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Thursday, March 9, 2017

Nondiscrimination: Hurdle or Tool?


Nondiscrimination is the concept that highly compensated employees cannot be favored more than a limited amount in coverage, contributions (including employee compensation deferrals) and benefits.  This concept is in qualified retirement plans and some other welfare and fringe benefit plans.

For today, let’s look at nondiscrimination in qualified retirement plans.

  1. Who is considered a highly compensated employee (HCEs)?
    1. Owns more than 5% of the employer, or
    2. Made more than $120,000 from the employer last year
  2. Who is not considered a highly compensated employee (NHCEs)?
    1. Does not own more than 5% of the employer, and
    2. Did not make more than $120,000 from the employer last year

There are two key conclusions you can draw from the above. 

  1. A non-owner is never an HCE for the first year of employment with the employer (with controlled group and affiliated service group considerations), no matter how much he/she is paid
  2. Discrimination against HCEs is not prohibited

There are two primary areas where nondiscrimination comes into play with qualified plans:

  1. Coverage (assuming plan takes full advantage of statutory exclusions)
    1. Consider the whole population of employees during the year (generally all Form W-2 recipients, unless some independent contractor misclassification has occurred).
    2. Eliminate from the population in “a”
      1. Those employed for less than a year
      2. Those with less than 1,000 hours of service during the year
      3. Non-resident aliens
      4. Union employees (assuming the CBA addresses benefits)
    3. Take the population left after “b” and segregate them into HCEs and NHCEs
    4. Determine the percentage of HCEs covered by the plan.
    5. Determine the percentage of NHCEs covered by the plan.
    6. If the ratio of “e” to “d” is at least 70% the plan passes coverage.  Under some circumstances and with more complex testing, the plan may pass coverage with an even lower percentage.
  2. Contributions and Benefits
    1. Different tolerances for discrimination in favor of HCEs exist for different types of plans and features.
    2. Some nondiscrimination testing is strictly numerical (e.g., 401(k) testing) and some is both numerical and subjective (e.g., defined benefit plan testing).

Now, let’s put this all together in a few examples.

Example Solution
Restaurant chain with about 5,200 total employees of whom 15 are HCEs. Their desire is to cover about 200 location managers and home office staff. Since discrimination against HCEs is allowable, the plan can be written to cover only NHCEs who are location managers or home office employees. An added bonus is that this design eliminates the need for 401(k) benefits testing.
Chain of pharmacies with 32 stores and about 450 employees. A primary goal of this chain is to recruit pharmacists. They are happy to make safe harbor matching contributions, but generally only for employees with more than a year of service. However, they want to be able to grant participation and give the match to pharmacists upon hire. Two plans. The main plan covers everyone with at least a year of service. The second covers first-year pharmacists only. The key tool here is that no matter how much money a non-owner makes in his first year of employment, he/she is an NHCE for that year.
Successful software consulting company with 40 employees, two of whom are owners. The two owners each make several hundred thousand dollars per year, but almost all their employees also make over $200,000 per year. They have been running a 401(k) plan for several years with a dollar-for-dollar match of up to $2,000 per year. For some reason, the non-owner HCE do not participate very much and the two owners (“key employees” under the top-heavy rules of IRC §416) are approaching more than 60% of the balances under the plan. This means that top heavy minimum contributions of 3% of compensation would be due to each of the other participants regardless of whether such participants contributed to the 401(k) plan. Given the level of compensation of many of these non-key HCEs (over $200,000) the 3% company contributions loom large. Although the software consultants are primarily HCEs for nondiscrimination purposes, they are non-key employees for top heavy purposes. Spin off a plan for non-owner software consultants which passes coverage standing on its own. It continues to offer the $2,000 match, but is not subject to the 3% top heavy minimum contribution for the non-key HCEs. The two owners and their secretary continue in the original plan. The solution (separate plan) was made possible by the fact that discrimination is only a factor if it is against NHCEs.
Moving company with 400 or so employees had difficulty with ADP/ACP testing of its 401(k) plan. Testing has been failed repeatedly because a significant contingent of the employees are never likely to contribute to the plan. The business owner has identified that non-driver moving truck employees are least likely to be plan contributors. Amend the plan to cease covering non-driver moving truck employees. These employees are less than 30% of the NHCEs. Testing results will improve dramatically.

 

For more information about nondiscrimination in coverage, contributions and benefits, or for general inquiries about compensation and benefits planning, contact your local Armanino expert.

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