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Insurance and Employee Benefits


NOTE:  This chapter on nondiscrimination is the shortest chapter in this text but it is one of the most important and needs to be addressed by itself as the IRS seems to look first at a plan that is being considered for qualification to see if there is any discrimination within the plan.  This can be troublesome for employers who want to reward outstanding employees with tax-free or tax deferred benefits as they are usually in a higher tax bracket so such benefit would mean more to them than a raise in their compensation.  Before ERISA there was rampant discrimination and one of the major purposes of ERISA was to eliminate discrimination among employees as much as possible.  Arguably, the government may have created some "overkill" in order to achieve their anti-discrimination agenda, but regardless of how much difficulty it may cause, in some instances, it seems to have accomplished it's stated purpose.



Nondiscrimination is an exceptionally important feature of a qualified plan and while the concept of not discriminating against some employees in favor of others is quite simple, in actual practice it can be rather complex and at time, cumbersome.

Basically, an employer may want to provide a retirement plan for only some employees, or perhaps provide coverage for only certain groups of employees.  However, differentiation in coverage can raise the flag for regulators of discrimination as federal law has attempted to prevent discrimination against lower-paid employees for a long time.

OK, the more an employee contributes to a company, the higher they are paid, so some preferential treatment is inevitable and is necessary.  Obviously, an employee who creates more profit for an organization because of their knowledge should be rewarded more than those who take his dictation, clean his floors, or drive his car.  With retirement plans, the higher-paid employees have more money to save and benefit more from the favored tax treatment of qualified plans, so they are more willing to substitute deferred, plan-based benefits for current income.  This is, of course, what drives these plans in most corporations.  The nondiscrimination rules do not say that an employer may not reward key employees by allowing them to participate in such a plan, but they do say that employers who establish such a plan for higher-paid employees must provide some comparable benefits to the lower-paid employees also.  This spreads the tax benefits over higher and lower-paid employees.

In respect to the coverage, there are specific rules concerning discrimination in plan coverage.  The principal and basic rule is that a plan must satisfy at least one of two minimum standards, each of which seeks to make sure that highly compensated employees are not covered disproportionately.364



First, it is necessary to define "highly compensated" employees.  The minimum coverage standards established by regulations limit the discrimination in favor of the highly compensated employees.  Basically, a highly compensated employee is that for a given year (called "the determination year") if the employee was a 5-percent owner in that year or the preceding year—or—in the preceding year he received compensation from the employer in excess of a specific sum (which is indexed for inflation and was, for instance, $90,000 in 2003), and, further, if the employer elects, he was in the top-paid group of employees for that year.  Obviously, this requires a lot of "definitions" and explanations.365

Five-percent Owners

Simply put, a 5-percent owner of a corporation in a given year, is a person who, at any time in the year, owns more than 5% of the outstanding stock, or stock possessing more than 5% of the combined voting power.  For a non-corporate employee, a 5% owner during any given year owns more than 5% of the capital or profit interest.  The law also states that "ownership" for this purpose, includes constructive ownership.366


"Compensation" includes wages, salary, commissions and other items that are includible in gross income, but also elective deferrals and elective contributions to Cafeteria Plans and certain other plans.367

"Top-Paid" Group

A "top-paid" employee for a year is one who is in the top 20% for that year, as ranked by compensation.  In determining which employees would be included in that count, there are several categories of excluded employees including part-time employees, seasonal employees, minor (under age 21) employees, certain union employees, and nonresident aliens.368

An employer may elect less stringent exclusions or have no exclusions, so the "top-20%" may consist of fewer than 20% of all employees.  These exclusions are for determining the size of the top 20%, not its membership—a top-compensated employee may have only worked there for 3 months.

Former Employees

A former employee may be considered as a highly compensated former employee if he left employment before the determinate year and was a highly compensated employee either for the year of separation or any year after he turned age 55.


The process and method for testing a group for nondiscrimination is regulated by a plethora of rules and regulations, the basic ones are as follows:

Single Plans

The basic unit that must satisfy the minimum coverage standard, is the single, or separate plan.  For these purposes, a plan is a single plan only if on an ongoing basis, all of its assets are available to pay the benefits under the plan to covered employees and beneficiaries.  Sounds simple, but actually a single plan may have several benefit structures, various & sometimes numerous plan documents, several contributing employers, or several trusts or annuity contracts.

Conversely, there may be multiple plans (even if it is covered under a single document) if part of the assets are not available to pay some of the benefits.  Regulations state succinctly, "(s)eparate pools are separate plans."369


Certain mandatory disaggregation rules must be applied.  [Definition of disaggregate is "to separate into component parts; to break up or to part.”370   Disaggregation is the process of breaking apart, etc.]  For instance, the part of a 401(k) plan that has been separated from the entire plan, is considered as a separate plan from the remainder.  A plan that separates those employees who are collectively bargained (unionized) must be treated as a separate plan, plus a part that benefits employees covered other such agreements is a separate plan from one that is covered under other collective bargaining agreements.  Also, a plan that benefits employees of more than one employer must be disaggregated into separate plans for each employer.  In actual practice, this is a conceptual rule—plans do not have to be rewritten or restructured.371


An employer may decide to aggregate (to combine-but only conceptually) separate plans so that they can apply the ratio percentage test and the nondiscriminatory test, except where the plans are subject to the mandatory disaggregation rules.  This would allow an employer to establish different plans for salaried employees and hourly employees without breaking any of the coverage rules.  But, if an employer elects to aggregate plans for the coverage rules, it must also aggregate them for purposes of the nondiscrimination rules.


The basic tests of coverage uses the highly-compensated employee and the plan subject to testing, and are quite straightforward.  In order to meet the coverage test, a plan must satisfy either (a) the ratio percentage test, or (b) both the nondiscriminatory classification test and average benefit percentage test.  Testing takes all employees into consideration, unless the employer elects to designate separate lines of business.

Both tests apply only to employees who benefit under the plan—an employee benefits under a plan in a given year if he receives an allocation to his account or increase in accrued benefits.  This can also apply to former employees, such as for a defined benefit plan amendment providing for a cost of living adjustment can benefit former employees.372

Ratio Percentage Test

The ratio percentage test requires the proportion of the non-highly compensated employees (NCEs) who benefit under the plan divided by the proportion of the highly-compensated employees (HCEs) to be at least 70%.373 As an example, if a plan benefits 50% of the HCEs, it must also benefit at least 35% pf the NCEs.  A plan will automatically satisfy the test if it benefits at least 70% of the NCEs.

Nondiscriminatory Classification & Average Benefit Tests

The other, alternative, test is comprised of two sub-tests.  First, the nondiscriminatory classification test requires that the classification used by the plan as a basis for including (and excluding) employees be both reasonable and nondiscriminatory.  The other test (average benefit percentage test) requires that the average benefit percentage of the plan be at least 70%.

The nondiscriminatory classification test states that a classification is reasonable if it is established under objective business criteria (an enumeration of covered employees by name is not a reasonable classification).  There are two ways for a classification to meet the additional requirement that it be nondiscriminatory.  One method uses a "safe harbor" approach which is too complicated to go into here, but is based on the 70% rule described earlier.

The other way that a plan can satisfy this test is by meeting two conditions—again a rather complicated method of determining the "unsafe harbor percentage."  If more information is needed on this subject, these methods are covered under Treasury Regulation 1.410(b)-4.

Average Benefit Percentage Test

Basically, the average benefit percentage test for discrimination is the actual benefit percentage of the NCEs divided by the actual benefit percentage of the HCEs.  These regulations go into the actual benefit percentage of a group by defining it as the unweighted average of the benefit percentage of each employee in the group, whether or not they participate in any plan.  Again, this test is quite complex, and beyond the scope of this text.  Further detailed information is available under Treasury Regulation 1.410(b) and under Internal Revenue Code 410(b).


For purposes of determining the average benefit percentage test and other nondiscrimination standards, regulations determine that compensation includes elective deferrals and amounts contributed or deferred by the employer at the election of the employee, and otherwise not includable in gross income because of Internal Revenue Code 4-2, 125, 132 or 457.  Obviously, this is a rather complicated set of rules that are used to define "compensation" for nondiscrimination purposes

Other Rules

Some of the rules regarding discrimination are rather simple (believe it or not), such as the rule that a plan maintained by an employer who has no NCEs automatically satisfies the coverage standards, and similarly, a plan that does not benefit any HCEs also satisfy the standards.  Yes, these are obvious, but they must be specified by regulation.374

Also, a plan that benefits only employees covered by a collective bargaining agreement automatically satisfies the coverage standards.375

Former Employees

If a plan benefits former employers in any calendar year, the plan is tested separate in respect to present and former employees.  A plan satisfies the regulations if the group of former employees benefiting under the plan does not discriminate significantly in favor of the HCEs.


Another obvious way to discriminate in such plans would be to classify employees in different classifications, with some employees in one group receiving more or higher benefits than those in another group.  Obviously, the IRS does not like that type of blatant discrimination, so the term "employee" for these purposes must be defined.

Business Aggregation Rules

The Internal Revenue Code provides that all employees of all corporations that are members of a controlled group of corporations shall be treated as being employed by a single employer.  That sounds simple, but the definition of "controlled group" is not so simple.  Also, the Code provides that employees of trades or businesses, whether or not incorporated, that are under common control shall be considered as employed by one employer—and "common control" definitions are rather complex.  Plus, all employees of members of an affiliated service group are treated as working for a single employer—in this case, an affiliated service group consists of a service organization and certain other related organizations.376   

Leased Employees

A leased employee is treated as an employee of the person for whom his services are provided, and benefits or contributions provided by the leasing organization are attributed to the person for whom the services are performed.377 A leased employee is a person who provides services to a recipient where (1) the services are provided pursuant to an agreement between the recipient and the a leasing organization; (2) the person has provided the services on a substantially full-time basis for at least one year; and (3) the services are performed under the primary direction or control of the recipient.378

There is an exception to this rule in cases where the leasing organization provides a generous broad-based money purchase plan with immediate participation and full and immediate vesting.379


Certain employees may be excluded or disregarded when applying the coverage tests, for various reasons.

Collective Bargaining Units

If a plan covers only non-union employees, members of a collective bargaining agreement may be ignored when applying the coverage tests if there is evidence that retirement benefits for them were the subject of good faith bargaining.  There are also some exclusions for plans that cover both union and non-union employees.380  The union employees will be disregarded, even if no plan was established for them.  Before one jumps to conclusions here, the reasoning for this exclusion is that it permits unions to opt for higher compensation or welfare benefits for its members instead of retirement benefits, without jeopardizing the ability of the employer to establish plans for other employees.  This exclusion is not available for bargaining units in which more than 2% of the employees are professionals.381

Minimum Age and Service Requirements

If a plan prescribes minimum age and service requirements, and excludes from participation all employees not meeting the requirements, then the plan may disregard those employees for purposes of the minimum coverage tests.  This, in effect, allows qualified plans to exclude part-time employees.

If some or all of the employees that do not meet ERISA's minimum age and service standards (or "excludable employees") are covered under a plan, the employer may disaggregate the plan into one for the otherwise excludable employees, and one for all other employees, and then test each separately, and when testing, employees covered under the other plan are disregarded.382

Former Employees

When testing for former employees, the employer may exclude those who terminated employment before a certain date and those who were or would have been excludable employees during the plan year in which they became former employees.383


The rules pertaining to separate lines of business comes into play if an employer has a diversified business and wants to offer plans to different parts of the enterprise.  The Code allows an employer that has a qualified separate line of business to have the coverage test applied to employees of each line of business individually and employees of the various lines of business are treated as excludable employees.384

For an employer to take this approach without violating nondiscrimination rules, all the employer's property and services that are provided to customers must be provided through separate lines of business and every employee must be treated as an employee of exactly one line of business.  If the employer elects to test one of its plans under this approach, it must test them all to satisfy the percentage test.

Basically, each of the sub-groups are tested individually, but the whole plan must still benefit employees on the basis of a nondiscriminatory classification as a result of the nondiscriminatory classification test or the ratio percentage test.

The regulations get pretty complex thereafter and require the employer to identify each line of business (LOB) and to prove that they are organized separately from each other (believe it or not, these are called "SLOBS" - separate lines of business).  And then, there are rules for qualifying the SLOBS, with the end result that they are called "QSLOBS."  Sometimes acronyms can be fun… In any respect, these regulations are too detailed and cumbersome to be discussed further in this text.


For defined benefit plans, using the plan aggregation to satisfy the minimum coverage test requires each qualified defined benefit plan to benefit, on each day of the year, at least the lesser of (a) 50 employees, or (b) the greatest of 40% of the workforce or two employees.  This is designed to prevent discrimination through fragmentation of the workforce into separate and small plans—it also helps the IRS to monitor compliance with discrimination rules as it applies to employers with one or a number of plans.385

The plans that are tested are the separate plans subject to special disaggregation rules, and the employees that will be taken into account exclude employees covered under collective bargaining agreements and employees who have not met minimum age or length of service requirements.

Other Exemptions

There are a number of exemptions too detailed for present discussion, but they are covered under IRC Section 401(a)(26) and Treasury Regulation 1.401(a)(26)


In addition to minimum coverage tests for discrimination, there are a barrage of tests that makes sure that a plan does not discriminate in contributions or benefits.

These regulations are too complex and numerous to discuss in detail here, but basically, under the regulations, every qualified plan must satisfy three conditions:

  1. Contributions or benefits must not be discriminatory in amount;
  2. Benefits, rights and features under the plan must be made available in a nondiscriminatory manner; and
  3. The effect of plan amendments and plan termination must not be discriminatory.

For defined contribution plans, there are three basic tests, two safe harbor tests and a general test and are used for single, nonintegrated plans.

"Safe harbor" plans are based on plan design, to make sure that the plan does not discriminate in the amount of contributions if it allocates contributions and forfeitures on the same percentage of compensation, the same dollar amount, or the same dollar amount per uniform unit of service.

The second "safe harbor" plan makes sure that in those plans where a contribution is based on units of annual of compensation, age &/or service, are uniform among all participants.

The third test is another complex test as it requires any group that cannot satisfy the safe harbor rules to satisfy the minimum coverage requirements for each rate group.  This test applies to highly compensated employees and to other employees with equal or greater allocation than those of the highly compensated employees.  In this test a ratio percentage of the plan or the average of the safe and unsafe harbor percentages of the plan are used.



With all of the nondiscriminatory tests in the regulations, it would seem that all bases are covered, but there are still other tests.  As an example, for defined benefit plans, there are five safe harbor tests and two general tests.  Then, in addition, "cross-testing" may be used as for a plan to be qualified, either contributions or benefits must be nondiscriminatory but not necessarily both.  The cross-testing, which can be used for either defined benefit or defined contribution plans, makes sure that they are equal by using equivalent accrual rates (which, as you can imagine, is defined in detail) and minimum allocation gateways (ditto).

Further, since Social Security benefits favors lower-paid employees with its structure, an employer might want to skew benefits or contributions under a plan in favor of the more highly-compensated employees in order to have a more uniform relationship between compensation and the total of the plan + Social Security benefits (or it could be the total of the plan + the FICA contributions).  Of course, the IRS has a barrage of tests to make sure that discrimination does not occur, particularly in the defined contribution excess plans and defined benefit excess plans, with the "excess" referring to benefits above Social Security levels.  These regulations are detailed and are contained in the many pages of the Treasury Regulations 1.401(a) and IRC Section 401(a).

In addition to the nondiscrimination rules as outlined above, there are also limitations on contributions and benefits in respect to the absolute (total) amount that a plan can benefit any employee.386 The dollar amount that can be contributed is set forth in formulae with a base annual addition in defined contribution plans of $40,000 or 100% of the participant's compensation, whichever is the lesser.  For defined benefit plans, the annual benefit cannot exceed the lesser of $160,000 (2003 amount, indexed) or 100% of the participant's average compensation for the higher consecutive three years. 





1.  Since some employees create more profit to a company than others, in view of the nondiscrimination laws certain rewards for outstanding performance may still be provided, such as

      A.  the employer contributing more towards a pension plan more each year of service.

      B.  setting up a "sub-plan" for those employees whose compensation is more than $100,000

            a year.

      C.  determining the most profitable employees and increasing their compensation proportion-

            ately to what they have contributed to the profits of the company.

      D.  administrative assistants of highly paid employees have more medical expense coverage

            as they tend to have children at home and they spend more time away from their children.


2.  The principal rule in respect to nondiscrimination is that highly compensated employees

      A.  do not make more money than their counterparts in similar industries in the same area.

      B.  must be equally male and female.

      C.  are not covered disproportionately.

      D.  is that stockownership of the company is not controlled by a family trust.



3.  A "top-paid" employee for a year is

      A.  an employee who is in the top 20% for that year, as ranked by compensation.

      B.  an employee who makes more than the President of the corporation.

      C.  an employee who has independent income from a family trust and with the combined

            income, his compensation is the highest in the corporation.

      D.  the President, Executive Vice President and all Senior Vice Presidents of any corporation.


4.  When an employer sets up a benefit plan for all employees except those who are covered under collective bargaining plans as they receive slightly different plans under their union agreement, this is called

      A.  disintermediation.

      B.  disaggregation.

      C.  discontinuity.

      D.  discombobulation.


5.  In order for a plan to meet the nondiscrimination coverage test, the plan must satisfy one of two requirements, one of which requires the proportion of the non-highly compensated employees to who benefit under the plan divided by the proportion of the highly compensated employees to be at least 70%.  This is called

      A.  the nondiscriminatory primary test.

      B.  the average benefit test.

      C.  the ratio percentage test.

      D.  the equivalency test.


6.  A classification of employees is considered as "reasonable" if

      A.  it is established under guidelines provided by the state Department of Insurance.

      B.  if more females than males are covered.

      C.  they are classified as to visual presentation even though the majority do not interface with

            the public or customers.

      D.  it is established under objective business criteria.


7.  For nondiscrimination purposes, all employees of all corporations of a controlled group of corporations

      A.  are considered as individual and separate groups.

      B.  are consolidated and then segregated by sex, age, income, race or any other "natural"


      C.  shall be treated as being employed by a single employer.

      D.  are considered as a multiple group, which eliminates any highly-compensated employee



8.  For nondiscrimination purposes, benefits or contributions for a leased employee provided by the leasing organization are

      A.  attributed to the leasing company.

      B.  attributed to the person for whom the services are performed.

      C.  consolidated with all other leased employees of the leasing organization, and then

            segregated by age, sex and/or compensation.

      D.  automatically in violation of nondiscrimination laws, so leased employees must

            provide their own individual health and retirement plans.


9.  The Acme Corporation purchases three other corporations, each of whom are in a different lines of business.  To avoid any charges of discrimination on employee benefits,

      A.  Acme may segregate their employee benefits by line of business (which they must be

            able to prove).

      B.  Acme must combine all of the employee benefit groups into one master group covering

            all of their employees in order to avoid discrimination charges.

      C.  Acme may first consolidate all of the employees, and then set up a separate plan for

            each compensation layer, such as one group for those making less than $50,000 per year

            another for those making between $50,000 and $100,000, etc.

      D.  The IRS will allow Acme to discriminate by education level if one or more of the lines of

            business requires higher education - such as computer programmers, medical personnel,



10.  For defined benefit plans, using the plan aggregation to satisfy the minimum coverage test requires each qualified defined benefit plan to benefit, on each day of the year

      A.  90% of ALL employees.

      B.  25% of all covered employees.

      C.  the lesser of (a) 50 employees, or (b) the greatest of 40% of the workforce or two

            employees; whichever is lesser.

      D.  the majority of those who are the 20% lowest compensated.



1C    2C     3A     4B     5C     6D     7C     8B     9A     10C

Insurance and Employee Benefits