The Affiliate the TPA Never Knew About: A 410(b) Coverage Failure
Company A sponsors a calendar-year 401(k) plan with age-21/one-year-of-service eligibility and semiannual entry. Company A owns 80% of Company B; there is no other plan. The plan document covers only Company A's employees. 2024 data: Company A - 5 HCEs, all benefiting; 40 NHCEs benefiting; and 5 NHCEs who have not yet met the one-year requirement. Company B - no HCEs and 60 NHCEs, none of whom benefit under any plan. Deferral rates among Company A's benefiting NHCEs average 5%; Company A's HCEs average 8%. The owner wants to know whether the plan is fine for 2024 and, if not, what can be done before the extended corporate return is filed. He insists Company B is 'a completely separate business.'
1. Compute the 2024 coverage ratio percentage for the plan as written and state whether it passes §410(b).
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Step 1 - Who is in the test. A and B are a parent-subsidiary controlled group under §414(b) (80% ownership), so they are one employer for §410(b). B's employees must be counted even though the document excludes them.
Step 2 - Permitted exclusions. The 5 Company A NHCEs who have not completed age 21/one year of service may be excluded from the test under §410(b)(4)(A) because the plan's eligibility conditions are the maximum permitted. B's 60 NHCEs are not excludable - they are simply not benefiting.
Step 3 - Counts. NHCEs = 40 benefiting + 60 not benefiting = 100. HCEs = 5, all benefiting.
Step 4 - Ratio percentage.
- NHCE benefiting percentage: 40 ÷ 100 = 40.00%
- HCE benefiting percentage: 5 ÷ 5 = 100%
- Ratio percentage: 40.00% ÷ 100% = 40.00%
Conclusion. 40.00% is below the 70% ratio percentage threshold, so the plan fails the ratio percentage test for 2024. (If the 5 not-yet-eligible NHCEs were improperly included in the denominator, the ratio would be 40 ÷ 105 = 38.1% - still a failure.)
2. Assume the ratio percentage test fails. Walk through the average benefit test, including the safe harbor percentage, and assess whether the plan can pass on these facts.
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The average benefit test has two prongs, and both must be satisfied.
Prong 1 - Nondiscriminatory classification.
- NHCE concentration percentage = 100 ÷ 105 = 95.24% (round to 95%).
- Safe harbor percentage = 50% − 0.75 × (95 − 60) = 50% − 26.25% = 23.75%.
- Unsafe harbor percentage = 40% − 0.75 × (95 − 60) = 13.75%, floored at 20%.
- The plan's 40.00% ratio exceeds 23.75%, so it clears the safe harbor and the classification prong is satisfied.
Prong 2 - Average benefit percentage test (ABPT). The ABPT compares the average of all employees' benefit percentages (deferrals, match, and nonelective, computed for every employee in the testing group, using 0% for non-benefiting employees) and requires the NHCE average to be at least 70% of the HCE average.
- NHCE average = (40 × 5% + 60 × 0%) ÷ 100 = 2.00%
- HCE average = 8.00%
- ABPT ratio = 2.00 ÷ 8.00 = 25.00%, far below 70%.
Conclusion. The plan fails the ABPT even though it passes the classification prong, so it fails §410(b) for 2024. Expanding the numbers does not save it: every fix must bring Company B's 60 NHCEs into the benefiting group (or into another plan) - the concentration of zero-rate employees is too large for an averaging argument to absorb. Note also that these are year-end averages only; the actual ABPT must be run on a consistent basis with all contributions normalized and, if elected, on a cross-tested basis.
3. What are the sponsor's correction options for 2024, and does the separate line of business rule under §414(r) provide an escape?
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Can the plan simply be amended now? No. A plan amendment expanding coverage generally cannot be made retroactively to a closed plan year outside of a correction program, because it would impermissibly change the coverage testing that already occurred. Prospective amendment to include B's employees fixes 2025 forward but leaves 2024 broken.
Correction route. A §410(b) coverage failure is a qualification failure, not an insignificant operational slip, so VCP (with IRS approval and a compliance fee) is the practical route: request approval to adopt a retroactive amendment extending coverage to Company B for 2024 and make a corrective employer contribution for B's NHCEs following the applicable EPCRS correction method for the failure. The document must also be conformed so it no longer excludes an entire member of the controlled group. SCP is not a safe harbor for a year-defining coverage failure of this size.
Does §414(r) help? Only theoretically. Separate line of business treatment requires each line to have at least 50 employees, satisfaction of the administrative-scrutiny/guideline tests, consistency across all plans of the employer, and a determination from the IRS that the employer operates qualified separate lines of business. Company B has 60 employees, and there is no ruling in place and no time to obtain one. It is not a workable answer for 2024.
Practical answer. Bring Company B into the plan now and negotiate 2024 through VCP; also confirm whether B has its own plan history, because that would create additional 410(b) and 414(b) aggregation issues.