When New Comp Allocation Is Worse Than Pro Rata

[mming]

A profit sharing plan is originally set up with a new comparability allocation method and works fine for a few years until the employer's demographics change drastically - many of the younger employees were replaced with workers who are older than the owner. The plan now cannot pass the cross-testing even when everyone (including the owner) receives the same percentage of compensation as an allocation. I remember hearing a while back that in a scenario like this you can always "default" to a pro-rata allocation and not have to worry about cross-testing, even if the document does not specifically state this - has anyone else heard of this?

[J Simmons]

You have to deal with the allocation formula that is in your plan document. You can demonstrate that the resultant allocations are nondiscriminatory in a number of ways--cross-testing, the 'pro rata' or permitted disparity. But you have to follow the parameters of your plan document for making the allocation in the first place.

[mming]

So, it sounds like unless the employer amends their allocation method in their document to either a pro-rata method, or one that's integrated with the SS wage base, for example, the owner would be forced to allocate to everyone a greater percentage of pay than what he himself would receive. Thank you for your reply.

[Tom Poje]

unless you had a document that said you must test on an accrual basis I don't see why that would be possible.

you can always test on an allocation basis

exactly how is the formula written in the document written?

If everyone is in different groups, and you give everyone a 5% alloaction and test on an alloaction basis, then you end up passing.

[Bird]

You can't default to a pro-rata allocation if the plan doesn't allow for it (but it probably does). But you can test whatever allocations you arrive at on a contributions basis, and if the "arbitrary" allocation turns out to be pro-rata then it will pass.

In fact you can impute permitted disparity and give those above the SSWB additional contributions and still pass; if the plan formula allows it, you should be able to come up with an allocation identical to that under an old-fashioned integration formula using the SSWB and 5.7%.

[Below Ground]

Since most plans allow for testing to be on a benefits or contribution basis, I suggest that you first look to see if the allocation must be tested using the benefits basis. If not, and coverage testing is passed, I don't see how a plan that gives everyone the same percent of pay could fail when etsting under a contribution basis. (Since testing on the current allocation basis is not using a projection, demographics have no impact.) Of course, if the document says you can only test on a benefits basis....

[mming]

Each participant in this case is their own allocation group. The document doesn't address how the testing should be done (it's an FT William doc). Just in case we're using different terms for the same thing, let me describe how the testing has been done in the past. The annual testing is solely based on the current year's allocations. This year, if all participants receive let's say 5%, the owner has the largest EBAR, so the "rate group" test fails, and the average benefits test also fails. The only way to make both tests pass (a necessity?) would be to reduce the owner to 3.5%. I suppose the lack of testing guidance in the document gives you maximum flexibility on how you can test, making it OK if everyone received the 5% - is this a correct interpretation?

[J Simmons]

I'm not familiar with the Ft. William document.

When you say that each person is in their own allocation group, I assume that is what the plan document provides. That is, that the plan document specifies that the ER can make and declare different contributions for each person.

If that is the case, then with no specification in the plan document about whether the testing will be limited to either on accruals or contributions should, I would think, allow either method to be used.

[Tom Poje]

since each person is in their own rate group, and you fail if you test on an accrual basis, then test on an alloaction basis.

there is no gateway minimum since you are not cross testing.

so lets say you give the rank and file 3% (e.g. covers top-heavy)

then you could give the HCE 3% + 3% on comp > twb

and test imputing disparity.

you should end up with everyone having the same alloaction rate.

[mming]

From a design standpoint, would it be wrong to say that all PS plan docs should be drafted to have a new comparability allocation method and not specify on what basis the testing should be done, that way you could always use an integrated allocation as a worst case scenario?

[J Simmons]

From a design standpoint, would it be wrong to say that all PS plan docs should be drafted to have a new comparability allocation method and not specify on what basis the testing should be done, that way you could always use an integrated allocation as a worst case scenario?

Generally speaking, yes. If you use a prototype plan, you might find integration difficult to accomplish given that the number of different groups you can put NHCEs into is limited. So there might be some further consideration in the planning phase if you are using a prototype plan.