A test that must be performed by plan administrators to determine whether matching and after-tax contributions are skewed in favor of highly compensated employees (HCE) in a discriminatory manner.
This test provides a limit on the amount that certain benefits provided under the plan to HCEs may exceed the benefits provided to non-highly compensated employees (NHCEs).
If the plan fails the ADP and/or ACP tests, corrective action must be taken to protect the qualified status of the arrangement. The law and related regulations provide various methods for correcting mistakes during a “correction period.” This statutory correction period is the 12-month period following the close of the plan year in which the mistake occurs. If corrective distributions are made after the first 2 ½ months of the correction period, the employer (not the HCE) is liable for an excise tax. If correction is not made within the correction period, the plan is considered “disqualified.”
The plan satisfies the nondiscrimination requirements of the law if it passes the ADP and ACP tests
IRC §401(m); Treas Reg §1.401(m)-2
Additional Helpful Information
- If the plan fails the ACP test, corrective steps can be taken, which include the following:
- Refunding amounts to HCEs
- Recharacterizing salary deferral contributions as after-tax contributions
- Contributing additional amounts for non-highly compensated employees
An employer may avoid the ACP test by adopting and abiding by the safe harbor provisions as described in IRS Notice 98-52 and Notice 2000-3
- According to the IRS, one of the most common mistakes submitted for correction under the Voluntary Correction Program (VCP) is the failure to timely test for and correct ADP or ACP mistakes. Common reasons for this mistake are:
- Incorrectly classifying employees as HCE or NHCE;
- Using an incorrect definition of compensation in the tests; and
- Calculating the test incorrectly.
Employers may get relief from treatment of the 401(k) plans as nonqualified through theEmployee Plans Compliance Resolution System (EPCRS) by correcting the mistakes after the statutory correction period has passed. The Self-Correction Program (SCP) or Voluntary Correction Program (VCP) can be used to correct the mistakes. In order to fix the mistake under SCP, generally the mistake must be fixed within two years after the end of the statutory correction period (i.e., the 12-month period following the close of the plan year). Unless the failure can be classified as insignificant, VCP must be used after this time.
Example: A calendar year plan with a 401(k) arrangement fails the ADP test for the plan year ending 12/31/04. The statutory correction period is the 12-month period from 01/01/05 to 12/31/05. The self-correction period under SCP runs from 01/01/06 to 12/31/07. After this date (unless the violation is considered insignificant), VCP must be used to correct the violation.
There is more than one way to correct ADP and ACP mistakes under EPCRS. Generally, if SCP or VCP is used to correct a violation of the ADP/ACP test after the statutory 12-month correction period, the employer is required to make Qualified Non-Elective contributions (QNECs) for the NHCEs. QNECs are contributions made by the employer that are 100% vested, have the same distribution rules as 401(k) deferrals and do not discriminate in favor of HCEs. Under one corrective approach, the employer contributes enough QNECs to all the NHCEs in order to raise the ADP of the NHCEs to a level necessary that satisfies the ADP test. Another approach under EPCRS permits correction solely by making distributions to the HCEs after the statutory correction period as long as the employer is willing to make a contribution for the NHCEs that equals the total amount being distributed.