Dale R. Vlasek
McDonald Hopkins LLC
P: (216) 348-5452
E: dvlasek@mcdonaldhopkins.com

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Qualified Retirement Plans are required to demonstrate that they are not discriminatory in amount of contributions, the level benefit provided and in the coverage of an employer’s workforce. That having been said, the Internal Revenue Code does not require that all employees be covered, only that the plan cover a group or groups of employees that does not discriminate in favor of highly compensated employees (HCEs).

Simplistically, HCEs are more than five-percent owners of the employer or employees who earned a set amount or more in the prior calendar year. For 2009, that amount is $105,000 earned in 2008. A non-HCE (NHCE) is an employee who is not an HCE.

Section 410(b) Testing

Section 410(b) of the Internal Revenue Code (Code) and its attendant regulations have elaborate rules on how to demonstrate that the coverage of a plan is non-discriminatory. The Code permits an employer to automatically ignore or exclude for non-discriminatory testing purposes the following groups of employees. Sometimes these groups are referred to as the Statutory Exclusions.

• Employees covered under a collective bargaining agreement whose retirement benefits have been the subject of good faith bargaining.
• Non-resident aliens with no U.S. source earned income.
• Employees who have not satisfied the plan’s minimum age and service requirements.
• Terminated employees who have terminated with less than 500 hours of service and who fail to benefit or receive an allocation because they failed to satisfy a service requirement or be employed on the last day of the plan year.

In addition to excluding employees who fall into the Statutory Exclusions, the Code still permits an employer to exclude other employees provided the plan satisfies at least one of three coverage tests.

1 - The General 70% Test. The first test is what is referred to as the 70% test. Under the general
70% test a plan must benefit 70% or more of the employer’s NHCEs. For example, if the employer had 72 NHCEs after excluding the Statutory Exclusions, the 70% test would be passed if 51 NHCEs were covered. (i.e., 70% of 72).

2 - The Ratio Percentage Test. An alternative test is what is called the ratio percentage test. Under the ratio percentage test a plan must benefit a percentage of NHCEs which is at least equal to 70% of the percentage of HCEs benefiting under the plan.

For example, if an employer has 10 HCEs and 72 NHCEs and sponsors a plan which benefits 8
HCEs, the plan would pass the ratio percentage test if it benefited at least 41 of the employer’s NHCEs.

This is calculated as follows:

• The percentage of HCEs benefiting is 80% (i.e. 8/10)
• The ratio percentage is 70% of 80% or 56%
• The number of NHCEs that must benefit is 56% of 72 or 41 employees

3 - The Average Benefits Test. The final test is more complicated but it can permit a fairly precise targeting of coverage. Under the average benefits test a plan must benefit a group of employees under an employer determined classification that the Internal Revenue Service (IRS) finds is reasonable and does not discriminate in favor of HCEs.

The IRS has indicated that a classification is generally reasonable if it is based on a bona fide business rationale such as job classification, nature of compensation (salary/hourly), or geographic location. The IRS has taken the position that “part-time” is not a classification it will approve.

The classification must also be non-discriminatory in favor of HCEs. The IRS includes an objective test in its regulations that measures a plan’s ratio percentage against a regulating set “safe harbor percentage”. This demonstrates the non-discriminatory coverage of the classification.

Once the plan’s classification is reasonable and non-discriminatory, the plan must then demonstrate that the benefit potentially provided to NHCEs is theoretically non-discriminatory.
Specifically, the average benefit percentage for the NHCEs who are covered by the plan must be at least 70% of the average benefit percentage of HCEs.

The average benefit percentage is the sum of contributions and benefits under the plan provided to the applicable group (i.e. NHCEs or HCEs) expressed as a percentage of compensation of all members of the group.

Conclusion

The upshot of the testing is to permit an employer to design a retirement plan program which targets the employees the employer wishes to target. The key is to use the design and the test which achieves the desired result. The testing as one can see can be complicated, but with some effort the employer’s goals can be achieved.

©McDonald Hopkins LLC (2009) Dale Vlasek