In explaining the rules of 401(k) Plans to sponsors, I will typically receive the response, “Oh, that doesn’t seem too complicated." It's true that most of the rules regarding 401(k) Plans aren’t too complex but there certainly are a lot of them! This class is no exception. Join us today to learn about the Ownership Attribution Rules as they apply to 401(k) Plans and your compliance testing.
To get started, let's define the Ownership Attribution Rules. The rules of ownership attribution state that specific family members of the owners are also to be treated as owners regarding your plan’s compliance testing. If you remember from an earlier class, owners of the organization are to be treated as Highly Compensated Employees (HCE’s) regardless of their level of compensation. For 2021, an HCE is defined as anyone who makes more than $130,000 per year (please note that the compensation level that dictates who is an HCE may change each year). The exception to this definition would be that the owners of the organization and certain family members of these owners are also considered HCE’s. This can have a significant impact on a plan’s compliance testing results and surprise many plan sponsors if you weren’t aware of this rule.
I often encounter this situation in smaller family-owned businesses where the employer would like to set up a Traditional 401(k) and max-out his own deferrals and so would his family members. This is where we can run into an issue. Let's use the example of an organization with nine eligible employees plus the business owner. In this example, let’s also assume that all of the employees make less than $130,000/year. Of the nine employees, five of them are family members of the owner (his wife, two sons, daughter, and father). If you didn't know about the Ownership Attribution Rule, you would say that the business owner is the only HCE and the nine employees are all NHCE’s. If this were the case, you might have favorable compliance testing results as the owner’s deferrals would be weighed against the average deferrals of the nine employees. However, due to the rules of attribution, this plan would actually have six HCE’s and four NHCE's. If this company sponsored a Traditional 401(k), the plan would be subject to compliance testing and I would have concerns about this plan passing the Average Deferral Percentage test as described in Class 204
So the big questions then become “Who are considered owners?” and “Who are considered family members of the owners?” For the sake of compliance testing, owners are considered to be those who have more than 5% ownership in the company. Although there are some nuances to this rule, family members are generally defined as spouses, parents, children, and grandparents of the above-referenced owners.
Now some of my more astute plan sponsors say, “Hey Mark, I've been doing some research and read about this Top 20% Rule. Would this help our compliance testing results?" Unfortunately, the answer is “no”. The Top 20% Rule states that you may have the ability to move the line on who is defined as an HCE and who is defined as an NHCE. The Top 20% Rule states that you can define only the top 20% of your earner's as HCE’s regardless of what their rate of compensation is. This may help your compliance testing results as several employees who make over $130,000 per year will actually be re-categorized as NHCE’s. However, there is one caveat to this rule. Business owners and family members of owners are always considered HCE’s regardless of their level of compensation. Therefore, the Top 20% Rule would not help us in the example above where 6 of the total 10 eligible employees are considered owners or family members of the owner.
We would typically recommend a Safe Harbor 401(k) Plan for companies structured in this manner so the family members can contribute up to the annual limits without concerns of passing compliance testing. If making a safe harbor contribution is not an option for your organization, would like to make sure that the plan sponsor is aware that the family members and other HCE’s may be limited in their annual deferrals depending on how much the NHCE’s are contributing to the plan. In this situation, we may suggest you consider the Auto-Enrollment & Auto-Escalation feature to encourage participation from the NHCE’s (please see Class 209
for more details).
Join us for next week’s class where we’ll review Controlled Groups & Affiliated Services Groups to see how one 401(k) plan can cover multiple organizations.