3862 / What are the requirements for cross tested plans?

Editor’s Note: The SECURE Act made changes that make it easier for certain sponsors of closed defined benefit plans to satisfy their nondiscrimination testing requirements.¹ See Q 3860 for details.

Cross testing is the process by which defined contribution plans are tested for prohibited discrimination on the basis of benefits and defined benefit plans are tested on the basis of contributions. The general rules for converting allocations under a defined contribution plan to equal benefits and for converting benefits under a defined benefit plan to equal allocation rates are explained at Treasury Regulation Section 1.401(a)(4)-8.

The most common form of cross testing is comparability testing of profit sharing plans. That is because it is normally more advantageous for older and more highly compensated participants to have contributions to a defined contribution plan tested on the basis of equivalent benefits than it is to have benefits in a defined benefit plan tested on the basis of allocations. The comparability feature uses cross testing to show that contributions under a plan provide nondiscriminatory benefits. Cross testing also can involve aggregating a defined benefit plan with a defined contribution plan, and testing plans together on the basis of the benefits they provide.

Cross-testing requires that a defined contribution plan pass two tests: the gateway test and the non-discrimination test.

The Gateway Test

The gateway test requires that even a cross-tested plan must provide a minimum level of benefits to all participants and is a precondition to moving on to the nondiscrimination test.

The minimum allocation gateway test sets forth two standards for comparability plans. First, if the allocation rate for each Nonhighly Compensated Employee (“NHCE”) in the plan is at least one-third of the allocation rate of the Highly Compensated Employee (“HCE”) with the highest allocation rate under the plan, the gateway will be satisfied. In the alternative, if the allocation rate for each NHCE is at least 5 percent of his or her plan year compensation, within the meaning of IRC Section 415(c)(3) ( Q 3867), the gateway will be satisfied.²

In lieu of the gateway contribution test, a comparability plan may pass through the gateway if it provides for “broadly available allocation rates.”³ To be broadly available, each allocation rate must be available to a group of employees that satisfies IRC Section 410(b), without regard to the average benefit percentage test ( Q 3842).⁴ Final regulations liberalized this determination somewhat by allowing groups receiving two different allocation rates to be aggregated for purposes of determining whether allocation rates are “broadly available.” Thus, for example, a group receiving a 3 percent allocation rate could be aggregated with a group receiving a
10 percent allocation rate if each group passes the coverage test (not counting the average benefit percentage test).⁵ Differences in allocation rates resulting from permitted disparity under the Section 1.401(l) regulations may be disregarded.⁶

A plan that provides for age-based allocation rates also will be excepted from the minimum allocation gateway if it has a gradual age or service schedule. A plan has a gradual age or service schedule if the allocation formula for all employees under the plan provides for a single schedule of allocation rates that (1) defines a series of bands based solely on age, years of service, or points representing the sum of age and years of service that applies to all employees whose age, years of service, or points are within each band, and (2) the allocation rates under the schedule increase smoothly at regular intervals (as defined in the regulations).

Samples of smoothly-increasing allocation schedules, based on the sum of age and service, are included in the final regulations.⁷ Certain plans that fail the safe harbor for target benefit plans⁸ may satisfy the requirements for age-based allocation rates if the plan’s allocation rates are based on a uniform target benefit allocation.⁹

The Nondiscrimination Test

Once the gateway test is passed, the equivalent benefit rate groups are subject to nondiscrimination testing. To pass nondiscrimination testing, every rate group must satisfy the coverage requirements of IRC Section 410(b) ( Q 3860). Both the ratio percentage test and average benefit test are available for this purpose.

A defined benefit plan, benefitting primarily HCEs, may be aggregated with a defined contribution plan benefitting primarily NHCEs (sometimes referred to as a “DB/DC plan”) if a gateway similar to the one described above is met, with the 5 percent safe harbor contribution being increased to 7.5 percent.¹⁰

In the alternative, if the combined plan is primarily defined benefit in character or consists of broadly available separate plans, as defined in regulations, it may be nondiscriminatory without satisfying the gateway.¹¹

The IRS recently advised that a DB/DC plan was not primarily defined benefit in character because the non-highly compensated employees participating in the arrangement received no meaningful benefit from the DB portion of the plan. In this case, a “floor offset arrangement” was created so that DB plan (cash balance plan) benefits were offset by DC plan (profit-sharing plan) benefits only for non-highly compensated, non-owner employees, and the arrangement essentially eliminated the DB plan benefits for these employees. The IRS found that in order to satisfy the minimum aggregate allocation gateway, non-highly compensated employees must receive sufficient allocations under the profit-sharing plan in order to demonstrate that the plans were nondiscriminatory based on equivalent benefits.¹²

The IRS released guidance expressing disapproval with plans that attempt to satisfy the nondiscrimination requirements by limiting participation to highly compensated employees and to rank and file employees with very short periods of service. By way of example, the IRS stated that a plan cross tested under the forgoing provisions violates the nondiscrimination requirements of IRC Section 401(a)(4) ( Q 3848) where:

(1)  the plan excludes most or all permanent NHCEs;

(2)  the plan covers a group of NHCEs who were hired temporarily for short periods of time;

(3)  the plan allocates a higher percentage of compensation to the accounts of the HCEs than to those of the NHCEs covered by the plan; and

(4)  compensation earned by the NHCEs covered by the plan is significantly less than the compensation earned by the NHCEs not covered by the plan.¹³