Plan Qualification Requirements Coverage Requirements; Examples Chapters 3&4

Overall Coverage Tests So the employer’s plan meets the age and service requirements – What next? The plan is not “qualified” unless it covers and benefits a certain percentage of eligible employees The minimum number of covered and benefitting employees for qualification purposes will depend on the size of the employer’s workforce, the composition of highly paid employees (HCE),and non-highly paid employees (NHCE)

Overall Coverage Tests Cont’d Purpose of Minimum Coverage Tests: Congress needed to ensure that enough NHCEs are benefitting under the plan The minimum coverage test determines if a sufficient number of NHCEs are receiving comparable benefits, rights and features under the plan when compared to the HCEs Note: HCEs and NHCEs classification will be important for compliance testing for minimum coverage, minimum participation, and nondiscrimination

The Coverage Tests Two statutory tests under IRC- Sec. 410(b)(1) The Ratio test The Average benefit test Ratio Test: The plan must meet one of the two requirements every plan year: (a) the 70 percent test or (b) the ratio percentage test (does not have to be the same test every year, but must pass one of the two tests) 70 percent test: At least 70% of the NHCEs must benefit under the plan (if 70% of NHCEs covered+benefits=good),OR Ratio percentage test: Must benefit a percentage of NHCEs which is at least 70% of the percentage of HCEs benefitting under the plan

The Coverage Tests Cont’d The Average benefit test: 2-part test:- both parts must be satisfied to pass the “ABT” Nondiscriminatory classification test- cannot discriminate in favor of HCEs Average benefit percentage test- average benefit received by the NHCEs must be at least 70% of the average benefit received by the HCEs (employer-provided benefits) Nondiscriminatory classification test: Plan passes if the classification of employees who benefit under the plan is reasonable AND nondiscriminatory Reasonable classification (Descriptive): Established under objective business criteria that identify the category of employees covered by the plan. Include specified job categories, (e.g. secretaries), nature of compensation (hourly or salaried), or geographic location

The Coverage Tests Cont’d Nondiscriminatory classification (Numerical): The classification is nondiscriminatory if the plan’s coverage ratio meets the safe harbor percentage test or the facts and circumstances test is satisfied (see: notes on calculation of coverage test) The winning number is based on (1) ratio % and (2) concentration % (% of entire workforce NHCEs concentration % goes up, safe harbor % goes down) Safe harbor percentage test: The plan’s coverage ratio must be at least equal to the safe harbor percentage. See: “Table of safe harbor percentages” Treas. Regs. Sec. 1.410(b)-4(c)(2) Note: If the plan’s actual percentage ratio is at or above the safe harbor percentage the first part of the average benefit test is satisfied.

Coverage Tests Cont’d Note cont’d: If the plan’s coverage ratio falls between the safe and unsafe harbor %, relevant facts and circumstances can be presented to the IRS to establish that the eligibility classification is nondiscriminatory (facts and circumstances test) Note: The highest safe harbor percentage is 50%. If the plan’s coverage ratio is at least 50%, this test is satisfied Example: 45% of NHCEs benefit; 90% of HCEs benefit Plan’s Coverage Ratio is 45/90 = 50%

Coverage Tests Cont’d If between safe harbor percentage and unsafe harbor percentage: facts and circumstances examined Factors to look at - Relevant factors include: 1)business reason for classification, 2) percentage of all employees benefiting under the plan; 3) whether the number of employees benefitting in each salary range is representative of the total number of employees in that salary range, 4) the difference between the plan’s coverage ratio and the safe harbor percentage, i.e., how close does the classification comes to the safe harbor percentage, and 5) extent to which the average benefit percentage (ABP) exceeds 70%. Example (Regs): 200 total employees; 120 NHCES, 80 HCEs Concentration %= 120/200= 60%, safe harbor = 50%; unsafe harbor = 40% Plan benefits 72/80 HCEs = 90%. Safe harbor = (.50(.90) = 45% of NHCEs = (.45)(120)=54 NHCEs must benefit. Unsafe harbor = (.40)(.90) = 36% of NHCEs – (.36)(120) = 43.2 = 44 NHCEs

Coverage Tests Cont’d Average Benefit Test - (2nd part): The ABP for NHCEs divided by ABP of HCEs must be at least 70 percent. ABP for NHCES is at least 70% of the ABP for HCEs. Methodology: Count employer’s total workforce. Identify excludable employees- employee who does not satisfy age/service requirements; participant credited with 500 or fewer hours of service; participant who is not employed on last day of plan year and credited with 500 of fewer hours of service (plan requires last day employment – optional) Subtract excludable employees from the workforce = coverage testing group Do not include participants in collectively bargained plan Note: If the plan benefits all members of the coverage testing group, the plan’s coverage is 100% and Sec. 410(b) is satisfied. If the plan benefits less than the entire coverage group, must be tested

Coverage Tests Cont’d Methodology Cont’d: Identify which employees are HCEs and which are NHCEs. See: IRC 414(q) and IRS Notice 97-45 NHCE ratio – the number of NHCEs in the benefitting group divided by the number of NHCEs in the coverage testing group HCE Ratio – the number of HCEs in the benefitting group divided by the number of HCEs in the coverage testing group Plan’s coverage ratio: Divide the NHCE ratio by HCE ratio Note: Aggregated plans – must aggregate plans of related employers (not if Single Line Of Business (SLOB)) Determine coverage testing period: Annual testing – (most popular). Anyone who is an employee at any time during the year is included in the workforce (identifying coverage testing group). Must be used by 401(k) and 401(m) arrangements – tested separately Snap shot testing: Single testing date is chosen. Quarterly testing. Daily testing