Prior year testing method/ADP/former employees

[billfgrady]

Do you disregard former employees for purposes of calculating ADP for the determination year under the prior year testing method? Our plan has a total of six participants, all of whom have been HCEs for all years the plan has been in existence. However, two of the employees retired in August and September of 2002, and, although each met minimum participation standards for 2002, each had compensation of well below $85,000 (using the limit in effect for the look-back year). In addition, neither employee is a 5% owner or meets any of the other qualifications for "highly compensated employee" under Section 414(q) or the regulations thereunder.

2001

Employee 1, $170,000, 10,500 401(k) deferral

Employee 2, $170,000, 10,500 401(k) deferral

Employee 3, $170,000, 10,500 401(k) deferral

Employee 4, $120,731, 10,500 401(k) deferral

Employee 5, $104,959, 10,500 401(k) deferral

Employee 6, $ 94,268, 10,500 401(k) deferral

2000 NHCE ADP: 100% (i.e., no cap for 2001 HCE ADP because no NHCEs from 1999 information)

2001 NHCE ADP: 100% (no cap for 2002 HCE ADP because no NHCEs from 2000 information)

2001 HCE ADP: 8.06%

2002

1, $200,000, 11,000

2, $200,000, 11,000

3, $200,000, 11,000

4, $132,619, 11,000

5, $ 74,481, 11,000

6, $ 50,850, 11,000

2001 NHCE ADP: 100%

2002 NHCE ADP: 100% (again, no NHCEs)

2002 HCE ADP: 8.03%

2001

2003

1, $200,000, 12,000

2, $200,000, 12,000

3, $200,000, 12,000

4, $100,000, 12,000

2002 NHCE ADP: 100%

2003 NHCE ADP: ?

2003 HCE ADP: 6.76%

The testing for 2002 is relatively straightforward: relying on compensation for the 2001 Plan year and the compensation limit of $85,000 for 2001, all of the employees are highly compensated for 2002 testing purposes. Thus, there are no limits to the amounts that HCEs can contribute in 2002.

Looking forward to 2003 and 2004, I am uncertain as to whether I need to include the former employees for 2003 ADP testing purposes. I assume that the 2003 NHCE ADP is 100% (i.e., there will be no cap as to the 2004 HCE contributions). If not, how do you compute the ADP if there were no contributions for those employees in 2003? Despite all of this, IRS Notice 98-1 suggests that, "under the prior year testing method, the prior year ADP or ACP for NHCEs is used even though some NHCEs may have first become eligible employees under the plan in the testing year because they meet existing plan eligibility requirements, and even though individuals who were eligible employees under the plan and NHCEs in the prior year are no longer employed by the employer or have become HCEs in the testing year." How does this work?

[Tom Poje]

ok, you run the ADP test for 2003.

Obviously the HCE avg is easy, cuz you look at 2003 results.

you compare that to 2002 NHCE avg. There is none, it doesn't exist - there were no NHCEs in 2002. It doesn't matter that the comps of some employees are now low. If those people had comtinued to work in 2003 they would be NHCEs and you would have an NHCE avg in 2003, but that would be used to test the 2004 numbers

[billfgrady]

Thanks, Tom. That's what I suspected.