Select-group qualified nonelective contributions.
The sponsor of a Sec. 401(k) plan may be able to avoid making distributions to highly compensated employees (HCEs) under the actual deferral percentage (ADP) test or under the actual contributions percentage (ACP) test by making qualified nonelective contributions (QNECs) to a select group of very low-paid employees. The difference in cost between giving a QNEC to all nonhighly compensated employees (NHCEs) and giving the QNEC to just a select group can be significant, making the latter worthwhile. This technique can also be used in the IRS correction programs, significantly reducing the cost of correction.
The Tax Reform Act of 1986 (TRA) significantly changed the rules for Sec. 401 (k) plans. Most obviously, the TRA added Sec. 402(g), limiting elective contributions made to Sec. 401 (k), Sec. 403(b) and other elective plans to $7,000. The TRA also tightened the ADP test, added the ACP test (for employee after-tax and matching contributions), and codified the right to correct failures of the ADP and ACP test with QNECs.
The ADP test permits a disparity between the elective contributions made by HCEs and NHCEs equal to the greater of
--1.25 X NHCE average deferral percentage, or --the lesser of 2 percentage points + NHCE average deferral percentage or 2 X NHCE average deferral percentage.
The ACP test is numerically the same as the ADP test but measures the disparity between the matching contributions and after-tax employee contributions for HCEs and NHCEs. For most plans, the maximum disparity between the HCEs and the NHCEs in either test is two percentage points above the NHCE average deferral percentage. In addition, if the employer must satisfy both the ADP and the ACP tests, the employer may also have to satisfy a third test--the multiple use test--which essentially allows the employer to use the more generous 2+/2x test only once, in either the ADP or the ACP test.
The ADP and ACP tests are run at the end of the plan year. If a plan does not satisfy the ADP or ACP test, the employer can either make distributions to HCEs (to reduce the HCE average to the level permitted under the test) or make QNECs to the NHCEs (to increase the NHCE average to the level needed to sustain the HCE average). QNECs and distributions may be made any time during the year following the year being tested. However, if the corrections are made by distribution, and the distribution is made more than 2 1/2 months after the end of the plan year, the employer must pay a 10% excise tax on the excess contributions. No excise tax applies if QNECs are made to correct the ADP test. However, if QNECs are made late in the year, they may not be deductible in the same period as the other contributions for the plan year.
Example 1: Employer A runs the ADP test for 1996 (for a calendar-year plan) and discovers the following:
HCE average deferral percentage 6% NHCE average deferral percentage 3%
By Dec. 31, 1997, A must distribute excess contributions to reduce the HCE average to 5% or make QNECs to increase the NHCE average to 4%.
This discussion will focus on using QNECs to satisfy the ADP test, but the same principles apply to the ACP test.
Under the regulations, QNECs are nonelective contributions made by the employer to a plan that are fully vested when contributed, are subject to the same distribution restrictions as elective contributions, and satisfy the nondiscrimination rules in Sec. 401(a)(4) both before and after the QNECs are used in the ADP (or ACP) test. This last restriction is intended to prevent employers from "borrowing" profit-sharing contributions made on behalf of the NHCEs for the ADP test without also using the profit-sharing contributions for the HCEs in the ADP test.
When the TRA was enacted, many employers assumed that QNECs would be prohibitively expensive for most plans. Most employers, and the Service, envisioned an across-the-board contribution to all NHCEs of whatever percentage or amount was necessary to increase the NHCE average to the HCE average. However, in working through the regulations and the IRS correction programs, it has become clear that other contributions will also work, provided they satisfy the nondiscrimination rules, the employer discretion rules, the Sec. 410(a) participation rules and the definitional requirements of a QNEC.
If an employer has a group of employees that is separately definable by a job classification and that has a very low rate of pay, the plan can be written to permit a QNEC for this group of employees. The contribution can be discretionary; that is, the employer can decide whether to correct a failure to satisfy the ADP test by distribution or by QNEC (or both) at the end of each year, provided that the plan clearly states the group that will receive the contribution and states how the contribution will be allocated among the members of that group. It is presumably possible to amend a plan shortly after the end of the plan year to add a QNEC provision of this sort (this has been allowed in the IRS correction programs).
Because the compensation within the select group is very low, any contribution made on behalf of that group is a significant percentage of income. A small contribution by the employer becomes a large deferral ratio for each of the select-group employees, quickly increasing the average percentage of the entire NHCE group.
In the Service's view, select-group QNECs target the corrective contributions to the group needing the most help saving for retirement, and are therefore desirable rather than suspect (assuming the group is properly selected).
Example 2: Employer B has 54 employees, 11 of whom are HCEs. The employer has a broad range of NHCEs working in various job classifications. Some of the NHCEs make as much as $60,000, but the majority are paid between $20,000 and $40,000. The lowest-paid group of employees is a group of 11 hourly wage loaders and handlers whose pay ranges from $5,000 to $18,000.
Assuming an average deferral of 6.98% for the 11 HCEs and an average of 2.30% for the other employees, it has been calculated that, to satisfy the ADP test for the 1996 plan year, B would have to distribute over $33, 000 to satisfy the ADP test. Under a conventional QNEC arrangement, in which B makes an across-the-board contribution of 2.6% to the NHCEs to satisfy the ADP test, the cost would be $31,356. However, if B makes an $870 contribution to each of the 11 hourly employees (representing from 6.83% to 17.40% of their pa,v), the total cost of the select-group QNEC for the hourly employees would be $9,570.
Note: To use this technique, the employer must have a group of employees who are very low-paid, and must have enough of them that QNECs on their behalf will have an impact on the overall NHCE ADP.
Choosing the Select Group
There has been some discussion between employers and the Service about the composition of a select group of employees. Some employers have discussed the idea of using "all employees who terminated during the year," or "all employees who make less than $10,000," or other classifications not readily determinable. The IRS has expressed discomfort with such groupings. Simply selecting a set of employees after the end of the year may not satisfy the definite allocation rules of Sec. 401 (a), and may violate the prohibition on employer discretion with respect to benefits (see Regs. Sec. 1.411 (d)4, Q&A-4: "A plan provision that makes a protected benefit available only to those employees as the employer may designate is within the scope of this prohibition").
It appears safer to use the "reasonable classification" rules in Regs. Sec. 1.410(b)-4(b) or the commonality rules the Service permitted in Regs. Sec. 1.401 (k)-1 (h) (3) (iii) (B) for ADP restructuring (before restructuring was banned) to define the group.
IRS Correction Programs
The IRS has a variety of voluntary correction programs that permit employers to correct retirement plan defects. Under the most widely used correction program,m, the Voluntary Compliance Resolution (VCR) Program, the Service permits employers to correct operational plan defects by submitting a list of the defects to the IRS and working with the Service to correct them. If the defects relate to failure to satisfy the ADP or ACP test, employers have two choices: the standardized submission program (SVP) or the regular VCR submission. Under an SVP submission, the employer must correct an ADP or ACP defect by contributing QNEGs in an equal dollar amount or equal percentage to all NHCEs. In the regular VCR submission, the IRS has occasionally permitted employers to make distributions from the plan (as would have been permitted if the employer had corrected in a timely manner), but has more commonly required the contribution of QNECs. In this program, the Service has permitted employers to make QNECs to select groups of employees in order to reduce the correction costs. In the IRS correction programs, the Service has refused to permit employee groupings that appeared to be based on compensation rather than a legitimate business classification.
Making a QNEC may reward behavior that is not desirable. If employees believe they will receive a contribution without having to make an elective contribution, they may not bother to contribute. By limiting the QNEC to a select group of very low-paid employees, however, the effect of this employee behavior can be minimized, because most very low-paid groups cannot afford to contribute at all There could also be morale problems if other employees perceive this as an "unfair" contribution.
QNECs, even select-group QNECs, are an extra and perhaps unnecessary expense for the employer. The plan can be corrected for far less by making timely distributions, though presumably the HCEs would be far happier (perhaps improving retention of valued employees) if they were permitted to keep their entire contribution in the plan.
FROM GARY Q. CVACH, CPA, LL.M., AND KAREN M. FIELD, J.D., WASHINGTON, D.C.
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|Author:||Field, Karen M.|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 1996|
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