New Comparability Plans

Posted By: Stacey Synder, CPA, QKA, TGPC

Profit-sharing plans give employers the option to make contributions to a retirement saving account for the benefit of their employees. These contributions may be made at the discretion of the company and do not need to be based on the actual profits of the company.

Traditional profit-sharing plans undergo compliance testing similar to the compliance testing performed on elective deferrals and employer match contributions and, therefore, owners and highly compensated employees generally are not able to receive contributions that are much higher than those allocated to the non-highly compensated employees. Plan sponsors who want to maximize the disparity between the allocations to the owners and the rank and file do so through a plan design called a new comparability profit-sharing plan, which uses cross-testing as the testing mechanism to legally maximize the allocation to the owners.

To determine if nondiscrimination requirements are satisfied, cross-testing considers the rate of the projected benefit at the age of retirement, the Equivalent Benefit Accrual Rate (EBAR), rather than the current contribution rates as done with traditional profit sharing plans. This allows owners and highly compensated employees, who are generally older than the non-highly compensated employees, to receive larger contributions.

Under a new comparability plan, different profit-sharing rates can be allocated to employees within different classes or groups. The groups can be based on age, years of service, job class, location, or can even consider each individual employee to be a separate group. However, for a plan to qualify for cross-testing, one of the following three requirements must be met:

1. Minimum Gateway Contribution – All non-highly compensated employees must receive an allocation that is no less than the lesser of 5% of the participant’s gross compensation, or 1/3 of the highest contribution rate given to any highly compensated employee. If the plan is also a 401(k) plan with a safe harbor nonelective contribution, the 3% contribution can be applied to the minimum gateway contribution.

2. Broadly Available Allocation Rate – Different allocation rates are provided to nondiscriminatory groups of employees, such as different locations or different profit centers.

3. Gradual Age or Service Schedule – The allocation increases based on age, years of service, or the number of points representing the sum of age and service, at regular intervals with the allocation bands equal in length, and the increase in rates is not more than the lesser of 200% of the prior allocation percentage or 5%. Additionally, the increase cannot exceed the ratio of the prior two allocations and the initial allocation percentage cannot be less than 1% of compensation.

Prior to starting cross-testing, the EBAR must be computed for each participant. The EBAR is computed by multiplying the current year contribution by the interest rate specified by the plan for making interest adjustments, factored by the number of years until the participant reaches retirement. It is then divided by the actuarially determined annuity purchase rate at retirement age times current year compensation. The result is then multiplied by 12 to produce the participant’s EBAR. The EBAR is used to complete cross-testing.

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________________________________________________________________x12

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The EBAR for a participant who is currently 35 years old (30 years left until retirement at age 65), receiving compensation of $45,000 per year and a profit sharing contribution of $2,000 in a defined contribution plan with a specified interest rate of 8.5% and actuarial determined annuity purchase rate of 95.38, would be 6.46%, computed as follows:

$2,000 Γ— 1.08530

Β  Β  Β  Β  Β  Β  Β  Β  Β  Β  Β  Β _________________ x 12 = 6.46%

95.38 x $45,000

Cross-Testing

The first part of cross-testing is the general test. The general test breaks up the plan into rate groups based on EBARs, and each rate group must satisfy IRC section 410(b) coverage testing individually. There is a separate rate group for every HCE EBAR which includes every participant whose EBAR is greater than or equal to the HCE’s EBAR. The ratio percentage is determined for each rate group by dividing the percentage of NHCEs in the rate group by the percentage of HCEs in the rate group. If the ratio percentage for each rate group is at least 70%, the plan is nondiscriminatory, and no further procedures are necessary. If each rate group does not satisfy the ratio percentage test, then the second part of cross-testing must be performed.

The second part of cross-testing is the average benefits test. The average benefits test consists of two parts: the nondiscriminatory classification test and average benefit percentage test. The nondiscriminatory test is further broken down into two parts: a reasonable classification and a nondiscriminatory classification. The first part of the nondiscriminatory test, the reasonable classification test, is a facts and circumstances analysis to determine whether the classifications are established under objective business criteria, including job class, location, hourly vs. salary, etc. The second part, nondiscriminatory classification, determines the percentage of total nonexcludable NHCEs to total nonexcludable employees, and compares the percentage to the IRC safe harbor and unsafe harbor percentages in section 1.401(b)-(4)(c)(4)(iv). If the plan’s ratio percentage is equal to or above the IRC safe harbor percentage, the plan is nondiscriminatory. If the plan’s percentage falls below the safe harbor percentage, but above the unsafe harbor, then the reasonable classification test must be satisfied in order to satisfy the nondiscriminatory test. If the plan’s percentage is below the unsafe harbor, the plan fails the nondiscriminatory test.

The final part of cross-testing is the average benefit percentage test. The plan’s average benefit percentage is calculated by dividing the average EBAR of the NHCEs by the average EBAR of the HCEs. The average benefit percentage has to be equal to or greater than 70% for the plan to satisfy the average benefit percentage test.

Example

A company wishes to contribute a profit sharing contribution that qualifies for cross-testing using the following allocation rates:

Age Rate Increase Ratio
Under 25 3%
25-34 6% 2.00
35-44 9% 1.50
45-54 12% 1.33
55-64 16% 1.33
65+ 21% 1.31

 

The first step is to ensure that the allocation formula satisfies one of the three criteria required for cross-testing. The formula satisfies the Gradual Age or Service Schedule requirement since the rates increase at regular intervals and in equal length, the increase between each band is not more than the lesser of 200% of t

he prior allocation rate or 5%, or greater than the increase ratio of the prior two allocations, and the lowest percentage is not less than 1%. Therefore, the plan qualifies for cross-testing.

The next step before moving onto cross-testing is to compute the EBARs for each participant:

HCE 1 HCE 2 HCE 3 HCE 4 NHCE 1 NCHE 2 NCHE 3 NCHE 4 NCHE 5 NCHE 6 NCHE 7 NCHE 8
Age 58 53 52 50 22 30 36 40 45 50 55 62
Years Until Retirement 7 12 13 15 43 35 29 25 20 15 10 3
Compensation 250,000 240,000 218,000 215,000 25,000 38,000 40,000 42,000 45,000 47,000 50,000 45,000
Profit Sharing Contribution 37,500 28,800 26,160 25,800 750 2280 2400 3780 5400 5640 8000 7200
Specified Interest Rate 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5%
Annuity Purchase Rate 95.38 95.38 95.38 95.38 95.38 95.38 95.38 95.38 95.38 95.38 95.38 95.38
EBAR 3.34% 4.02% 4.36% 5.13% 12.60% 13.12% 8.04% 8.70% 7.72% 5.13% 4.55% 2.57%

 

Once the EBARs are computed, cross-testing can be performed.

Part 1 – The General Test

Rate Group #1:

Percentage of NHCEs with EBAR greater than or equal to 3.34% 7/8 = 88%

Percentage of HCEs with EBAR greater than or equal to 3.34% 4/4 = 100%

Ratio Percentage 88%

Rate Group #2:

Percentage of NHCEs with EBAR greater than or equal to 4.02% 7/8 = 88%

Percentage of HCEs with EBAR greater than or equal to 4.02% 3/4 = 75%

Ratio Percentage 117%

Rate Group #3:

Percentage of NHCEs with EBAR greater than or equal to 4.36% 7/8 = 88%

Percentage of HCEs with EBAR greater than or equal to 4.36% 2/4 = 50%

Ratio Percentage 175%

Rate Group #4:

Percentage of NHCEs with EBAR greater than or equal to 5.13% 6/8 = 75%

Percentage of HCEs with EBAR greater than or equal to 5.13% 1/4 = 25%

Ratio Percentage 300%

The plan passes the general test since the ratio percentage for all rate groups is greater than 70%.

Part 2 – Average Benefits Test

A) Nondiscriminatory Classification Test:

Total number of nonexcludable NHCEs 8

Total number of nonexcludable employees 12

NHCE Concentration Percentage 67%

IRC section 1.401(b)-(4)(c)(4)(iv) safe harbor percentage 44.75

IRC section 1.401(b)-(4)(c)(4)(iv) unsafe harbor percentage 34.75

Percentage of benefiting NHCEs 8/8 = 100%

Percentage of benefiting NHCEs 4/4 = 100%

Ratio Percentage 100%

The plan is nondiscriminatory since the ratio percentage is greater than the safe harbor percentage, and the final step of cross-testing, Average Benefit Percentage Test, may now be performed.

B) Average Benefit Percentage

Average NHCE EBAR: 7.80%

Average HCE EBAR: 4.21%

Average Benefit Percentage: 185%

Since the average benefit percentage is greater than 70%, the plan passes cross-testing!

 

While new comparability plans are a good option for providing owners and highly compensated employees a higher contribution, they will only work for companies whose owners and HCEs are generally older than the NHCEs. As discussed, nondiscrimination is determined by projecting the benefit to the participant at retirement based on the current contribution. Therefore, older participants with few years left until retirement can receive a larger contribution today than the younger participants who have more years until retirement.

Photo By: Mike Cohen (License)