ERISA Conference 2006 September 5 6, 2006

1
ERISA Conference 2006September 5 6, 2006
July Business Services
Presented by

• Charles Lockwood
• ASC Institute
• Littleton, CO
• clockwood_at_asc-net.com

2
Coverage and Nondiscrimination

• Tests are interconnected must pass both
  coverage and nondiscrimination tests every plan
  year
• Coverage measures relative coverage of HCEs and
  NHCEs
• Nondiscrimination measures level of benefits
  provided to HCEs and NHCEs
• ADP test elective deferrals
• ACP test matching contributions / after-tax
• 401(a)(4) nondiscrimination test ER
  contributions

3
Coverage Tests

• Percentage test 70 of NHCEs
• of NHCEs
• Ratio test ------------------ gt 70
  
• of HCEs
• Average benefits test
• Nondiscriminatory classification test
• Average benefit percentage test

4
Coverage Testing Group

• All EEs who are not excludable EEs
• Excludable EEs
• Minimum age and service
• Union employees
• Nonresident aliens with no U.S. source income
• Certain airline pilots
• Employees who terminate employment during the
  year with lt 501 HOS
• All other employees in coverage testing group
  even if excluded for other reasons

5
Benefiting Group

• Benefiting group employees in coverage testing
  group who are benefiting under the plan
• Benefiting
• Profit sharing plan receives a contribution or
  allocation of forfeitures
• 401(k) plan eligible to make deferrals
• 401(m) plan (matching contributions) eligible
  to receive match
• Each type of plan must be tested for coverage
  separately

6
Testing 401(k)/401(m) Plans

• Must separately test ER contributions, elective
  deferrals, and matching contributions
• Plan must satisfy coverage and nondiscrimination
  tests separately with respect to each type of
  contribution
• Different allocation/eligibility conditions may
  apply to different contribution types
• Allocation conditions do not apply to salary
  deferrals
• Plan may exclude EEs from certain types of
  contributions

7
Ratio Test

• of NHCEs
• Ratio test -------------- gt 70
• of HCEs
• Include all employees of ER in test except for
  excludible EEs
• Coverage problems often arise where ER is part of
  a controlled group
• Can exclude for any reason as long as pass
  coverage
• Can exclude EEs by name if satisfy ratio coverage
  test

8
Average Benefits Test

• Must satisfy both parts of test
• Nondiscriminatory classification test
• Average benefit ratio test (ABR test)
• Allows must greater disparity in coverage than is
  permitted under ratio coverage test
• May be better option than amending plan to expand
  coverage
• Most common uses related employers and excluded
  employees

9
Example

• Company X is part of a controlled group with
  Company Y. Company X maintains a 401(k) plan but
  Company Y does not maintain a plan. The Company X
  plan does not cover employees of Company Y.
• Total EEs of X 34 4 HCE, 30 NHCE
• 5 NHCEs lt 1 YOS/age 21
• 3 NHCEs termed with lt 501 HOS
• 4 NHCEs termed with gt 501 HOS
• Total EEs of Y 26 6 HCE, 20 NHCE
• 5 NHCEs lt 1 YOS/age 21
• 2 NHCEs termed with lt 501 HOS
• 3 NHCEs termed with gt 501 HOS

10
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?

11
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group

12
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10

13
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10
• NHCEs 30 20

14
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10
• NHCEs 30 20 10

15
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10
• NHCEs 30 20 10 3

16
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10
• NHCEs 30 20 10 3 37

17
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10
• NHCEs 30 20 10 3 37
• Benefiting group

18
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10
• NHCEs 30 20 10 3 37
• Benefiting group
• HCEs 10

19
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10
• NHCEs 30 20 10 3 37
• Benefiting group
• HCEs 10 6 4

20
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10
• NHCEs 30 20 10 3 37
• Benefiting group
• HCEs 10 6 4
• NHCEs 37

21
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10
• NHCEs 30 20 10 3 37
• Benefiting group
• HCEs 10 6 4
• NHCEs 37 4

22
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10
• NHCEs 30 20 10 3 37
• Benefiting group
• HCEs 10 6 4
• NHCEs 37 4 15 18

23
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10 NHCEs 30 20 5 5 3
  37
• Benefiting group
• HCEs 10 6 4 NHCEs 37 4 15 18
• Coverage test

24
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10 NHCEs 30 20 5 5 3
  37
• Benefiting group
• HCEs 10 6 4 NHCEs 37 4 15 18
• Coverage test
• HCE 40 4/10

25
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10 NHCEs 30 20 5 5 3
  37
• Benefiting group
• HCEs 10 6 4 NHCEs 37 4 15 18
• Coverage test
• HCE 40 4/10 NHCE 48.65 18/37

26
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• Does X Plan pass coverage?
• Nonexcludible EE group
• HCEs 4 6 10 NHCEs 30 20 5 5 3
  37
• Benefiting group
• HCEs 10 6 4 NHCEs 37 4 15 18
• Coverage test
• HCE 40 4/10 NHCE 48.65 18/37
• 48.65 / 40 121.63

27
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• What if Y also maintains a plan?

28
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• What if Y also maintains a plan?
• Nonexcludible EE group
• HCEs 4 6 10 NHCEs 30 20 5 5 2
  38
• Benefiting group
• HCEs 10 4 6 NHCEs 38 3 25 10
• Coverage test
• HCE 60 6/10 NHCE 26.32 10/38
• 26.32 / 60 43.87

29
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• What are Ys options?
• Expand coverage to include Xs EEs
• Permissively aggregate plans
• Does not work if use different plan years
• Even if aggregate still may fail
  nondiscrimination
• May be able to pass coverage independently if new
  controlled group

30
Transition Rule

• Applies when there is a change in related group
  members due to an acquisition or disposition
• If plan satisfies coverage at the time of
  acquisition or disposition deemed to pass
  coverage during the transition period
• Transition period - year of transaction and
  following plan year
• Cannot be substantial change in plan coverage
• Does not apply for nondiscrimination testing

31
Example
Y Company6 HCEs, 20 NHCEs5 NHCEs lt 1 YOS/age
21 2 NHCEs lt 501 HOS 3 NHCEs gt 501 HOS
X Company4 HCEs, 30 NHCEs5 NHCEs lt 1 YOS/age
21 3 NHCEs lt 501 HOS 4 NHCEs gt 501 HOS

• What are Ys options?
• Expand coverage to include Xs EEs
• Permissively aggregate plans
• Does not work if use different plan years
• Even if aggregate still may fail
  nondiscrimination
• May be able to pass coverage independently if new
  controlled group
• Run average benefit test

32

Nondiscriminatory Classification Test

• Reasonable classification
• Based on business criteria e.g., job
  classification, nature of compensation,
  geographic location
• Naming individuals is not reasonable
  classification
• Nondiscriminatory classification
• Use same ratio as under ratio test
• Must satisfy safe harbor percentage see chart
  on pg. 17 of materials
• If between safe harbor and unsafe harbor facts
  and circumstances

33

Average Benefit Percentage Test

• NHCE average benefit
• ----------------------------- gt 70
• HCE average benefit
• Only include benefit percentages of nonexcludable
  employees
• 
  allocation
• Allocation rate -----------------------
• 414(s)
  compensation
• Must include benefits under all plans of the
  employer -- including 401(k)/401(m) plans

34

Special Rules

• Testing group must include benefits under all
  plans of the ER, even if normally disaggregated
• Must include contributions under all plans
  maintained by ER
• Can run separate ABR test for DC and DB plans
• Must include elective deferrals under 401(k) plan
  
• Must include matching contributions
• Must include contributions under ESOP
• All nonexcludable employees are included even if
  do not benefit benefit is 0

35

Special Rules

• Can perform average benefits test on the basis of
  contributions or benefits
• Can cross-test without regard to minimum
  gateway
• Can impute permitted disparity
• Presumably include ADP/ACP corrective
  distributions and excess deferrals
• Catch-up contributions NOT included in test
• ABR does not include amounts for otherwise
  excludible EEs
• Need to make sure gather information regarding
  all plans of ER

36

Otherwise Excludible EEs

• ER is permitted to disaggregate the portion of
  the plan covering otherwise excludable EEs from
  rest of EEs
• Coverage testing is done separately for otherwise
  excludable employees and for statutory employees,
  as if in separate plans
• When testing plan covering otherwise excludable
  EEs, exclude statutory EEs and any EEs who fail
  to meet minimum age and service requirements
• When testing plan covering statutory EEs, exclude
  all EEs who fail to meet statutory age and
  service reqs.

37

Nondiscrimination Testing

• Safe harbor uniform allocation
• Permitted disparity
• General rate group test
• Can test on allocation or benefits basis
• Each HCE rate group must satisfy coverage test
• ADP/ACP test
• Availability of benefits, rights and features

38
Pro Rata Safe Harbor Formula

• ER contribution is allocated to eligible
  participants on basis of compensation
• ER can have discretion to change amount
  contributed to plan each year
• Compensation must be defined in plan document
• Compensation must satisfy definition of
  nondiscriminatory compensation under Code 414(s)
• Be careful of allocation conditions

39

Safe Harbor ER Contributions

• Plan may condition contribution on allocation
  conditions may cause plan to fail safe harbor
• Exception for top-heavy contributions
• Example X Corp 401(k) plan provides for
  discretionary ER contribution. For 2006 PY, X
  makes 5 contribution. Sam terminates employment
  on November 15 and only receives 3 top heavy
  contribution. Does plan satisfy 401(a)(4) safe
  harbor?
• Would answer change if Sam receives 3 SH ER
  contribution?

40
Permitted Disparity Formula

• Permitted disparity formula takes into account
  social security benefits
• Allocates more as a percentage of compensation to
  highly compensated employees
• Additional allocation is made for compensation
  above the integration level (e.g., taxable wage
  base)
• If drafted correctly, plan still qualifies as
  safe harbor plan

41

Permitted Disparity Formula

• If taxable wage base is used as integration level
  maximum disparity allowance equals lesser of
• 5.7 or
• Amount allocated on base compensation (Code
  414(s) compensation)
• Example
• If 5 on base comp no more than 5 on excess
  compensation
• If 8 on base comp no more than 5.7 on excess
  compensation

42

Permitted Disparity Formula

43

Permitted Disparity Formula

• Plan may provide for a lower integration level
  (e.g., 80 of TWB)
• If integration level is less than the TWB but
  greater than 80 of the TWB 5.4
• If integration level is more than 20 of TWB but
  not more than 80 of TWB 4.3
• Common formula 80 of TWB (rounded up) with
  maximum disparity of 5.4
• Plan may not provide for integration level
  greater than TWB

44

General Nondiscrimination Test

• Must test each HCE rate group for coverage
• May use ratio test or average benefit test
• Applies only to ER contributions do not include
  matching contributions or elective deferrals
• Can determine rate groups on basis of allocations
  or benefits
• Cross-testing permits ER to convert
  contributions under DC plan to equivalent
  benefits under DB plan
• ER also may be able to impute permitted disparity

45

New Comparability Plan
46

Minimum Gateway Requirements

• Gateway test to use cross-testing for
  discrimination testing, plan must satisfy one of
  gateway tests
• All benefiting NHCEs must receive at least 5
  allocation (based on 415(c) compensation) OR
• Lowest allocation to any NHCE must be at least
  1/3 of highest allocation to any HCE (based on
  any definition of 414(s) compensation)
• Example. If highest HCE rate is 12, lowest NHC
  rate must be 4. If highest HCE rate is 20,
  lowest NHC rate must be 5.

47

New Comparability Plan
48

New Comparability Plan

• Phil 5.69 rate group
• NHCE 6/6 100
• ------------------------------ 100
• HCE 3/3 100
• Brad 15.14 rate group
• NHCE 2/6 33.33
• ----------------------------- 50
• HCE 2/3 66.67
• Julie 19.34 rate group
• NHCE 1/6 16.67
• ----------------------------- 50
• HCE 1/3 33.33

49

New Comparability Plan

• Does plan satisfy the rate group test?
• NHCE concentration 6/9 66.67
• Midpoint safe harbor from page 17 of materials
  based on 66 NHCE concentration 40.50
• Average benefit percentage test
• NHCE ratio (7.88 9.28 13.95 6.17
  15.14 19.35) / 6 11.96
• HCE ratio (5.69 15.14 19.34) / 3
  13.39
• Average benefit ratio 11.96 / 13.39 89.32
• Plan satisfies the average benefit test
• Plan is nondiscriminatory!

50

New Comparability Plan
Add SH 401(k) plan to reduce amount to be
contributed to NHCEs (by offsetting ER
contribution to HCEs by deferrals). Plan still
must meet minimum gateway requirements.
51

New Comparability Plan

• Does plan satisfy the rate group test?
• NHCE concentration 6/9 66.67
• Midpoint safe harbor from page 17 of materials
  based on 66 NHCE concentration 40.50
• Average benefit percentage test
• NHCE ratio (8.21 7.52 11.31 5.00
  12.01 15.67) / 6 9.95
• HCE ratio (5.69 20.30 27.25) / 3
  17.75
• Average benefit ratio 9.95 / 17.75 56.06
• Plan FAILS average benefit test

52

How to Fix a Failed ADP/ACP Test

• Four permitted correction methods
• Refunds to HCEs
• Making QNECs/QMACs to NHCEs
• Shifting QNECs/QMACs or deferrals
• Recharacterization
• Impermissible correction methods
• Allocation to suspense account
• Forfeiture of vested matching contributions
  forfeiture may be required if matching
  contributions based on refunded deferrals
• Disregarding plans allocation formula

53

Avoiding ADP/ACP Test Failure

• Plan may authorize ER to adjust deferral rates of
  HCEs to prevent plan from failing ADP/ACP test
• Plan should authorize ER to impose limit on HCE
  deferrals/after-tax contributions
• Can create right to make catch-up contributions
  if limit and method of reduction is contained in
  the plan
• ER may reduce discretionary contribution or amend
  plan to reduce fixed matching contribution if
  plan has last day employment requirement
• Be careful of EE relations issue

54

Avoiding ADP/ACP Test Failure

• Use different definition of testing compensation
• Plan may use any definition of 414(s)
  compensation not bound by definition used in
  plan for allocation purposes
• 414(s) compensation limited to 220,000
• Shift amounts between ADP and ACP tests

55
Corrective Distributions

• Correction period 12 months following the close
  of the plan year
• If plan terminates, correction period ends 12
  months following date of termination
• Amount to be distributed -- leveling method
• Based on highest dollar amount of deferrals
• Two-step method
• Allocable earnings
• Gap period earnings
• Treatment of net loss

56
Determining Amount of Refund
BB maintains a CY 401(k) plan. On 3/1/07, BB
runs 2006 ADP test using current year testing.
The ADP of NHCEs is 5 and HCE deferrals are as
follows
57

Determining Amount of Refund
Can BB recharacterize any of HCE 6s deferrals
as catch-up contributions based on ADP limit?
58

Determining Amount of Refund
The ADP of the NHCEs for 2006 is 5. The plan
uses current year testing method. To correct ADP
test, must bring HCE-3, HCE-4, HCE-5 and HCE-6
down to 7.09.
59

Determining Amount of Refund
The total amount to be returned is 8,673 --
2,656 to correct HCE-3 1.66 x 160,000
1,488 to correct HCE-4 1.24 x 120,000
1,910 to correct HCE-5 1.91 x 100,000
2,619 to correct HCE-6 2.91 x 90,000.
60

Determining Amount of Refund
Refunds are returned based on highest dollars of
deferrals. Level to next lowest dollar amount.
61

Determining Amount of Refund
3,000 refunded to HCE-1 and HCE-2. Remaining
refund 2,673 8,673 - 6,000
62

Determining Amount of Refund
891 refunded to HCE-1, HCE-2 and
HCE-3. Remaining refund 0
63

Determining Amount of Refund
If plan permits catch-up contributions how
would refunds be made under plan?
64

Determining Amount of Refund
If plan permits catch-up contributions how
would refunds be made under plan?
65

Determining Amount of Refund
If plan permits catch-up contributions how
would refunds be made under plan?
66

Determining Amount of Refund
If plan permits catch-up contributions how
would refunds be made under plan?
67

Determining Amount of Refund
If plan permits catch-up contributions how
would refunds be made under plan?
68

Using QNECs in ADP Test

• QNEC ER contribution that looks like a
  deferral
• 100 vested when made
• Subject to 401(k) distribution restrictions
• Special nondiscrimination rules
• Must be made within 12 months following end of
  plan year
• Bottom-up QNECs
• Effectively eliminated under final regulations
  not effective until 2007 when make corrective
  distributions for 2006

69

Using QNECs in ADP Test

• Plan must satisfy nondiscrimination requirements
  with and without QNECs orused in ADP test
• Example ER makes 3 QNEC to all EEs. May ER
  treat 1 of NHCE QNECs in ADP test?
• Plan must be able to satisfy 401(a)(4)
  nondiscrimination requirement after carving
  out QNECs
• Could test by imputing permitted disparity or
  using cross-testing
• If use cross-testing must satisfy minimum
  gateway based on contributions being tested

70
QNECs and Prior Year Testing

• If make QNECs and using prior year testing must
  exclude such QNECs when running 401(a)(4) for
  year in which QNEC is allocated
• Requires ER to know how much of QNECs are to be
  used in ADP/ACP test for next year before final
  401(a)(4) test can be performed
• If ER wants to make QNEC to correct 2006 ADP test
  (which uses prior year testing), by when must ER
  contribute the QNEC to the plan?
• End of 2005 plan year

71
Targeted QNECs

• Targeted QNEC can only use QNEC in ADP or ACP
  test to extent does not exceed greater of
• 5 of compensation
• 2x plans representative contribution rate
• The lowest QNEC rate of any NHCE, taking into
  account at least 50 of total eligible NHCEs
• The lowest QNEC rate of any NHCE employed as of
  the last day of the plan year
• Not applicable until 2006 plan year can still
  make bottom-up QNECs to correct 2005 test

72
Example

• ABC Corp. has 44 NHCEs eligible for plan. For
  the 2006 plan year, the ABC plan fails the ADP
  test. ABC Corp. would like to make a QNEC for
  Joe, the lowest paid EE. How much may ABC Corp.
  give Joe (and include in the ADP test) without
  making a QNEC for any of the other NHCEs?

73
Example

• ABC Corp. has 44 NHCEs eligible for plan. For
  the 2006 plan year, the ABC plan fails the ADP
  test. ABC Corp. would like to make a QNEC for
  Joe, the lowest paid EE. How much may ABC Corp.
  give Joe (and include in the ADP test) without
  making a QNEC for any of the other NHCEs?
• 5 of compensation

74
Example

• ABC Corp. has 44 NHCEs eligible for plan. For
  the 2006 plan year, the ABC plan fails the ADP
  test. ABC Corp. would like to make a QNEC for
  Joe, the lowest paid EE. How much may ABC Corp.
  give Joe (and include in the ADP test) without
  making a QNEC for any of the other NHCEs?
• 5 of compensation
• If ABC Corp. gives Joe 15 QNEC, how much must
  it give to the other NHCEs?

75
Example

• ABC Corp. has 44 NHCEs eligible for plan. For
  the 2006 plan year, the ABC plan fails the ADP
  test. ABC Corp. would like to make a QNEC for
  Joe, the lowest paid EE. How much may ABC Corp.
  give Joe (and include in the ADP test) without
  making a QNEC for any of the other NHCEs?
• 5 of compensation
• If ABC Corp. gives Joe 15 QNEC, how much must
  it give to the other NHCEs?
• At least 22 NHCEs must receive a QNEC of at least
  7½ of compensation

76
Are Bottom-Up QNECs Dead?

• Almost!
• Plan design option
• Allocate using bottom-up concepts up to 5 of
  compensation to lowest ½ of NHCEs
• If need additional QNECs, allocate using
  bottom-up concepts up to 10 of compensation to
  lowest ½ of NHCEs
• Continue this allocation method until satisfy ADP
  test
• Not as good as old bottom-up method but gives
  some bang for the buck and provides QNEC to a
  broader group of NHCEs

77
Using QMACs in ADP Test

• QMAC ER matching contribution that looks like a
  deferral
• 100 vested
• Subject to distribution restrictions
• Cannot be used in ACP test to extent used in ADP
  test
• May use all or any portion of the QMACs in the
  ADP test
• If only matching contributions are QMACs plan
  could avoid any ACP testing by including QMACs in
  ADP test
• Can only shift QMACs to ADP test if both ADP
  and ACP test use same testing method

78
Using Deferrals in ACP Test

• Plan may shift deferrals into ACP test
  provided plan satisfies following requirements
• ADP test is satisfied taking into account all
  deferrals including those in ACP test)
• ADP test is satisfied only with deferrals that
  are not shifted to ACP test
• Effectively requires deferrals to be tested under
  both ADP and ACP tests
• Can only shift QMACs to ADP test if both ADP
  and ACP test use same testing method

79
Example of Shifting

• 2006 ADP 2006 ACP
• HCE 6.1 4.0
• NHCE 4.9 1.5
• Does the plan pass the 2002 ADP and ACP tests?
• Is there an alternative to making corrective
  distributions?

80
Example of Shifting

• 2006 ADP 2006 ACP
• HCE 6.1 4.0
• NHCE 4.9 1.5
• Employer moves 0.5 from NHCE ADP to NHCE ACP
• Now plan passes both ADP and ACP tests since NHCE
  ADP is 4.4 (still passes) and NHCE ACP is 2.0
  (passes)

.5
81
Otherwise Excludible EEs

• If use eligibility conditions less than 1 YOS/age
  21 special testing rules apply
• Can use one of two testing options
• Can run separate ADP test for each group
• Early participation rule allows ER to run a
  single ADP/ACP test after excluding otherwise
  excludible NHCEs
• Must run separate coverage test for otherwise
  excludible EEs
• May also be an issue in safe harbor 401(k) plans

82
Otherwise Excludible EEs

• For 2006, JJ Inc. fails ADP test using prior
  year test. Plan has immediate eligibility for
  deferrals. For 2005, 10 of 50 NHCEs did not
  satisfy 1 YOS/age 21 requirements. May JJ use
  early participation rule to exclude 10 NHCEs?

83
Otherwise Excludible EEs

• For 2006, JJ Inc. fails ADP test using prior
  year test. Plan has immediate eligibility for
  deferrals. For 2005, 10 of 50 NHCEs did not
  satisfy 1 YOS/age 21 requirements. May JJ use
  early participation rule to exclude 10 NHCEs?
• Yes can use early participation rule even
  if using prior year test

84
Otherwise Excludible EEs

• For 2006, JJ Inc. fails ADP test using prior
  year test. Plan has immediate eligibility for
  deferrals. For 2005, 10 of 50 NHCEs did not
  satisfy 1 YOS/age 21 requirements. May JJ use
  early participation rule to exclude 10 NHCEs?
• Yes can use early participation rule even
  if using prior year test
• Results will depend on whether JJ disaggregated
  in prior year
• If disaggregated in prior year, use ADP of 40
  NHCEs and compare to current HCE ADP
• If did not disaggregate in prior year, treated
  as coverage change

85
ADP Test Coverage Change

• ADP/ACP for NHCEs for prior year is determined
  without regard to changes in group of NHCEs in
  testing year, unless coverage change (e.g.,
  merger, spinoff, consolidation, etc.)
• ADP is weighted average of all prior year
  subgroups
• If have merger of plans in current year
  weighted average of ADPs for each prior year
  subgroup
• If have spinoff of plans in current year use
  ADP of single prior year subgroup for each plan

86
Otherwise Excludible EEs

• If JJ did not disaggregate in prior year
  treated as coverage change similar to spinoff
  (i.e., plan is dividing up NHCE group for current
  year test)

87
Otherwise Excludible EEs

• If JJ did not disaggregate in prior year
  treated as coverage change similar to spinoff
  (i.e., plan is dividing up NHCE group for current
  year test)
• JJ would have to use ADP of all NHCEs for 2005
  (without disaggregation) because plan has single
  prior year subgroup

88
Otherwise Excludible EEs

• If JJ did not disaggregate in prior year
  treated as coverage change similar to spinoff
  (i.e., plan is dividing up NHCE group for current
  year test)
• JJ would have to use ADP of all NHCEs for 2005
  (without disaggregation) because plan has single
  prior year subgroup
• If JJ disaggregates in prior year but does not
  disaggregate in current year treated as
  coverage change similar to merger

89
Otherwise Excludible EEs

• If JJ did not disaggregate in prior year
  treated as coverage change similar to spinoff
  (i.e., plan is dividing up NHCE group for current
  year test)
• JJ would have to use ADP of all NHCEs for 2005
  (without disaggregation) because plan has single
  prior year subgroup
• If JJ disaggregates in prior year but does not
  disaggregate in current year treated as
  coverage change similar to merger
• JJ would have to use weighted average of both
  prior year subgroups

90

Application to SH 401(k) Plan
NHCE 5 and 8 were hired in 2/2005. Under the
plan, they are eligible to defer immediately but
must earn a YOS to receive the SH contribution.
Does this satisfy 401(k) safe harbor rules?
91

Application to SH 401(k) Plan

• Plan covering lt 1 YOS
• Does not satisfy SH
• Must perform ADP test
• (if any HCEs in this plan)
• Subject to top-heavy

• Plan covering gt 1 YOS
• Satisfies SH requirement
• (all EEs eligible for SH)
• Subject to top-heavy

92

Leased Employees

• Leased EE issues seem to be more prevalent
• ERs often do not consider impact of entering into
  leased EE arrangement on qualified plan
• Failure to properly take leased EEs into account
  can result in plan disqualification
• Can design plan to exclude leased EEs from the
  plan
• May cause plan to fail coverage

93

Leased Employees

• If an individual is a leased EE such individual
  is treated as a common law EE of the recipient ER
• To be a leased EE
• Recipient ER must pay fee for services of the
  leased EE
• The leased EE must perform services on
  substantially full-time basis for at least one
  year
• The leased EE must be under the primary direction
  or control of the recipient ER
• Leasing organization must be common law ER of the
  individual

94

Leased Employees

• Recipient ER must have agreement with leasing
  organization to receive services of leased EE
• Substantially full time service means 1,500 HOS
  in a 12-month period or 75 of customary hours
  for that position, if less
• All service with recipient ER counts including
  prior service as common law EE
• Cannot terminate EE and then lease back and avoid
  treating as EE

95

Primary Direction and Control

• Primary direction and control based on ERs
  control of when, where and how services are
  performed
• Does not matter if ER has right to hire or fire
  individual or whether individual works for other
  ERs
• Typical leased EEs secretaries, receptionists,
  office personnel, nurses
• Historically performed by EEs test no longer
  applies
• Fine line between primary direction or control
  and actual EE/ER relationship (e.g., PEOs)

96

Coordination of Contributions

• In applying qualification rules, benefits
  provided under leasing organization plan are
  treated as provided by ER
• Only take into account benefits based on service
  performed for ER
• Must aggregate contributions under ERs plan and
  leasing organizations plan for purposes of Code
  415
• Contributions provided under leasing organization
  plan treated as provided under separate plan
  maintained by ER
• Permissive aggregation rules apply

97

Example

• Corporation X maintains PS plan covering EEs of X
  5 HCEs and 8 NHCEs. X also leases 15 NHCEs from
  Leasing Organization M. M maintains PS plan with
  5 contribution.
• X may elect to permissively aggregate the portion
  of the M plan which covers the 15 leased EEs with
  Xs PS plan to determine if Xs plan satisfies
  coverage
• Without permissive aggregation plan fails
  coverage 34.78 ratio (8/23 NHCEs)
• With permissive aggregation plan passes coverage
  now must pass nondiscrimination on aggregated
  basis

98

Example

• Suppose Ms plan is 401(k) plan under which there
  are no ER contributions
• Cannot permissively aggregate plans
• X plan will fail coverage unless provides ER
  contributions to leased EEs
• Same problem would occur if M provides for
  matching contributions
• If recipient ERs plan is relying on average
  benefits test to pass coverage deferrals under
  Ms plan would be included in ABR testing group

99

Service Crediting

• Brian is a leased EE of ABC Corp. Brian is
  leased on 4/1/05 and works substantially
  full-time with ABC. ABC plan does not exclude
  leased EEs and requires 1 YOS with semi-annual
  entry dates. When is Brian eligible?

100

Service Crediting

• Brian is a leased EE of ABC Corp. Brian is
  leased on 4/1/05 and works substantially
  full-time with ABC. ABC plan does not exclude
  leased EEs and requires 1 YOS with semi-annual
  entry dates. When is Brian eligible?
• Brian satisfies leased EE requirements on 3/31/06
• All service with ER counts including service
  earned prior to becoming leased EE
• Brian is eligible to enter plan on 7/1/06

101

Service Crediting

• Brian is a leased EE of ABC Corp. Brian is
  leased on 4/1/05 and works substantially
  full-time with ABC. ABC plan does not exclude
  leased EEs and requires 1 YOS with semi-annual
  entry dates. When is Brian eligible?
• Brian satisfies leased EE requirements on 3/31/06
• All service with ER counts including service
  earned prior to becoming leased EE
• Brian is eligible to enter plan on 7/1/06
• Could plan cover Brian before 1 YOS?

102

Service Crediting

• Brian is a leased EE of ABC Corp. Brian is
  leased on 4/1/05 and works substantially
  full-time with ABC. ABC plan does not exclude
  leased EEs and requires 1 YOS with semi-annual
  entry dates. When is Brian eligible?
• Brian satisfies leased EE requirements on 3/31/06
• All service with ER counts including service
  earned prior to becoming leased EE
• Brian is eligible to enter plan on 7/1/06
• Could plan cover Brian before 1 YOS?
• Unclear safe answer is to wait until completes
  1 YOS (Notice 84-11)

103

Participation in 401(k) Plan

• IRS has not issued any guidance on leased EEs
  participation in 401(k) plan
• Leased EE can participate in recipient ERs
  401(k) plan
• ER can withhold elective deferrals from fees it
  pays the leasing organization, and the leasing
  organization withholds such amounts from
  paychecks
• Leased EE can participate in leasing
  organizations 401(k) plan
• Recipient ER may establish separate 401(k) plan
  for its EEs and take credit for deferrals made by
  leased EEs when applying coverage and
  nondiscrimination tests

104

Participation in PEO Plan

• PEO is generally not the common law ER of
  worksite EEs
• Results in exclusive benefit violation if PEO
  maintains plan as sole ER
• To correct exclusive benefit violation, PEO had
  to convert plan to multiple ER plan or terminate
  plan by last day of 2003 plan year
• PEOs must permit ERs to create own plan to accept
  transfer from PEO plan

105

Nonqualified Deferred Comp

• On October 22, 2004 President signed American
  Jobs Creation Act of 2004 (JOBS Act)
• Added Code 409A which changes tax rules
  affecting nonqualified deferred compensation
  arrangements
• Requires practitioners to review (and amend)
  existing nonqualified deferred compensation
  arrangements
• IRS also issued proposed regulations and various
  Notices addressing nonqualified deferred
  compensation arrangements

106

Nonqualified Deferred Comp

• Arrangement under which an ER promises to pay
  comp in the future for past, present or future
  services
• Usually, ERs use nonqualified deferred
  compensation plans to compensate executives and
  key EEs in excess of statutory limits and to
  allow deferral of tax until tax bracket will be
  lower
• Not subject to vesting, coverage,
  nondiscrimination or funding rules applicable to
  qualified retirement plans

107

Nonqualified Deferred Comp

• Nonqualified deferred compensation plan allows EE
  to defer compensation outside of qualified plan
  structure
• May be elective or nonelective
• Elective formula -- similar to 401(k) plan
• Nonelective formula -- similar to defined
  contribution or defined benefit plan
• If elective, election must be made before the tax
  year starts
• Exception for first year of new plan election
  can be made up to 30 days after plan is first
  established or up to 30 days after EE first
  becomes eligible

108

Taxation of Deferred Comp

• New rules regarding taxation of nonqualified
  deferred compensation issued under Code 409A
• Imposes additional requirements that must be
  satisfied or all amounts under nonqualified
  deferred comp arrangement become taxable without
  regard to constructive receipt
• Code 409A will restrict flexibility to change
  time and form of distributions and place limits
  on timing of deferral elections
• Code 409A will also require nonqualified plans
  to be in writing
• Amendments required by 12/31/2006

109

Taxation of Deferred Comp

• ERs deduction and EEs recognition of income are
  matched
• ER is entitled to deduction and EE recognizes
  amounts in income when benefits are paid
• EE may be subject to employment tax at earlier
  date when benefits are earned (accrued) or
  vested (if later)
• Different from qualified plans
• ER is entitled to deduction when contributions
  are made to plan but EE does not recognize
  amounts in income until distributions are made
  from the plan

110

Taxation of Deferred Comp

• Constructive receipt doctrine
• Deferred compensation becomes taxable if
  participant has control over receipt of comp
  i.e., no substantial restrictions on receipt
  (such as passage of time)
• Any election to defer compensation must be
  entered into before the compensation is earned
  and must be irrevocable
• Economic benefit doctrine
• EE may be taxed immediately if ER secures its
  promise to pay in the future amounts will be
  taxable benefit if funded and not subject to
  substantial risk of forfeiture
• Rabbi trust is an unfunded benefit

111

Taxation of Deferred Comp

• To avoid taxation, plan must be unfunded for tax
  purposes and for ERISA purposes
• Rabbi trust may be used without causing the plan
  to be "funded
• To avoid ERISA funding requirements plan must
  be a top hat plan or an excess benefit plan
• Top hat plan maintained primarily for select
  group of management or highly compensated
  employees
• Excess benefit plan maintained solely for
  purpose of providing benefits in excess of Code
  415 limits under qualified plan

112

Top Hat Plan

• Top hat plan definition (Title I of ERISA)
• Select group of management or highly compensated
  employees
• Looks at participants influence over plan design
• Forces plan to be discriminatory
• If top hat plan definition isnt satisfied, ERISA
  generally requires the plan to be funded, which
  will trigger taxation unless there is a
  substantial risk of forfeiture

113

Rabbi Trust

• Trust established by ER to hold assets of
  nonqualified deferred compensation plan
• Generally irrevocable except that assets are
  subject to claims of ERs creditors
• Amounts held under a rabbi trust are not
  considered as funded for taxation purposes
• Rev. Proc. 92-64 contains model rabbi trust
  provisions

114

Payment of Benefits

• Time and method for payment must be stated for
  each event that entitles the participant to
  receipt of benefits.
• Payment of benefits is permissible only under the
  following circumstances
• Separation from service
• Disability
• Death
• A specified time specified under the plan at the
  date of the deferral
• Change in ownership
• Unforeseeable emergency

115

Payment of Benefits

• Plan may provide for payment in case of
  unforeseeable emergency
• Severe financial hardship resulting from an
  illness or accident of the EE, beneficiary, or
  spouse or dependent
• Loss of the EEs or beneficiarys property due to
  casualty
• Other similar extraordinary and unforeseeable
  circumstances arising from events beyond the
  control of the EE

116

Taxation of Deferred Comp

• Generally, EE is not taxed on deferred
  compensation until distribution (constructive
  receipt)
• However, such amounts are subject to FICA when
  there is no substantial risk of forfeiture
• Must be conditioned on future performance of
  services
• Merely having to wait until future date to
  receive deferred comp is not enough
• Ability to periodically extend, or roll, the risk
  of forfeiture is considered by IRS to be
  sufficiently suspect to question whether there
  is a true substantial risk

117

Tandem 401(k) Plans

• Tandem 401(k) plans allow EEs to defer into a
  401(k) plan through a nonqualified arrangement
  thereby avoiding the possibility of refunds
• Example
• EE earns 400,000 and before beginning of CY
  elects to defer 40,000 to nonqualified plan with
  maximum deferral to 401(k) plan
• On 2/20/07, it is determined that maximum amount
  allowable under ADP test is 9,200
• By 3/15/07, 9,200 transferred into 401(k) plan
  and 30,800 stays in rabbi trust
• Can also provide for transfer of matching
  contribution to 401(k) plan

118
Tandem 401(k) Plans

• Proposed regs under Code 409A allow for tandem
  401(k) plans
• Deferral elections must be made at the same time
  if dont defer into 401(k), is payable in cash
• Elections must be made before CY begins
  (accommodates rules for nonqualified plan)
• Deferral initially made to nonqualified plan
• Maximum permitted qualified deferral determined
  after year end, following application of ADP, ACP
  and 402(g) must run ADP/ACP tests before March
  15
• Maximum qualified deferral must be transferred
  from rabbi trust to qualified plan by March 15 of
  following year

119
Advantages of Tandem Plan

• Qualified plan limits do not apply to amount
  deferred under nonqualified plan
• No deferrals ever have to be refunded from 401(k)
  for violation of ADP test
• No match ever have to be distributed from 401(k)
  for violation of ACP test
• EE can receive match on full comp (without regard
  to 401(a)(17) comp limit) under nonqualified plan

120
Disadvantages of Nonqualified Plan

• Benefits not secured from creditors of employer
• Employer must postpone its deduction until
  employee recognizes income
• EE recognizes amounts as wages for income tax
  purposes (but not FICA) when distributions are
  made
• Employer receives deduction when distributions
  are made
• Title I of ERISA -- cannot cover NHCEs

121
457 Plan

• Nonqualified plan maintained by governmental or
  tax-exempt ER
• Code 457 imposes limits on amounts that can be
  deferred into nonqualified plan by government /
  tax-exempt ERs
• Recognizes that such ERs are not affected by
  deduction rules
• If satisfies requirements under Code 457(b)
  eligible 457 plan
• Compensation deferred under eligible 457 plan is
  not taxable until distributed
• If does not satisfy 457(b) ineligible 457(f)
  plan

122

Annual Deferral Limit

• Applies to all deferred compensation
• Includes both elective and nonelective
  contributions
• Does not include rollover contributions
• Lesser of
• The applicable dollar limit
• 100 of includible compensation
• Applicable dollar amount
• 2002 - 11,000 ? 2003 - 12,000
• 2004 - 13,000 ? 2005 - 14,000
• 2006 - 15,000

123

Annual Deferral Limit

• Includible compensation Code 415(c)(3)
  compensation
• Gross compensation not reduced by elective
  deferrals, cafeteria plan contributions, or
  qualified transportation fringe benefits
• No coordination with 403(b) or 401(k) deferral
  limits
• Changed under EGTRRA
• No longer reduce 457 limit by deferrals under
  401(k) or 403(b) plan
• Can double up deferrals to 457 plan and 403(b) or
  401(k) plan

124

Age 50 Catch-Up Limit

• Available only to governmental ERs
• 2002 - 1,000
• 2003 - 2,000
• 2004 - 3,000
• 2005 - 4,000
• 2006 - 5,000
• Employee must be age 50 by end of calendar year
  same catch-up rules as apply to 401(k) plans

125

Special Catch-Up Limit

• Different from age 50 catch-up EE gets greater
  of two catch-up limits
• Available to participants who are within three
  taxable years ending before NRA
• Limit is the lesser of
• the annual deferral limit or
• the underutilized limit from prior years
• Underutilized limit
• The basic limit in effect for each prior year
  less the amount of annual deferrals for each year
• NRA must be stated in plan age 65 or later

126

Reporting 457 Plan Deferrals

• Deferrals under 457 plan not subject to taxation
  or withholding
• Reported on Form W-2
• Reported in Box 12 with Code G (same box report
  401(k) deferrals)
• Elective and nonelective deferrals, unless
  subject to a substantial risk of forfeiture
• If deferrals are subject to substantial risk of
  forfeiture (e.g., vesting schedule) not reported
  until no longer subject to substantial risk of
  forfeiture

127

Participant Must Perform Services

• Individual must perform services for employer to
  participate in 457 plan
• Code 457 does not require services as an EE
  can allow participation by independent
  contractors
• 457 rules applied the same for independent
  contractors as for EEs
• Independent contractors cannot participate in a
  qualified plan sponsored by the employer

128

Timing of Deferral Agreement

• If plan allows for elective deferrals deferral
  election must be entered into before the first
  day of the month in which the compensation is
  paid or made available
• Nonelective contributions deemed to satisfy
  requirement no formal agreement required

129

Distribution Restrictions

• Distributions events
• Severance from employment
• Attainment of age 70 1/2
• Unforeseeable emergency
• Certain small accounts
• Termination of plan
• QDRO

130

Distribution Restrictions

• Unforeseeable emergency severe financial
  hardship defined in the plan
• Illness or accident
• Loss of property due to casualty
• Other extraordinary circumstances beyond the
  participants control
• Regulations list additional events
• Foreclosure or eviction from primary residence
• Medical expenses
• Funeral expenses
• Unforeseeable emergency cannot be relieved
  through other resources

131

Distribution Restrictions

• Loans
• Governmental 457 only because of funding rules
• Reasonable rate of interest
• Rules of 72(p) apply
• Distribution restrictions apply to offset
• Minimum distribution rules apply
• Apply rules under Code 401(a)(9)

132

Funding Restrictions

• Tax-exempt organization
• Must be unfunded
• Potential conflict with Title I of ERISA
• Top-hat plan
• Excess benefit plan
• If funded, taxed when no longer subject to a
  substantial risk of forfeiture

133