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I do not think you are missing anything here with a caveat I ain't a 401(k) expert. Somehow random words like Paychex and ADP are floating through my head.

If you continue with this client, make and keep records of the written advice you provide. Your descriptions of the client’s behavior suggest the client might assert it did not receive, or did not understand, your advice.

I think the informal IRS position was that there would be 2 different classes of implicit ERFs - one for HCEs and another for NHCEs thus it automatically fails the BRF test.

Are you sure that's what the plan says? Read the exact wording in your plan document. I bet it actually says something to the effect that non-resident aliens with no U.S.-source income are excluded. If someone worked in the U.S. then they would not fall under that excludable employee classification, even if they are not a citizen and not a permanent resident.

Segregation is common only when the stock is replaced with cash. The cash will need to be prudently invested. If you question is whether a company can keep a terminated employee invested in shares and freeze their value to a set price, there is no legal way to accomplishing that result. Stock held in an ESOP is required to be valued at least annually.

I have had clients comment that it seemed unfair for terminated participants to benefit from future increases in share value since the terminated participants were not adding value to the company. Almost all of them put in place a mechanism to replace the shares of terminated participants with cash. The rest have gone the route of replacing the shares with a secured note. I have not heard anyone just freezing the price. Keeping shares in the accounts of terminated participants but not allowing the share value to fluctuate is treating these shares differently from the shares held in other participants' accounts. This sounds to me like a problem. Assuming the shares are not publicly traded, it would be interesting to see if the independent appraiser has commented on this policy.