Prior Year ADP testing - No eligible NHCEs in prior year

[Guest Gary Rouse]

401(k) plan adopted in 2003 using prior year testing. The only eligible employee in 2003 is a HCE. For 2004 will be both HCE and NHCE eligible in the 401(k) plan. For ADP testing for 2004 (prior year testing), does the Plan automatically pass as no eligible NHCE in prior year? or since no eligible NHCE in 2003 is my NHCE ADP % 0%.

[Tom Poje]

I believe since there are no eligible NHCEs you automatically pass.

If you followed the logic of saying

"since no eligible NHCE in 2003 is my NHCE ADP % 0%."

then a plan with only HCEs could never pass whether you use current or prior year testing.

[Blinky the 3-eyed Fish]

I don't agree that there is an automatic pass in 2004. With eligible NHCE's in 2004, you are looking back to 2003's NHCE ADP results and counting a 0%. Now if there were no NHCE's in 2004, then I see an automatic pass. I see that either you need to use current 2004 data or no HCE deferrals are allowed in 2004.

[R. Butler]

Oh no! Tom Poje & Blinky arrive at different answers. Who can we come to for help when 2 of the more prolific professionals do not agree? The sky is falling.

In this case I would go with the fish. It is my understanding that whether or not sponsor can rely on the "No NHCE rule" is determined by looking at the current plan year.

[Tom Poje]

If there were no NHCEs eligible in the prior year, then I would hold you are left with a 'plan' (at least for testing purposes) which consists only of HCEs, which is given a free ride under the regs.

Lets say I had 2 NHCE who were ineligible in the prior year, and are now eligible. If I count them because they are eligible now but had 0 last year then test would fail.

But lets change things a bit.

Suppose one of them was eligilbe last year, deferred 5% and quit last year.

In the current year I am left with one NHCE. now when I use prior year testing would I use his '0' from last year, simply because he is eligible this year? That wouldn't seem to make sense to use an average of 2.5%.

or for that matter, lets say both of them quit. Would you say there is no test because you only have HCEs or would you still compare the results to the prior years average.

[Guest DFerrare]

According to the ERISA Outline Book, 1.401(k)-2(a)(1)(ii) of the proposed 401(k) regulations allows you to look at the prior year. The reg says "If, for the applicable year for determining the ADP of the NHCEs, there are no eligible NHCEs...the arrangement is deemed to satisfy the ADP test for the plan year."

The issue then is if the proposed regs can be used. Since there is no current conflicitng guidance and the method is reasonable it could be argued that the method is approrpriate.

[R. Butler]

If there were no NHCEs eligible in the prior year, then I would hold you are left with a 'plan' (at least for testing purposes) which consists only of HCEs, which is given a free ride under the regs.

Lets say I had 2 NHCE who were ineligible in the prior year, and are now eligible. If I count them because they are eligible now but had 0 last year then test would fail.

Yes, but it doesn't it make sense to interpret the rule one way for coverage tests & another for ADP/ACP test? The rule is that all nonexcludible employees are HCEs. The same rule is used for coverage testing. If there is an NHCE eligible in the current year, you don't meet it.

But lets change things a bit.

Suppose one of them was eligilbe last year, deferred 5% and quit last year.

In the current year I am left with one NHCE. now when I use prior year testing would I use his '0' from last year, simply because he is eligible this year? That wouldn't seem to make sense to use an average of 2.5%.

I'm not sure I follow you here. The prior year NHCE ADP was 5%. You use the 5% because that is the rule. I am fairly sure that the prior year rule is allowed to provide HCE's a level of certainty of their deferral amount. I don't see that the prior year rules change "No eligible NHCE" rules. I don't even see that it thwarts the purpose.

[Kevin C]

I agree with Tom.

If there are no NHCE's in 2003, the NHCE ADP for 2003 is not 0. The average of zero items is not zero, it is indeterminate. To take the average, you would have to divide by zero.

Notice 98-1 spells out the prior year testing rules. It also says that the existing regs only continue in effect to the extent they are consistent with the new guidance. Under the prior year method, you are testing prior year data for NHCE's against current year data for HCE's. If you apply the exemption for having no NHCE's to mean no NHCE's in the current year, then you are actually using data for both the current and prior years for NHCE's in the test. I don't see that as being consistent with the rules of Notice 98-1. On the other hand, I think looking solely at the prior year NCHE population to determine if the exemption applies under prior year testing is being consistent with Notice 98-1.

Even though we can't rely on them yet, it also doesn't hurt that the new proposed 401(k) regs support the position that under prior year testing having no NHCE's in the prior year is an exemption.

[Blinky the 3-eyed Fish]

I now agree with Tom based on the proposed regs. It appears to clarify how 98-1 should be interpreted.

Sorry to leave you stranded on the boat Butler.

[R. Butler]

Based on the proposed regs & the fact I don't want to be the lone wolf crying in the wilderness I will change my answer also.

2 things though:

1. I can't be expected to know proposed regs when its iffy that I know the current regs.

2. Whoever cited Sal; that is cheating. Thats like brining a MLB player into the church softball league. My answer appears to be wrong, but it was my answer.

[rcline46]

I think you get a free pass.

If no NCEs eligible last year then they do not have an ADP % for last year. This does not mean a -0- ADP, it means NO ADP. If you have no ADP % last year to test against, then you get a free pass.

Tom, would your answer change if all NCEs were hire in current year with immediate eligibility - ie no NCEs employed at all?

What if NCEs hire in current year but not eligible?

What if you are using statutory exclusions?

I think all of the above cases give a free pass.

[Kevin C]

R. Butler,

Don't feel bad about it. Sal changed his mind (and his book), too after the proposed regs came out.

[Tom Poje]

I would take the following stance on the proposed regs,

especially when you read the preamble

sometimes it says something like "this clarifies...." I'd hold that is the IRS way of saying you really should be doing it this way.

This would be different than the proposed regs which will do away with bottom up QNECs. That is not a clarification but rather a change.

as for the idea that it doesn't make sense to do coverage one way and nondiscrim testing another, actually that is what is taking place. and not just using prior year testing.

consider the rule which says all HCEs can be treated as meeting the 1 yr age 21 requirement even if they haven't. there is no similar rule in coverage.