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Pay attention to compliance testing of retirement plans in a controlled group

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An entity’s ownership structure is key to keeping a retirement plan compliant with IRS coverage requirements. Retirement plans in a controlled group ― or companies under common ownership as defined in Internal Revenue Code (IRC) Sections 1563 and 414 ― must meet the Section 401(a) test, to ensure plans don’t favor owners or other high-income earners.

Many companies may not even know the IRS considers them part of a controlled group. For example, they may test on a stand-alone basis without taking into account other plans that may be part of affiliated companies, such as with a parent-child organization (when one company owns 80% of another), a brother-sister organization (when five or fewer individuals own 80% of more of the business) or some combination. They may be used to operating independently and not even know affiliates exist. Yet getting the testing right is important. Corrections for doing the test improperly can vary from making additional contributions and paying penalties to the rare worst-case scenario of a disqualification of the retirement plan. Before retaining a qualified professional to do the test, employers should know what to expect.

Requirements
To be a qualified retirement plan under IRC Section 401(a), a plan must meet specific coverage and nondiscrimination requirements as to the minimum number of non-highly compensated employees (NHCEs) covered under the plan. The minimum coverage requirements are set forth in Section 410(b), as satisfying one of the following coverage tests:
  • The ratio percentage test
  • The average benefit test

A plan satisfies the ratio percentage test if the percentage of the employer’s NHCEs who benefit under the plan, divided by the percentage of highly compensated employees (HCEs) who benefit under the plan, is at least 70%. Here’s an example:

Ratio percentage chart 1

The results are as follows:

Ratio percentage calculation chart 2

Nondiscriminatory test
A plan satisfies the average benefit test if it fulfills a “nondiscriminatory classification test,” which examines whether the classification of employees who benefit under the plan is both reasonable and nondiscriminatory, as determined by several other tests.

The average benefit test measures the percentage of compensation each employee contributed to the plan in a previous year (salary deferral and matching contributions as a percent of compensation). To satisfy this test, the NHCEs’ average benefit percentage must equal at least 70% of the HCEs’ average benefit percentage.

To satisfy requirements of the nondiscrimination test, numbers can be run in a variety of ways. Some plans or portions of plans may need to be disaggregated to meet minimum coverage requirements. Disaggregation rules specify that certain parts of single plans must be treated as separate plans, each of which is subject to minimum coverage requirements applied separately to the following components: 401(k) salary deferral contributions, employee stock ownership plan (ESOP) contributions, 401(m) matching employer contributions and 401(a) profit-sharing contributions. The test is applied to each company separately but takes into consideration the affiliated company’s employees, as employees not benefiting under the plan.

Alternately, if an employer doesn’t pass on a stand-alone basis, it may be able to permissively aggregate some of the plans and treat them as one. This method can lead to intricate calculations and considerations. For example, if you aggregate several 401(k) plans for 410(b) coverage testing, you must also aggregate the Average Deferral Percentage (ADP) and Average Contribution Percentage (ACP) nondiscrimination tests. This aggregation may lead to different nondiscrimination testing results from when the plans perform these tests separately. Other consequences may occur as well: If, for example, two aggregated plans have different matching contribution formulas, the formulas must also pass the general nondiscrimination requirements for difference in rights, benefits and features.

The best tester
In many cases, an employer may have different plans with different subsidiaries, most likely with different record-keepers, or third-party administrators, to oversee those plans. Tapping one such record-keeper to consolidate all the information to do the test can be risky, as he or she will not have all the necessary data in-house, may not know all the rules and ways to test, and may not want the liability.

Ideally, an employer wants to leave testing to someone knowledgeable about all the levels of testing, and the nuances of the regulations and how to apply them, especially if the numbers don’t work with the simplest method.

Frequency
An employer who passes the test can generally perform the tests one year out of every three if there are no significant demographic changes. There is also a special transition rule for new affiliates joining a controlled group which provides that the new affiliate does not have to be included in testing until the end of the plan year following the year in which the affiliate joined the group.

If after performing the various tests described above, one or more plans still do not pass, the company must take corrective measures. This often requires the company to bring additional employees into the plans that aren’t passing and providing contributions for those additional employees.

The IRS will often inquire about controlled group coverage testing when the agency observes that the sponsor of a plan it is auditing is a member of a controlled group. Should the IRS identify testing failures, it will propose corrective action as described above and may additionally impose penalties on the plan sponsor.

It’s definitely best practice, then, to proactively obtain accurate testing results and self-correct before the IRS shows up and increases the overall cost of the correction by adding penalties on top of the costs of the corrections themselves. Putting plans properly in place to begin with, and doing the testing right, is a much better approach.

Contact
Mark Ritter
T +1 404 704 0114
E mark.ritter@us.gt.com

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