In applying the average benefit percentage test to demonstrate compliance with the general nondiscrimination test (e.g., for cross-tested plans) must an employer take into consideration benefits disregarded under the early participation rule (Code §§401(k)(3)(F) and 401(m)(5)(C))?

In applying rate group testing under the general nondiscrimination test, many plans use the average benefit test. The second step in the average benefit test (the average benefit percentage test) requires an employer to aggregate all qualified plans maintained by the employer. However, in a previous technical update (7/8/04), we explained that the regulations specifically exclude from the aggregation requirement benefits provided to otherwise excludible employees if the employer elects to apply the otherwise excludible employee rule.

The early participation rule is similar to the otherwise excludible employee rule. Under the early participation rule, the employer may disregard the elective deferrals and matching contributions of nonhighly compensated employee (NHCE) participants who would not have satisfied the eligibility requirements of Code §410(a)(1)(A) (one year of service and attainment of age 21) in applying the ADP and ACP tests. However, (unlike the otherwise excludible employee rule) under the early participation rule, the NHCE participants who are disregarded for purposes of the ACP and ACP tests do not constitute a separate “plan” that is excluded from the average benefit percentage test. Furthermore, neither the Code nor the regulations permit the employer to disregard for purposes of the average benefit percentage test the benefits disregarded under the early participation rule. The statute limits the employer to disregarding the elective deferrals and the matching contributions for purposes of the ADP and ACP test. Accordingly, the employer, in determining the average benefit percentage, must include the deferrals and the matching contributions disregarded under the early participation rule.

Example. Employer X maintains a cross-tested plan that provides for immediate eligibility for the elective deferrals and matching contribution. The plan requires an employee to complete one year of service for the profit sharing contribution. For 2004, X has (1) 40 employees who have satisfied the one year of service requirement and are eligible for elective deferrals, matching and profit sharing contributions, and (2) 5 NHCE employees who have not completed one year of service, and therefore are only eligible for elective deferrals and matching contributions. X elects the early participation rule and disregards the 5 NHCEs who have not completed a year of service in applying the ADP and ACP tests. X uses the average benefit test to demonstrate compliance with the general nondiscrimination test. X must include the 5 NHCE participants and their benefits in calculating the average benefit percentage test for purposes of the nondiscrimination test.

The SunGard Corbel Cross-Tested Plan Workshops are now open for registration. In these, we explain how to design and test cross-tested plans.