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Summary of EGTRRA Employee Benefits Provisions   |   "Following the Terms of the Plan"   |   Sales of Stock Options to Family Limited Partnerships: Caveats   |   Light Through the Glass   |   Section 410(b): A Cascading Case Study
Section 410(b): A Cascading Case Study
[This paper was presented at the annual AICPA conference on employee benefits, May 5, 2003.]
Methodology: The qualification standards of the Internal Revenue Code prohibit plans from skewing either coverage or benefits in favor of highly compensated employees.  This paper reviews the application of that principle to controlled groups of corporations, trades or businesses.  The method employed is to follow the history of an originally simple pair of plans, a pension plan and a 401(k) plan, through a series of corporate transactions and plan design changes that gradually complicate the nondiscrimination analysis.
The Beginning: A Corporation is as boring as its name, a long-established manufacturer of industrial grade widgets.  It has one factory, located in Freeport, Illinois, where it employs about a hundred assembly line workers and a small headquarters staff.  All employees with at least one year of service, except for the small sales force, are covered by its defined benefit pension plan.  The company’s 401(k) plan, which provides for elective deferrals and a match, is open to anyone with three months of service, but only those with a year of service are entitled to the match.  Employer and plan demographics look like this:
HCE
NHCE
Total
Headquarters
4/4
6/6
10/10
Salesmen
1/1
4/4
5/5
Factory
0/0
90/100
90/100
Pension Plan
4
96
100
§401(k) Plan – Elective deferrals
5
110
115
§401(k) Plan – Matching contributions
5
100
105
[Note:  The number to the left of the slash in all tables is the number of employees with one or more years of service, the number to the right the number with 3 or more months.]
Points to Observe:
The plan administrator needs to perform three section 410(b) “nondiscrimination” tests: one for the pension plan, one for the elective deferral feature of the 401(k) plan and one for the matching contributions feature of that plan.
Before we can do any testing under section 410(b), we must determine which employees are “excludible” and “nonexcludible” with respect to each plan.  Excludible employees are ignored in testing.  The main excludible categories are (i) workers covered by collective bargaining agreements, (ii) nonresident aliens without U.S. source income and (iii) employees who do not meet the plan’s age or service conditions.  Since plans may have different age and service conditions, each may have a different population of “excludibles” and “nonexcludibles”.  That is the case here.  For the pension plan and the matching contributions feature of the 401(k) plan, employees who have completed at least one year of service are nonexcludible.  For the elective deferral portion of the 401(k) plan, anyone who has worked for three months or longer is nonexcludible.
In each of the three cases that must be tested, the percentage of nonexcludible, nonhighly compensated employees who benefit under the plan is 70 percent or higher (100 percent for the elective deferrals and matching contributions, 96 percent for the pension plan), thus satisfying the section 410(b) percentage test.  (Remember that any employee who is eligible for elective deferrals or matches is counted as benefitting from those features, regardless of whether he takes advantage of them.)
Event 1 – Changes to Work Force: For many years, A has relied primarily on third party distributors to sell its product and has done little marketing.  That approach is no longer working.  Falling sales have necessitated layoffs at the factory.  Management decides to add a sales and marketing division to promote aggressively the vital role of widgets in the 21st Century.  Employees of the new division are eligible for the 401(k) plan but not for the pension plan.
HCE
NHCE
Total
Headquarters
4/4
6/6
10/10
Marketing Division
2/2
40/42
42/44
Factory
0/0
74/82
74/82
Pension Plan
4
80
84
§401(k) Plan – Elective deferrals
6
130
136
§401(k) Plan – Matching contributions
6
120
126
Points to Observe:
The 410(b) testing is unchanged for the 401(k) plan.  Both the elective deferral and matching contributions features cover 100 percent of the nonexcludible NHCE’s.
The pension plan covers only 80 out of 120 nonexcludible NHCE’s, which is less than 70 percent, but can pass the “ratio percentage test”.  It benefits 66.7 percent of the company’s HCE’s.  To satisfy section 410(b), it must cover at least 70 percent of that percentage of NHCE’s (i. e., 70% x 66.7% = 46.7%), which it does.
Event 2 – Internal Expansion: “What we need,” says the head of marketing one day, “is widgets for consumers.  The industrial market’s mature, but there’s huge potential demand among yuppies and soccer moms.”  Much impressed, the company builds a new plant in nearby Pearl City.  To obtain financing, it establishes an employee stock ownership plan.  The ESOP covers all non-sales employees who have completed at least one year of service.  The new hires in Pearl City are made eligible to participate in the 401(k) plan on the same terms as anybody else but are excluded from the pension plan.
HCE
NHCE
Total
Headquarters
5/5
6/6
11/11
Marketing Division
2/2
40/42
42/44
Freeport Factory
0/0
74/82
74/82
Pearl City Factory
0/0
50/65
50/65
Pension Plan
5
80
85
ESOP
5
130
135
§401(k) Plan – Elective deferrals
7
195
202
§401(k) Plan – Matching contributions
7
170
177
Points to Observe:
The addition of the ESOP brings us to four testing entities.  The ESOP covers 76.5 percent of all nonexcludible NHCE’s, and the elective deferral and matching contribution features of the 401(k) plan each continue to cover 100 percent of their nonexcludible NHCE groups.  All three entities therefore satisfy section 410(b).
The pension plan no longer satisfies the ratio percentage test.  It covers 71.43 percent of the HCE’s.  Seventy percent of that percentage is 50 percent, but only 47.06 percent of nonexcludible NHCE’s are covered.  The next possible way to satisfy section 410(b) is the average benefits test.  That test has three elements:
The reasonable classification test: The group covered by the plan must be based on some job-related or other rational classification.  It cannot be an arbitrary list of employees.  A’s pension plan easily passes this test, because it coverage is based on the division for which one works.
The nondiscriminatory classification test: This is a numerical test, the details of which are set out in Treas. Regs., §1.410(b)-4.  Like the ratio percentage test, it compares the percentage of HCE’s benefitting under the plan to the percentage of benefitting NHCE’s.  The ratio needed to pass the test varies with the proportion of the employer’s work force that is nonhighly compensated.  The greater the percentage of NHCE’s, the lower the passing ratio.  Furthermore, there is a range within which whether plan passes or fails depends upon “facts and circumstances”.
In A’s case, 96.05 percent of its employees with one or more years of service are nonhighly compensated.  That means that it will automatically pass the test if the ratio of benefitting NHCE’s to benefitting HCE’s is at least .23 (the “safe harbor”) and will automatically fail if the ratio is less than .20 (the “unsafe harbor”).  Between those bounds, the result depends upon subjective factors, principally the extent to which it appears that the plan was designed to skew benefits toward the highly compensated group.
The plan’s NHCE/HCE benefitting ratio is 47.06% ÷ 71.43%, or .6588, comfortably within the “safe harbor”.
The average benefit percentage test: The benefit of the “average” NHCE under all of the controlled group’s qualified plans must be at least 70 percent of the benefit of the average HCE.
All benefits are taken into account, including elective deferrals and matching contributions.
“Averages” are determined by calculating a benefit percentage for each employee, then adding up the percentages for each group and dividing by the number of employees in the group.
If desired, a test for a defined benefit plan may ignore benefits under defined contribution plans, and vice versa.
Benefit percentages may be determined on either a “benefits” or a “contributions” basis, with one exception: If an ESOP is being tested, the test must be performed on a contributions basis.  Some IRS officials and practitioners believe that the same rule applies if an ESOP is merely one of the plans in the testing group, though that is less certain. [Benefits basis: Benefits are expressed as an annuity beginning at normal retirement age.  Traditional DB plan benefits are already in that form.  DC and cash balance benefits are converted into an actuarially equivalent annuity.  Contributions basis: Benefits are expressed as the present value of the benefit accrued in the current year.  DC and cash balance benefits are already in that form.  Traditional DB benefits are converted into an actuarially equivalent immediate lump sum.  Both of the preceding descriptions are oversimplified, of course, but they will do for our purposes.]
To avoid data overload, we will not show average benefit percentage calculations but will assume that A’s plans pass whenever it is pertinent.
Event 3 – A New Profit Sharing Plan: Widgets quickly become a hot item in the consumer market, and management decides to reward the marketing division with a profit sharing plan.  The plan also covers HQ employees.  At the same time, more employees are added to the Pearl City plant to keep up with demand.
HCE
NHCE
Total
Headquarters
5/5
6/6
11/11
Marketing Division
2/2
40/42
42/44
Freeport Factory
0/0
74/82
74/82
Pearl City Factory
0/0
85/95
85/95
Profit Sharing Plan
7
46
53
Pension Plan
5
80
85
ESOP
5
165
170
§401(k) Plan – Elective deferrals
7
225
232
§401(k) Plan – Matching contributions
7
205
212
Points to Observe:
The addition of the profit sharing plan brings us to five testing entities.  The changes in demographics do not create any problems for the four old entities.  As the reader can demonstrate for himself, each satisfies section 410(b) quite comfortably.
For the profit sharing plan, the picture is different.  It covers 100 percent of the HCE’s but only 22.44 percent of the nonexcludible NHCE’s, very far from enough to pass the ratio percentage test.  Looking at the average benefits test, the plan covers a “reasonable classification” of employees, and we shall assume that it satisfies the average benefit percentage test.  NHCE coverage falls short of the nondiscriminatory classification test safe harbor, which is 23 percent in this instance.  It might still scrape by on a “facts and circumstances” basis, but it would be better to find a technique that offers greater certainty.
The solution is to “aggregate” the profit sharing plan with the pension plan and see whether the aggregated plan can satisfy section 410(b).  Combining plans for testing purposes is allowed, subject to a few limitations.  The most important is that benefits under the combination of plans cannot discriminate in favor of HCE’s.  The rules for analyzing discrimination are contained in the regulations under section 401(a)(4).  In addition, some types of plans cannot be aggregated with plans of a different type.  “Mandatory disaggregation” (the regulations’ hideous neologism) applies to ESOP’s, elective deferrals, matching contributions and plans established through collective bargaining.  Hence, the pension plan is the only candidate that A Corporation has for aggregation with its profit sharing plan.
Taken together, the pension and profit sharing plans cover 7 HCE’s and 120 NHCE’s.  (HQ employees get the benefit of both.)  That coverage (100 percent of HCE’s and 60 percent of NHCE’s) is still not good enough to pass the ratio percentage test, but the aggregated plan will have no difficulty with the average benefits test.  Demonstrating that the aggregated benefits satisfy section 401(a)(4) is beyond the scope of this presentation.
Event 4 – Acquisition: Now-flourishing A Corp. has buckets of cash and starts looking for promising acquisitions.  B Co., a widget maker located in Tuscaloosa, Alabama, missed the consumer widget boom and has fallen on hard times.  A buys B in January 200x.  The new subsidiary has 50 full-time NHCE’s and three HCE’s.  All were covered by B’s 401(k) plan (elective deferrals and matching contributions) and its defined benefit pension plan.  A decides to leave B’s 401(k) plan in place and merge its pension plan into A’s, which will now cover the former B employees.  The acquired employees are also added to the ESOP.
HCE
NHCE
Total
Headquarters
5/5
6/6
11/11
Marketing Division
2/2
40/42
42/44
Freeport Factory
0/0
74/82
74/82
Pearl City Factory
0/0
85/95
80/95
B Corporation (200x)
0/0
53/53
53/53
B Corporation (after 200x)
3/3
50/50
53/53
Profit Sharing Plan
7
46
53
Pension Plan
5
133
138
Pension Plan (after 200x)
8
130
138
ESOP
5
218
223
ESOP (after 200x)
8
215
223
A Corp. §401(k) Plan – Elective deferrals
7
225
232
A Corp. §401(k) Plan – Matching contributions
7
205
212
B Corp. §401(k) Plan – Elective deferrals
0
53
53
B Corp. §401(k) Plan – Matching contributions                         
0
53
53
B Corp. §401(k) Plan - Elective deferrals (after 200x)

3

50

53
B Corp. §401(k) Plan – Matching contributions (after 200x)

3

50

53
Points to Observe:
Why does the table show no HCE’s at B Corporation in the year of the acquisition?  HCE status is based on compensation received from the employer in the prior year.  The B HCE’s were not employees of A’s controlled group during the year before the acquisition.  Hence, their controlled group compensation was zero.  Note, however, that the IRS has never issued guidance on how to identify HCE’s following an acquisition.  It is possible that it will someday decide that, under at least some circumstances, compensation from the prior employer should be attributed to the present one.
Section 410(b)(6)(C) sets forth a transitional rule for changes in a controlled group resulting from acquisitions or dispositions of business units.  Under this rule, any plan that satisfied section 410(b) immediately before the transaction is automatically treated as continuing to meet the nondiscriminatory coverage standards until the end of the first plan year following the year of the transaction, unless its coverage changes “significantly”.  Here the profit sharing plan and the two 401(k) plans can take advantage of this relief.  They do not need any section 410(b) testing until the transition period ends.  Much about section 410(b)(6)(C) remains uncertain, as the IRS has never furnished any guidance and it is easy to construct absurd interpretations.
The pension plan and the ESOP cannot use the transition rule, because the addition of the B Corporation employees undoubtedly meets whatever the standard may be for the significance of a change in coverage.  Each plan can satisfy section 410(b) by passing the ratio percentage test.  For the pension plan, the ratio of benefitting NHCE’s (133 out of 258, or 51.55 percent) to benefitting HCE’s (5 of 7, or 71.43 percent) is .72, above the required .70.  The ESOP passes easily (proof left as an exercise for the reader).
Once the transition period ends, regular section 410(b) testing resumes.  Note that B Corporation now has three HCE’s.  Here is an overview of the ratio percentages for each plan:
NHCE%
HCE%
Ratio
Profit Sharing Plan
18.04%
70.00%
0.2577
Pension Plan
50.98%
80.00%
0.6373
ESOP
84.31%
80.00%
1.0539
A Corp. Elective Deferrals
81.82%
70.00%
1.1689
A Corp. Matching Contributions
80.39%
70.00%
1.1485
B Corp. Elective Deferrals
18.18%
30.00%
0.6161
B Corp. Matching Contributions
19.61%
30.00%
0.6536
Four of the testing entities (the Profit Sharing Plan, the Pension Plan and both features of the B Corporation section 401(k) plan) fail the ratio percentage test.  All four can, however, satisfy the average benefits test (another exercise for the reader).  The demographics have improved enough that the Profit Sharing Plan can pass the nondiscriminatory classification test safe harbor.  Aggregating the A and B 401(k) plans or the Pension and Profit Sharing Plans is also possible.
Event 5 - Another Acquisition: Pleased with the outcome of its first acquisition, A undertakes another.  In a bold move, it acquires C Corporation, a chain of specialty stores that sell widgets, gadgets, fidgets, geegaws, wombats and related merchandise.  C’s work force is low-paid with high turnover, and the company never had any qualified plans.  In the course of the acquisition talks, A agrees to let C’s managers (five HCE’s and 15 NHCE’s) participate in the Profit Sharing Plan and the ESOP and to make all C employees eligible for A’s 401(k) plan.  Once the section 410(b)(6)(C) transition period expires, A’s controlled group has five new HCE’s and 500 more NHCE’s.
HCE
NHCE
Total
Headquarters
5/5
6/6
11/11
Marketing Division
2/2
40/42
42/44
Freeport Factory
0/0
74/82
74/82
Pearl City Factory
0/0
85/95
80/95
B Corporation
3/3
50/50
53/53
C Corporation
5/5
400/500
405/505
Profit Sharing Plan
12
61
73
Pension Plan
8
130
138
ESOP
13
230
243
A Corp. §401(k) Plan – Elective deferrals
12
725
737
A Corp. §401(k) Plan – Matching contributions
12
605
617
B Corp. §401(k) Plan - Elective deferrals
3
50
53
B Corp. §401(k) Plan – Matching contributions
3
50
53
Points to Observe:
After the massive influx of new employees, the plans’ ratio percentages look like this:
NHCE%
HCE%
Ratio
Profit Sharing Plan
9.31%
80.00%
0.1164
Pension Plan
19.85%
53.33%
0.3722
ESOP
35.11%
86.67%
0.4052
A Corp. Elective Deferrals
93.55%
80.00%
1.1694
A Corp. Matching Contributions
92.37%
80.00%
1.1546
B Corp. Elective Deferrals
6.45%
20.00%
0.3226
B Corp. Matching Contributions
7.63%
20.00%
0.3817
Even with these numbers, it is possible that the plans can satisfy section 410(b).  The Pension Plan, ESOP and B Corporation 401(k) Plan have reasonable prospects of passing the average benefits test.  That option isn’t available to the Profit Sharing Plan, which has sunk well below the nondiscriminatory classification safe harbor, but it may be possible to aggregate it successfully with the Pension Plan.  Unfortunately, the large number of C Corporation employees who are eligible only for 401(k) contributions greatly increases the likelihood that the plans will fail the average benefit percentage test.  It is time to look for other alternatives.
Testing by Qualified Separate Lines of Business was devised as an escape hatch for controlled groups whose business units varied widely in demographics and in type of plan coverage.  In outline, the technique works like this:
The controlled group is divided into two or more separate business units that meet the criteria for “qualified separate lines of business” (“QSLOB’s”).
For section 410(b) testing purposes, each QSLOB is treated as if it were an independent employer, i. e., everyone who is employed by a different QSLOB is an excludible employee.
Each plan tested on a QSLOB basis must also satisfy the reasonable classification and nondiscriminatory classification tests on a controlled group basis (the “gateway test”).  The nondiscriminatory test is modified by reducing the unsafe harbor percentage (but not the safe harbor percentage) for plans that have a coverage ratio (NHCE covered percentage divided by HCE covered percentage) of at least 90 percent.  It is also possible to obtain an IRS ruling that a plan satisfies the gateway test on a facts and circumstances basis.
If QSLOB testing is used for any plan, it must be used for all plans except those that qualify for an “employer-wide plan” exception.
The employer must notify the IRS that it is using QSLOB testing by filing Form 5310-A.  The form is due 9½ months after the end of the plan year.  If the employer has plans with different plan years, one form is filed for each calendar year and is due 9½ months after the end of the plan year that begins earliest in the calendar year.
Can A solve its problems by taking the QSLOB route?  The first step is to figure out whether it can be split into valid QSLOB’s.  A QSLOB must –
Have at least 50 employees (including those not eligible to participate in the plan) [E. g., the Marketing Division could not be a QSLOB, even if it met all other criteria, because it has only 44 employees.]
Must be organized and operated separately from the remainder of the employer, with its own management and work force [E. g., the Freeport and Pearl City factories could not be QSLOB’s, because they have no separate management]
Satisfy an “administrative scrutiny” requirement that is intended to limit the ability of employers to set up QSLOB’s purely for the sake of maximizing benefits for HCE’s
For a more detailed summary of these requirements, see the Appendix.
There are more possible permutations and combinations than this outline can cover.  For illustrative purposes, we will set up A, B and C Corporations as separate QSLOB’s.  Each of them has at least 50 employees and is separately organized.  We will assume that they can survive “administrative scrutiny”.  Here are the resulting demographics.  Where a plan includes employees assigned to more than one QSLOB, the portion of the plan within each QSLOB is tested independently.
HCE
NHCE
Total
QSLOB 1 (A Corporation)
7/7
205/225
212/232
Profit Sharing Plan
7
46
53
Pension Plan
5
80
85
ESOP
5
165
172
Elective Deferrals
7
205
212
Matching Contributions
7
225
232
QSLOB 2 (B Corporation)
3/3
50/50
53/53
Pension Plan
3
50
53
ESOP
3
50
53
Elective deferrals
3
50
53
Matching contributions
3
50
53
QSLOB 3 (C Corporation)
5/5
400/500
405/505
Profit Sharing Plan
5
15
20
ESOP
5
15
20
Elective Deferrals          
5
500
505
Matching Contributions
5
400
405
Plan-by-Plan Analysis:
The A Corporation 401(k) plan, which covers employees of both A and C Corporations will have no difficulty satisfying section 410(b) on any basis.  Because the plan covers at 70 percent of all of the employees in the controlled group, the employer has the option of treating it as an “employer-wide plan” and ignoring the separate lines of business.  Why would it want to do that?  If the plan is tested on a QSLOB basis, separate “nondiscrimination” tests for elective and matching contributions will have to be performed for the portion of the plan included in each QSLOB.  Thus there will be two sets of ADP/ACP tests, one for the A Corporation participants and one for those employed by C Corporation.  An employer-wide plan performs only one set of tests.
If desired, the B Corporation 401(k) plan can be aggregated with A’s plan, and both can be treated as a single employer-wide plan.  If B’s plan is tested separately, it must pass two tests: the nondiscriminatory classification test on an employer-wide basis and the regular section 410(b) test on a QSLOB basis.  Employer-wide, the plan benefits 20 percent of all HCE’s for both elective deferrals and matching contributions.  The percentages for NHCE’s are 6.45 (elective deferrals) and 7.63 (matching contributions).  The NHCE%/HCE% ratios are 0.3226 and 0.3817, which are high enough to demonstrate nondiscriminatory classification.  The second test is easy.  Each feature of the plan benefits every nonexcludible employee of the QSLOB and thus satisfies the ratio percentage test.
The Profit Sharing Plan cannot be an employer-wide plan.  It covers far less than 70 percent of the controlled groups employees, and no amount of permissible aggregation will bring it up to that mark.  Since it covers employees of two QSLOB’s, each portion of the plan must be analyzed separately.
The A Corporation portion of the plan benefits seven of 15 HCE’s in the controlled group (46.67%) and only 46 of 655 NHCE’s (7.02%).  The resulting ratio is 0.1505, which falls below the nondiscriminatory classification test’s unsafe harbor.  A possible remedy is to aggregate the plan with the Pension Plan.  We will come back to that possibility in a moment.
The C Corporation portion of the plan is in yet a worse plight, benefiting 33.33 percent of HCE’s and 2.29 percent of NHCE’s, for a pitiful ratio of 0.0687.  There are no other plans within the QSLOB with which aggregation is possible.  We shall put this problem aside until our next round of analysis.
The Pension Plan covers employees of both A and B Corporations and is too small to be an employer-wide plan.  As with the Profit Sharing Plan, the two portions are tested separately.
The A Corporation portion benefits 33.33 percent of the controlled group’s HCE’s and 12.21 percent of its NHCE’s, producing an adequate 0.3664 ratio.  With the QSLOB, the plan benefits 71.43 percent of HCE’s (5 of 7) and 39.02 percent of NHCE’s (80 of 205).  Its ratio of 0.5463 isn’t high enough to pass the ratio percentage test, but it should have no trouble passing the average benefits test.  Instead of testing it separately, however, we will try to aggregate it with the Profit Sharing Plan in hopes of solving that plan’s problems, too.  The aggregated plan satisfies the gateway test (7 HCE’s, 120 HCE’s; proof that the employer-wide NHCE%/HCE% ratio is a healthy 0.3926 is left to the reader).  Within the QSLOB, the aggregated plan covers 100 percent of the HCE’s and 58.54 percent of the NHCE’s.  It will have to utilize the average benefits test but should pass comfortably.
The B Corporation portion has the same numbers as its 401(k) plan’s matching contributions feature and thus satisfies section 410(b) for the same reasons.
The ESOP benefits employees of all three QSLOB’s.  The analysis for the B portion is the same as for the Pension Plan and of the C portion the same as for the Profit Sharing Plan.  The A portion passes the gateway test: On a controlled group basis, it benefits 33.33 percent of HCE’s and 25.19 percent of NHCE’s, for a ratio of 0.7557.  Within the QSLOB, it covers 80.49 percent of NHCE’s, thus passing the ratio percentage test.
Can anything be done to salvage the portions of the Profit Sharing Plan and the ESOP that cover C Corporation employees?  Here are some ideas that won’t work:
Transfer the Profit Sharing Plan participants to A’s payroll.  This is the kind of “solution” that clients think up on their own, but there are two obstacles.  First, the QSLOB rules assign employees to the units for which they actually perform services, so that those who work for C Corporation must be treated as part of its QSLOB.  Second, if the rules on employee attribution can be manipulated to attach the employees to A, C Corporation will no longer have “separate management” and will no longer qualify as a QSLOB.
Add a trivial benefit for a large group of C Corporation NHCE’s.  Suppose that the Profit Sharing Plan and the ESOP are amended to give every employee of C an allocation of a hundred dollars a year.  On the surface, the plan will then pass the gateway test easily.  Unfortunately, it almost certainly won’t satisfy section 401(a)(4), because contributions will “discriminate” in favor of highly compensated employees.
Combine A and C into a single QSLOB.  The deluge of C employees with minimal benefits will all but guarantee that the aggregated Pension and Profit Sharing plans will fail the average benefit percentage prong of the average benefits test.
Combine B and C into a single QSLOB, then aggregate the Pension and Profit Sharing Plans.  Alas, the numbers won’t work out (left as an exercise for the reader).
The moral is, of course, that QSLOB’s are not a magic formula.  Sometimes the only way to satisfy section 410(b) is to provide more benefits to more NHCE’s or reduce HCE benefits.
APPENDIX – Overview of Qualified Separate Lines of Business
A “qualified separate line of business” (“QSLOB”) must satisfy four conditions:
It must have at least 50 employees.
It must be a separately organized business unit.
It must satisfy an “administrative scrutiny” test.
The employer must give timely notice to the IRS that it has elected to test its qualified plans on a separate line of business basis.
50-Employee Requirement (Treas. Regs., §1.414(r)-4(b))
A QSLOB must have at least 50 employees who do not render services to any other line of business.  Employees who do not participate in the plan and those who are covered by collective bargaining are counted.  Excluded from the count are –
employees who normally work less than six months a year
employees who normally work less than 17½ hours a week
employees who are under age 21 as of the end of the year
nonresident aliens without U.S. source income
Separate Organization Requirement (Treas. Regs., §1.414-3)
To be considered separately organized, a QSLOB must satisfy all of these following conditions:
It must be a separate organizational unit, such as a division or subsidiary.
It must have separate financial accountability with “books and records that provide separate revenue and expense information that is used for internal planning and control”.
It must have a separate work force.  The regulations include elaborate, though rarely pertinent, rules for assigning employees to a particular line of business when they perform services for more than one.
It must have separate management.  The regulations set forth a rather convoluted arithmetical test, which can be summarized (omitting a number of less important details) thus: At least 80 percent of the highest paid ten percent of employees who devote 25 percent or more of their time to the line of business must devote at least 75 percent of their time to it.  Example: D Division is a purported QSLOB with the E Controlled Group.  During 2003, 100 employees work at least 25 percent of their time for D.  Of the highest paid ten members of that group, at least eight must devote at least 75 percent of their time to D in order to satisfy the separate management test.
If the employer is an affiliated service group described in section 414(m), QSLOB’s cannot be set up in a way that separates employees who are required to be aggregated under the affiliated service group rules.  As an example, suppose that A Corporation’s president forms a company, wholly owned by himself, whose principal business is furnishing management services to A.  The management company forms an affiliated service group with A (I.R.C., §414(m)(5)).  It cannot be designated as a QSLOB, even if it otherwise satisfies the applicable requirements.  Instead, it must be included within one of the group’s other QSLOB’s.
Administrative Scrutiny Requirement (Treas. Regs., §1.414(r)-5)
To prevent clever use of QSLOB’s to reach unreasonable ends (at least, unreasonable to the IRS), the Regulations require that each line of business satisfy one of the following tests.  Each QSLOB may use a different test.
Test 1.  The percentage of HCE’s in the line’s work force is no more than 200 percent, and no less than 50 percent, of the percentage in the controlled group as a whole.  In the corporations used in our case study, the HCE percentages looked like this:
HCE’s
NHCE’s
HCE Pct.
Pct of Avg
A Corporation
7
225
3.02%
156.03%
B Corporation
3
50
5.66%
292.43%
C Corporation
5
500
0.99%
51.15%
Controlled Group
15
775
1.94%
Both A and C satisfy the 200%/50% safe harbor.  B must pass administrative scrutiny in some other manner.
Test 2.  All of the goods and services provided by the line fall within one of the 12 industry categories set forth in Revenue Procedure 91-64, 1991-2 C.B. 866, and no other line provides any goods or services in the same category.
Test 3.  The line was acquired through a merger or similar transaction and meet various other requirements.  This test cannot be relied on for longer than three years after the year of the acquisition.
Test 4.  The line is reported as one or more industry segments on the employer’s SEC Form 10-K or 20-F.
Test 5.  The average benefit percentage for employees of the line falls within stated perimeters when compared to the average for the controlled group as a whole.  If the line’s HCE percentage is less than 50 percent of the HCE percentage for the controlled group, the average benefit percentage for the line’s NHCE’s must be at least as high as the NHCE average for the rest of the controlled group.  If the line’s HCE percentage is greater than 200 percent of the controlled group’s percentage (as with our B Corporation), the average benefit percentage for its HCE’s must be no higher than the average for all other HCE’s in the group.
Test 6.  The line provides benefits at least equal to a stated minimum to at least 80 percent of its NHCE’s (if its HCE percentage is below 50 percent of the controlled group’s percentage) or provides no benefits to HCE’s above a stated maximum (if its HCE percentage exceeds 200 percent of the controlled group’s).
Test 7.  If all else fails, the employer can seek an IRS ruling that its proposed QSLOB’s are acceptable.  See Revenue Procedure 93-41, 1993-2 C.B. 536.
Notice Requirement (Treas. Regs., §1.414(r)-4(c))
In order to make use of QSLOB testing, an employer must file Form 5310-A.  The due date is determined on a calendar year basis and is 9½ months after the end of the plan year that begins earliest in the calendar year.  For example, if the employer’s controlled group has one plan that operates on a January 31st year and another on a June 30th year, the due date for the notice covering the plan years beginning in 2003, is November 15, 2004 (9½ months after the end of the year that started on February 1, 2003).
Once the deadline for filing has passed, the notice is irrevocable.  Moreover, it remains in effect in future years unless modified or revoked by a timely filed Form 5310-A.  Only a single Form 5310-A is filed for the entire controlled group in any particular year.
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