Small Business 401(k) Blog

Owners of a partnership or sole proprietorship (or an LLC taxed as either) are considered “self-employed individuals” for 401(k) plan purposes. 401(k) plans must allocate and test the annual contributions made to self-employed individuals using a special definition of plan compensation called earned income. When applicable, earned income is calculated by the plan’s Third-Party Administrator (TPA) based on information prepared by the employer’s Certified Public Accountant (CPA). The CPA, in turn, will use the TPA's calculation to finalize the employer’s year-end tax returns. 

Each year, 401(k) plans must pass certain IRS-mandated nondiscrimination tests to confirm Highly-Compensated Employees (HCEs) do not disproportionately benefit and no IRS contribution limits are exceeded. These tests are often completed soon after the close of the year so test correction and tax deduction deadlines are not missed. For calendar-based 401(k) plans, that means now.

To meet IRS qualification requirements, 401(k) plans must pass nondiscrimination testing annually to ensure plan contributions do not disproportionately benefit Highly-Compensated Employees (HCEs) or exceed legal limits. While most employers hire a professional third-party administrator (TPA) to complete this work, all employers should understand the deadlines that apply to the process – which generally relate to failed testing and contribution funding. This basic knowledge can help avoid the often painful consequences of late testing – including missed tax deductions, IRS penalties, and plan disqualification.

It’s impossible to complete annual 401(k) plan testing accurately without a clear understanding of the plan sponsor’s ownership structure. This information is used to determine the company’s controlled or affiliated service group status as well as the Highly Compensated Employee (HCE) and key employee status of plan participants. To make these determinations properly, certain “family attribution” rules must be applied correctly. These IRS rules exist to thwart ownership structures that would otherwise permit a 401(k) plan to discriminate in favor of business owners.

Safe harbor 401(k) plans are the most popular type of 401(k) used by small businesses today. Unlike a traditional 401(k) plan, they automatically pass the ADP/ACP and top heavy nondiscrimination tests when mandatory contribution and participant disclosure requirements are met. This trade-off is worth it for many business owners, who often bear the brunt of the consequences when their 401(k) plan fails testing. However, a safe harbor 401(k) plan is not the best fit for every small business. They can cost more than a traditional 401(k) plan, but offer less plan design flexibility – making it harder for some business owners to meet their plan priorities

All 401(k) plan contributions have deposit deadlines – and it’s up to 401(k) fiduciaries to meet them. Yet, many employers are unclear about the deadlines applicable to their 401(k) plan. That confusion can easily lead to late contributions. When that happens, there are always consequences for the employer. They range from mild (losing a tax deduction, making participants whole for lost earnings) to severe (plan disqualification, IRS and/or civil penalties). Fortunately, these consequences are easily avoided with some basic education.