This is the third in a series of articles designed to inform you of the significance of the so-called “coverage rules” and the “minimum participation rules” applicable to qualified retirement plans, (here are Part 1 and Part 2 if you missed them). In this article we will finish our discussion of the coverage rules by exploring: (a) the average benefit test; (b) the rules for aggregating and disaggregating plans for coverage testing purposes; and (c) the transition rule for certain business acquisitions and dispositions.
The “Other” Coverage Test
Although the vast majority of retirement plans satisfy the Code’s coverage requirements by passing the ratio percentage test, which is based on numbers of participants (discussed in our second installment), there is another way to skin the cat – by passing the average benefit test. In essence, the average benefit test permits a plan that would not otherwise pass the ratio percentage test to satisfy the Code’s coverage requirements, provided that the average benefit provided to the NHCEs is at least 70% of the average benefit provided to the HCEs.
In order for a plan to pass the average benefit test, two requirements must be met:
- The plan must satisfy the nondiscriminatory classification test contained in the coverage regulations; and
- The plan must provide an average benefit for all nonexcludable NHCEs of the employer which is at least 70% of average benefit provided to the HCEs.
The coverage regulations explain that the nondiscriminatory classification test will be met if (a) the plan’s failure to pass the ratio percentage test is due to the plan’s exclusion of a “reasonable classification” of employees, and (b) the plan’s ratio percentage test is at least as great as certain safe harbor percentages contained in the regulations (generally, between 20.75% and 50%, depending on the percentage of employees who are NHCEs). Whether the classification and resulting exclusion of a group of employees from plan coverage is reasonable will depend on the facts and circumstances of each case. The regulations presume that the deliberate exclusion of employees under the terms of a plan is reasonable if the excluded employees comprise a bona fide job classification, are either salaried employees or hourly employees, or are located at a different geographic location.
The safe harbor percentages contained in the regulations represent a sliding scale which call for a higher ratio percentage (at least 50% for plans of companies where the percentage of NHCEs as part of the total workforce is less than 60%) and a lower percentage (as low as 20.75%) where at least 99% of the company’s nonexcludable employees are NHCEs.
For example, Cover-up Auto Painting (Cover-up) employs 100 nonexcludable employees at two business locations, 80 of whom are NHCEs and 20 are HCEs. Cover-up maintains a retirement plan at one of its two locations that benefits 40 NHCEs and 15 HCEs. None of the employees at the other location receive retirement benefits. The plan’s ratio percentage is 66.67% ([40/80] / [15/20]) = 50%/75% = 66.67%), which is below the 70% necessary to pass the ratio percentage test. Even though the ratio percentage test is not satisfied, Cover-up still may be able to pass coverage testing on an average benefit percentage test basis since, under the regulations, it appears that Cover-up’s exclusion of the 45 employees at location two is a reasonable classification and the plan’s ratio percentage far exceeds the regulation’s safe harbor percentage (35% in this case, where 80% of Cover-up’s nonexcludable employees are NHCEs). But wait, Cover-up is not yet through with its coverage testing.
As we mentioned earlier, Cover-up must also demonstrate that the actual benefit percentage for all of its nonexcludable NHCEs is at least 70% of the actual benefit percentage provided to all of its nonexcludable HCEs. Returning to our example, let us assume that each of the 55 employees participating in Cover-up’s plan, a profit sharing plan, receives a 10% of pay profit sharing allocation. The average benefit percentage for the plan is determined by dividing the actual benefit percentage of the NHCEs by the actual benefit percentage of the HCEs. The actual benefit percentage of the NHCEs would normally be determined by calculating the average allocation rate for all nonexcludable NHCEs of Cover-up, including those benefiting under the plan and those not benefiting. In the case of the Cover-up’s plan, the actual benefit percentage of the NHCEs, based on the rate of contribution, would be 5% ([40 x 10%] / 80 = 5%). Similarly, the actual benefit percentage of the HCEs would be 7.5% ([15 x 10%] / 20 = 7.5%). Unfortunately, this would yield an average benefit percentage for the plan of 66.67% (5%/7.5%), which would not pass.
How can this situation be remedied? One way to change this result would be for Cover-up to retroactively increase the plan’s actual benefit percentage for NHCEs. This can be accomplished by either increasing the number of NHCEs benefiting under the plan or increasing the rate of contribution for the NHCEs. For example, if Cover-up simply increased the number of NHCEs benefiting under the plan by two of the NHCEs at location two, the average benefit percentage would be increased to 70% ([42 x 10%] / 80 = 5.25%; 5.25%/7.5% = 70%) and the coverage test would be passed. Alternatively, Cover-up could satisfy the average benefit test by retroactively increasing the rate of contribution for NHCEs from 10% to 10.5% ([40 x 10.5%] / 80 = 5.25%; 5.25%/7.5% = 70%). Yet another way to alter the result would be to compare actual benefit percentages of the NHCEs and the HCEs on a “benefits” basis rather than on a “contributions” basis.
All for One and One for All (Maybe)
Our understanding of the coverage testing rules cannot be considered complete without some appreciation of:
- The rules for aggregating and disaggregating plans for coverage testing purposes.
- The transition rule for certain business acquisitions and dispositions.
To Be Together or Not To Be Together . . . That Is the Question
The rules for aggregating and disaggregating plans for coverage testing purposes are good to know a little about since they can offer both useful plan design opportunities as well as testing pitfalls for the unwary. In order to avoid application of the coverage tests to the wrong groups of employees, the coverage regulations first direct us to identify what constitutes a “plan” for coverage testing purposes. Next, we are told that we must disaggregate (that is, consider separately) certain features of plans or groups of covered employees for coverage testing purposes. Finally, the regulations permit us, in some cases, to aggregate (if we choose) certain separate plans so that we can pass either the ratio percentage test or average benefit test on a combined basis.
In general, the regulations treat a plan as a “single plan” for coverage testing if and only if, on an ongoing basis, all of the plan assets are available to pay benefits to employees who are covered by the plan . . . . Under this general rule, a plan will be considered a single plan (not multiple plans), despite the fact that:
- The plan may have multiple benefit or contribution formulas which apply to different groups of employees.
- The plan has several plan documents.
- More than one employer contributes to the plan.
- The assets of the plan are invested in more than one trust or annuity contract; or
- Separate accounting is maintained for purposes of cost allocation but not for purposes of providing benefits under the plan.
The regulations make clear that the defined contribution portion of a plan would be treated as a separate plan for testing purposes from the defined benefit portion of the plan. The regulations also make clear that a defined contribution plan may permit participants to direct the investments of their accounts without creating separate plans.
Once we have applied the general rule to confirm that we are dealing with a single plan for coverage purposes, we must next consider whether any of the so-called “mandatory disaggregation rules” apply. Without getting too bogged down in the details, it is worth noting that the regulations require us to disaggregate and separately test:
- 401(k) elective deferrals, 401(m) matching contributions, and employer profit sharing contributions (even though all are made under the same 401(k) profit sharing plan); or
- The ESOP and non-ESOP portions of a plan.
Although the regulations prohibit us from combining portions of plans which have been disaggregated on a mandatory basis (for example, the elective deferrals and profit sharing contributions under a 401(k) plan), they permit us to combine most other plans if such aggregation will help one or more of the combined plans to satisfy either the ratio percentage test or the average benefit test. If we utilize the permissive aggregation rules to combine two or more plans for coverage testing purposes, we must also apply the Code’s nondiscrimination rules on an aggregated basis. The permissive aggregation rules effectively allow an employer to maintain separate retirement plans for different groups of its employees with the ability to combine these plans in order to meet the overall coverage and nondiscrimination requirements. For example, Cover-up could maintain two separate plans, one for each business location, and test the plans together on a combined basis. Since the fact that the plans are being combined for testing purposes need not be explained to the participants, this allows an employer to provide considerably different benefit packages to different groups of its employees!
Coverage Testing in the Land of Merger Mania
Who hasn’t heard of or been caught up in the ground swell of mergers and acquisitions activity? Unfortunately for many human resource managers (and their employee benefits advisors), the retirement plan implications of many of these deals are not considered until the eleventh hour, if at all. Fortunately for the acquiring company that has just assumed responsibility for another company’s employees and benefit plans, there is a special transition rule that eases the burden of complying with the coverage and nondiscrimination tests. This same rule also makes coverage compliance easier for a company that has just sold off a portion of its business and transferred the employees associated with those assets to a new employer.
Basically, the transition rule allows the parties to an asset or stock acquisition, merger, or similar transaction involving the change in employer of the employees of a trade or business a limited time to test their plans for coverage and nondiscrimination purposes as though the transaction did not occur. Therefore, as long as the plan or plans of a party to such a transaction satisfied the coverage tests prior to the transaction (and provided that the party does not make significant changes to its retirement program during the so-called “transition period”), it need not be immediately concerned whether its resulting plan or plans meet the coverage rules. The transition period extends from the date of transfer of the affected employees through the last day of the plan year beginning after the date of such change.
For example, let’s assume that Cover-up decides to go into the oil change and lube business by purchasing the assets of one of Slick Willy’s Three-Minit Lube and Bagel Shops on Ground Hog’s Day 2025. By the way, Slick Willy’s is doing a land‑office business with 60 total employees (20 at each location). Last year Slick Willy adopted a defined benefit pension plan for himself and his employees. As you can imagine, the addition of some 20 employees to Cover-up’s payroll and the corresponding decrease in Slick Willy’s payroll could have dramatic effects on whether their respective retirement plans still meet the coverage tests. Fortunately, as long as neither party makes major changes to their retirement programs following the transaction, they can each take at least a full plan-year to sort out the employee benefits impacts of their deal. Since Cover-up’s profit sharing plan operates on a calendar-year plan-year, Cover-up would have until the end of 2026 to deal with the coverage issues generated by the transaction. If Cover-up does not intend to cover its newly acquired employees during this transition period, it should amend its plan if necessary to take care of this point.
Minimizing the Minimum Participation Rule
The Code section 401(a)(26)’s minimum participation rule required every plan (other than certain “frozen” plans), standing alone, to benefit at least the lesser of 50 employees or 40% of the employer’s nonexcludable employees. Ostensibly, this rule was designed to prevent professionals such as doctors, lawyers, and accountants from establishing a separate defined benefit pension plan covering only themselves while satisfying the coverage and nondiscrimination rules by covering their remaining employees under a comparable but less generous defined contribution plan. Although the legislative change was primarily directed at so-called “one-man pension plans,” it originally applied to all defined contribution plans as well.
Smaller employers (generally, those with fewer than 50 employees) can, for a variety of reasons, maintain several defined contribution plans such as 401(k) plans, profit sharing plans, or money purchase pension plans for different groups of employees. As long as these separate plans pass the coverage rules standing alone, or can be permissively aggregated to pass the coverage requirements on a combined basis, the plan design opportunities provide important flexibility to small business – flexibility that much larger businesses have always had.
What to Do
For those of you who have managed to hang in there throughout our series on the coverage rules (an admittedly dry area of employee benefits law), give yourselves an “A” and a pat on the back. Hopefully, this introduction to the fundamentals of testing and designing retirement plans, with an eye out for the intricacies of the coverage and minimum participation rules, will better equip you to analyze your current plan situation and anticipate possible compliance problems. It also may give you an idea or two about how you can restructure your company’s retirement program to better meet the needs of the company and its employees.
