April 2008 - Benefit Insights Newsletter

A plan is considered top heavy if more than 60% of the benefits under the plan belong to "key employees" as of the applicable determination date. Multiple plans of an employer in which a key employee participates must be aggregated to form a top heavy group. Plans of the same employer not covering a key employee can also be aggregated as part of the top heavy group under certain circumstances.

The classification of key employee is sometimes confused with "highly compensated employee" (HCE) which is used for nondiscrimination purposes. In fact, the definitions are similar in some respects, and while most key employees are HCEs, many HCEs are not key employees.

A key employee is an employee who at any time during the determination year was:

• An owner of more than 5% of the employer;
• An owner of more than 1% of the employer with annual compensation in excess of $150,000; and
• An officer of the employer with annual compensation exceeding a specified dollar amount, adjusted for cost-of-living ($150,000 for 2008).

Stock attribution rules apply in determining ownership for key employee purposes. An employee is considered as owning the stock or interest owned by his spouse, parents, children and grandchildren.

The number of officers who can be considered key employees is limited to the greater of (a) 10% of the total number of employees, to a maximum of 50 officers, or (b) three.

The date for determining if an ongoing plan is top heavy is generally the last day of the preceding plan year (determination year). For the initial year of a plan the determination date is the last day of the first plan year.

In defined benefit plans, the present value of accrued benefits is used to calculate if the key employees' share exceeds 60% of the total. In defined contribution plans, the participants' total account balances are used to perform the test. Vesting is not considered in top heavy calculations.

Certain adjustments must be made to the accrued benefits or account balances when performing the top heavy test. The following items must be included:

• Outstanding balances of participant loans;
• Related rollovers, e.g., from another plan previously maintained by the same employer, and unrelated rollovers received prior to 1984;
• Distributions during the determination year to participants who terminated employment that year;
• In-service distributions during the five-year period ending on the determination date to those still employed as of the first day of the determination year;
• The cash surrender value of any whole life insurance policies in the plan; and
• Salary deferrals and required employer contributions for the determination year that are deposited after the determination date. For the first plan year accrued discretionary contributions are also included.

The following items are not included in the top heavy test:

• Benefits of prior year terminees (those who did not perform an hour of service during the determination year);
• Distributions to prior year terminees;
• Benefits of former key employees (those who were key employees but are now classified as non-key employees in the determination year). The same holds true for any amounts distributed to former key employees; and
• Unrelated rollovers received after 1983.

Top heavy plans must provide certain minimum accrued benefits or contributions to non-key employees and meet special vesting requirements. These provisions do not apply to union employees.

The minimum benefit in a defined benefit plan is a life annuity at normal retirement age of 2% of average compensation for each year of service up to a maximum of 10 years (a maximum required benefit of 20% of average compensation). It must be provided to each non-key employee who is credited with at least 1,000 hours of service during the plan year. Frozen defined benefit plans are no longer required to provide top heavy benefits.

For defined contribution plans, the minimum contribution is the lesser of 3% of compensation or the highest contribution rate allocated to a key employee. For example, if the highest contribution rate for a key employee is 2%, then the top heavy minimum contribution is 2%; if the highest contribution rate for a key employee is 5%, then the top heavy minimum contribution is 3%; and if no key employee receives a contribution, then the top heavy contribution is 0%.

The top heavy contribution must be given to each eligible non-key employee who is employed on the last day of the plan year, regardless of the number of hours worked. An allocation of forfeitures, derived from the accounts of participants who terminated employment without full vesting, is counted towards satisfaction of the minimum top heavy contribution. The deadline for making the contribution is the last day of the following plan year.

Where an employer sponsors multiple plans, only one plan has to provide the top heavy benefit. Special rules apply where an employer sponsors both a defined benefit and a defined contribution plan.

Top heavy plans must have a vesting schedule no less restrictive than one of the following two schedules:

Under the Pension Protection Act of 2006, all defined contribution plans are required to use a vesting schedule no less restrictive than one of the top heavy schedules as of 2007. Only certain defined benefit plans can still use a non-top heavy schedule (7-year graded or 5-year cliff).