In Bad Economic Times for a Client, Watch Out for Nasty Top Heavy Minimum Contribution Surprise

For relatively small employers, CPA's need to be aware of a nasty little surprise called "Top Heavy". Often people respond to this statement with "Oh, I know all about the ADP test and how there might have to be refunds of salary deferrals to some of the Highly Compensated Employees."

We are talking about a completely different subject. Suppose a company was really small for a number of years and it made recurring profit sharing contributions for its small staff of mostly key people. Yes, others shared in the Profit Sharing contributions too, but over the years most of them have left the company and have been paid-out or rolled over distributions. The result is that the plan is now "Top Heavy", meaning that the Key Employees have more than 60% of the total account balances. I won't go into it here, but the Key Employee definition is not quite the same as the definition of Highly Compensated Employees. Along the way, probably at the request of the employees, the plan has been modified allowing personal salary deferrals thereby making the plan into a 401(k) plan.

This is not problem as long as times are good and the company continues it generous ways of making Profit Sharing contributions of 3% of pay or more each year. But along comes a recession or difficult business times for the company and the management decides that they will simply skip Profit Sharing contributions for a couple of years. Profit Sharing contributions are, after all, completely discretionary, aren't they? And that is the big surprise!

If a 401(k) Plan is Top Heavy and if ANY of the Key Employees engage in salary deferrals, then the company is going to be faced with making Top Heavy minimum contributions, whether they can afford to or not. Ouch! If any of the Key Employees have made salary deferrals of 3% of pay or more, then the Top Heavy minimum contribution is 3% of the pay of all of the Non-Key Employees. So, for example, if a small company had a payroll of $1,000,000 for all of the Non-Key employees, the Top Heavy minimum contribution would be $30,000.

If the highest rate of salary deferrals is less than 3%, then that percentage becomes the Top Heavy obligation.  For example, let's suppose salary deferrals have already taken place for a couple of months before the client discovers that they are Top Heavy.  Let's further suppose there is only one Key Employee (the owner) and he or she suspends their salary deferrals after doing $1,000 and their pay for the year ends up being $100,000.  So, the salary deferrals is 1% of pay and the Top Heavy minimum contribution becomes 1% of everyone's pay.

When a small business is really struggling to survive in these kind of economic times, the business owner is going to be really upset  when they find out they have to make a Top Heavy minimum contribution that they cannot afford and they are going to blame the TPA, investment advisor and maybe even their CPA for not proactively helping this avoid this problem.  The solution is easy - don't let any Key Employees do salary deferrals for any part of the Top Heavy plan year.

It takes a bit of foward planning to avoid this situation. First, you have to be aware of whether or not the Key Employees might have more than 60% of the total assets as of the last day of a Plan Year - might be hard to know this since the year end accounting may not be available for a few weeks after the year is over. If they do have greater than 60% on the last day of a year, then the next year is Top Heavy. Second, if it appears likely that the plan will be Top Heavy, to avoid the Top Heavy Minimum, you will need to tell all of the Key Employees that you are going to cease their salary deferrals as of the first day of the Top Heavy year. They can do salary deferrals later in the year if it is determined that the company will be able to afford a Profit Sharing contribution of 3% of pay or more for everybody.

Don't forget to tell the person handling payroll to actually cease the deferrals for the Key Employees as of the first day of the new year.

If the plan is close to being Top Heavy, you may want to routinely cease the salary deferrals of all Key Employees at the beginning of each plan year until you can determine if that year is going to be Top Heavy or not.