. Note that is a pretty high bar to attain. The second coverage test does not assume that 100% of the HCE group is eligible to participate under the plan, but instead calculates the ratio of the HCEs actually covered under the plan relative to its test group of 100 HCEs. So if a third criteria under eligibility (e.g., salaried status) results in 50 HCEs being covered under the plan, the ratio of HCEs participating relative to its test group of 100 is 50%. The second test asks whether the coverage of the NHCE group (relative to its test group of 600) is at least 70% of this 50% ratio (or 35%). Hence if the plan actually covers 35% of the 600 NHCEs (210 NHCEs), the test has been satisfied. An equivalent method would be to compare the ratio of NHCEs under the plan relative to its test group to the ratio of HCEs under the plan relative to its test group and see if the NHCEs ratio is at least 70% of the HCE ratio: 210/600 compared to 50/100 35% compared to 50% which is at least 70% In this example, the plan’s Ratio Percentage is [210 ÷ 600] ÷ [50 ÷ 100] = 70%, which satisfies the second coverage test, known as the Ratio Percentage test. It is also possible to aggregate certain plans for coverage purposes provided the plan is not one listed on the mandatory disaggregation table in the regulations.

Third coverage test Test 3: RP comparison is less than 70%. Under test 3, there are two components: The classification test which requires that the 3rd eligibility criteria be a reasonable business criteria and a modified RP test to be applied, which produces a range of RP percentages The average benefits component that compares the “average” benefit % for all NHCEs to the “average” benefit % for all NHCEs The average benefit % test (the second component) goes beyond a head count and looks at the actual benefits provided to NHCEs and HCEs under all qualified plans maintained by the employer Use of the third test presumes that the plan was unable to satisfy the 70% ratio percentage test; hence the regulations permit a ratio comparison of less than 70% depending on where the plan sponsor falls within the chart. There are two components of the ABT: First, the 3rd criteria used for eligibility must meet a reasonable business criteria (e.g., salaried vs. hourly, location). Then the 70% RP test is replaced with a modified RP test that could go as low as 20% and as high as 50%. Going back to the test group of 700 – 600 of which were NHCEs and 100 of which were HCEs. Compute another ratio – how highly concentrated is the test group with NHCEs (i.e., 600/700 = 85.7% , lowered to 85%). If it’s fairly concentrated, the modified RP comparison is allowed to dip pretty low – 31.25% to 21.25% -- according to the table in the regulations. This is the new range. If the plan’s RP is greater than or equal the top of the range (31.25%), this part of the test is satisfied. If the plan’s RP falls within the range, facts and circumstances are required. If the plan’s RP falls below the bottom of the range, this modified RP test is not met. Let’s do an example. The test group of 700 has 600 NHCEs and 100 HCEs. Applying the third criteria under the plan’s eligibility provision (say salaried status), only 300 NHCEs are covered compared to 80 HCEs covered. Hence, The use of “salaried status” is a reasonable business criteria; The NHCE ratio is 300/600 =50% compared to HCE ratio of 80/100 = 80% The plan’s RP equals 50% ÷ 80% = 62.5%, which is above the 31.25% range, hence this part of the test is met. For the second component of the ABT, the actuary would commute benefit accruals for each NHCE as a percentage of compensation and then average those percentages for the NHCE group for benefits under any and all qualified plans maintained by the ER. He/she would do a similar calculation for the HCEs. The NHCE group average benefit percentage must be at least 70% of the HCE group average benefit percentage. If so, the ABT is met.

Example of ABT Employer maintains two qualified plans – one for store #1 (plan A) and one for store #2 (plan B), both with age 21 + one year wait. They are both defined contribution plans, one profit sharing and one money purchase. Test group = 100 – 90 are NHCEs and 10 are HCEs; for the ABT test, NHCE concentration % = 90/100 = 90% Plan A covers 30 NHCEs and 8 HCEs NHCE ratio = 30/90 = 33% versus HCE ratio = 8/10=80% The RP for Plan A is 33%/80% = 41%, hence fails the 70% RP Under 1st prong of ABT, classification of “store #1” is reasonable Under 2nd prong of ABT, modified RP range is 27.5% - 20%. Since Plan A’s RP of 41% is above the top of the range, hence test met. Under 3rd prong of ABT, compare the average benefit % for NHCEs under Plans A and B (say 5%) and compares that to the average benefit % for HCEs under Plans A and B (say 7%). The ratio of 5%/7% must be at least 70%, which it is. Hence ABT is satisfied. Step 1: Compute the test group, which will equal total employees less permissible exclusions. For the sake of simplicity, we’re assuming the test group equals all 100 employees. Of those 100 employees, 10 are HCEs and therefore 90 are NHCEs. Later, if we need the NHCE concentration % for the ABT, it is 90 ÷ 100 = 90%. Step 2: How many employees are covered/participate under Plan A? 38 employees – of which 8 are HCEs and therefore 30 are NHCEs. Step 3: What is the NHCE ratio of covered NHCEs relative to the NHCE test group (i.e., 30 ÷ 90 = 33⅓%). What is the HCE ratio of covered HCEs relative to the HCE test group (i.e., 8 ÷ 10 = 80%). The RP of this plan is 33⅓% ÷ 80% = 41%. Such a RP fails the 70% RP test. Step 4: There are three requirements of the ABT: First, the classification of Plan A’s eligibility (i.e., employed at store #1) must be reasonable. Usually geographical location is permissible. Second, there is a modified RP test. For a NHCE concentration % of 90%, there is a corridor of 27.5% to 20% (Treas. Reg. §1.410(b)-4(c)(4)(iii)). Since Plan A’s actual RP is 41%, it falls above the safe harbor of 27.5% and therefore meets this part of the test. Third, the average benefit % for NHCEs under all qualified plans maintained by the employer must be at least 70% of the average benefit % for the HCEs under all qualified plans maintained by the employer. Since 5% is at least 70% of 7%, this test is met.

Aggregation/Disaggregation of Plans If the employer has two plans and one would fail the RP and/or ABT, you may be able to aggregate the plans, recompute the numbers and then satisfy either the RP or ABT. If plans are aggregated for 410(b) purposes, they remain aggregated for 401(a)(4) purposes. Certain plans cannot be aggregated – see mandatory disaggregation list in regs If a qualified plan on its own cannot satisfy either the RP or the ABT, it may be possible to aggregate it with another plan and then meet the RP and/or ABT on a combined basis. The IRS regulations permit certain plans to be aggregated provided they are not listed on the mandatory disaggregation list set forth in the regulations. For example, a non-401(k) plan cannot be aggregated with a 401(k) plan. For example, Plan X covers 100 employees, all NHCEs; but Plan Y covers 200 NHCEs and 100 HCEs. If the Test Group = 500 employees – 400 are NHCEs and 100 are HCEs. RP for Plan Y: 200/400 = 50% compared to 100/100 = 100%, 50%/100% fails the 70% test. But if we were to combine Plan X and Plan Y, RP for both plans: 300/400 = 75% compared to 100/100 = 100%, 75% ÷ 100% = 75%, which meets the RP test. If Plan X was a 401(k) profit sharing plan and Plan Y was a money purchase plan, they cannot be aggregated as a 401(k) plan cannot be aggregated with a non-401(k) plan.

Additional coverage rule of IRC §401(a)(26) Applies only to qualified defined benefit plans Requires that the plan cover at least 50 employees or if less, 40% of the test group No aggregation of plans is allowed for purposes of meeting this rule Sanction assessed against HCEs TRA ‘86 added this separate coverage test which required each plan to stand on its own and cover at least 40% of the test group (for small plans) or 50 employees (for large plans). Later it was revised so that it applied only to qualified defined benefit plans. Example: Small employer has a qualified defined benefit plan covering 7 employees. Its test group equals 20 employees. Since 40% of the test group of 20 is 8 employees, this plan fails the test as it only covers 7 employees. No aggregation with another defined benefit plans is allowed for purposes of this test. Sanction for failure to satisfy this test is to penalize only the HCEs, not the NHCEs.