Annual Compliance Testing
The Internal Revenue Code (“Code”) requires that retirement plans pass certain compliance tests each year to maintain qualified tax status. Alerus Retirement and Benefits (“Alerus”) prepares these tests based on information from the plan sponsor, including the Annual Compliance Questionnaire, census, contribution data, and other related documentation. The accuracy of the information provided to Alerus is critical to the accuracy of the tests. Following is a summary of the tests and issues which may affect the plan.
The Code treats certain related employer entities as a single employer for purposes of testing. Alerus relies on the plan sponsor’s determination regarding whether the business is a member of a controlled group of businesses or an affiliated service group under the Code (a “Related Group”). If the plan sponsor is part of a Related Group, Alerus must be provided with information for all related entities for accurate testing. This issue often arises when an organization buys, sells, merges with, or creates another business entity.
The Code requires plan sponsors to consider all plans offered by the organization or any related employer when completing testing. Failure to do so would result in inaccurate testing results. Alerus’ testing only covers the plans serviced by Alerus unless the plan sponsor has entered into a written agreement with Alerus to test multiple plans.
Actual Deferral Percentage Test – 401(k)
If the plan sponsor offers a 401(k) plan to employees, it must either meet certain “Safe Harbor” criteria or pass the Actual Deferral Percentage (ADP) test. The test compares the average 401(k) contribution percentages of Highly Compensated Employees (HCEs) to that of Non-Highly Compensated Employees (NHCEs). In general, the average for HCEs cannot exceed that of NHCEs by more than 2%.
Most plans permit participants age 50 or over to make “catch-up” 401(k) salary contributions. Catch-up contributions are not included in the ADP test and are identified on the “Summary of Catch-up Contributions” page within the test.
Generally, if an ADP test fails, the plan must correct the failure by refunding the excess to the HCEs or, if eligible, characterizing the excess as catch-up contributions. To avoid penalties, the correction must be made by the 15th day of the third month following the end of the plan year (March 15 for a calendar year-end plan).
Actual Contribution Percentage Test – 401(m)
If the plan provides a match contribution, it must either meet certain “Safe Harbor” criteria or pass the Actual Contribution Percentage (ACP) test. The ACP test compares the average match rate of HCEs to that of NHCEs. In general, the average for HCEs cannot exceed that of NHCEs by more than 2%. Plans that allow employee after-tax contributions (other than Roth contributions) are also subject to this test.
Generally, if an ACP test fails, the plan must correct the failure by refunding the excess to HCEs. To avoid penalties, the correction must be made by the 15th day of the third month following the end of the plan year (March 15 for a calendar year-end plan).
Contribution Nondiscrimination Test – 401(a)(4)
Most plans allocate employer contributions using the same rate for all participants; however, plans may provide for allocations based on employee classifications. In this case, a general test under Code section 401(a)(4) must be completed to show that employer contribution allocations do not discriminate in favor of HCEs. Alerus only completes this test if the plan has a non-uniform allocation formula such as in a “cross-tested” plan.
Minimum Coverage Test – 410(b)
Code Section 410(b) requires that a plan satisfy a coverage test. Generally, a plan satisfies the Ratio Percentage Test if the percentage of NHCEs who benefit is at least 70% of the percentage of HCEs who benefit under the plan, and the plan must make benefits available to a non-discriminatory group of employees. Each portion of the plan must meet the minimum coverage tests. If the Ratio Percentage Test fails, an Average Benefits Test will be performed. If the plan cannot pass coverage with either test, it may need to be amended to address the issue.
This test is often relevant for plans which exclude certain groups of employees or have allocation conditions that require employees to be employed on the last day of the plan year and/or work 1,000 hours. If the class exclusion or allocation condition prevents contributions to a group of NHCEs that is too large, then the plan “fails coverage.”
Annual Additions Test – 415
Code Section 415 limits the total contributions (“Annual Additions”) to a participant’s account each limitation year (usually the plan year). The Annual Additions limit is the lesser of an indexed dollar amount or 100% of a participant’s compensation. Annual additions include employer contributions, salary deferrals, and forfeitures. If participants are covered under more than one qualified plan sponsored by the same employer, combined limitations may apply. Alerus does not prepare combined testing except upon request.
Top Heavy Determination – 416
Code Section 416 requires an annual determination regarding whether the plan is “top-heavy.” The plan is top-heavy if the aggregate value of key employee accounts exceeds 60% of that of all employee accounts under the plan. The measurement is made on the last day of each plan year, applies to the coming year, and includes participant in-service distributions made in the last five years. If a plan is top-heavy, the employer must make a “top-heavy” minimum contribution of 3% of eligible compensation, subject to certain exceptions and crediting rules. If the report indicates a top-heavy percentage of 50% or more, contact the plan’s Alerus representative to discuss possible changes to the plan design.
Non-Discrimination Compensation Testing – 414(s)
The plan’s definition of compensation must not discriminate in favor of HCEs. If plan provisions exclude a form of compensation, it must be tested under Code 414(s). The definition of compensation is generally non-discriminatory if the percentage of the total compensation included for HCEs does not exceed that of NHCEs by more than a de minimis amount.
Excess Deferral Testing – 402(g)
The Code limits the amount an individual may defer in any calendar year. The deferral limit must take into account all retirement plans under which a participant is eligible to make deferrals. Alerus only tests the participant’s annual deferral amount at plan year-end. Employers and their payroll service providers should install procedures so this limit is not exceeded during the plan year. Also, participants must monitor this limit if they participate in more than one plan during the calendar year and advise the employer if they exceed the limit.
S-Corporation Anti-Abuse Test – IRC §409(p)
Internal Revenue Code 409(p) imposes an income tax and/or an excise tax if the tax benefits of the S Corporation ESOP disproportionately benefit a group of shareholders that control the S Corporation, either directly or indirectly. IRC §409(p) imposes an income tax on Disqualified Persons for the value of amounts allocated by the ESOP, directly or indirectly, to such individuals if said allocations are made during a Non-allocation Year. In general, the purpose of this test is to prevent companies from avoiding paying corporate and personal income taxes, without broadening the base of company ownership.
A Disqualified Person is defined as: (1) any person if the such person and the family members of such person hold an aggregate of 20% or more of the deemed-owned shares in the S Corporation, or (2) any person who holds 10% or more of the deemed-owned shares of stock in the S Corporation. If at any time during the plan year Disqualified Person(s) in aggregate own 50% or more of the shares in the S Corporation, the plan year is considered to be a Non-allocation Year.
In addition, IRC §4979A was amended to impose an excise tax on the S Corporation equal to 50% of: (1) the total prohibited allocations made to Disqualified Persons, and (2) the total value of Synthetic Equity owned by Disqualified Persons during a Non-allocation Year, regardless of whether allocations were made to Disqualified Persons during the year.
Employer Contribution Deductibility Calculation – 404
Code Section 404 limits the deductibility of employer contributions. This issue, though rare, can only be addressed by working with the plan sponsor’s accountant when completing the organization’s tax return. In a defined contribution plan the deduction limit is generally 25% of eligible compensation. Alerus does not complete this calculation.
Compensation for Sole Proprietor, Partnership, Limited Liability Partnership, or Limited Liability Company Entities
Alerus does not calculate the Earned Income or contributions of any employee considered to be self-employed. Generally, these calculations are made by the plan sponsor’s accountant. Alerus relies on data the plan sponsor provides.