Nondiscrimination Testing: Compensation Ratio Test
The compensation ratio test is one of several nondiscrimination tests a plan must satisfy in order to remain compliant with IRS rules.
The term “compensation” can seem uncomplicated; however, when we start discussing things like bonuses, commissions and fringe benefits, things can get a little more complex. Although many companies include all forms of employee compensation when it comes to determining retirement benefits, other companies may choose to exclude certain types of payments. For example, an employer might budget a certain dollar amount to pay bonuses and, therefore, may not also wish to calculate retirement plan contributions on those amounts.
What Is the Purpose?
In recognition of the above, the retirement plan rules include a test designed to make sure a given plan does not carve out certain forms of compensation in such a way that disproportionately benefits the highly compensated employees or HCEs. That test is called the compensation ratio test.
How Much Is “Proportionate”?
This is where we get to use the all-too-familiar Latin phrase “de minimus.” What, not a Latin fan? Neither are we, but that is pass/fail standard for this test. Read on, and it will all make sense soon.
How Does the Test Work?
As the name suggests, the test considers each participant’s compensation ratio, which is simply his or her included compensation divided by his or her total compensation.
Example: John Doe received total compensation from his employer of $100,000 per year. This is comprised of $80,000 in base salary and $20,000 in bonus. If the plan excludes bonuses in determining retirement benefits, John’s compensation ratio is $80,000/$100,000 or 80%.
The mechanics of the test are quite simple and consist of the following steps:
- Determine who is eligible for the plan. These are the participants.
- Calculate the compensation ratio for each participant.
- Divide the participants into two groups — HCEs and non-HCEs.
- Average the compensation ratios for each group.
The most ambiguous part of the test is determining whether it passes or fails. The reason is that the rules say that the average compensation ratio for the HCEs cannot exceed that of the NHCEs by more than a "de minimus" amount, but they do not define what "de minimus" means.
As a result, the interpretation has had to come from anecdotal evidence of what the IRS accepts when they review plans in audits or other situations. The rule of thumb that has developed is that as long as the HCE average is within three percentage points of the NHCE average, the test passes.
What Does This Mean?
It means several things, including:
- When considering whether or not certain forms of compensation should be included or excluded, it is critical to work with someone who is knowledgeable in the nuances of compensation definitions. Some items can be excluded without triggering the compensation ratio test, while other exclusions mandate testing.
- It is important to be precise in describing any excluded forms of compensation. It is not uncommon for companies to pay different types of bonuses. For example, there may be a formal, performance-based bonus program, a discretionary bonus and a casual cash bonus that is handed out at the annual holiday party. If the company wishes to exclude all bonus payments, a more broadly worded description may be fine. However, if the goal is only to exclude the holiday cash bonus, precise wording is needed to make sure the other bonuses are not inadvertently thrown out also.
- Changing economic conditions that do not seem to impact the plan can create challenges. The best way to explain this is through an example. Consider a plan that excludes both bonuses (primarily paid to HCEs) and overtime (primarily paid to NHCEs) from its definition of compensation. Since these exclusions impact HCEs and NHCEs alike, the plan easily passed the compensation ratio test. However, during an economic decline, the company stopped paying bonuses and laid off a number of employees, requiring the remaining employees to put in more overtime to get all the work done. Because bonuses (again, primarily for HCEs) dropped off and overtime (to NHCEs) increased, the same definition of retirement plan compensation became discriminatory.
As with so many of these retirement plan rules, the key is to plan ahead. If you are considering changes to your plan or you anticipate upcoming business changes, give us a call to discuss the potential impacts and prepare any projections that might make sense.
Additional information about the compensation ratio test can be found in Internal Revenue Code section 414(s).