{"id":1808,"date":"2025-09-28T15:11:41","date_gmt":"2025-09-28T15:11:41","guid":{"rendered":"https:\/\/igorsplayground.com\/appcheckr\/coverage-testing-the-forgotten-nondiscrimination-rule\/"},"modified":"2025-09-28T15:11:41","modified_gmt":"2025-09-28T15:11:41","slug":"coverage-testing-the-forgotten-nondiscrimination-rule","status":"publish","type":"post","link":"https:\/\/igorsplayground.com\/appcheckr\/coverage-testing-the-forgotten-nondiscrimination-rule\/","title":{"rendered":"Coverage Testing \u2013 The Forgotten Nondiscrimination Rule"},"content":{"rendered":"<p><\/p>\n<div id=\"\">\n<p><strong>This blog post addresses retirement plans that are intended to be tax-qualified under Section 401(a) of the Internal Revenue Code (Code).<\/strong><\/p>\n<p>Specifically, this post will provide information related to:<\/p>\n<ul>\n<li>\u201cCoverage Testing\u201d rules under Code Section 410(b)<\/li>\n<li>Related \u201cControlled Group\u201d rules under Code Section 414<\/li>\n<\/ul>\n<p>Employers, especially smaller ones, often design and implement tax-qualified retirement plans without fully understanding how these rules apply. This can lead to confusion regarding whether corrective actions are necessary in a given plan year.<\/p>\n<p>This blog post aims to equip employers with a fundamental understanding of these rules, enabling plan sponsors to mitigate potential compliance issues during the plan&#8217;s implementation.<\/p>\n<p><strong>Background<\/strong><\/p>\n<p>For an employer-sponsored retirement plan to be considered \u201ctax-qualified,\u201d it must not discriminate in favor of \u201chighly compensated employees\u201d (HCEs) in either design or administration.<\/p>\n<p>Discrimination in favor of HCEs is generally assessed in two primary ways:<\/p>\n<ol>\n<li>The group of employees covered by the plan cannot favor HCEs (Coverage Testing).<\/li>\n<li>The benefits provided within the plan cannot favor HCEs (Benefits Testing).<\/li>\n<\/ol>\n<p>Plan administration service providers typically include Benefits Testing, and many do an excellent job of monitoring compliance with these rules. For instance, in a standard 401(k) plan, providers conduct the average deferral percentage (ADP) and average contribution percentage (ACP) tests to ensure contributions do not favor HCEs. They also check compliance with other tax law rules, such as \u201ctop-heavy\u201d rules and limits on maximum deferrals and benefits.<\/p>\n<p>However, Coverage Testing often goes overlooked, particularly by smaller employers, which can lead to significant issues regarding the plan&#8217;s tax qualification. Below is a primer on Coverage Testing rules.<\/p>\n<p><strong>Basics of Coverage Testing<\/strong><\/p>\n<p>The basic Coverage Testing rules for tax-qualified retirement plans under Code Section 401(a) are outlined in Code Section 410(b).<\/p>\n<p>While the Section 410(b) rules can be complex, the core idea is straightforward: the group of employees eligible to participate in the plan cannot be limited solely to company executives; the plan must be accessible to both HCEs and non-highly compensated employees (NHCEs).<\/p>\n<p>Historically, Coverage Testing rules were somewhat ambiguous, but they are now more defined:<\/p>\n<ol>\n<li>HCEs include employees earning above a specific threshold (e.g., over $150,000 in 2023 for determining HCE status for 2024) and 5% owners of the business.<\/li>\n<li>The general Coverage Test is known as the \u201cRatio Percentage Test.\u201d If the plan covers all HCEs, it must also cover at least 70% of NHCEs.<\/li>\n<\/ol>\n<p>It&#8217;s important to note that under the Ratio Percentage Test, a plan does not need to cover all NHCEs; covering 70% suffices, allowing some flexibility for excluding certain NHCEs.<\/p>\n<p>If the plan does not cover all HCEs, the required coverage for NHCEs decreases. For example, if 90% of HCEs are covered, only 63% of NHCEs need to be included (70% of 90%).<\/p>\n<p><strong>Coverage Testing Complications<\/strong><\/p>\n<p>The description of the Ratio Percentage Test is simplified; numerous complications can arise. Detailed rules dictate which employees must be counted in the testing data and which can be excluded. Typically, collectively bargained employees are excluded, and employees under age 21 or with less than one year of service do not need to be counted.<\/p>\n<p>If a plan fails the Ratio Percentage Test, an alternative called the \u201cAverage Benefits Test\u201d exists, though it is more complex. A competent service provider can assist employers in navigating these complications.<\/p>\n<p>Should a plan fail the Coverage Tests, corrective measures must be taken within nine-and-a-half months of the plan year\u2019s end. Failure to correct can lead to penalties, taxes, and even disqualification.<\/p>\n<p><strong>Controlled Group Rules<\/strong><\/p>\n<p>To avoid issues with Coverage Testing, plan sponsors must gather all necessary information, including employee demographics for both their employees and those of any companies in their controlled group or affiliated service group. The rules determining which companies belong to the same controlled group are known as the \u201cControlled Group\u201d rules.<\/p>\n<p>In the 1970s, some employers attempted to bypass Coverage Testing rules by creating multiple companies. Executives could work for one company and participate in its retirement plan, while other employees worked for a different company and were excluded. However, the introduction of Section 414(b) and Section 414(c) in 1974 addressed this issue:<\/p>\n<ul>\n<li>Section 414(b) states that a corporation and its 80% or more owned subsidiaries are treated as one employer.<\/li>\n<li>Section 414(c) allows groups of businesses with common ownership by five or fewer individuals, estates, or trusts to be treated as one employer.<\/li>\n<\/ul>\n<p>For example, a parent holding corporation and its wholly-owned subsidiaries are treated as one employer, meaning retirement benefits must be extended to employees at the subsidiary level as well.<\/p>\n<p>Additionally, if an individual owns 100% of three different businesses, those businesses must be treated as one employer for Coverage Testing purposes.<\/p>\n<p>In 1980, Code Section 414(m) was added to ensure that businesses comprising an \u201caffiliated service group\u201d are also treated as a single employer.<\/p>\n<p>The Controlled Group rules in Code Sections 414(b), (c), and (m) are intricate and have detailed regulations. While an exhaustive explanation is beyond this post&#8217;s scope, it is crucial for employers, especially small ones, to recognize the existence of these rules and their potential impact on a retirement plan&#8217;s tax-qualified status. Ignoring Controlled Group rules can lead to serious tax consequences.<\/p>\n<p>Employers should annually review retirement plan eligibility concerning all members of their controlled group to ensure compliance with Coverage Testing requirements. Consulting legal counsel is advisable. Once the Controlled Group issue is assessed, employers can inform their plan service provider and make necessary adjustments to the plan design.<\/p>\n<\/div>\n","protected":false},"excerpt":{"rendered":"<p>This blog post addresses retirement plans that are intended to be tax-qualified under Section 401(a) of the Internal Revenue Code (Code). Specifically, this post will provide information related to: \u201cCoverage Testing\u201d rules under Code Section 410(b) Related \u201cControlled Group\u201d rules under Code Section 414 Employers, especially smaller ones, often design and implement tax-qualified retirement plans [&hellip;]<\/p>\n","protected":false},"author":1,"featured_media":1749,"comment_status":"","ping_status":"","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[57],"tags":[],"class_list":["post-1808","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-retirement"],"_links":{"self":[{"href":"https:\/\/igorsplayground.com\/appcheckr\/wp-json\/wp\/v2\/posts\/1808","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/igorsplayground.com\/appcheckr\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/igorsplayground.com\/appcheckr\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/igorsplayground.com\/appcheckr\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/igorsplayground.com\/appcheckr\/wp-json\/wp\/v2\/comments?post=1808"}],"version-history":[{"count":0,"href":"https:\/\/igorsplayground.com\/appcheckr\/wp-json\/wp\/v2\/posts\/1808\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/igorsplayground.com\/appcheckr\/wp-json\/wp\/v2\/media\/1749"}],"wp:attachment":[{"href":"https:\/\/igorsplayground.com\/appcheckr\/wp-json\/wp\/v2\/media?parent=1808"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/igorsplayground.com\/appcheckr\/wp-json\/wp\/v2\/categories?post=1808"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/igorsplayground.com\/appcheckr\/wp-json\/wp\/v2\/tags?post=1808"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}