Generally, the average benefit percentage test (the second step in the average benefit test) requires an employer to aggregate all qualified plans maintained by the employer. However, if the employer elects to apply the otherwise excludible employee rule, the employer may not aggregate the benefits under the portion of the plan benefiting otherwise excludible employees. Treas. Reg. §1.410(b)-7(e). Of course, if the employer elects not to apply the otherwise excludible employee rule, the employer would include the portion of the plan benefiting the otherwise excludible employees.

As 401(k) plans have become more popular, employees have pressured employers to liberalize the eligibility requirements. The disadvantage of liberalizing the eligibility requirements is that it permits participation by part-time and short-term employees who generally do not defer. So as not to penalize an employer for liberalizing its eligibility requirements, Congress provided the otherwise excludible employee rule. The otherwise excludible employee rule permits an employer to divide the plan into two “deemed" plans and separately to test the plans for coverage and nondiscrimination: one plan for those employees who have satisfied the statutory eligibility requirements (one year of service and attainment of age 21) and the other plan for the employees who could not have satisfied the statutory eligibility requirements if the plan had imposed such requirements. Furthermore, in applying the coverage test to each of the “deemed" plans, the employer disregards the employees of the other plan. Since the rule is a testing rule, the employer need not include any special language to apply the rule. The plan for the otherwise excludible employees generally consists only of nonhighly compensated employees, and therefore automatically satisfies the nondiscrimination requirements. If the otherwise excludible employee plan includes a highly compensated employee, the employer separately would test the plan for nondiscrimination.

Although most plans utilize the ratio percentage test to satisfy the coverage requirements, some plans use the average benefit test. Furthermore, cross-tested plans often use the average benefit test to demonstrate compliance with the general nondiscrimination test. In applying the average benefit percentage test (the second step in the average benefit test), an employer generally must take into consideration all plans maintained by the employer. However, as discussed in the beginning of this article, the employer does not take into consideration benefits provided under the plan for otherwise excludible employees.

Example. Employer X maintains a 401(k) cross-tested plan. The plan provides for immediate eligibility for the elective deferral portion of the plan and one year of service for the profit sharing contribution portion of the plan. For 2011, X has: (1) 40 employees who satisfied the statutory eligibility requirements and who are eligible for both the elective deferrals and the profit sharing contributions; and (2) 10 employees who have not satisfied the eligibility requirements, and therefore are only eligible to make elective deferrals. For coverage and nondiscrimination testing, X elects to apply the otherwise excludible employee rule and treats the 10 employees who have not satisfied the statutory requirements as comprising a separate plan. X uses the average benefit test to demonstrate the profit sharing contributions comply with the general nondiscrimination test. X does not include the 10 otherwise excludible employees in rate group testing or in applying the average benefit percentage test.

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Upcoming Web Seminars:
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