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Correct a Failed ADP Test
Has it happened to you? Did you fail your ADP test?
What do you do next?
There are a couple of ways to remedy the
failed test. Depending
on your situation
here are some options…
The QNEC…
One method of passing an
otherwise failed test is for the employer to make a qualified
non-elective
contribution (QNEC) to some or all of the non-highly compensated
employees
(NHCE) to bring the ADP of the HCEs up resulting in the
test passing. In
order to be utilized in the test for a particular
plan year, these QNEC contributions must be made by the last day of the
following plan year. The
timing issues
that apply to the deduction of matching contributions also apply to
QNEC
contributions.
Highly Compensated Employee (HCE)
Deferral Reduction…
If the amount of the QNEC
needed to pass the ADP test ends up to be rather large
and you as the plan
sponsor feel that it is too expensive, then another option is to reduce
the
amount of the deferrals each HCE made to bring the ADP of the HCEs down to a passing
percentage. This is
done by distributing back to the HCEs
part of the $ they deferred during the plan year.
If the distributions are made within the
first 2 1/2 months following the end of the plan year (by March 15),
the
distributed amounts are treated (for income tax purposes) as if they
were
received by the employee as of the earliest date the employee could
have
received the amount in cash. In most cases, this means the
distributions will
be taxable in the preceding calendar year. If the distributions are
made after
the first 21/2months, the distributions are taxable in the year
distributed
(and the employer is subject to the 10% tax under IRC section 4979
tax).
However, under IRC section 4979(f)(2)(B), if the total excess
contributions and
any excess aggregate contributions are less than $100 (without regard
to
attributable earnings), the amount is included in gross income in the
year
distributed even if the distribution is made in the 21/2 month period. The additional income that
the HCE will now
be showing for the year will not be shown on the W-2 but rather the
plan will
issue a 1099R.
The above method can be done
in equal percentage amounts for each HCE, or in whatever percentages
per HCE
needed to satisfy the ADP test.
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Pension
Administration and Trust Accounting