Jump to content

Correcting Failure of Key Employee Concentration Test


Guest RBJ

Recommended Posts

Many professional corporations have difficulty passing the Key Emloyee concentration test. My firm fails the test annually. My question involves how you correct the failure.

Most TPAs recommend that you adjust §125 deferrals mid-year when you project a concentration test failure. The problem with this approach is that it is imprecise. For example, if non-key employee participation picks up substantially through new hires or changes in family status, you will likely "over-correct" key employee deferrals if you take action as soon as you project a testing failure.

An approach that makes a great deal of sense to me is to perform the concentration test at year-end. If you fail the test, then it is necessary to adjust key employee contributions. However, there are no contributions remaining in the Plan Year, so the only way to correct is to "recharacterize" contributions by key employees to the extent necessary to pass the concentration test. To recharacterize, you simply report the §125 contributions that are in excess of the concentration test as taxable compensation to the key employee and adjust FICA withholdings to the extent necessary in the key employee's last paycheck of the year. This approach has the same income tax effect as reducing contributions mid-year, but is much more exact.

I have spoken with several other benefits attorneys regarding this approach, and while we agree that it should be allowed, we can not find support for it in the §125 regs or statute and find that most TPAs resist it. Any thoughts?

Link to comment
Share on other sites

I'm a little confused by your suggested correction method.

First, if you perform the test at the end of the year and fail, then it appears (based on the statute) that the key employee must include all amounts in income -- not just the excess. That's why correction mid-year is the safest approach, even if you end up overcorrecting.

Second, based on your approach, regardless of whether it's the full amount or just the excess that's included in income, you stated that there are no amounts left in the year to correct. But, you then state that you adjust FICA withholding in the last pay check. It seems to me both of those statements are inconsistent. The correction must relate to the year the test is failed and if you wait to the end of the year to test, it will be too late to adjust the last paycheck for that year.

Unfortunately, I haven't that even addresses the situation of how to handle a failed test. I guess that means any reasonable interpretation will work.

Link to comment
Share on other sites

Thanks for your input Bob. I'll try to clarify the approach I'm advocating.

First, if my approach works, it corrects the failure and you pass the test, so the statutory provision is irrelevant.

Second, what I was particularly unclear about in my first message was that under my approach, you run the test with one payroll period left (I had said at the end of the year, which was misleading). This timing allows you to predict with certainty the total §125 contributions for key and non-key employees. You complete the test before running the last payroll so you have time to withhold the additional FICA due for key employees. The additional FICA is a small amount since a key employee's wages are almost always over the SSTWB and is are taxed at the 1.45% rate. As I said before, you also report taxable income to the key employee via the W-2 to the extent necessary to reduce the §125 benefit and to pass the concentration test.

My approach would not work well for a large employer, due to the last minute rush you would create for payroll, but I do think it is worth considering for smaller employers.

What I find particularly frustrating is the absolute lack of guidance on these points from the IRS, especially when you consider the level of detail available from the Service for correcting 401(k) test failures.

Link to comment
Share on other sites

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account in our community. It's easy!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now
×
×
  • Create New...