|Under the proposed new comparability regulations, effective for the 2002 plan year, a new comparability plan must use the top heavy definition of compensation (Code §415(c)(3)) in determining whether a plan satisfies the 5% minimum allocation gateway described in the regulations. This means such plans may not use any Code §414(s) compensation definition (414(s) compensation) as is normally required in testing under the Code §401(a)(4) nondiscrimination rules. Although the two definitions are similar, the requirement to use Code §415(c)(3) compensation will have the effect of increasing the required employer contribution for eligible nonhighly compensated employees under a new comparability plan using the 5% gateway.
Code §415(c)(3) Compensation. Code §415(c)(3) compensation (415 compensation) is the definition of compensation for purposes of the Code §415 limit, determination of highly compensated employees, and top-heavy requirements. Under 415 compensation, an Employer may designate any one of the three alternative compensation definitions: (1) traditional 415 compensation (current income definition), (2) W-2 compensation, or (3) federal income tax withholding wages. With respect to each alternative 415 definition of compensation, an employer must include ("gross up" for) elective deferrals (e.g., 401(k) and cafeteria plan) in compensation. Code §415(c)(3)(D) and Treas. Reg. §1.415-2(d)(10) and (11).
Compensation for nondiscrimination purposes. The nondiscrimination requirements utilize 414(s) compensation. Although Code §414(s) uses 415 compensation as its starting point, it permits certain modifications to that definition which provide flexibility and which improve plan economics. Practitioners often refer to the three alternative 415 definitions of compensation as "safe harbors." The regulations permit an employer to make the following modifications to the 415 compensation definitions and remain within the safe harbor compensation definition for nondiscrimination testing purposes: (1) disregard elective deferrals (i.e., use compensation net of elective deferrals); (2) exclude fringe benefits; and (3) exclude an item of compensation applicable only to highly compensated employees. Treas. Reg. §1.414(s)-1(c)(3)-(5). A more significant modification an Employer may make without losing safe harbor status is that the plan may limit compensation to that which is earned while a plan participant. For example, if an employee enters a calendar year plan on July 1, the Employer may limit compensation to that amount earned from July 1 through the end of the plan year for nondiscrimination testing purposes. Finally, under Code §414(s), an Employer may exclude other items of compensation (e.g., bonuses and overtime) as long as the modified definition can satisfy the compensation ratio test. Treas. Reg. §1.414(s)-1(d).
Under the Code §415(c)(3) definition of compensation, an employer may not: (1) exclude elective deferrals or fringe benefits; (2) limit compensation to that paid while a participant; or (3) make additional modifications even if the employer demonstrates the modifications are nondiscriminatory under the compensation ratio test.
The requirement to use Code §415(c)(3) compensation under a 5% gateway new comparability plan will likely further increase the required allocations for eligible nonhighly compensated employees under the plan over what the Employer might expect. For example, suppose a new comparability plan provides a 4% allocation to the NHCEs based on net compensation (resulting in a higher rate of allocation) and limits the allocation to compensation paid while a participant. If the Employer uses the 5% minimum allocation gateway, then the Employer not only must increase its allocation percentage from 4% to 5%, but the requirement to use the more inclusive 415 compensation definition also will result in greater nonhighly compensated employee allocations.
Alternatives. The requirement to use 415 compensation applies only for purposes of satisfying the 5% minimum allocation gateway. Accordingly, a plan is not required to use 415 compensation for the alternative gateway (i.e., the lowest allocation gateway for an eligible nonhighly compensated employee is not less than one-third of the highest allocation provided for any highly compensated employee). Furthermore, the proposed regulations do not require an employer to use 415 compensation for purposes of complying with the "broadly available" requirement.
Once an employer satisfies one of the gateways or satisfies the broadly available requirement, the employer will use 414(s) compensation in determining whether the plan is nondiscriminatory under the cross-testing rules. Therefore, for nondiscrimination testing, the employer may use 415 compensation or an alternative 414(s) definition.
For example, assume employee A, earning $30,000 annually, enters a calendar year profit sharing plan on July 1. Assume further that the employer intends to use cross-testing to demonstrate that the plan is nondiscriminatory. If the Employer uses the 5% minimum allocation gateway, the Employer would need to provide a $1,500 contribution (5% x $30,000) rather than $750 contribution (5% x $15,000). Once the plan satisfies the gateway, the employer may use 414(s) compensation to determine if the plan is nondiscriminatory under the cross-testing rules.
By using 415 compensation for the 5% minimum allocation gateway, the proposed regulations, in effect, would require the employer to make a "super" top-heavy minimum if it wants to use this gateway.