Chapter 7

Coverage, Eligibility, and Participation Rules

Introduction

Shouldn’t employers be able to offer whatever benefits they want to whichever employees they want? In a perfect world where employers always have their employees’ best interests in mind, this could be left to self-supervision. The reality is that left unchecked, many large employers would probably continue to offer a plan for attraction and retention purposes, but they would slant the plan in favor of the executives. Small businesses would certainly slant the plans in favor of employee owners. Knowing these tendencies, and seeing them in practice, regulators have installed a series of checks and balances to ensure that plan offerings are fair for the little guy and that offerings are properly disclosed so that employees know what benefits are available to them. There also must be a mechanism for providing common benefits if common ownership is shared between multiple companies.

Learning Goals

•Explain why the adoption agreement is necessary

•Understand the application of the 410(b) coverage test

•Identify opportunities created by the coverage requirements

•Understand the impact of a controlled group, an affiliated service group, and a leased employee on employer-sponsored retirement plans

Initial Core Concepts

All plans will have a formal document called an adoption agreement, which outlines who is eligible for the plan, the vesting schedule for participants, the nature of the benefits, the timing of the benefits, and any miscellaneous options that the participant(s) may have. This document helps to organize the design process. You might see a template (premade generic version) adoption agreement in use, but it is also possible to customize one based on an employer’s unique objectives. Adoption agreement design is a natural outflow of the fact-finding and due diligence process. This document is used internally within the plan and is not submitted to any regulator for approval.

We used the concept of a highly compensated employee (HCE) in the actual deferral percentage (ADP) and actual contribution percentage (ACP) compliance testing. Now we will define it clearly. An HCE is technically only someone who meets one of two criteria. The first criterion is that the individual owns at least 5 percent of a given company in either the current or prior year. The second criterion is that their income level is above $115,000 (2014 limit). In lieu of this second criterion, the company could choose to use the top 20 percent of wage earners. They might choose this alternate method if they do not have people making above $115,000 (2014 limit).

A company has an employee who owned 4 percent of the business last year and 6 percent this year with a salary of $100,000. Is this person considered an HCE? Yes, this employee is considered an HCE. The same company has an employee who does not own any portion of the business, but the salary was $120,000. What about this employee? This person is also considered an HCE.

410(b) Testing

The 410(b) minimum coverage test is a form of nondiscrimination testing applied to qualified plans to verify that the rank-and-file employees are not being treated improperly. It is easy to mix up the 410(b) minimum coverage test with the 415(b) defined benefit contribution limit test. Think of the 415 test being a higher number and therefore associated with the word “limit” as in “contribution limit.”

With the 410(b) test, an employer must satisfy one of three rules. The three tests are the percentage test, the ratio test, and the average benefits test. If they satisfy at least one rule, then they pass the test and do not have a compliance issue. If an employer has separate business lines, then the tests can be applied to each business line separately with the proviso that the separate business lines exist for legitimate business reasons and they have at least 50 employees. General Electric could legitimately have separate business lines for kitchen equipment, locomotives, and jet engines among others. These are legitimate business lines and could have 410(b) testing applied separately.

There are certain types of employees that can always be excluded from 410(b) minimum coverage testing. These employees would not pass standard eligibility requirements. Examples of this type of employee include union (collective bargaining agreement) employees, employees who have worked less than one year, employees who work less than 1,000 hours in a given year, and employees who are younger than 21 years old.

The percentage test is the easiest to conceptualize. At least 70 percent of the eligible nonhighly compensated employees (NHCEs) must be covered by the plan. Simple to understand. Simple to apply. Consider a company with 24 employees of which four are part-time. Their current plan covers 12 of the HCEs and six out of the eight eligible NHCEs. Does this company pass the percentage test? Yes! They cover six out of eight of the eligible NHCEs. This is 75 percent (6/8) coverage. Since 75 percent is greater than 70 percent, they pass the test. No further testing required for this company!

The ratio test is also fairly straightforward. The percentage of covered eligible NHCEs must be at least 70 percent of the percentage of covered eligible HCEs. Thankfully, the regulators kept the percentage at 70, which makes it easier to remember given the previous test. Consider a different company whose employee census reveals 100 eligible employees. There are a total of 30 eligible HCEs and 15 of them are currently covered by the plan. There are therefore a total of 70 eligible NHCEs and 40 of them are covered. Does this company pass the ratio test? Since we need to determine the compliance threshold percentage for the NHCEs relative to a percentage of the HCEs’ percentage, the first step is to calculate the HCEs’ percentage. We know that 50 percent (15/30) of the HCEs are covered. Therefore, the NHCE compliance threshold is 35 percent (50% × 70%). We also know that 57 percent (40/70) of the NHCEs are currently being covered. Since 57 percent is greater than 35 percent, this company will pass the ratio test! But only 57 percent of eligible NHCEs are covered by this company’s plan. They do not pass the percentage test. Is this company compliant? Yes! They only need to pass one of the three tests.

The percentage test and the ratio test are sometimes viewed as one percentage coverage requirement where you pass either one or the other. We will consider them as separate tests for ease of discussion.

The third test is called the average benefits test. The average benefits test differs from the percentage-style tests in that it examines both the percentage of NHCEs covered and the level of benefits that they receive. In §410(b) of the Internal Revenue Code, the description of the average benefits test is somewhat vague. The Department of the Treasury has issued several clarifying statements. What we know about this test is that the employer must base eligibility upon objective job classifications like job grade or hourly versus salaried employees. The “group the owner likes” is not an acceptable job classification. The second hurdle for this test is related to the benefits available under the plan. The average benefits of the NHCEs must be at least 70 percent of the benefits of the HCEs. This test is more complex to apply due to the various Treasury Department statements. A company will hire a firm that specializes in this type of testing if it becomes necessary. This test is designed for large employers who cover employees under several different plan types.

401(a)(26) Testing

Defined benefit (DB) plans must pass a second layer of coverage testing, which is found in §401(a)(26) of the Internal Revenue Code. This DB plan-specific testing requires that employers cover the lesser of 50 employees or 40 percent of all employees. There is a caveat that if the company has only two employees, then both must be covered. There is no reference to HCE or NHCE in the 401(a)(26) testing.

Consider a company with 50 employees. How many must be covered? The answer is 20 employees (50 employees × 40%). What about a company with 1,000 employees? The answer is 50 employees! Remember that it is the lesser of 50 employees or 40 percent of the workforce.

Notice that there is no mention about dollar amounts in either the 410(b) or the 401(a)(26) testing. These tests are only concerned with discrimination as it relates to the percentage of eligible NHCEs who are covered by a plan.

Planning Opportunities

One option that a company has is to cover all its employees. Since coverage creates another layer of expense for the business, companies typically want to keep coverage as limited as possible, but still offer enough incentive to attract and retain key talent. This is a complex trade-off.

As a general rule, companies can exclude a few groups of employees without any issue: employees under the age of 21, those with less than one year of service, or part-time workers with less than 1,000 hours of service in a given year. The company can always exclude HCEs and not have a compliance issue. Most testing revolves around discrimination against the rank-and-file employees. Employers can discriminate against the HCEs and not have a compliance issue.

Another option for the employer is to exclude as many as 30 percent of the NHCEs. This would pass the testing that has a 70 percent threshold. As more and more HCEs are removed, the compliance threshold from the ratio test will become lower and lower. In the previous example, if only 40 percent of HCEs were included in the plan, then the compliance threshold to pass the test would be 28 percent (40% × 70%) instead of the 35 percent as given in our example.

The real challenge for the company is to find the optimal level of benefits whereby the company is not paying anything more than what it needs to and the employees feel valued, motivated, and committed to give 110 percent to the company for as long as they intend to work. Starbucks is an excellent example of corporate leadership in valuing their employees.

One additional nuance that can work in the company’s favor, while at the same time appearing to be a responsible corporate citizen, is that the company can delay coverage by up to six months once an employee first becomes eligible for an employer-sponsored retirement plan.

Analogous to the decision of a company’s level of generosity is the matter of who is required to be able to participate in a plan.

One important rule for participation is called the “21-and-1” rule. It is fairly easy to guess what it means. Employees must be eligible for coverage once they have attained age 21 and they have worked for the company for at least 1 year. The exception to the 21-and-1 rule is that the employment tenure requirement can be extended to two years IF the employee is 100 percent fully vested from the moment he or she becomes a participant. We would call this immediate vesting. Remember that after an employee becomes eligible for benefits, the employer can wait up to an additional six months before benefits begin to accrue and be contributed for the employee.

Everything involved with legislation and regulation is open to interpretation. The regulators have gone as far as to define what they mean by “one year of service.” A full year of service is technically the completion of 1,000 hours of service to the company in any consecutive 12-month period. Technically, completing 600 hours in the first six months of the year, then taking two months off, and then working another 400 hours does not qualify as a year of service. As a bonus to the employee, “hours worked” also includes time, for which the employee is entitled to be paid (holidays).

Aggregation Rules

Regulators put in place aggregation rules to prevent one individual from establishing multiple businesses and then contributing up to the stated plan type maximum contribution limit in each separate plan. If someone could do this, then they could theoretically shelter a tremendous amount of money each year from current taxation.

It has been decided that entities that share common ownership should be aggregated together for purposes of compliance testing and determining contribution limits for participants. Any violation of the aggregation rules could result in plan disqualification, which is when the Internal Revenue Service (IRS) revokes the tax-deferred status, and all contributions need to be unwound with lots of corporate and individual tax consequences.

Related to this concept is what is known as a controlled group. There are two types of controlled groups: a parent–subsidiary relationship and a brother–sister relationship. In a parent–subsidiary-controlled group, one entity owns at least 80 percent of another entity. It is possible for company A to own 80 percent of company B who in turn owns 80 percent of company C. All three companies are now aggregated together as a parent–subsidiary-controlled group. The brother–sister-controlled group gets more complex. A brother–sister group exists when the same five (or fewer) individuals own 80 percent or more of each entity AND “identical ownership” is greater than 50 percent. The concept of identical ownership is best explained using an example. Consider the data presented in Table 7.1.

The identical ownership is essentially a tally of the smallest ownership percentage held between two companies in question. In this example, Tim, John, and Rachelle do own more than 80 percent of each company, but their identical ownership is less than the 50 percent benchmark. This means that they are NOT considered a brother–sister-controlled group.

If any two (or more) companies are considered to be in a controlled group, then all entities within the group need to have access to the same retirement plans. If the data in Table 7.1 had instead indicated that Rachelle owned 26 percent of company A, then the identical ownership would have crossed the 50 percent threshold and they would be a brother–sister-controlled group. In that scenario, company A could not offer a plan while company B offers no plan whatsoever. This is an incentive for these owners to monitor their ownership percentages closely to avoid a retirement plan offering issue.

Family Attribution and Affiliated Service Groups

Another loophole that some have tried to exploit in an attempt to avoid percentage of ownership tests inherent in the consolidated group rules is to have their spouse, or their child, “own” a portion of the business on paper to such an extent that they fall below a compliance threshold.

Under the concept of family attribution, the regulators have closed this loophole. A spouse is deemed to own the other spouse’s percentage of the company for compliance testing unless one of three events occurs. Attribution would not be applied if the spouses are divorced. Attribution would not be applied if the spouses are legally separated. Attribution would also not be applied if one of the spouses has no involvement with the operations of the business.

Another layer of family attribution is applied to ownership by minor children. The CEO’s second grader might be an honor roll student, but probably not contributing much for new product launches and global competitive pressures. The ownership interest of a minor child is attributed back to the parents.

The third layer of family attribution is for adult children, grandchildren, and parents of the owner. If the owner holds more than 50 percent of the outstanding shares, then the ownership interests of adult children, grandchildren, and the owner’s parents will be attributed back to the owner for compliance testing purposes.

There is a separate category for companies that produce a service and do not rely on investments in fixed assets to produce a return. These companies are known as affiliated service groups. If there is a scenario where a few businesses work together to produce a common product, they share common ownership and at least one of the companies is a service organization, then they are considered an affiliated service group. Affiliated service groups are treated just like a controlled group in terms of compliance testing.

Leased Employees and Coverage Rules for Other-Type Plans

Some companies prefer to lease employees from a third party like you might lease a car. Use their services for a period of time and then turn them back in for a different model year. Think of temporary workers. It is possible for a company to take advantage of their NHCE population by leasing a substantial percentage of that category of employees and thereby excluding them from any retirement plans offered by the company.

To be considered a leased employee, an individual must meet three criteria. First, he or she must be working under a signed agreement between the service recipient (hiring company) and a third party (employee-leasing agency). Second, the leased employee in question must be working full-time. In this case, full-time is defined as 1,500 hours per service year unless the company’s normal employees commonly work less than 40 hours per week, in which case the 1,500-hour benchmark will be reduced to reflect the culture of the company. Third, the leased employee’s services must be under the control of the service recipient.

If someone meets all three criteria, then he or she is deemed a “leased” employee. Leased employees can legally be excluded from a company’s retirement plan, assuming two events occur. The first qualifying event is that leased employees cannot comprise more than 20 percent of the NHCE population of the service recipient. The second event is that the company must offer a specific safe harbor plan to its nonleased, regular employees. The safe harbor plan must be a money purchase pension plan with the contribution set no less than 10 percent of covered compensation AND with immediate vesting. If the company does not meet these two criteria, then the leased employees will need to be included in the company’s retirement plan, whatever that may be.

Throughout this chapter, you have been learning about coverage testing requirements for qualified plans. Recall from Chapter 1 that there is a second category of tax-advantaged retirement plans simply called other for lack of a better term. The other category includes simplified employee pensions (SEPs), savings incentive match plans for employees (SIMPLEs), and 403(b) plans.

With a SEP plan, the employer can exclude employees from the company-sponsored plan for the first three years of their employment. As we described in Chapter 6, anyone who is not a union member, is at least 21 years old, and has earned at least $550 in three of the last five years must be included in the plan. The very low dollar threshold will mean that part-time employees will be included in the plan along with the full-time employees, assuming that the part-timers have been with the company for a long period of time (3 years).

A SIMPLE is very similar to a SEP. Recall from Chapter 6 that employees can be excluded for up to two years. SIMPLEs must include all employees (even those under age 21) who have meet the two-year tenure requirement and have earned at least $5,000 per year during their employment and are expected to earn at least $5,000 in the current year as well.

In the nonprofit world, employers use the 403(b) plan, which is treated much like a qualified plan. All employees subject to a 403(b) plan must be given access to salary deferrals (which are commonly matched by the employer) if they could make at least a $200 contribution. A special exception is made for those working less than 20 hours per week. If the employer is not a church or a governmental body and they offer a 403(b) plan, most of their employees will likely be eligible for participation.

Discussion Questions

1.You approach the CFO of a small company about adding a retirement plan for the employees. The CFO tells you that your timing is perfect. The company is actively considering adding a SEP plan. He further tells you that he has already put together an adoption agreement and has sent it to the Department of Labor for approval. Once the official approval comes in the mail, the company would be happy to talk with you about your ideas for implementing a SEP plan. What would communicate to the CFO before you leave his office?

2.Why do you think that a company might choose to define its HCEs as the top 20 percent of wage earners?

3.A plastics company is trying to find a loophole for 410(b) coverage testing. They have separated their production department from their materials acquisition department. The idea is to only offer a plan to the materials acquisition department which mainly comprises skilled workers, while the production department is mainly hourly employees that are easily replaceable. What advice would you give them?

4.A company has 20 retirement plan-eligible HCEs, and 16 of them participate. They also have 75 eligible NHCEs, and 37 of them participate. Does this company pass the ratio test?

5.Is it correct that a company can extend the normal eligibility rule of 21 years of age with 1 year of service to 21 years of age and 2 years of service if they offer full vesting within 2 years of inception of contributions?

6.You are the HR manager at a small company. A mid-tier manager who earns $150,000 annually requests a meeting to discuss his lack of access to the company’s 401(k) plan. He appreciates the other benefits and the stock option grants, but by the tone in his voice over the phone, you get the idea that he is frustrated. In fact, he even mentioned that he is being discriminated against because he does not have access to the plan. What would you tell him when he comes to your office?

7.Consider the scenario below where three individuals have differing levels of common ownership over two separate companies. Company A offers a retirement plan, while company B does not. From the perspective of a controlled group, is there any issue here?

8.In the previous example, Roger has transferred 10 percent of his ownership interest in company A to his 12-year-old daughter. Could he use this technique to avoid any potential issues with controlled group status?

9.In the previous example, assume that Roger only owns 13 percent of company A, while his wife, who manages the sale team at company A, owns the other 10 percent. Does this new information change the potential issues with controlled group status?

10.A company is in the habit of hiring long-term temp workers for its manufacturing plant. They only use temp workers for noncore production jobs. Of the 400-member population of NHCEs, there are typically about 95 long-term temp workers with the remainder being full-time employees. The company’s policy is to exclude temp workers both from health benefits and retirement plan benefits. The temp agency provides those services for the workers, albeit a lesser benefit than the company itself would have otherwise provided. Are this company’s actions justified?