This weblog put up addresses retirement plans which are supposed to be tax-qualified underneath Part 401(a) of the Inner Income Code (Code).

Particularly, this put up will present data associated to:

• “ Protection Testing” guidelines underneath Code Part 410(b)
• Associated “ Managed Group” guidelines underneath Code Part 414

Very often, we see employers, notably smaller employers, design and implement tax-qualified retirement plans and not using a fundamental understanding of how these guidelines apply to their plans. This leads to confusion over if the plan is required to take corrective motion underneath these guidelines in a selected plan yr.

This weblog put up is meant to supply employers with a basic understanding of those guidelines, in order that the plan sponsor can mitigate potential compliance points on the time of the plan’s implementation.

Background

To ensure that an employer sponsored retirement plan to be “ tax-qualified,” the plan should not discriminate in favor of “ extremely compensated staff” (HCEs), in both the plan design or administration.

“ Discrimination” in favor of HCEs is usually measured in two basic methods:

1. The group of staff who’re coated by the plan can not discriminate in favor of HCEs (Protection Testing)
2. The advantages offered throughout the plan can not discriminate in favor of HCEs (Advantages Testing)

Plan administration service suppliers will normally embrace Advantages Testing for the plan, and most plan suppliers do a terrific job of monitoring compliance with the Advantages Testing guidelines.

For instance, in a typical 401(ok) plan, the supplier will conduct the typical deferral share (ADP) and common contribution share (ACP) assessments for the plan, which measure whether or not contributions to the plan (each worker and employer matching contributions) discriminate in favor of HCEs. The plan supplier additionally will study the plan’s compliance with different tax regulation guidelines, such because the “ top-heavy” guidelines, and guidelines that restrict most deferrals of contributors and most advantages for contributors.

Nonetheless, very often, and notably with smaller employers, we don’t see anybody specializing in Protection Testing for the plan. This could create vital points pertaining to the tax-qualification of the plan. Beneath is a primer on the Protection Testing guidelines.

Fundamentals of Protection Testing

For retirement plans which are supposed to be tax-qualified underneath Code Part 401(a), the essential Protection Testing guidelines are present in Code Part 410(b).

The Part 410(b) guidelines have complexities that can boggle the thoughts, and an in-depth overview is past the scope of this weblog put up. Nonetheless, the essential notion is that the group of staff who’re eligible to take part within the plan can not simply be restricted to the corporate executives – the plan should be accessible to HCEs and non-highly compensated staff (NCHEs) alike.

Traditionally, Protection Testing guidelines have been considerably obscure. At this time, the principles are way more mechanical:

1. HCEs embrace staff who earn greater than a particular threshold (e.g., greater than US$150,000 in 2023 for a dedication of HCE standing for 2024), in addition to 5% homeowners of the employer’s enterprise.
2. The final Protection Take a look at is named a “ Ratio Proportion Take a look at.” If the Plan covers all the HCEs of the employer, it has to cowl not less than 70% of the NHCEs.

Notice that underneath the Ratio Proportion Take a look at, an employer’s plan doesn’t should cowl all the NHCEs. The take a look at is met if solely 70% of the NHCEs are coated. That provides the employer some leeway for excluding some NHCEs.

If the plan doesn’t cowl all the HCEs, the variety of NHCEs that should be coated will go down. For instance, if the plan covers 90% of the HCEs, it solely has to cowl 63% of the NHCEs (70% of 90%).

Protection Testing Problems

The foregoing description of the Ratio Proportion could be very simplified. There are lots of issues to the testing that may come up.

For instance, there are detailed guidelines about which staff should be counted within the testing knowledge, and which staff may be excluded. Collectively bargained staff are nearly at all times excluded. Workers shouldn’t have to be counted within the testing knowledge in the event that they haven’t attained age 21 or have lower than one yr of service.

As well as, if the plan can not meet the Ratio Proportion Take a look at, there’s another take a look at referred to as the “Common Advantages Take a look at,” which is extra sophisticated. A great service supplier can present help to an employer to make it possible for all the issues to the Protection Testing guidelines are addressed.

If a plan fails the Protection Checks, the plan should implement corrective measures to convey the plan into compliance, which might embrace extending eligibility to extra NHCEs or by rising the contributions made for them. A protection failure should be corrected inside nine-and-a-half months of the tip of the plan yr during which the failure occurred – if left uncorrected, the plan might be topic to penalties, taxes and even disqualification.

Managed Group Guidelines

To keep away from any points with the Protection Testing guidelines, it will be significant for the plan sponsor to have all the data wanted to precisely full the assessments – this implies worker demographics for the plan sponsor’s staff and for workers of the opposite firms that could be a part of the plan sponsor’s managed group or affiliated service group. The principles that decide which firms are a part of the identical managed group or affiliated service group are known as the “ Managed Group” guidelines.

In the event you return in time to the Seventies, it had turn out to be trendy for some employers to attempt to keep away from the Protection Testing guidelines by merely creating a number of firms. The executives or different professionals (e.g., medical doctors or legal professionals) might be employed by one firm and take part in that firm’s retirement plan, and the remainder of the workers might be employed by one other firm and be excluded from participation within the retirement plan.

The passage of Part 414(b) and Part 414(c) of the Code in 1974 addressed this try by employers to avoid the Protection Testing guidelines. For nondiscrimination testing functions:

• Part 414(b) gives {that a} company and all of its 80% or extra owned subsidiaries will likely be handled as one employer.
• Part 414(c) might deal with teams of companies as one employer, if they’ve widespread possession by 5 or fewer people, estates or trusts. These are sometimes called “ brother-sister” firm guidelines.

For instance, a dad or mum holding company and all of its wholly-owned subsidiaries are handled as one employer. Thus, the dad or mum firm can not simply have a separate tax-qualified retirement plan for all for all the executives and exclude the workers of its wholly-owned subsidiaries. For a retirement plan to be tax-qualified, retirement advantages may even should be offered to staff on the subsidiary degree.

Equally, if a person owns 100% of three totally different companies, these three companies should be handled as one employer for Protection Testing functions.

In a while, individuals began to seek out inventive methods across the Code Part 414(b) and (c) guidelines. Thus, in 1980, the regulation was amended so as to add Code Part 414(m). Underneath Part 414(m), companies additionally should be handled as single employer, in the event that they comprise an “ affiliated service group.”

The Managed Group guidelines in Code Part 414(b), (c) and (m) are very advanced and have very detailed rules underneath them. An evidence of the small print of these guidelines is past the scope of this weblog put up. Nonetheless, there’s one necessary take away for an employer. All employers, notably small employers, should be conscious that the Managed Group guidelines exist, and will influence the retirement plan’s tax-qualified standing. Very often, we see an employer contract with a plan service supplier, and ignore the Managed Group Guidelines, which may lead to some very critical opposed tax penalties associated to the retirement plan (famous above).

Thus, an employer ought to study retirement plan eligibility with respect to all members of its managed group (if any) on an annual foundation, to make sure that its tax-qualified retirement plans go the Protection Testing necessities. Consulting authorized counsel might be essentially the most fascinating method. As soon as the Managed Group situation is examined, the employer can advise the plan service supplier of the result and, if obligatory, handle it within the design of the plan.