Questions and Answers

What is coverage testing?

The employees covered by benefits under a tax-qualified plan cannot be significantly skewed in favor of highly compensated employees. Coverage testing [I.R.C. § 410(b)] is intended to ensure that plan coverage does not significantly discriminate in favor of HCEs. In essence, coverage testing compares the number of NHCEs benefiting under a plan relative to the total number of NHCEs of an employer (controlled or affiliated service group) against the number of HCEs benefiting under the plan relative to the total umber of HCEs of the employer. Note, however, that certain employees must be included in coverage and nondiscrimination testing, while others are excludable.

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When is an employee considered to be benefiting under a plan?

An employee is considered to benefit under a cash balance plan for a plan year if and only if the employee has an increase in a benefit accrued, or treated as an accrued benefit, that is subject to the anti-cutback rules of IRC Section 411(d)(6), which is the rule for any defined benefit plan. [Treas. Reg. § 1.410(b)-3(a)(1)] An employee is considered to benefit under a defined contribution plan for a plan year if and only if the employee receives an allocation taken into account to determine the employee's allocation rate. [Treas. Reg. § 1.410(b)-3(a)(1)] However, in the case of a 401(k) plan (and any associated matching 401(m) plan), an employee is considered to benefit if and only if the employee is an eligible employee, even if the employee makes no elective deferrals to the 401(k) plan (makes no employee after-tax contributions and receives no employer matching contributions under the 401(m) plan). [Treas. Reg. § 1.410(b)-3(a)(2)(i)] In determining whether an employee is an eligible employee, a suspension in elective deferrals or after-tax employee contributions due to a distribution, loan, or election not to contribute is disregarded. [See definition of eligible employee under Treas. Reg. §§ 1.401(k)-6, 1.401(m)-5]

An employee who, prior to first becoming eligible to make a cash or deferred election (or to make after-tax employee contributions or receive employer matching contributions) under any plan of the employer, makes a one-time irrevocable election not to make elective deferrals (and not to make after-tax employee contributions or receive employer matching contributions) is not treated as an eligible employee. However, in no event will such an election made after December 23, 1994 excuse an employee from being an eligible employee (for purposes of the 401(k) or 401(m) plan) if the employee was previously eligible under any plan of the employer, whether or not the plan has terminated. [See definition of eligible employee under Treas. Reg. §§ 1.401(k)-6, 1.401(m)-5] Note that if the employee agrees to lower compensation in exchange for greater tax-qualified benefits (whether defined contribution or defined benefit) as part of this one-time election, the election is not treated as a cash or deferred election (under IRC Section 401(k) or otherwise) and neither the reduced compensation nor the increased benefit is included in the employee's compensation from the employer. [Treas. Reg. § 1.401(k)-3(a)(3)(v)] Of course, the increased benefit is subject to coverage testing under IRC Section 410(b) and nondiscrimination testing under IRC Section 401(a)(4).

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What is ratio percentage test?

One of the ways a plan can satisfy the coverage test is through the ratio percentage test. [Treas. Reg. § 1.410(b)-2(b)(1)] The ratio percentage test is strictly a head-count test. If the percentage of all nonexcludable NHCEs of an employer who benefit under a plan for a plan year is at least 70 percent of the percentage of all nonexcludable HCEs of the employer who benefit under the plan for the plan year, the plan satisfies the minimum coverage requirement. Again, employer refers to the entire controlled group and/or affiliated service group, if applicable. This ratio of the percentage of NHCEs benefiting to the percentage of HCEs benefiting is referred as the ratio percentage. When this ratio percentage is at least 70 percent, the plan passes coverage testing. [Treas. Reg. § 1.410(b)-1.410(b)-2(b)(2)] If no HCEs benefit under the plan, or if the employer employs no NHCEs during the plan year, the plan is deemed to pass the ratio percentage test. [Treas. Reg. §§ 1.410(b)-2(b)(5), (6)] A plan that benefits only collectively bargained employees is also deemed to pass the ratio percentage test. [Treas. Reg. § 1.410(b)-2(b)(7)]

Written as a formula, the ratio percentage test requires the following:

Where:

• all HCEs means the number of all nonexcludable HCEs of the employer;
• all NHCEs means the number of all nonexcludable NHCEs of the employer;
• HCEs benefiting means the number of nonexcludable HCEs of the employer who benefit under the plan; and
• NHCEs benefiting means the number of nonexcludable NHCEs of the employer who benefit under the plan.

Example. The controlled group of Wheaton Cairn Corporation has three tax-qualified plans that together cover 100 percent of the controlled group's employees. The percentage of HCEs and NHCEs covered by each plan and the resulting ratio percentage test results are shown in the table below.

Plan	NHCEs covered	HCEs covered	Ratio percentage	Ratio Percentage Test result
A	30%	60%	50%	Fail
B	40%	20%	200%	Pass
C	30%	20%	150%	Pass

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What is the average benefit test?

A plan that does not pass the ratio percentage test can satisfy the coverage test through the average benefit test. [Treas. Reg. § 1.410(b)-2(b)(1)] The average benefit test consists of two parts, a nondiscriminatory classification test and an average benefit percentage test. [Treas. Reg. § 1.410(b)-2(b)(3)] The nondiscriminatory classification test looks at the ratio percentage used for a (failing) ratio percentage test, and the average benefit percentage test compares the average benefit of NHCEs to the average benefit of HCEs.