Top heavy contribution for key employee

I think I need a sanity check on this one.  I was referred a plan to review for a possible vcp or self-correction due to missed top heavy contributions going back for several years.  One out of 3 key employees made a small deferral contribution of 1.6%.  There are no employer non-elective or match contributions.  The plan document states that all participants (key and non-key) receive top heavy contributions.  The TPA has calculated a top heavy contribution amount of 1.6% for all participants including the key employee who had a deferral contribution of 1.6%.  

Should this key employee receive the additional 1.6% top heavy allocation, or is this key employee's deferral contribution deemed to satisfy the minimum required allocation of 1.6%?  If the additional allocation is required, does that then mean that there is one key employee with at least a combined 3% allocation and now all other participants must be increased to 3%? 

Also, what is your opinion on whether this can be self-corrected pursuant to Notice 2023-43 or a vcp application should be filed?

Thanks for any and all input.

In this case, the amount of the top heavy contribution for the non-key employees is 1.6% of compensation (since there are no other employer NEC or match contributions, and non-key deferrals don't count toward the TH contribution).  Employee deferrals for key employees do count, the there is no additional contribution for the non-key that made deferrals.  See 1.416-1 Q&A M-20.  The two key employees who did not defer would get a TH contribution.

Thank you.  As I said, I really needed this sanity check.  I know that the key employee deferral counts for purposes of determining the level of any key employee allocation and I thought it also counted for purposes of satisfying the allocation, but this TPA's report made me question my memory.  (Age has a way of doing that to me!)

Update to this message -- I requested a copy of the plan document which is a FIS pre-approved document.  The following language is included:

"Notwithstanding anything in the Plan to the contrary, in determining whether a Non-Key Employee (and Key Employee if elected in the Adoption Agreement) has received the required minimum allocation pursuant to Section 4.3(f) such Non-Key Employee's (and Key Employee's) Elective Deferrals shall not be taken into account."

This language seems to run counter to our discussion above.  The plan would not count the deferral of the key employee towards the satisfaction of the top heavy minimum (even though the plan counts it for the determination of the minimum rate of allocation). 

In that case, going back to my example, if the key employee deferred 1.6% and also received an additional allocation of 1.6%, does that now mean that the top heavy rate of allocation has to increase to 3%?

What a strained result!! 

Unless your plan excludes Keys from the TH minimum, that is the circular result you are going to get. If the highest allocation rate is 1.6% and you then give the key another 1.6% "because everyone is getting it" then that key's highest allocation rate is now 3.2% so everyone now needs to get 3%.

At least that's how I understand how the rules work.

Thanks.  That's what I was concerned about.  I'm going to suggest that the plan sponsor amend the plan to limit TH to non-key employees, but that doesn't help them for the missed contributions since 2020.

This feels like something that 25 years ago should have been addressed at a symposium with IRS people around - Hey, are you sure that's how we're supposed to interpret this?  No Key could defer even a nickel without triggering the full 3% by the time everything cascades.

I respect that it's such a reasonable fact pattern.

1 hour ago, Bri said:

This feels like something that 25 years ago should have been addressed at a symposium with IRS people around - Hey, are you sure that's how we're supposed to interpret this?  No Key could defer even a nickel without triggering the full 3% by the time everything cascades.

I respect that it's such a reasonable fact pattern.

The simple solution to avoid that is to exclude key employees from the T-H minimum in the plan document. 

Otherwise yes if the key employees get the TH minimum along with everyone else then any key deferral or VAT would trigger a 3% for everyone when it is all said and done.

The disconnect in the conversation may by that the TH contribution for each non-key participant is enough so that when the TH is added to the participant's employer contributions and match, the total equals the TH minimum.  Everyone does not get the same TH contribution, and if a participant already has contributions from the employer that exceed the participant's TH minimum amount, that participant does not get an additional TH contribution.

Keep in mind that elective deferrals count towards the TH amount for key employees, so in this case if the TH is 1.6% of compensation, this key employee already has 1.6% counted and does not get any more employer contributions.

That was my original question, whether the key employee's deferral can be used to satisfy the top heavy minimum.  But I subsequently posted the plan document provision that clearly states that the key employee's deferral is not counted towards satisfying the top heavy minimum.

"Notwithstanding anything in the Plan to the contrary, in determining whether a Non-Key Employee (and Key Employee if elected in the Adoption Agreement) has received the required minimum allocation pursuant to Section 4.3(f) such Non-Key Employee's (and Key Employee's) Elective Deferrals shall not be taken into account."

So now the only hanging issue is whether once this top heavy allocation is made to the key employee whether that key employee's contribution percentage is recalculated which would result in additional allocations...on and on until they hit 3%.  Clearly the fix going forward is to amend the plan to only allocate top heavy contributions to non-key employees.  As for the past years, the plan sponsor is contemplating a VCP proposing no allocation to the 3 key employees who are the stockholders and one daughter.

If you are going through VCP, suggest the lower amount as the correction to the IRS and see if the IRS agrees. Calculate it both ways so your client knows the potential liability if the IRS doesn't agree with the proposed correction and requires 3%.

But I think the IRS would likely allow your correction, especially if you can show 3% to everyone would cause a business hardship.

If you look at I.R.C. § 416(c)(2)(B) Special Rule Where Maximum Contribution Less Than 3 Percent, it says:

"(i) In general

The percentage referred to in subparagraph (A) for any year shall not exceed the percentage at which contributions are made (or required to be made) under the plan for the year for the key employee for whom such percentage is the highest for the year."

There is no mention anywhere of recalculating the top heavy percentage to take into account the top heavy contribution.