401(k) plans are subject to annual IRS-required nondiscrimination compliance testing. The purpose of these tests are to ensure the plan is fair to all employees and does not overly favor owners and highly compensated employees.
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While certain plan elements may be out of your control, plan sponsors should be aware that some business and plan characteristics may result in increased compliance risks – making the plan more likely to fail required testing.
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Here are several business and plan scenarios to consider as well as how to effectively manage risks through purposeful plan design.
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The following are the primary nondiscrimination tests that your company may be subject to after the end of each plan year.

Plans with a small number of participants should be particularly mindful that low employee participation rates can greatly impact compliance testing results. With fewer participants, it is more likely that 401(k) contributions from key employees (typically officers and owners) could exceed 60% of plan assets, resulting in a Top Heavy testing failure.
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Additionally, in a smaller company, one HCE contributing a large amount or one NHCE deciding to unenroll can have an outsized impact on the HCE and NHCE deferral rates, causing the plan to fail the testing. This would result in either HCEs having to remove their deferrals or the company having to make additional contributions to raise the testing ratios.
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One approach to addressing potential risks related to having a small number of participants is for owners to contribute consistently over the year, observing NHCE deferral rates and adjusting their deferrals accordingly. Both of these concerns could also be addressed by adding a safe harbor provision.
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Generally, S-corporation owners only have a portion of their income reported as W-2 wages eligible for 401(k) contributions and the remaining portion of their wages reported on a K-1 (IRS Form 1065). For S-corporations, the IRS only permits the W-2 wages to be considered compensation for plan purposes.
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Owners who elect to defer a high portion of their W-2 compensation to their 401(k) can have a very high Actual Deferral Percentage (ADP), putting the plan at risk of failing the ADP test.
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For example, say Ace is an S-corp owner who reports $70,000 of income on a K-1 and receives $30,000 in wages. If Ace defers $9,000 (only half the annual limit and less than 10% of her total combined income), she will have an actual deferral percentage of 30% as only the $30,000 can be used in the test. It is unlikely that non-owners will be able to contribute at a similar deferral percentage, which means the plan would be outside ADP limits and require corrections at year-end.
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Owners who wish to contribute larger amounts to the 401(k) plan should be aware that their wage deferral percentage is what is used for testing purposes.
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Large variations in employee pay can cause compliance issues for your 401(k) plan because of the following:

For example, Bad Wolf Inc. has one HCE earning $185,000 annually and deferring 10% to their 401(k) account. At the same time, the company has 9 employees earning an average of $40,000, who can only defer an average of 3%. The ADP disparity of 7% (10%-3%) exceeds the IRS allowed 2% difference. Further, the one key employee’s 401(k) account would likely constitute greater than 60% of total plan assets, making the plan top heavy, as well.
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When a large proportion of a company is made up of partners or owners, it is easy to fall outside of the limits for Top-Heavy testing.
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For instance, Atmos Law has 3 partners, 3 associates, 1 executive assistant, and 2 paralegals. Because the partners earn more, save more, and have been with the firm longer than the other employees, the partners’ 401(k) account assets exceed 60% of plan assets. Therefore, Atmos Law is required to make Top-Heavy minimum contributions.
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Due to ownership attribution rules, family businesses can face the same challenges as businesses that have a high proportion of owners, as they may be deemed to be owners due to the relationship. Employees who are the spouses, parents, children, or sometimes even grandchildren of owners can be treated as having the same ownership stake of a business when determining key employee and HCE status.
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For example, Alice and Ben own 100% of Family Farms and their 401(k) assets make up 40% of plan assets. Charles, Diana, and Eric are Alice and Ben’s children, who work at Family Farms, and together their assets make up 25% of plan assets. Because children are considered key employees due to attribution of their parents’ ownership, key employee assets for Family Farms make up 65% of the plan’s total assets. As a result the plan is top-heavy.
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If relatives work for your company, know that they may be considered key employees or HCEs whose deferrals can affect compliance testing results – even if they are modestly compensated and do not hold any ownership in the company itself.
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Many new companies use stock options, grants, or warrants as a way of rewarding early employees. This can result in a larger number of employee-owners, who may be considered key or HCEs. If such key employees’ 401(k) contribution assets exceed 60% of plan assets, the plan will experience a Top Heavy testing failure.
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If your company has issued or will issue significant stock options to employees, you should review them before beginning a 401(k) plan to determine who at that time and in the future will be considered a key employee.
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If your plan falls into one or more of the scenarios above, you should be especially diligent at monitoring your plan’s compliance scores. You can easily keep track of your estimated compliance status throughout the year within the Compliance section of your Guideline administrator dashboard.*
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Additionally, adopting specific plan features can help reduce risk that comes with certain business and plan designs.

​*Please note, if you are part of a legally related group, compliance information will not be available.

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