Failed Compensation Ratio Test

[Guest Rachelw]

I have a plan that excludes bonus and overtime from the definition of compensation. My results show a difference of 6%.

The test has a paragraph that says as a rule of thumb, results 3% and under are considered de minimis. So, I think I have a non-passing test and I am not sure how to proceed.

Another person in my office thought if the Comp Ratio test "failed", you could run the ABT. And if the ABT passed, you were o.k. I couldn't find anything specifically stating that in the reg. books. I did find some information that said if audited, it would pretty much be up to the individual auditor to determine if failing amount is de minimis or not.

Has anyone had this situation before? And how did you handle it?

Thank you,

Rachel

[austin3515]

There is no requirement that contributions be ALLOCATED based on a 414(s) definition of compensation. So if you're plan document excludes bonuses, then so be it.

There IS a requirement that you use a 414(s) definition of compensation for NONDISCRIMINATION TESTING. So what you need to do is run your rate group testing, which presumably will fail based on allocation rates for the same reason your ratio test failed. So now you'll need to use cross-testing which MAY involve the Average Benefits Test (i.e., if each rate group doesn't pass the ratio percentage test). Also, make sure you pass the gateway contribution requirement.

In other words, you basically have a New Comp. plan.

If the allocation provisions as currently written preclude the plan from passing nondiscrimination, then a "-11(g)" amendment would be required to bring the plan back into compliance. For example, I would think an amendment to bring in bonus for compensation might be a solution. My 11(g) experience has related solely to fixing coverage/nondiscrimination issues, and not for a definition of comp, though I suppose the same logic would apply. Perhaps someone with more specific experience can chime in.

[Tom Poje]

or, put another way:

you have an allocation based on comp less overtime and bonus.

you failed comp test, so comp less overtime less bonus can not be used for testing purposes.

therefore, run as you would a cross tested plan, using total comp (instead of comp less bonus less overtime)for tesing purposes, but keep your allocation as such (because of course you follow the terms of the document in regards to the allocation)

actually, you might not even need to cross test, plan might pass on alloaction basis if you impute disparity.

if you cross test, while doubtful it would kick into play, but the gateway minimum still has to be satisfied.

[austin3515]

Tom, would -11(g) work to correct 414(s) issues?

[Tom Poje]

well, if you fail your nondiscrim test (using total comp) then you can correct by allocating a larger contribution under -11g.

but I don't see how you can use it to correct a comp test failure.

[Kevin C]

Before you cross test, make sure the testing method you are using is allowed by your document. GUST prototypes are not allowed to provide for 401(a)(4) testing on the basis of benefits. {Rev. Proc 2000-20 Section 8.03(7)}

[John Feldt ERPA CPC QPA]

Which reminds me to ask, how many providers that have used prototypes in the past will now just switch (during the EGTRRA restatement) to use mostly volume submitter documents?

[Guest QuestionerDiva]

I have a client with the same issues. Could you please give me the regulation number where it mentions passing the compensation ratio test at 3% and under? Thanks.

[Tom Poje]

the only thing in the regs is found in 1.414(s)-1(d)(3) which simply says the HCEs cant exceed the NHCEs by more than a 'de minimus' amount. the 3% is not written in concrete anywhere. according to some sources the 3% is a rough guideline used by some IRS folks, but at that point it probably boils down to a facts and circumstances test.

[ak2ary]

You should be very very careful anytime you have to rely on the deminimis exception... the IRS has never used 3% as a safe harbor in fact they are very clear that if you have a definition of pay that will consistently yield a lower inclusion percentage for NHCes, it likely fails, regardless of the differential. For instance assume a plan has a definition of 415©(3) pay excluding overtime...and only NHCEs get overtime...I would not be comfortable that it is allowable even if the differential was less than 1%

I have heard National Office IRS reps warn people off this saying that if you need to use the deminimis exception due to normal plan operations rather than a one-time anomaly; you are likely not eligible to use it. The example I have heard given is if the plan has consistently passed 414(s) for a number of years and in a single year the difference is 1%., then you are probably ok, depending on why you failed. For instance, if plan pay excludes bonuses and, in a down year, the company continued bonuses to staff but cut them for HCEs, that may be ok

[John Feldt ERPA CPC QPA]

Thanks Tom, that is extremely valuable info to know.

[PensionPro]

We have a plan that fails the compensation test. The plan only has 401(k) deferrals and employer matching contributions. Can we still run the rate group test to prove nondiscrimination?

[Mike Preston]

No. The rate group test is only for employer contributions/allocations that are NOT matching contributions.

[austin3515]

I would say that there is no such thing as failing the test when all you are doing is running APD/ACP testing. You must simply use a 414(s) definition to run testing, such as W-2 wages (either adding back deferrals or not, whichever is better). Some really poorly drafted plans (my opinion only) will specify the definition of comp that must be used for testing, and if your plan does it would have to be a safe harbor definition of comp (assuming it went through the DL process or was drafted by someone who knows what they're doing).

[Guest Pension Girl]

what happens if a safe harbor plan excludes bonuses, commissions and overtime, and fails the compensation ratio test - does the plan become a non safe harbor plan, or can the def. of comp be amended so as to pass comp ratio?

[Mike Preston]

I believe the IRS position is that in order to actually be a safe-harbor, the plan's provisions must actually be a safe-harbor. If you need to change something after the fact, it isn't a safe-harbor and, further, it isn't something that can be thrown out with the morning coffee filter. If the intention is to be a safe-harbor and you fail in your endeavors, the only correction is through EPCRS.

[Guest Pension Girl]

I cannot find any regulatory guidance per se, other than the definition of comp must satisfy 414(s). IF you run the test before the end of the plan year, fail, corrrect via plan amendment and allocate the safe harbor based on the amended definition, why does this invalidate your safe harbor plan?

[austin3515]

I think it would be very atypical to run the 414s test before the end of the plan year. But certainly if you're not using a safe harbor definition, it would be advisable to do just that and amend before year end. I don't see any anticutback issues as long as you are adding comp for NHCE's, as opposed to taking comp away from HCE's.

[Guest Rutager]

I'm interested in a response to Pension Girls question - I have a Safe Harbor Basic Match plan with only 401(k) and SHBM contribuitons. The plan excludes OT and Bonus - and fails compensation ratio test. I'm not sure how to handle it from here - if I can't rate group test 401(k) or match - do I have to do an 11(g) amendment? what should the 11(g) amendment state and does the employer need to recalculate its safe harbor basic match? The match is allocated on a pay period basis. I really don't know what to do with this.

Sorry - did not see page 2 of question - please disregard.