A Cross-testing Primer
Rev. 08/05/10; E-mail Alert 2010-12

A profit sharing plan may not treat highly compensated employees (HCEs) more favorably than nonhighly compensated employees (NHCEs). Thus, the plan must have a definitely determinable allocation formula that passes nondiscrimination testing.

Allocation Options
There are two allocation methods that are routinely used to automatically satisfy nondiscrimination and do not require testing. The first is a pro rata allocation based on compensation. This method provides every eligible employee with a pro rata portion of the allocation based on each person’s compensation as a ratio of total compensation. To determine pro rata allocations, each employee’s compensation is divided by the total of all eligible employees’ compensation and the resulting number is then multiplied by the employer’s total allocation. Compensation is limited (by Internal Revenue Code Section 401(a)(17)) to $245,000 for 2010. When an eligible employee’s compensation exceeds the limit, the compensation used in the allocation formula would be $245,000 (for 2010).

The other allocation method is known as permitted disparity (or Social Security integration). This is also a pro rata allocation method based on compensation. However, with this method, eligible employees who earn more than the Social Security wage base ($106,800 in 2010) receive an additional allocation based on the amount of earnings above the wage base (up to the $245,000 compensation limit) because the employer is not contributing to Social Security on that amount. Theoretically, under this approach the employer contributions to both the public and private retirement systems on behalf of their employees are the same percentage of pre-retirement compensation.

Cross-testing Allocation Method
An alternative allocation method used since the early 1990s is a “new comparability approach” also known as cross-tested.  A cross-tested plan allows an employer to create separate groups and provide each group with a different allocation. HCEs may receive a higher allocation rate than NHCEs, provided  the nondiscrimination tests are passed. The cross-tested approach works by converting the defined contribution allocation into a defined benefit accrual rate and performing the nondiscrimination test on a benefits basis. Certain demographics are more favorable. For cross-testing to pass, the NHCEs should generally be younger and further away from retirement than the HCEs, giving the NHCEs a longer time horizon for their benefits to accrue than the older HCEs have.  This does not have to be true for every employee for this design to work.

The cross-test involves passing two tests. The first is the gateway test, which ensures a minimal allocation for all NHCEs. The second is the nondiscrimination test. If the gateway test is not satisfied, the cross-test fails and there is no need to perform the other test.

Gateway test. There are two common ways of satisfying the gateway test. One method is to provide a 5% gateway allocation to all NHCEs. The other method is the three times allocation method, which restricts the highest allocation any HCE may receive to no more than three times the lowest allocation (other than zero) provided to any NHCE. For example, if the lowest allocation rate to any NHCE is 2%, then the highest allocation rate to any HCE is 6%. There is also the broadly available allocation method.

Nondiscrimination test. There are a number of complex steps in the nondiscrimination testing process of converting the allocations to an equivalent benefit accrual rate (or EBAR) and determining that the benefit accrual for each employee passes nondiscrimination. Furthermore, just because this annual test passes in the current year, there is no guarantee that it will pass in future years as employee demographics change. One of the most common causes of test failure in later years is the hiring of an HCE’s child. Family attribution of ownership from the parent will make the child an HCE. As a general rule, adding a young HCE to a cross-test calculation will cause it to fail.  Employers thinking about this design may want to exclude their children from participating in the plan.

Continued Flexibility
Cross-tested allocations are usually discretionary contributions determined annually by the employer. The plan’s rate groups and allocations may be changed from year to year, providing employers with flexibility as employee demographics change. Keep in mind that a defined contribution plan must have a definitely determinable allocation formula, which must be spelled out explicitly in the plan document and/or board resolution.

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For more information on Cross-tested Plans, click here for information about our Overview of Cross-testing eSeminar.