Three Partners, Two 900-Hour Staff, and a New Comparability Allocation
Ridgeway & Sato LLP has 12 employees: three equity partners (ages 49, 52, and 55; W-2 compensation $310,000 each) and nine staff (average compensation $58,000). The partners want to defer the maximum and save more than the 2025 §402(g)/§415(c) limits allow through a 401(k) alone. The firm proposes a safe harbor 401(k) with a 3% nonelective contribution, immediate eligibility for deferrals, a one-year eligibility requirement for the match, and a new comparability profit sharing allocation funded at 8% of covered payroll using a 1,000-hour/last-day rule. Two staff members work about 900 hours per year. The controller asks whether the 3% safe harbor contribution satisfies the top-heavy minimum for everyone and whether the partners can take 6% while staff receive 5%.
1. Is the plan top-heavy, and does the 3% safe harbor nonelective satisfy the top-heavy minimum for the two 900-hour staff who fail the last-day and 1,000-hour conditions?
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The three partners are 5% owners and therefore key employees; their combined compensation ($930,000) is a large share of total compensation, so key-employee account balances are likely over 60%. More importantly, adding profit sharing destroys the §416(g)(4)(H) exemption for a plan consisting solely of 401(k) deferrals and safe harbor contributions. The plan is top-heavy.
The 3% safe harbor nonelective can be counted toward the 3% top-heavy minimum if the document permits and it is allocated to all non-key employees who are participants for the year. A last-day or 1,000-hour condition does not cut off the top-heavy minimum; those conditions govern the profit sharing allocation, not the §416 minimum. Assuming the two 900-hour staff met the plan's eligibility for the year, each must receive at least 3% of §415(c) compensation even though she shares in no profit sharing. If they had not met the one-year eligibility requirement, they would not yet be participants and no minimum would apply to them.
2. The partners want 6% and staff 5% under the new comparability formula. Identify the nondiscrimination gates and explain what happens if the general test fails.
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Two gates apply. First, the §410(b) coverage test must be met for the plan and for each rate group under §401(a)(4). With three HCEs and nine NHCEs, each rate group generally needs at least seven NHCEs (70%) or must pass the average benefit test. Second, the new comparability gateway under Treas. Reg. §1.401(a)(4)-8(b)(1)(vi): each NHCE's allocation rate must be at least 5% of compensation, or one-third of the highest HCE allocation rate if that is lower. Because the highest HCE rate is 6%, one-third is 2%, so the 5% floor applies. A 5% staff allocation clears the gateway.
The plan must then pass the §401(a)(4) general test on a cross-tested basis, converting allocations to equivalent benefit accrual rates using age and testing assumptions. Younger staff may need more than 5% to produce rates comparable to the partners'. If the general test fails, the 6%/5% allocation cannot be used as proposed. Options include increasing NHCE allocations, reducing HCE allocations, changing to an integrated or age-weighted formula, or correcting under EPCRS.
3. If the firm adds a cash balance plan, what combined deduction and testing limits apply, and does PBGC coverage matter?
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A law firm with 25 or fewer active participants is a professional service employer and is generally exempt from PBGC coverage. That matters because the §404(a)(7) combined deduction limit applies unless the DB plan is PBGC-covered. With no PBGC coverage, combined employer contributions are deductible up to the greater of 25% of compensation or the DB minimum required contribution, but DC contributions up to 6% of compensation are disregarded in applying the limit.
Testing also becomes combined. The DB and DC plans must pass §401(a)(4) together, generally with a 7.5% of compensation DC gateway when the DB/DC plan is not primarily DB in character. The DB plan must satisfy §401(a)(26) minimum participation (the lesser of 50 employees or 40% of employees). If the combined plan is top-heavy, the minimum is generally 5% of compensation in the DC plan or 2% per year of service in the DB plan, and the §415 combined limit applies. The firm should model the deduction limit and gateway before adopting the cash balance plan.