Compensation Ratio Testing
Rev. 09/18/09; E-mail Alert 2009-15

The IRS allows for preapproved qualified plans to use a safe harbor definition of compensation under IRC Sec. 414(s), as it is considered nondiscriminatory. There are three Sec. 414(s) safe harbor definitions of compensation: Sec. 415 compensation (known as the soup-to-nuts definition), Sec. 3401(a) compensation (generally known as payroll compensation), and Sec. 6041/6051 compensation (known as W-2 compensation). These methods are each available in the McKay Hochman Basic Plan Document and may be selected with pre-tax amounts (such as deferrals) added in or excluded.

Under the Sec. 414(s) safe harbor definition, a nonstandard plan may use an alternative definition for the purpose of elective deferrals and allocating employer contributions provided the definition is reasonable, and is not designed to favor highly compensated employees (HCEs). A ratio compensation test is required anytime an exclusion from compensation is selected on a nonstandard prototype plan. (Keep in mind that standardized prototype plans may not make exclusions from compensation.) The ratio test involves showing that the average percentage of total compensation included for highly compensated employees as a group does not exceed the average percentage for nonhighly compensated employees (NHCEs) by more than a de minimis amount.

Some modifications to a plan’s definition of compensation are considered safe harbor exclusions and will not require compensation discrimination testing, among these are: excluding reimbursements or other allowances, cash and non-cash fringe benefits, moving expenses, deferred compensation, and welfare benefits.

Note that an employer may exclude any portion of compensation from only the HCEs and still be within the compensation safe harbor as none of the NHCEs compensation has been excluded.

Electing to modify a plan’s definition of compensation with exclusions such as commissions, bonuses, and overtime is considered reasonable definition but will require a demonstration that the definition of compensation is nondiscriminatory by passing compensation ratio testing (also known as Demo 9). The demonstration should be labeled “Demo 9” and attached to a Schedule Q (Form 5300). Instructions for the Demo 9 can be found at the IRS website (http://www.irs.gov/instructions/i5300q/ch02.html). McKay Hochman also provides a sample Demo 9 Nondiscrimination Compensation Worksheet on the 401(k) Portal. If a Schedule Q is not filed, a plan that has received a determination letter may not rely upon the letter for purposes of the definition of compensation provisions of Sec. 414(s).

The compensation ratio test starts by dividing each participant’s net compensation (gross compensation less the excluded compensation) by their gross compensation to determine the ratio of each participant’s compensation. The participants are divided into HCEs and NHCEs and then the ratios for each group are averaged. Finally, divide the NHCE average by the HCE average. Although regulations do not provide a standard for passing this test (it is based on facts and circumstances), a variance of less than 3% between the HCE and NHCE group is generally acceptable as the de minimis amount. Due to the lack of published guidance, some practitioners will go to 5%. Further, the test is generally considered to be passing if the average of the NHCE group is higher than the HCE group.

Note that it may also be considered reasonable to use the aggregated compensation for the entire group of NHCEs using their net compensations and then dividing by the aggregated gross compensation of all the NHCEs. This would be followed by the same procedure for the HCEs.

The maximum compensation used in the test is based on the IRC Sec. 401(a)(17) dollar limit ($245,000 for 2009). Participants that are not eligible for the particular contribution are not to be included in the compensation ratio test. When a participant is only eligible for part of the plan year the test allows for partial year compensation to be used when calculating the ratio.

The compensation ratio test does not need to be performed if the compensation being excluded only applies to HCEs. There is currently no published guidance related to the proper testing method for a plan that excludes multiple types of compensation; therefore, it may be possible to test on the total amount being excluded rather than each separate compensation exclusion.

Example 1: Plan excludes bonuses

In the example above, the compensation ratio would be satisfied since the average for the NHCEs is greater than the HCE average.

Example 2: Plan excludes overtime         

In this example, the plan’s definition of compensation is likely to be deemed discriminatory since the ratio is less than 100% and the spread is greater than the 3% or 5% range discussed earlier.

The employer has two options if the modified definition of compensation fails compensation ratio testing. The first would be to amend the definition of compensation to remove some of the exclusions and recalculate the test to see if it will pass. This could result in the employer having to make additional contributions to participants for the plan year that the ratio test fails, by having to take into consideration the compensation that was previously excluded. The second option is for the plan to perform the general test under Sec. 401(a)(4). The general test is quite complex, and will involve completing a Demo 6, which is beyond the scope of this article.

Click here for the IRS Demo 9 instructions

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