Employment Law Cases

“Why can’t I get more money into my 401(k) plan?”

Business owners often wonder what keeps them from full pension participation. There are many answers, but one important thing to understand is annual discrimination testing and how it works.

The law stipulates that all pension plans be operated for the exclusive benefit of the employees. The pension must not act as a mere private savings vehicle for company officers and owners. One way that the law evaluates this requirement is through annual “top heavy” discrimination testing. A plan is top heavy if the account balances for key employees exceeds 60% of the total account balances of all participants.

So, what is a key employee and why does it matter? A key employee is defined by law and must not benefit disproportionately from other employees. The following explanation is a very simple flyover and is not posing as a fully-orbed treatment. But, at least you will know some basics.

Essentially, key employees are determined by three variables. First, are they “includable officers?” Second, are they owners? The category of “owner” is further distinguished as “1% owners” or “5% owners.” Third, is there “constructive ownership” or “attribution?”

OK. Here goes.

First, are you an “includable officer?” This is not determined by mere title. Instead, an includable officer is an officer whose compensation is $160,000 (indexed for 2009) and also meets a concentration standard. In other words, there is a minimum and maximum number of includable officers. The maximum is 50 and the minimum is 3.

The includable count is determined by multiplying the employee population by 10%. So, a company with 600 employees is limited to 50 includable officers and a company of 20 is assigned at least 3 officers.

Whew. How are we doing?

The compensation standard, however, is not the exclusive standard. A company may still have includable officers who do NOT earn the currently indexed $160,000 annually. The other criterion is ownership. Ownership is defined in two ways. There is direct ownership and indirect ownership.

Direct ownership is either a 1% owner or a 5% owner, differently defined. A “1% owner” is any person who owns “more than” 1% of the company AND earns $150,00 annually (not indexed). A “5% owner” is a person who owns “more than” 5% of the company regardless of annual compensation. “More than” is important. Ownership must exceed the 1 or 5%, even if by a fraction.

Stay with me. This stuff matters.

What, then, is indirect ownership? Indirect ownership, or “constructive” ownership, means that when a family member owns the stock, the company shares are automatically “attributed” as ownership to other family members, depending on the relationship. In other words, you can’t sneak extra money into the plan for spouses, children, grandchildren and parents, claiming that they are not company owners. If they are married to you as the owner, for instance, they also own the company for discrimination testing purposes. Your kids own it too. So, be careful.

So, the first step in discrimination testing is determining whether or not the plan is “top heavy” and unfairly favors a particular category of employee. Here’s the thing. You do NOT want to fail this test. Why? Under the worst case scenarios, failure eliminates all tax-deductability of the plan and imposes serious financial sanctions. Whoops. Remedies exist, but navigation takes serious “know-how.”

So, if you are a “key employee” as either an includable officer or owner or family member, then your 401(k) contributions are limited by the actual contributions of those who are not key employees. These annual calculations are complex, but they are designed to ensure that the owners do not create a pension plan that becomes the personal wallet of a favored class of employee.

Although this treatment is far too superficial and requires in-depth analysis, knowing whether or not your plan is “top heavy” keeps you out of legal trouble. Furthermore, this knowledge allows an opportunity for new pension design and allowable remedies that might alleviate some of the contribution issues.

It’s better to know than not know. Really. Much better.