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What is a New Comparability or Cross-Tested Plan?

Dale R. Vlasek
McDonald Hopkins LLC
P: 213.348.5452
E: dvlasek@mcdonaldhopkins.com

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In the late 1970s and early 1980s the Internal Revenue Service (“IRS”) permitted plans to skew benefits or contributions to highly paid employees as long as the benefits or contributions were comparable to benefits or contributions for lower paid employees. The IRS subsequently eliminated this comparability analysis. In the early 1990s, the IRS issued regulations under Code 401(a)(4) of the Internal Revenue Code (“Code”) which created a new type of non-discrimination testing for Plans.

By using the testing technique under these regulations, a qualified defined contribution plan, such as a 401(k) profit sharing plan or simple profit sharing plan without a 401(k) feature can utilize an allocation formula for its discretionary employer contribution which targets designated participants at what can be a significantly reduced contribution to non-targets participants. Practitioners have informally labeled the new approach “New Comparability” to distinguish it from the obsolete “old” comparability analysis.

New Comparability Plans and Non-Discrimination Requirement

As mentioned above, a fundamental requirement for every qualified retirement plan is that the benefits or contributions must be provided in a manner that does not discriminate in favor of Highly Compensated Employees (HCEs). The Code requires a qualified plan to demonstrate its compliance with this non-discrimination requirement by satisfying a particular test. Some tests are specific to the type of contribution. For example, a 401(k) plan demonstrates its compliance by having its salary reduction contribution satisfy the Actual Deferral Percentage Test (ADP) and its matching contributions satisfy the Actual Contribution Percentage Test (ACP).

Other types of contributions or benefits must demonstrate compliance by passing other tests. Typically, profit sharing or discretionary contribution plans will prove their contribution or benefits are non-discriminatory by allocating the contributions as an equal percentage for all participants. This formula satisfies a regulatory “safe harbor test.”

The General Test for Contributions

However, a discretionary contribution plan can show that its contributions or benefits do not discriminate in favor of HCEs by satisfying a fairly complex objective test described in the regulation. Very simplistically, the basic test or what the regulation describes as the “general test” for defined contribution plans, works as follows:

• Step One – Determine “allocation rates” for all participants. An allocation rate is determined by taking the sum of all employer contributions and forfeitures allocated to the participant’s account for the year and dividing it by the participant’s compensation.

• Step Two – The allocation rates for all participants are compared by rate groups. A rate group exists for each HCE. A rate group for a particular HCE includes all participants who have an allocation rate equal to or greater than the HCE.

• Step Three – Each rate group is treated as if it were a separate plan and as such each rate group must then satisfy the coverage rules of Code §410(b). Specifically, each rate group must either satisfy the typical coverage tests provided under the Code:
                      i) 70% ratio percentage test; or
                      ii) the Average Benefits Test.

Cross-Testing

In lieu of the general test which tests contributions to HCEs in comparison to the contributions for NHCEs, a defined contribution plan can test contributions on the benefits such contributions could theoretically provide. Because the plan is testing contributions based on the benefit provided, it is “cross-testing.”

Simplistically, cross-testing works as follows:

• Step One – Determine the increase in the participant’s account. (Typically, this is just contributions and forfeitures).

• Step Two – Project that amount with interest to a testing age (typically age 65). The interest rate is 7.5% and 8.5%.

• Step Three – The amount determined in Step Two is converted actuarially into a straight life annuity at the testing age using a standard mortality table specified in the Regulations and an interest rate between 7.5% and 8.5%. This is done for every participant.

• Step Four – The annuity amount so determined is divided by the participant compensation and creates an “equivalent accrual rate.”

• Step Five – The equivalent accrual rates are then tested in the same manner as the general test described above as if they were allocation rates.

Special Rules for Cross-Testing

Because cross-testing can result in very large disparities between the contributions to HCEs who are typically older and the contributions to NHCEs who are typically younger, in order to use cross-testing to demonstrate non-discrimination, the Plan must either have “broadly based allocation rates” or pass a fixed “gateway.”

Broadly Based Allocation Rates - An allocation rate is broadly based if it is available to a group of employees which would satisfy the 70% ratio percentage test under Code 410(b). In addition, an allocation rate is broadly available if the rate increases as a participant ages or accumulates additional service. All participants in the plan must be able to potentially “grow” into the increasing rate. The rates must also increase smoothly at regular intervals of age or service.

Gateways -A plan does not need broadly based allocation rates if it passes either of two gateways.

i) Each NHCE has an allocation rate that is at least one-third of the allocation rate of the HCE with the highest allocation rate (For example, if a NHCE gets 3% allocation rate, the maximum allocation rate for HCEs can only be 9%); or

ii) Each NHCE receives an allocation of a contribution of at least 5% of compensation.

Effect of Testing – Comparability of Benefits or Contributions

The effect of using the General Test or Cross-Testing when designing a plan is to permit a plan to target HCEs for what could be relatively large contributions (the maximum of $46,000 for 2008 (or $49,000 for 2009) and make a significantly lower contributions to NHCEs.

©McDonald Hopkins LLC (2008) Dale Vlasek

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