Avoiding Corrective Distributions And Using Retirement Planning As A Compensation Tool For Business Owners

Introduction:

Nick Pirani was an Italian American whose family had lived in Mississippi for 3 generations.

The 57-year-old business owner was married with two grown kids, and his wife Sophie was a partner in his company.

Nick owned and operated a plumbing services company that employed 45 employees, including plumbers, customer service and other staff.

From the point of view of Retirement Plan design, Nick and Sophie were considered Highly Compensated Employees or HCEs, while the rest of the company were NHCEs, or Non-Highly Compensated Employees.

Nick’s business had a basic 401(k) retirement plan benefit with a company match.  The mostly “blue collar” NHCEs were not aggressively encouraged to participate in the plan, and most of the deferrals came from the HCEs, Nick and Sophie.  As a result, the plan was failing a “discrimination test” called the ADP test.

Nick didn’t really understand the ins and outs of what “failing the ADP” meant; all he knew was that he and Sophie were on the hook for $3700 apiece from the deferrals they had already made, that they would now have to pay back out, and pay taxes on.

It was a pain, but what could you do?  Somewhat to the exasperation of his pension plan consultant, to Nick’s way of thinking the company retirement plan was mostly a business expense, and being taxed on an extra $7400 wasn’t something he planned to lose any sleep over.

In his mind, Nick had a bigger problem.

It was a wet day in February, and Nick was standing at his office window, watching the rain fall outside.  His most senior plumber, Joe McKenzie, a long-term employee and a personal friend, had just been in to see him.

Joe had told Nick that the employees were considering becoming part of the union, because, in Joe’s words, “we want to have the same benefits as the union does.”

Nick didn’t want his family run business to become a union shop.  He’d told Joe “If you guys agree not to join the union, I’ll make sure we provide the same level of benefit as they do”.

After some discussion, Nick committed to Joe that he would “pay each employee an extra $1/hour towards their retirement.”  He and Joe had shaken hands on that deal, and Joe had left with a smile on his rugged face.  Joe knew that Nick’s handshake was as good as any written contract.

Nick knew that too.  His personal honor was something he had always prided himself on, a vein of his Italian cultural heritage that was still alive in the American Deep South.  Trouble was: he had no idea how he was going to carry out his promise.  Heck, he didn’t even know if he could legally carry out his promise.

Brightening somewhat, Nick turned away from the dreary view outside his window, picked up the phone and called us for help.

The Plan’s Problems:

1) Failing the ADP Test

Unless a retirement plan is subject to safe harbor protection, it must be tested annually to evaluate whether the contributions to the plan discriminate in favor of Highly Compensated Employees (HCEs).  In the case of Nick’s plumbing business, the HCEs were Nick and Sophie.

The tests that are performed to do this evaluation are therefore called “Discrimination Tests.”  The discrimination test that is typically performed first on a plan is the ADP, or Actual Deferral Percentage test.  This test measures whether the amount of contributions made to the plan by, and on behalf of, non-highly compensated employees (NHCEs, the plumbers and admin staff) are of a sufficient level in relation to contributions made by or on behalf of HCEs (Nick and Sophie).

The aggregate NHCE ADP% must be within 2% of the aggregate HCE ADP%.

The company paid Nick and Sophie a salary of approximately $158,000/yr each.  Both of them contributed $18,500 to the company retirement plan, which works out to an aggregate ADP percentage for the company’s HCEs of 11.71% (18,500/158,000 x 100 = 11.71%).

In order to pass the ADP test therefore, the NHCEs would have to contribute, on aggregate, at least 9.71% of their salary (11.71% – 2% = 9.71%).  For various reasons, the aggregate ADP% of the NHCEs was less than 9.71%, and the company’s plan was consequently failing its ADP test.

When a plan fails its ADP test, corrective action is needed in order to keep it qualified.  Plan sponsors can choose to correct testing failure by:

  • making additional qualified non-elective contributions (QNECs) on behalf of the NHCEs (if permitted under the plan)
  • distributing excess 401(k) contributions to HCEs (this is what Nick and Sophie did; this money then becomes taxable again)
  • forfeiting excess vested matching contributions made to HCEs back to the company (or forfeiting such contributions if not vested)

If a plan continuously fails the ADP test, the plan sponsor is typically encouraged to adopt a safe harbor plan, which relieves the testing obligation for the plan when certain stated contribution requirements are met.

2) Matching the Union Benefit

Unionization would change the corporate culture of Nick’s business forever.  The family-style atmosphere would be lost, and the additional costs of running a union shop would impact the company’s competitiveness in the markets it served.

Nick had offered in good faith a $1/hour per employee company contribution to retirement as incentive not to join the union.  However he had no idea how to implement this intention, or even whether he was legally able to.  He just knew he needed help to make it work out.

The Solution: Redesigning The Plan

We understood that Nick Pirani did not want to see his company become unionized.  He also knew that he couldn’t in good faith allow the company to continue to fail its annual ADP discrimination test.

The safe harbor plan was certainly an alternative, but we wanted to do something more comprehensive for our client.

We viewed the potential union crisis as an opportunity to restructure the company’s retirement plan so that not only would the employees receive the benefits they desired, but that the business owners would come to view their company retirement plan as a compensation tool, and not simply a business expense.

Consequently, we performed a redesign of the plan to add a profit sharing component that both satisfied the employee demands and significantly increased the tax deferrals available to Nick and Sophie.

We took advantage of the tax laws specified under IRS Code 401(a)(4), and the so called Gateway Rules, which allows for a profit sharing contribution for each owner in addition to their 401(k) deferral. Under these rules, the 2018 maximum contribution limit to a Defined Contribution Plan is $55,000 per owner.

The maximum contribution of $55,000 is split between what the owner can contribute to the profit sharing plan, and what then is available to defer into the 401(k) plan.

The profit sharing contribution for the HCEs is calculated using a complex algorithm based on the amount of money contributed to the profit sharing plan on behalf of the NHCEs.  We used the $1/hr “company retirement contribution” agreed to by Nick as the company’s profit sharing contribution on behalf of the NHCEs.

The amount of $1/hr works out to be approximately $2080/employee/year, which given the compensation schedules at the company worked out to an average of 6% of pay.

Working backwards from this amount of $2080, and using the algorithm mentioned above, Nick and Sophie’s profit sharing contribution came to $44,640 each.  This worked out to a tax deferral of 28.25% per owner.

Given the maximum allowed HCE contribution of $55,000, an additional $10,360 (or 6.56% of income) could be deferred into the 401(k) plan on their behalf.

(Under this arrangement, a total of 34.81% of income (28.25% + 6.56%) could be sheltered from tax exposure by Nick and Sophie every year, compared to the 11.71% previously).

The 6.56% of income that Nick and Sophie were now contributing to their 401(k) became the new aggregate ADP% used for calculation in the ADP discrimination test.  This meant that the required aggregate ADP% for the NHCEs fell to 4.56% (6.56%-2% = 4.56%).

(The default profit sharing benefit now offered by the company was at 6% of NHCE pay, so the ADP discrimination test would no longer be an issue.)

When asked why we didn’t want to simply use a safe harbor provision to protect Nick from having to meet the ADP testing requirement, we shared that safe harbor plans in a profit sharing structure are not without risk to business owners.

Although the safe harbor plan protects owners from failing the ADP discrimination test, the safe harbor plan under a profit sharing arrangement has an immediate 100% vesting schedule.  This means that money contributed to employees under the safe harbor profit sharing arrangement is immediately theirs to keep no matter how brief their time of employment with the company.

We did not want to expose Nick to this immediate vesting schedule, given that he was an owner in a high-employee-turnover business like plumbing.  One of the successes of the company’s profit sharing plan therefore is that it avoided this risk of safe harbor design and still more than met ADP testing requirements.

Outcomes:

  • The ADP testing issue was solved, and the company did not need to pay further corrective distributions.
  • The safe harbor risk of immediate vesting was a non-issue because the ADP testing requirements were met, and the plan did not need a safe harbor provision.
  • The Union issue disappeared because the employees were granted a retirement benefit that met their demands.
  • The owners were able to increase the proportion of their income sheltered from taxation from 11.71% to approximately 35% of compensation.
  • These tax savings, combined with the significant incremental retirement savings available to Nick and Sophie, allowed them to change their perspective of their company retirement plan from being a necessary business expense to a realization that it was a powerful compensation tool.

This case demonstrates the power of effective company retirement plan design to not only optimize tax and retirement benefits for owners and participants, but also to shape and preserve the business’ structure and organizational culture.