The MC Academy
The Employee Benefits and Executive Compensation Series
Qualified Plans
Part 2
June 4, 2013
Nondiscrimination
Nondiscrimination in General
 Qualified Retirement Plans may not Impermissibly
Discriminate in Favor of Highly Compensated Employees
(“HCEs”)
3
Who is an HCE?
 An HCE is an employee who either:
 Received more than $115,000 in compensation from the
employer in the prior year; or
 Was a 5% owner in either the current year or the prior
year
 The $115,000 threshold is indexed annually
4
HCE Example
 2012 Compensation = $105,000
 2013 Compensation = $120,000
 Not an HCE for 2013
Note: Unless an individual is a 5% owner, he will never be an
HCE in his first year of hire (because no compensation
from the employer in the prior year)
5
Top-Paid Group Election
 Can limit HCEs under the first prong (i.e., by
compensation instead of ownership) to top 20% of all
employees by compensation
 Cannot expand the group of HCEs (i.e., will not pick up
an individual with less than $115,000 in compensation
in the prior year)
6
How Does a Plan Show That It is
Nondiscriminatory?
 Various Numerical Tests
 Safe Harbors
7
Plan Features Subject to
Nondiscrimination Requirements
 Contributions to a Defined Contribution Plan
 Benefits under a Defined Benefit Plan
 Coverage
 Benefits, Rights and Features
8
Examples of Benefits, Rights and
Features
 Optional Forms of Payment
 Death Benefits
 Investment Options
 Deferral Limits
 Rates of Match
 Vesting Schedules
9
Coverage
Minimum Coverage in General
 The number of an employer’s HCEs who benefit under
a plan cannot be too disproportionate to the employer’s
other employees who benefit under that plan
11
Minimum Coverage in General
 Five basic questions:
 Who is an HCE?
 Who is the employer?
 Which employees are counted?
 What is the plan?
 What is “too disproportionate”?
12
Who is the Employer?
 To prevent employers from avoiding the coverage rules
by moving all non-HCEs to a related company, certain
related companies are treated as a single company for
coverage purposes
13
Which Employees Are Counted?
 Subject to 4 specific exceptions, all employees of the
employer are taken into account for coverage purposes
14
Employees Not Taken Into
Account in the Coverage Test
 Employees who do not satisfy the plan’s age and
service requirements
 Union employees (but subject to separate testing)
 Nonresident aliens with no U.S. source income
15
Employees Not Taken Into
Account in the Coverage Test
 For a plan with a last-day or minimum service accrual
requirement, employees who:
 Are eligible but do not benefit under the plan
 Are not employed on the last day of the plan year and
 Complete less than 500 hours of service during the plan
year
16
What is the Plan?
 Multiple plans may be combined for coverage testing
purposes (“aggregation”)
 A single plan may be treated as separate plans for
coverage testing purposes (“disaggregation”)
17
Plan Aggregation
 Always permissive (never required to aggregate plans
for coverage testing purposes)
 If plans are aggregated for coverage testing purposes,
the plans must also satisfy the nondiscrimination
requirements on a combined basis
18
Plan Disaggregation
 Permissive disaggregation – if two (or more) portions
of a single plan separately satisfy coverage, these
portions may be treated as separate plans for
nondiscrimination testing purposes
 Mandatory disaggregation – certain plan components
and/or groups of employees must be treated as
separate plans for coverage testing purposes
19
What is “Too Disproportionate”?
 A plan may satisfy coverage by satisfying one of two
tests:
 Ratio Percentage Test
 Average Benefits Test
20
Ratio Percentage Test
 The percentage of non-HCEs participating in the plan
must be at least 70% of the percentage of HCEs
participating in the plan
21
Ratio Percentage Test
Example
Benefiting
Not Benefiting
Total
Non-HCEs
56
44
100
HCEs
8
2
10
64
46
110
Total
Non-HCE percentage = 56/100 = 56%
HCE percentage = 8/10 = 80%
Ratio percentage = 56%/80% = 70%
The plan PASSES coverage
22
Average Benefits Test
 More complicated than the Ratio Percentage Test
 Takes into account the level of contributions and/or
benefits under the plan, not just whether an employee
is participating
23
ADP & ACP Testing
What Contributions are Tested?
 Actual Deferral Percentage (ADP) Test
 Before-tax employee contributions
 Roth employee contributions
 Actual Contribution Percentage (ACP) Test
 Employer matching contributions
 After-tax employee contributions
 2 alternative formulas for each test – pass either formula
to pass test
25
What is ADP?
 Each eligible employee’s actual deferral ratio (ADR) is
Before-Tax and Roth Deferrals (no catch-ups)
Compensation
 An eligible participant who made no deferral contributions
has a 0% ADR
 ADP = Average of individual ADRs
26
ADP Tests: 1.25 Times Test
Example
HCE ADP  NHCE ADP  1.25
NHCE ADP = 2.5%
HCE ADP = 5%
5% is not  3.13% (2.5%  1.25)
Therefore, 1.25 Times Test FAILED and go on to 2 Plus / 2 Times Test
27
ADP Tests: 2 Plus / 2 Times Test
HCE ADP  NHCE ADP + 2%
and
HCE ADP  NHCE ADP  2
28
ADP Tests: 2 Plus / 2 Times Test
Example
2 Plus Portion
2 Times Portion
NHCE ADP = 2.5%
NHCE ADP = 2.5%
HCE ADP = 5%
HCE ADP = 5%
5% is not  4.5% (2.5% + 2%)
5% is  5% (2.5%  2)
Therefore, 2 Plus portion FAILED
Therefore, 2 Times portion PASSED
Since 2 Plus portion failed, entire 2 Plus / 2 Times Test FAILED
Since both 1.25 Times Test and 2 Plus / 2 Times Test failed, ADP Test FAILED
29
How Can Failing Test Be Corrected?
 Return Deferrals to HCEs
 Make Additional Contributions for NHCEs
 Rerun test with different parameters
 Disaggregate test group
 Alternative test compensation definition
30
Return Excess Deferrals to HCEs
 10% excise tax applies if excess deferrals are not
returned within 2½ months of end of plan year
 6 months for an Eligible Automatic Contribution Arrangement
 Excess deferrals returned 12 months after plan year
can only be corrected through IRS correction program
 Excess deferrals for catch-up eligible participants can
be reclassified as catch-up contributions and stay in
plan
 Match on HCE excess deferrals that are distributed
must be forfeited
31
Additional Contributions for NHCEs
 Qualified Nonelective Contributions (QNECs)
 Contributed by employer
 Subject to withdrawal and distribution restrictions that
apply to before-tax and Roth contributions
 100% vested
 Must be made within 12 months after plan year end
 Generally, must be made by October 15 of the following
year for participants who terminated in the test year
 Different allocation methods with varying cost, but
subject to restrictions
32
ACP Test
 Calculation is largely identical to ADP Test
 Employer matching contributions and employee after-tax
contributions are used in place of deferrals
 Must pass either 1.25 Times Test or 2 Plus / 2 Times
Test
 Failed test corrected by either
 Making QNECs to NHCEs
 Distributing (if vested) or forfeiting (if not vested) HCEs’
contributions
33
How To Improve Testing Results
 Limit amount that HCEs can contribute
 Encourage participation by NHCEs
 Auto-enrollment of employees
 Auto-increase of employee deferral rates
 Employee Education
 Matching contributions
 Safe Harbor plan design
34
Prior-Year Testing
 Tests can be run on a prior-year basis
 Same tests apply (1.25 Times and 2 Plus / 2 Times)
current year’s HCE contribution rate is
compared to prior-year’s NHCE contribution rate
 Allows employer to anticipate how much HCEs can
contribute
 Limits availability of QNECs as correction method
 Plan document must provide for current or prior-year
test method
 However
35
Safe Harbor 401(k) Plans
What is a Safe Harbor 401(k) Plan?
 A plan that meets certain requirements in order to
avoid ADP test and/or ACP test
 General Requirements:
 Safe Harbor Employer Contribution (matching or non-
elective)
 Vesting Rules
 Withdrawal Restrictions
 Annual Notice
 Significant restrictions on making changes during a plan
year
37
Two Types of Safe Harbor Plans
 Safe Harbor without Qualified Automatic Contribution
Arrangement (“Non-QACA Safe Harbor”)
 Safe Harbor with Qualified Automatic Contribution
Arrangement (“QACA Safe Harbor”)
38
Non-QACA ADP Safe Harbor
Employer Contribution Options
 Non-Elective Contribution – 3% of compensation for all
participants (whether or not participant has deferrals)
 Safe Harbor Match – Basic or Enhanced Match
 Contribution Requirements:
 Immediate, 100% vesting
 No allocation conditions (no last day of plan year or
1,000 hours requirements)
 No in-service withdrawals prior to age 59 ½
 No hardship withdrawals
 Can have eligibility requirements
39
Basic Safe Harbor Match
100% of first 3% of compensation
plus
50% of next 2% of compensation
(4% total match)
40
Enhanced Safe Harbor Match
 At least as generous as Basic Safe Harbor Match (e.g.,
100% of 4%)
 Rate of match may not increase as deferral percentage
increases (50% of first 3% and 100% of next 3% is not
a safe harbor match)
 No higher rate of match for any HCE than any NHCE
41
Other Considerations for ADP
Safe Harbor
 Must match catch-up contributions
 Can make other employer contributions in addition to
safe harbor contribution
 Match may be made on a payroll by payroll or on a
plan year basis
42
ACP Safe Harbor
 Nonelective safe harbor contribution (3% of compensation)
will satisfy ACP test
 Safe harbor match will satisfy ACP test as long as:
 Do not match deferrals in excess of 6% of compensation
 Discretionary matching contributions do not exceed 4%
of compensation
43
Notice Delivery Requirements
 Deliver annual notice between 30 and 90 days before
beginning of every plan year
 Deliver notice to newly eligible employees
 No more than 90 days before employee becomes
eligible, or
 If it is not administratively practicable to do so (e.g.,
plans with immediate eligibility), as soon as possible
after eligibility
44
Notice Content Requirement
 Description of safe harbor contribution
 Description of any other contributions*
 How to make elective deferrals
 Description of plan compensation*
 Withdrawal and vesting provisions
 How to obtain additional information
* Can be incorporated from SPD
45
Conditional Safe Harbor –
“Wait and See” Approach
 Applies only to 3% non-elective (not match)
 Plan document must provide for current year nondiscrimination testing
 Safe harbor notice before plan year says employer
may make safe harbor contribution
 Must adopt safe harbor amendment and provide followup notice no later than 30 days before end of plan year
 If the employer does not adopt the amendment, must
satisfy ADP and ACP tests for year
46
Safe Harbor Plan with QACA
 Contribution Alternatives:
3% non-elective contribution
or
Match of 100% of first 1% of compensation
plus 50% of next 5% of compensation
 3.5% total possible match vs. 4% for Non-QACA Safe
Harbor
 Match must be made on behalf of all employees who make
employee contributions, not just those who are autoenrolled
 Vesting: 2-year cliff vesting (or faster schedule) permitted vs.
immediate, 100% vesting for Non-QACA Safe Harbor
47
QACA Requirements
 Must auto-enroll any participant who has not made an
affirmative election as of QACA effective date
 Participant must be automatically enrolled at 3% (or more)
from initial eligibility through end of following plan year
 Automatic deferrals must automatically increase to 4% in
third year of participation, 5% in fourth year and 6% for
every year thereafter
 Participant can always opt out of initial automatic
enrollment or from automatic increases
 Automatic enrollment percentage cannot exceed 10%
48
Compensation
Importance of Compensation
 Calculation of Benefits
 Satisfying Legal Requirements
 Contribution and Benefit Limits
 Nondiscrimination Testing
 Identifying HCEs
50
Statutory Compensation Definition
 Uses:
 Identify highly compensated employees for testing
 Calculate statutory limits on contributions and benefits
 Can be used for ADP and ACP testing
 Must use an IRS-approved 415 definition
51
IRS-Approved 415 Definitions
 All amounts received for personal services and
includable in income (i.e., gross income), before pretax deductions, but excluding nonqualified deferred
compensation, stock options, restricted stock, group term
life insurance premiums and similar items
 Wages subject to withholding, before pre-tax deductions
 W-2 wages, before pre-tax deductions
52
Benefits Compensation
 Used to calculate amount of contributions and/or benefits
 May also be used for ADP and ACP testing
 Described in plan document
 Must not discriminate in favor of highly compensated
employees
53
Benefits Compensation –
Safe Harbors
 Any IRS-approved 415 definition
 Any IRS-approved 415 definition, but excluding all of
the following:
 Reimbursements or other expense allowances
 Fringe benefits
 Moving expenses
 Deferred compensation
 Welfare benefits
54
Compensation Limit
 Compensation taken into account under the plan in a
year may not exceed IRS dollar limit ($255,000 for 2013)
 Does not apply when determining HCEs
 Does not require participant deferrals to be cut off when
the participant reaches the dollar limit
 Limit may be applied by prorating limit for each pay
period, or based on YTD compensation
55
Post-Termination Pay
 Compensation for contributions made after termination
of employment is restricted in a 401(k) plan
 Post-termination severance may not be deferred
 Post-termination trailing pay may be deferred (e.g., salary,
bonus, commissions, shift premiums and similar pay)
 Post-termination leave payouts may be deferred
 Plan is not required to allow deferral post-termination
 The default restrictions also apply to IRS 415 definitions
56
Compensation and Payroll
 Payroll must coordinate with plan terms to ensure that
correct compensation items are being used for each
purpose
 Area of frequent errors in IRS audits
 Post-termination items may be different than included
before termination
 Must be updated when payroll codes are added
57
Internal Revenue Service
Correction Programs
Employee Plans Compliance
Resolution System (“EPCRS”)
 IRS-approved corrections
 3 Components:
 Self-Correction Program (“SCP”)
 Voluntary Correction Program (“VCP”)
 Audit Closing Agreement Program (“Audit CAP”)
59
General EPCRS Principles
 Encourages voluntary correction of errors
 Corrections should:
 Restore plan to the position it would have been in had
the failure not occurred
 Be adjusted for earnings
 Not favor highly compensated employees
 May be more than one reasonable method of correction
 Must update administrative procedures to avoid
recurrence of the failures
60
Self Correction Program (“SCP”)
 Allows correction without disclosure to IRS or filing
fees
 Can self-correct “insignificant” failures at any time
 Can self-correct “significant” failures through the last
day of the second plan year following the plan year in
which the failure occurred
61
Self Correction Program (“SCP”)
 “Insignificant” Failures:
 Frequency
 Percentage of plan assets involved
 Number of affected participants
 Reason for the failure
 No single factor is determinative
Example: 6 out of 80 participants receive extra profit sharing
contributions during one plan year. The failure is
insignificant
62
Voluntary Correction Program (“VCP”)
 Requires IRS filing and approval
 Filing fees based on number of plan participants
 Fees generally range from $750 to $25,000
 Reduced fees for certain common failures
 VCP filings can cover more than one error
 Can typically add errors while VCP filing is outstanding
 IRS issues compliance statement after agreement is
reached
63
Voluntary Correction Program (“VCP”)
 Why would you use VCP?
 Error not eligible for correction under SCP

Retroactive plan amendments

Significant failure that is beyond 2-year correction period
 No standard correction under EPCRS
 Different method of correction than as described by IRS
 IRS can waive excise/penalty taxes that apply to certain
errors
64
Voluntary Correction Program (“VCP”)
 Streamlined submissions for common errors follow preapproved methods of correction:
 Nonamender Failures

Correction: Execute missed amendments
 Missed Loan Repayments

Correction: Reamortize impacted loans or allow participants to
repay missed payments in one lump sum

Tax relief available
 Failure to pay required minimum distributions

Correction: Distribute missed required minimum distributions

Excise tax relief available
65
Audit CAP
 Errors the IRS identifies
 IRS-required correction plus penalty
 Audit CAP penalties extremely unpredictable
 Failure to reach resolution with the IRS will result in
plan disqualification
66
Common Errors and Corrections
 Improperly Excluded Employees
 Corrective contribution equal to 50% of “missed deferral
opportunity”

Based on average deferral percentage (ADP) for the year

Special rules apply to safe harbor and 403(b) plans
 Corrective contribution equal to 100% of matching
contributions participant would
“missed deferral opportunity”

have
received
on
Can be treated as a matching contribution subject to the
plan’s vesting schedule
67
Common Errors and Corrections
 Overpayments
 Participant must return overpayment
 Under a defined benefit plan, if participant is receiving
periodic payments, overpayment may be recovered from
future payments

Plan sponsor may be required to make the plan whole if
participant does not return overpayment
 Notify participant that overpayment is not eligible for
rollover
68
Common Errors and Corrections
 Plan Eligibility Errors
 If letting participants in early, amend the plan to conform
to operations (does not require VCP submission)
Example: The plan document requires 1 year of service. The
employer has been allowing employees to
participate after 6 months
 If letting participants in late, follow correction for
improperly excluded employees
 Plan Compensation Errors
 If more favorable to participants, amend the plan to
conform to operations (VCP submission may be required)
 If
less favorable to participants, make corrective
contribution based on plan definition of compensation
69
Department of Labor
Correction Programs
Department of Labor Corrections
 Voluntary Fiduciary Correction Program (“VFCP”)
 Delinquent Filer Voluntary Compliance Program (“DFVCP”)
71
Voluntary Fiduciary Correction
Program (“VFCP”)
 Voluntary correction of fiduciary breach under ERISA
 Only covers certain errors and correction methods
 19 categories of transactions
 Requires Department of Labor filing
 No filing fees
 Employer will avoid civil penalties, and, in certain instances,
excise taxes if it follows program requirements
72
Voluntary Fiduciary Correction
Program (“VFCP”)
 Most common error – late participant contributions
 Pay contributions to plan
 Adjust contributions for earnings (or, if greater, profits
earned by employer from use of contributions)

Use DOL online calculator to determine earnings
 Correction will typically eliminate excise taxes
73
Delinquent Filer Voluntary
Compliance Program (“DFVCP”)
 Available to employers who fail to file Form 5500s
 By using correction program, eligible to pay reduced
penalties
 $10 per day for each late filing
 Per Filing Cap: $750 for small plans (under 100
participants); $2,000 for large plans
 Per Plan Cap: $1,500 for small plans; $4,000 for large
plans
74
Plan Audits and Common Errors
IRS Audits
IRS Audits – Common Problems
 Missing Amendments
 Amendments required by law changes must be adopted by
date specified by law or regulation
 Discretionary plan amendments – design changes generally
must be adopted by last day of plan year, but some
amendments (e.g., those that cut back eligibility or benefits)
must be adopted before they become effective
77
IRS Audits – Common Problems
 Eligibility Errors
 Participants not timely enrolled after meeting age/service
requirements
 Rehires
improperly
requirements
required
to
re-complete
service
78
IRS Audits – Common Problems
 Safe Harbor Notice not provided
 Automatic Enrollment
 Notice not provided but deferrals implemented
 Notice provided but deferrals not implemented
 Automatic Deferral Increase
 Notice not provided
 Increase not properly implemented
79
IRS Audits – Common Problems
 Matching Contributions
 Plan formula not followed
 Plan match eligibility rules not followed
80
IRS Audits – Common Problems
 Hardship Distributions
 Hardships not in plan document, but allowed in practice
 Hardship requirements not met
 Suspension errors
 Loans
 Original loan terms do not comply with IRS rules
 Payroll errors in withholding
 Participants who do not repay are not timely defaulted and
issued a Form 1099-R
81
IRS Audits – Common Problems
 Failure to follow written plan document
 “Compensation” definition not followed in determining
participant deferrals and/or employer contributions
 Plan document does not cover all entities whose
employees participate

Participation by subsidiaries may require written action of
both plan sponsor and subsidiary
 Defined benefit plan formula not followed
82
IRS Audits – Common Problems
 Vesting
 Vesting service not properly calculated
 Partial termination (20% active participant reduction) not
identified
 Minimum Required Distributions (Age 70½) are not
timely made
83
IRS Audits – Common Problems
 Forfeitures Not Timely Used
 Forfeitures must be used to pay plan expenses, reduce
employer contributions or (rarely) allocated to participants
 Plan document may require that forfeitures be used in
the year they arise or the next following year

Some documents are more flexible than others
 Failure to use forfeitures may be both a qualification
defect and excise tax on nondeductible contributions
84
IRS Audits – Common Problems
 ADP/ACP Testing Issues
 Incorrect
compensation used to identify
compensated employees” or in performing test
“highly
 Other data errors affecting tests
 Failure to perform test for safe-harbor plan with delayed
eligibility for matching contributions
85
IRS Audits –
Corrections and Penalties
 “Insignificant” errors identified in IRS audit may be
corrected without penalty
 Significant errors may be corrected through a closing
agreement (“Audit CAP”) and payment of a
negotiated sanction
86
IRS Audits – Audit CAP Sanction
 Amount of sanction will depend on size of plan and
nature of error(s)
 Sponsor has no real leverage in negotiating the
sanction
 Alternative is likely plan disqualification with far
greater consequences
87
DOL Audits
DOL Audits – Common Problems
 Late Deposit of Participant Contributions
 Deadline – earliest date on which contributions can be
reasonably segregated from sponsor’s general assets
 15th business day of the following month will never be
considered timely
 7 business day safe harbor for plans with under 100
participants
 DOL will look to sponsor’s shortest period as setting
standard for reasonableness
89
DOL Audits – Common Problems
 Improper Plan Expenses
 Employer (“settlor”) expenses cannot be paid from the
Trust
Examples: Cost of optional amendment; accounting expenses
relating to preparation of the employer’s financial
statements
 Expenses paid from wrong plan (e.g., 401(k) plan
expenses paid from defined benefit plan)
 Nonqualified plan expenses paid for by related qualified
plan
 For multi-purpose communications, may need to allocate
between different plans and plan-employer
90
DOL Audits – Common Problems
 Fiduciary Oversight Issues
 Fiduciaries are unaware of their fiduciary roles
 Lack of fiduciary processes (e.g., including 401(k)
investment fund review)
 Failure to monitor vendor expenses (e.g., annuity
contract costs)
91
Reliance on Form 5500 Auditor
 Financial accounting audits are limited in scope and
consistency
 Do not rely on Form 5500 auditors to identify errors
 Late contributions and other errors sometimes, but not
always, identified in Form 5500 audit
92