Repeal of the family aggregation rules in defining HCEs in a qualified plan.

The definition of a highly compensated employee (HCE) is one of the fundamental concepts inherent in qualified retirement plans governed by Sec. 401(a). The pervasive theme of the qualification requirements is that a plan may not discriminate in favor of HCEs. Prior to the enactment of the Tax Reform Act of 1986 (TRA '86), there was no statutory definition of HCE. The TRA '86 enacted Sec. 414(q), which defined HCEs to mean generally any employee who, during the year or the preceding year:

* Was at any time a 5% owner;

* Received compensation from an employer in excess of $75,000;

* Received compensation from an employer in excess of $50,000 and was in the top 20% of employees when ranked on the basis of compensation for such year; or

* Was at any time an officer and received compensation greater than 50% of the maximum annual defined benefit plan benefit limit.

(The $75,000 and $50,000 amounts have been adjusted for cost-of-living increases.)

The Small Business Job Protection Act of 1996 (SBJPA) amended the definition of HCE to mean an employee who was a 5% owner during the current or preceding year or an employee who earned in excess of $80,000 during the preceding year. A top 20% group election is available as to the second definition.

The definition of 5% owner in Sec. 414(q)(2) includes direct or indirect ownership through family attribution under Sec. 318. Under Sec. 318, an individual is considered to own any stock owned directly or indirectly by his spouse, children. grandchildren or parents. As a result, an employee who is the spouse, child, parent or grandparent ("family member") of an individual with a 5% interest in the employer is treated as an HCE. regardless of the family member's compensation level.

Prior to the SBJPA, Sec. 414(q)(6) included the family aggregation rules. Members of the family of either a 5% owner or of an HCE in the top ten HCEs were also treated as HCEs. Such family aggregation group members were treated as a single HCE. In addition, any compensation paid to a family-aggregated employee was treated as if it were paid to the HCE. For purposes of aggregation under Sec. 414(q)(6),"family" includes an employee's spouse, lineal ascendants and descendants, and their spouses. The SBJPA repealed the family aggregation rules for plan years beginning in 1997.

The family aggregation rules impose a variety of constraints on family-aggregated plan participants. First, there is a dollar limit on the amount of compensation that may be used in determining contributions or benefits under a qualified retirement plan under Sec. 401(a)(17); this limit was $150,000 for 1994 through 1996. As a result, the family aggregation group was limited to $150,000 in combined compensation, regardless of the actual compensation of the individual family members. This resulted in an unfair disadvantage to business owners that sponsored qualified retirement plans with essentially uniform allocation mechanisms.

Similarly, in performing the actual deferral percentage (ADP) or actual contribution percentage tests applicable to Sec. 401(k) plan pre-tax contributions or matching contributions, respectively, the family aggregation rules limited the denominator (i.e., the amount of compensation included for testing purposes) to the Sec. 401 (a)(17) limit in the aggregate. Tax advisers should note, however, that the individual limit on the amount that may be deferred on a pre-tax basis to a Sec. 401(k) plan is not limited by family aggregation. Thus, in 1997, when the maximum pre-tax contribution to a Sec. 401(k) plan was $9,500, a family aggregation group composed or a husband and wife might have a $19,000 numerator ($9,500 X 2) for ADP testing purposes. The denominator, however, would be limited to $160,000 (the 1997 Sec. 401(a)(17) compensation limit), notwithstanding actual compensation. The result is an ADP (the amount deferred divided by compensation) of 12.67%. This is a very high ADP for HCEs in a Sec. 401(k) plan, and would likely result in either a distribution of excess contributions to the HCEs or some form of employer nonelective contribution on behalf of non-HCEs.

As previously noted, the family attribution rules of Sec. 318, however, are still applicable in defining HCEs. Thus, a family member of a 5% owner is considered an HCE through family attribution. However, unlike under family aggregation, all employee considered highly compensated due to family attribution is still considered a separate employee.

The repeal of the family aggregation rules may permit qualified plans to be designed in a manner that increases benefits to highly compensated family members. In Example 1, the owners would each receive an allocation equal to the employee's, doubling the amount allocated under family attribution. In addition, the treatment of family members as separate HCEs may provide additional leveraging of the 70% ratio test coverage requirement of Sec. 410(b).

Example 1: Company C consisted of the following in
1996:
                                           Contribution
Employee         Family    Compensation     allocation

Owner 1           Yes       $150,000         $11,250
Owner 2           Yes       $150,000         $11,250
Employee 3        No        $150,000         $22,500

C sponsors a profit-sharing plan to which it contributes 15% of compensation. Employee 3 receives the same contribution amount as the total amount contributed on behalf of C's owners, because, notwithstanding the actual owners' compensation, their family aggregation compensation is limited to $150,000.

Example 2: Physician P, whose compensation exceeds the Sec. 401(a)(17) limit, employs her father F as office manager for $50,000 per year. There is no need to provide retirement benefits to E The practice also has two non-highly compensated X-ray technicians earning between $50,000 and $75,000 per year, and two administrative personnel earning between $30,000 and $40,000 per year. Under the prior family aggregation rule, P and F were treated as a single employee, such that any plan that covered P would have to cover at least 70% of the non-HCEs (i.e., at least three of the four others).

P's father is still considered an HCE under family attribution. Because of the family aggregation repeal, however, if a plan covers P and not F, only 50% of the HCEs are covered by the plan. Therefore, only 35% of the non-HCEs need to be covered by the plan. Thus, if the plan excluded the X-ray technicians, it would still satisfy coverage. Such exclusions may significantly reduce the cost of employer contributions, particularly in money purchase plans, defined benefit plans and top-heavy plans.