TOP-HEAVY PLANS

The top-heavy rules are another addition to the arsenal of weapons Congress has provided against the use of qualified plans by small businesses primarily as tax shelters for owners and highly compensated employees. The rules (Code Section 416) provide additional requirements that must be met by all qualified plans that meet the definition of top-heavy. To summarize, the top-heavy requirements do the following:

• Put a ceiling on the amount of a participant's compensation that may be taken into account in a plan contribution or benefit formula

• Provide faster vesting of benefits for plan participants who are not key employees

• Provide minimum unintegrated benefit or contribution levels for plan participants who are not key employees

• Reduce the aggregate Section 415 limit on contributions and benefits for key employees in certain situations

• Restrict distributions to key employees

The top-heavy restrictions must be written into the plan document itself, even a plan for a large employer that is unlikely ever to be top-heavy. The plan document must provide that if the plan meets the definition of top-heavy on a given determination date, all of the top-heavy restrictions automatically become part of the plan. So long as the plan is not top-heavy, the top-heavy restrictions need not necessarily apply, although, of course, the planner is free to add these restrictions to the plan even if it is not top-heavy.

Definition of Top-Heavy

A defined-benefit plan is a top-heavy plan for a given plan year if (as of the determination date—see below) the present value of the accumulated accrued benefits for participants who are key employees is more than 60 percent of the present value of all accumulated accrued benefits in the plan. A defined-contribution plan is considered top-heavy if, as of the determination date, the sum of the account balances of participants who are key employees exceeds 60 percent of the aggregate value of the accounts of all employees. Benefits and account balances attributable to both employer and employee contributions are to be taken into account, except for accumulated voluntary deductible employee contributions or rollovers from other plans. The present value of a participant's accrued benefit or the value of the participant's account balance is to be increased by any aggregate distributions made with respect to the participant during the five-year period ending on the determination date. Plans of related groups can be lumped together, and if the contributions or benefits of the overall group are top-heavy, each plan in the group will be considered top-heavy.

Determination Date

The determination date for any given plan year is the last day of the preceding plan year. For the first year of the new plan, the determination date is the last day of the first plan year. The IRS also has the authority to apply the top-heavy provisions on the basis of years other than plan years.

Definition of Key Employee

A key employee is any participant in the plan, including a self-employed person, who at any time in the four preceding years was an officer earning more than 50 percent of the Section 415 defined-benefit dollar limit, an employee owning one of the ten largest interests in the employer (under attribution-of-ownership rules), a more-than-5-percent owner, or a more-than-1-percent owner earning more than $150,000. Because the term officer is not clearly defined, there is a limit on the number of employees that can be treated as officers. No more than 50 employees can be treated as officers in general, while for small employers the limit on the number of officers is the greater of three individuals or 10 percent of the employees (presumably the highest paid). For example, suppose a small company has 25 employees. In determining who are key employees, the IRS cannot designate more than three of these employees (the greater of three individuals or 10 percent of the employees) as officers.

Note that key employee is defined differently from highly compensated employee used in all other nondiscrimination provisions of the law.

In determining ownership in the business for purposes of identifying key employees, the top-heavy provisions have rules for attributing stock ownership from related persons, and there are special rules for aggregating commonly controlled groups of employers and affiliated service groups.

An illustration of what constitutes a top-heavy plan might be helpful in defining the concept of top-heavy.

Suppose that a corporation with ten employees has a defined-contribution money-purchase pension plan. The employees include Wolfe (president and sole shareholder), Hare (vice-president), and Flynn (foreman). All of the other employees are clerical or production workers paid by the hour. The IRS would most likely identify the three named employees as the plan's key employees. As of the end of the 2000 plan year, aggregate account balances of all participants in the plan total $200,000. The account balances for Wolfe, Hare, and Flynn total $100,000. On these facts, the plan is not top-heavy for the plan year 2001 because the aggregate account balances for the three key employees total less than 60 percent of the total account balances as of the determination date, the end of 2000. However, suppose that in 1999 Wolfe received a distribution of $100,000 from the plan. In this case, the account balances as of the end of 2000 would have to be increased by the amount of this distribution, so they would total $300,000. The account balances for the key employees would then be $200,000, because the $100,000 distribution to Wolfe would have to be included for this purpose. Now the plan would be deemed to be top-heavy for the plan year 2001 because the account balances for key employees would be more than 60 percent of the total.

Although the example above involved a plan of a small employer that fell on the line between being top-heavy and avoiding that status, planners find that virtually all plans of employers with fewer than ten employees will be top-heavy at all times. Key employees in such businesses usually have not only higher salaries but also much longer service than regular employees, so their account balances or accrued benefits are much higher as a percentage of the total. Therefore, the top-heavy rules become an additional set of qualification requirements that must be met by all small plans.

Minimum Benefit Requirements

A qualified plan must provide minimum benefits or contributions for top-heavy years. For defined-benefit plans, the benefit for each nonkey employee must be at least a minimum percentage of average compensation. The applicable minimum percentage of compensation for a given employee is two multiplied by the number of the employee's years of service, with a maximum percentage of 20 percent (i.e., ten years of service or more). The average compensation used for this test will generally be based on the highest five years of compensation.

For a defined-contribution plan, employer contributions during a year of topheaviness must be not less than 3 percent of each nonkey employee's compensation.

A top-heavy plan can consider only nonintegrated benefits in meeting the vesting and minimum benefit requirements. That is, these requirements must be met based on benefits from the plan itself. Benefits received by the participant from Social Security cannot be taken into account.