Jun 27, 2009


In addition to the specific rules relating to age and service eligibility provisions, the second major limitation on the employer's freedom to exclude employees from a qualified plan is a set of two alternative statutory tests (Code Section 410) to be applied to the plan in actual operation to determine if coverage is discriminatory. A qualified plan must satisfy one of two coverage tests:

The ratio percentage test: The plan must cover a percentage of nonhighly compensated employee that is at least 70 percent of the percentage of highly compensated employees covered.

The average benefit test: The plan must benefit a nondiscriminatory classification of employees, and the average benefit, as a percentage of compensation, for all non-highly compensated employees of the employer, must be at least 70 percent of that for highly compensated employees.

In addition, no defined-benefit plan can be qualified unless it covers, on each day of the plan year, the lesser of (1) 50 employees of the employer or (2) 40 percent or more of all employees of the employer [Code Section 401(a)(26)].

Employees Excluded
In applying these tests, certain employees are not taken into account:

  • Employees who have not satisfied the plan's minimum age and service requirements, if any
  • Employees included in a collective bargaining unit, if there is evidence that retirement benefits were the subject of good-faith bargaining under a collective bargaining agreement
  • Employees excluded under a collective bargaining agreement between air pilots and employers under Title II of the Railway Labor Act
  • Employees who are nonresident aliens and who receive no earned income from sources within the United States
The coverage tests apply not only at the plan's inception but on an ongoing basis. Generally, all of the nondiscrimination requirements must be met by a plan on at least one day of each quarter of the plan's taxable year [Code Section 401(a)(6)]. Although the IRS does not perpetually monitor a plan's compliance with the percentage coverage requirements, these requirements give the IRS an ongoing weapon to challenge a plan that may have become discriminatory.

Highly Compensated

For purposes of the coverage tests just described (and for many other employee benefit purposes as well), Code Section 414(q) provides a specific definition of a highly compensated employee. A highly compensated employee is any employee who during the preceding year met either of the following tests:
  • Was at any time an owner of a more than 5 percent interest in the employer or
  • Received compensation from the employer in excess of $80,000 (this nominal $80,000 amount is indexed annually for inflation; the 2000 amount is $85,000).

Features of the Average Benefit Test
In some respects, the average benefit test is the least stringent of the two coverage tests, and many types of plan design will be able to qualify only under this test. For example, a common plan design provides separate plans for salaried and hourly employees. In many cases, neither plan individually—the salaried plan in particular—can meet the ratio percentage test and thus meets the average benefit test.

The average benefit test is two-pronged. First, the plan must cover a nondiscriminatory classification of employees. Because of this aspect of the test, the IRS has a degree of discretion in the determination of whether a classification is nondiscriminatory. However, the IRS has issued detailed regulations as guidance in interpreting whether there is a nondiscriminatory classification.

The second requirement of the average benefit test is that the average benefit, as a percentage of compensation for non-highly compensated employees, must be at least 70 percent of that for highly compensated employees. In making this determination, all employees, whether covered or not under the plan in question, are counted and benefits from all qualified plans are taken into account.

Examples of Plan Coverage Meeting Various Tests
  • Acme Trucking Company has ten employees, three of whom are highly compensated. A qualified plan covers the three highly compensated employees and five of the seven nonhighly compensated employees. This plan meets the ratio percentage test because it covers at least 70 percent of nonhighly compensated employees.

  • Barpt Products, Inc., has 20 employees, 5 of whom are highly compensated. If a qualified plan covers four of the highly compensated employees (80 percent), then the plan meets the ratio percentage test if it covers at least 56 percent of non-highly compensated employees—70 percent of 80 percent—or, in this case, nine nonhighly compensated employees.

  • Flim Company, Inc. has 500 employees, 100 of whom are salaried. Flim has a plan for salaried employees that covers 50 employees. Flim has received a determination from the IRS that the 50 salaried employees covered do not form a discriminatory classification, presumably because some low-paid salaried employees are covered as well as highly paid employees. The Flim Company Plan will qualify, so long as benefits are provided for non-highly compensated employees as a group that are at least 70 percent of those for highly compensated employees as a group. Thus, some kind of retirement plan coverage for the hourly employees would be necessary.

Plans for Separate Lines of Business
If an employer has separate lines of business, the participation tests can be applied separately to employees in each line of business [Code Section 414(r)]. A separate line of business must be operated for bona fide business reasons and must have at least 50 employees. If highly compensated employees constitute more than a specified percentage of the employees in the separate line of business, special guidelines apply or IRS approval may be required to use the separate line of business provision.

The separate line of business provision may allow a larger employer, or a controlled group of employers, to design separate plans—with separate coverage provisions—for its various operations. This increases the flexibility available in plan design to some extent.


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