Employee Benefit Plans: The 411

Valuable Information on 401ks, Pensions, ESOPs, Form 5500 Preparation + More

IRS Compliance Testing: ADP/ACP Test

In order to ensure that employee benefit plans do not violate certain standards that the DOL/IRS believe are important, plans must be subjected to numerous compliance tests annually.  These tests are designed to ensure that the amount that employees are deferring is within certain maximum limits and that plans are not operating is a manner that discriminates against certain classes of employees.  The most common compliance testing performed by defined benefit plans on an annual basis are the ADP and ACP Tests, the Top-Heavy Test, the 415 limits testing and the multiple use test.

Following we will just address the ADP and ACP test.  The other tests will be covered in subsequent articles.  The ADP (“Actual Deferral Percentage”) and ACP (“Actual Contribution Percentage”) test are annual compliance tests, mandated by the IRS, is to ensure that the 401(k) plan does not discriminate in favor of highly-compensated employees.  Before we discuss the test, we first need to understand who is considered to be highly compensated.

HCE

Highly Compensated Employees (HCEs) (414(q)(1)) are employees who:

• For the preceding year had compensation of more than $110,000 (for 2009 and 2010, subject to COLA in later years) and, if the employer so elects, was in the top 20% of paid employees OR
• Who owns greater than 5% of the business, or a family member of a 5% owner
ADP Test

The ADP test measures the deferral rates of two groups: Highly Compensated Employees (HCEs) and Non-Highly-Compensated Employees (Non-HCEs).  For the ADP test the ratio is salary deferred divided by compensation.  The average percent of salary deferred by and to HCEs cannot exceed certain limits based on the average percent of salary deferred by and to the Non-HCEs in the current or preceding year. Essentially, the Non-HCEs of salary deferred as a group on average determine how much the HCEs of salary deferred can be as a group on average. A plan will pass the test if:

• The average deferrals for the HCEs do not exceed 1.25 times that of the average deferrals for the Non-HCEs, or

• Average deferrals of HCEs do not exceed the lesser of (a) two percentage points above or (b) two times the average deferrals of Non-HCEs

ACP Test

The ACP test is exactly the same as the ADP only the numerator of the ratio are matching contributions and/or employee after-tax contributions instead of salary deferrals.  The same ratio limits between HCE’s and Non-HCE’s are applied to this ratio to determine if the plan has passed the ACP test.

If it is determined that the Plan has failed either the ADP or ACP test, corrective action must be taken with in certain time limits in order for the Plan to maintain it’s qualified status.  The employer may select from various options depending on the time period when the failure was discovered.  These options will be discussed in future articles.

Joe Goodmiller