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Pro-Rata Allocation and Gateway Test


emmetttrudy

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But the HCEs are not receiving a different amount of profit sharing than the NHCEs are. A pro-rata allocation is a safe harbor allocation, it doesn't require additional testing, right? The only reason ONE of the NHCEs is not receiving 15% profit sharing is because he failed to meet the allocation conditions (he was not employed on the last day of the year and he did not work 1,000 hours). The other NHCE is receiving 15% profit sharing because he did meet both of the allocation criteria. Same as the 5 HCEs, 15%. So why is there clearly a need for additional testing?

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Because we all fell into the trap of thinking that the plan was designed to provide for different percentages for each employee.

This disucssion got off on the wrong foot because not enough detail about the plan was known and the first few questions didn't fill in the right gaps.

In the case you are describing in #26, that is the first I've heard of it being a safe-harbor allocation formula in the plan (not to be confused with a 401(k) 3% SH, which is a totally different animal.

In fact, you started out by saying the plan was a new comp design. Can't really blame anybody for being confused.

So, let's start over.

There are two cases here, one is terribly esoteric and the other is blatantly obvious. Both end up needing the same tests.

First, let's assume the plan document calls for a 401(a)(4) safe-harbor formula (which is different from a 3% SH one finds in a 401(k) plan), you can allocate a pro-rata contribution of 12% to the 5 HCE's who satisfy the allocation conditions of the plan and 12% to the one NHCE who satisfies the allocation conditions of the plan. In addition, all 7 receive the 3% SH allocation. Hence, 6 end up with 15% and one NHCE ends up with 3%. All 7 are benefitting so the plan easily passes coverage. And most people think the plan automatically passes 401(a)(4), but it doesn't. In this case you have two separate allocation requirements. 6 people satisfy one, 7 satisfy the other. This means, unfortunately, that the plan, as a whole, is not eligible for 401(a)(4) safe-harbor treatment and must be general tested. There is an exception to this rule if the 7th person is getting an allocation of the top-heavy minimum only (like a person employed throughout the year who works only 100 hours and is given 3% of pay to satisfy the top-heavy rules). But there is no exception to this rule if the 7th person gets an allocation due to the 401(k) SH provisions. I know we argued a lot with the IRS and asked for another exception in the 401(a)(4) rules but if memory serves they didn't acquiesce. One way around this is to have the plan's top-heavy provisions match the plan's 401(k) SH provisions (that is, everybody gets 3% whether employed at EOY or not). Most plans don't even have that as an option. So, as far as I know, this problem can't typically be "cured" with a document provision unless you go individually designed (or treat the modification as not serious enough to bounce it out of pre-approved status).

In any event, you should read 1.401(a)(4)-3(b)(6)(xi) for more information on this esoteric situation.

Now, most of the time, when you have a 401(k) SH you don't have such skewed demographics, so it just isn't usually an issue.

But the result is the same as if the plan were designed as a new comp plan to begin with. That is, if the allocation is pro-rata (and you are not cross-testing for anything but the ABPT - which I've already said doesn't count as cross-testing for purposes of determining whether a gateway contribution is required), the way you demonstrate that you have satisfied 401(a)(4) is that you restructure the plan into two plans. One plan gives everybody in it 12% (in this case everybody is 6 people). And the other plan gives everybody in it 3% (in this case everybody is 7 people). EDIT: I mis-used the term "restructure". I meant to use another word like "break" because "restructure" is a defined term that only allows a given participant to be in one of the "restructured" plan. I'm not talking about that sort of restructuring. I'm talking about "breaking" the plan into pieces to demonstrate how it would fail the "multiple formulas" section of the 401(a)(4) regulations. END OF EDIT

Everybody agrees that the 7 person "plan" satisfies coverage and 401(a)(4).

But the 6 person "plan" has a challenge to overcome when it comes to determining whether it satisfies coverage. There is only one rate group and the coverage percentage of that rate group is only 50% so the only way to satisfy coverage is for the plan as a whole to satisfy the ABPT. Running the numbers on the ABPT without using cross-testing we find that the HCE's average 15% and the NHCE's average 9%. That doesn't satisfy the ABPT because 70% of 15% is 10.5%, so it fails. You didn't give us enough information to determine whether running the ABPT by imputing permitted disparity would result in the ABPT passing (if it does, then everything works out fine). But let's assume that running the ABPT with imputed disparity still fails. The next step is to run the ABPT on a cross-tested basis and see if it passes. The bottom line is that you have to satisfy the ABPT to satisfy the 401(a)(4) non-discrimination rules in this case.

General comments: 1) very few people are aware of this requirement 2) I think even the IRS thinks that if they were to re-draft the section of the 401(a)(4) regs cited earlier they would carve out an exception not only for TH but also for 401(k) SH.

It is even possible that the IRS has gone on record saying that the addition of a 401(k) SH provision can't cause a plan to fail to satisfy the 401(a)(4) safe-harbor design test if it would otherwise do so. I'd love to see it if that is the case.

I haven't paid attention to this issue in years since none of my plans have the skewed demographics that your plan has; but as I said, if the IRS has extended the safe-harbor rules to cover this situation, I'd be happy.

WIth all that said, the above is based on a 401(a)(4) safe-harbor formula.

You don't start a message with the words "new comp" and expect anybody to stick to an analysis which is focused on the document formula being a 401(a)(4) safe harbor design.

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I understand what you are saying but I still think there is some confusion. The actual plan design is a 3% safe harbor nonelective with a discretionary profit sharing contribution and each participant is in his own classification (new comp). However, the plan document allows for a pro-rata allocation, which in this case we are trying to rely on because given the demographics and disparity between HCEs and NHCEs the new comp testing does not work out well. HCEs are excluded from receiving the 3% safe harbor contribution. So each of the 5 HCEs are getting a 15% profit sharing contribution. One of the NHCEs is getting a 3% SH contribution, and a 15% profit sharing contribution. The other NHCE (who terminated and did not meet allocation conditions) is getting a 3% SH contribution, which satisfies his need for the top heavy minimum, and 0% profit sharing.

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I understand what you are saying but I still think there is some confusion. The actual plan design is a 3% safe harbor nonelective with a discretionary profit sharing contribution and each participant is in his own classification (new comp). However, the plan document allows for a pro-rata allocation, which in this case we are trying to rely on because given the demographics and disparity between HCEs and NHCEs the new comp testing does not work out well. HCEs are excluded from receiving the 3% safe harbor contribution. So each of the 5 HCEs are getting a 15% profit sharing contribution. One of the NHCEs is getting a 3% SH contribution, and a 15% profit sharing contribution. The other NHCE (who terminated and did not meet allocation conditions) is getting a 3% SH contribution, which satisfies his need for the top heavy minimum, and 0% profit sharing.

disregard the TH minimum comment since he's obviously terminated and doesnt need one. but the rest of the other details are accurate.

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I understand what you are saying but I still think there is some confusion. The actual plan design is a 3% safe harbor nonelective with a discretionary profit sharing contribution and each participant is in his own classification (new comp). However, the plan document allows for a pro-rata allocation, which in this case we are trying to rely on because given the demographics and disparity between HCEs and NHCEs the new comp testing does not work out well. HCEs are excluded from receiving the 3% safe harbor contribution. So each of the 5 HCEs are getting a 15% profit sharing contribution. One of the NHCEs is getting a 3% SH contribution, and a 15% profit sharing contribution. The other NHCE (who terminated and did not meet allocation conditions) is getting a 3% SH contribution, which satisfies his need for the top heavy minimum, and 0% profit sharing.

OK, so we are back to new comp. Note that it is fundamentally impossible to have a plan satisfy 401(a)(4) as a 401(a)(4) safe-harbor formula (for example: comp to comp) when the plan's terms allow each participant a different amount. Even if the employer ends up allocating the same percentage to each participant it must be general tested.

That is your major confusion.

Now you mention that notwithstanding the fact that everybody is in their own allocation group the "document allows for a pro-rata allocation". Sorry to say it, but this means absolutely nothing. In order to be a 401(a)(4) safe-harbor formula it would need to mandate a pro-rata allocation, not merely allow for it.

So, we are back to general testing the plan and you want to general test the plan on an allocations basis. Fair enough. If you pass your general test on an allocations basis you have no need to ever consider a gateway contribution. In the process of running your general test you might need to pass the ABPT (in this case "might" is "definitely" because your coverage percentage of the rate group where HCE's receive 15% of pay is less than 70%). You can run your ABPT any way you want (impute permitted disparity, cross-test, change the definition of 414(s) compensation used, etc.) and it will have no effect on whether a gateway contribution is required. If you fail to pass the ABPT no matter how hard you try, now you will need to cross-test in your general test and, if you pass, the only increase required would be the gateway. If you still failed, however, then you would need to save the plan by way of a 1.401(a)(4)-11(g) amendment. There are a myriad of ways that such an amendment might be structured, some of which would invoke gateway others of which would not (for example, one way to "fix" the broken test would be to give more money to the NHCE who is already receiving 15%. If you did that and the plan now passed the ABPT it would allow the plan to say that it passed the general test on an allocations basis and no gateway would be required).

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So, we are back to general testing the plan and you want to general test the plan on an allocations basis. Fair enough. If you pass your general test on an allocations basis you have no need to ever consider a gateway contribution. In the process of running your general test you might need to pass the ABPT (in this case "might" is "definitely" because your coverage percentage of the rate group where HCE's receive 15% of pay is less than 70%). You can run your ABPT any way you want (impute permitted disparity, cross-test, change the definition of 414(s) compensation used, etc.) and it will have no effect on whether a gateway contribution is required. If you fail to pass the ABPT no matter how hard you try, now you will need to cross-test in your general test and, if you pass, the only increase required would be the gateway. If you still failed, however, then you would need to save the plan by way of a 1.401(a)(4)-11(g) amendment. There are a myriad of ways that such an amendment might be structured, some of which would invoke gateway others of which would not (for example, one way to "fix" the broken test would be to give more money to the NHCE who is already receiving 15%. If you did that and the plan now passed the ABPT it would allow the plan to say that it passed the general test on an allocations basis and no gateway would be required).

Mike... I'm confused by the bolded part above (or at least, not understanding). In order to cross-test in the general test, don't you need to pass the APBT at >=70% first?

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So, we are back to general testing the plan and you want to general test the plan on an allocations basis. Fair enough. If you pass your general test on an allocations basis you have no need to ever consider a gateway contribution. In the process of running your general test you might need to pass the ABPT (in this case "might" is "definitely" because your coverage percentage of the rate group where HCE's receive 15% of pay is less than 70%). You can run your ABPT any way you want (impute permitted disparity, cross-test, change the definition of 414(s) compensation used, etc.) and it will have no effect on whether a gateway contribution is required. If you fail to pass the ABPT no matter how hard you try, now you will need to cross-test in your general test and, if you pass, the only increase required would be the gateway. If you still failed, however, then you would need to save the plan by way of a 1.401(a)(4)-11(g) amendment. There are a myriad of ways that such an amendment might be structured, some of which would invoke gateway others of which would not (for example, one way to "fix" the broken test would be to give more money to the NHCE who is already receiving 15%. If you did that and the plan now passed the ABPT it would allow the plan to say that it passed the general test on an allocations basis and no gateway would be required).

Mike... I'm confused by the bolded part above (or at least, not understanding). In order to cross-test in the general test, don't you need to pass the APBT at >=70% first?

Not at all; there is no tie between the two. The consequences of not passing the ABPT is that each rate group must satisfy a 70% threshold. You can reach that 70% threshold by testing on contributions or benefits. If you do happen to pass the ABPT then each rate group merely has to satisfy the mid-point of the safe and un-safe harbors.

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