I took some time when we had no cable and no internet to ruminate on the Internal Revenue Code. Ultimately, the statute has been created by Congress (or Congressional staffers). I've got to tell you, somebody has had some strange ideas. In fact, a lot of people have had some strange ideas.
Let's start with the math behind the ADP and ACP tests (If you don't know what they are, the math will make just about an identical amount of sense). Essentially, you get to use your choice of three tests, but mathematically, the tests work like this:
- If your eligible nonhighly compensated employees (NHCEs) defer on average less than 2% of pay, then your highly compensated employees (HCEs) are allowed to defer on average the NHCE percentage times 2.
- If your eligible NHCEs defer at least 2% of pay on average, but less than 8% of pay, then your HCEs are allowed to defer on average the NHCE percentage plus 2%.
- If your eligible NHCEs defer on average at least 8% of pay on average, then you are doing something really right, and your HCEs are allowed to defer on average the NHCE percentage times 1.25.
Does that make sense to you? It makes no sense to me. George Carlin could have had a field day with it. Can you imagine, a whole comedy routine on the ADP test? Nobody would get it, but it would be funny. Come to think of it, nobody that I know of really understands the rationale for the ADP test.
And, then there's Section 162(m) of the Code. Generally, it disallows corporate tax deductions when they pay someone a salary in excess of $1,000,000, unless of course the company was a TARP recipient (until they pay back their TARP loans) or the company is for the most part, a health insurance provider, in which case the limit is $500,000. Those are nice numbers, I suppose. Why pick them? Why not have a limit of $836,297? It would make just as much sense. But, then if a piece of that pay is performance-based, it doesn't count against the $1,000,000 limit. Nothing in the law says that the performance targets need to be reasonable, the excess just needs to be based on performance. Please tell me how that makes sense. By the way, since Section 162(m) was added to the Code, virtually any observer would tell you that pay for top executives has gotten more out of hand rather than less. Another great job -- let's have a round of applause for Congress.
And, then there are some of the rules that Congress left to the IRS to interpret and regulate. I think that Congress and the IRS must share some of the same staffers (although I have to say that in recent years, the IRS has gotten much better and sought more input from regular people on what might be appropriate in regulations). But, get this one. Suppose you are performing something called the Average Benefit Test (you can find it in Code Section 410(b) if you want to look). It's a 2-part test and one of the parts called the Nondiscriminatory Classification Test (NDT) has two parts. One of those two parts is subjective and one is objective. We'll focus here on the objective part. Here is (oversimplified, believe it or not) the math behind this one.
- Determine the percentage of your population who are NHCEs
- Round it down to the next lower integer (unless it's already an integer)
- Subtract that result from 100% (now wouldn't it have been easier to do the same calculation on the HCEs and round up to the next higher integral percentage, but not have to do a subtraction?)
- Multiply that result by 0.75
- Add that result to 20%, but don't let the answer get above 50%. That is called the safe harbor percentage, one of perhaps two or three hundred safe harbor percentages that you can find in the Code.
- Subtract 10% from the safe harbor percentage, but don't let the answer go below 20%. That is called the unsafe harbor percentage, a far more unique term within the universe of the Code.
- If your ratio percentage, defined as the percentage of nonexcludible NHCEs who are currently benefiting under the plan divided by the percentage of nonexcludible HCEs who are currently benefitting under the plan, is at least as big as the safe harbor percentage, you pass this part of that part of the test. If your ratio percentage is below the unsafe harbor percentage, then you fail this part of the test which means that you will likely have to resort to qualified separate lines of business (QSLOBs) which are far more complicated than the NDT could ever dream of being. And, finally, if your ratio percentage is between the harbors (but not near Somalia where they have pirates), it all comes down to facts and circumstances which means you still don't know if you pass, but your legal counsel will probably tell you that you are just fine.
It sure feels good to be done with that explanation since it makes oh so much sense.
Well, enough on lambasting our rulemakers for the moment. It's time to look for something more useful to write about.