Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are IRS requirements for employer-sponsored retirement plans. An ADP/ACP Safe Harbor 401(k)plan allows employers to automatically pass these tests if they meet certain contribution, vesting and notification rules.

Employers experiencing the following situations may benefit from Safe Harbor:

• Owners and highly paid employees’ contributions are limited because of low participation or low contribution rates by other employees
• Plans are consistently top heavy, and additional employer contributions must be made to satisfy the top-heavy requirements
• Generous (more than 3%) profit sharing or matching contributions are made consistently

Employers must amend their plan document to reflect one of the following Safe Harbor formulas.

Basic Match
• A dollar-for-dollar (100%) match on an eligible employee’s deferral up to 3% of compensation for the year and,
• A 50% match on the next 2% of the employee’s deferrals

Enhanced Match
• A matching contribution that is, at a minimum, equivalent to the basic match
• The most common formula gives eligible employees a100% match on deferrals up to 4% of their compensation

Non-Elective Contribution
• A contribution given to all eligible employees – even those who don’t make contributions – that equals 3% of their annual compensation
• With a non-elective contribution, the plan sponsor has the option to wait until the end of the plan year to decide whether or not to adopt the Safe Harbor plan

Required Safe Harbor contributions must be 100% vested.

The annual cost of the Safe Harbor contribution for the employer depends on the level of participation. If few eligible employees make deferrals, a matching formula may be more cost effective than the non-elective contribution. If the employer wants to bolster deferral rates, even at a higher cost, he may choose the 4% enhanced match formula.

Aside from the typical operational compliance rules(following plan provisions, filing Form 5500 annually, etc.),the employer must:

• Operate as a Safe Harbor plan for the entire plan year
• Amend the 401(k) document to add the Safe Harbor provisions
• Notify participants about the Safe Harbor provisions 30 to 90 days before the start of each new plan year

If an employer fails to provide the proper notification, the plan will not be considered a Safe Harbor, and ADP,ACP and top-heavy testing rules will apply.

Occasionally, an employer may want to make matching contributions in addition to the basic match. This is permissible, provided the additional contributions don’t exceed certain limitations that prevent highly compensated employees (HCEs) from receiving a disproportionate amount.

To illustrate: an employer generally cannot provide a matching contribution on deferrals that exceed 6% because non-HCEs typically don’t defer higher percentages of their compensation. If an employer exceeds this limitation (and others), the Safe Harbor relief no longer applies and the employer is subject to various non-discrimination tests, thus losing the benefit of making the contributions.

Because of the vast number of possibilities, employers should consult a qualified tax specialist before making contributions beyond what the Safe Harbor rules allow.

Highlights: Employer pays premium to provide life insurance coverage to key employees and owners.
Purposes: Provides tax-free death benefit protection and tax-deferred cash value accumulation potential, and may help retain valuable employees.

Appropriate business entity:
• Sole Proprietorship
• Partnership
• C & S Corporation
• Limited Liability Company

Owner/Employer Benefits:
• Helps retain key employees
• Freedom to favor select employees
• Fringe benefit to key contributors
• Tax-deductible premium to business
• Easy to implement
• No IRS approval needed

Employee benefits:
• Very low- or no-cost life insurance protection•
Tax-deferred cash value accumulation potential
• Completely portable

Additional considerations:
• Premium bonus may place employee in higher individual income tax bracket
• Failure to follow the terms of a redemption agreement may cause the value of the death benefit to be included in the value of the business interests being redeemed for estate tax purposes

Premium payor:
• Business pays premium for convenience OR business pays cash to employee who pays premium
• Employee reports premium as bonus
• Double bonus can cover employee's tax

Owner and beneficiary:
Employee owns policy and designates their beneficiary

Income tax:
• Premium tax-deductible by business if overall compensation is reasonable
• Premium bonus included in employee's taxable earnings
• Income-tax-free death benefit to employee beneficiaries.

Estate tax:
Insurance included in employee's taxable estate

Highlights: Employer pays premium to provide life insurance coverage for key employees. The employee cannot access the available cash value without the employer's consent; generally not used with the business owner(s).
Purposes: Provides tax-free death benefit protection and tax-deferred cash value accumulation potential, and may help retain valuable employees.

Appropriate business entity:
• Sole Proprietorship
• Partnership
• C & S Corporation
• Limited Liability Company

Owner/Employer Benefits:
• Helps retain key employees
• Freedom to favor select employees
• Fringe benefit to key contributors
• Tax-deductible premium to business
• No IRS approval needed

Employee benefits:
• Very low- or no-cost life insurance protection•
Tax-deferred cash value accumulation potential

Additional considerations:
• Premium bonus may place employee in higher individual income tax bracket
• Requires signed Restricted Policy Agreement

Premium payor:
• Business pays premium for convenience OR business pays cash to employee who pays premium
• Employee reports premium as bonus
• Double bonus can cover employee's tax

Owner and beneficiary:
Employee owns policy and designates their beneficiary

Income tax:
• Premium tax-deductible by business if overall compensation is reasonable
• Premium bonus included in employee's taxable earnings
• Income-tax-free death benefit to employee beneficiaries.

Estate tax:
Insurance included in employee's taxable estate

Highlights: Life insurance with cash value accumulation potential con be used to help secure future benefits
Purposes: Helps retain valuable employees through obligations to pay future benefits to key employees, which con be informally funded by life insurance

Appropriate business entity:
• C & S Corporation
• Limited Liability Company

Owner/Employer Benefits:
• Helps retain key employees
• Must favor select employees
• Employer moy recover all costs
• No IRS process approval needed

Employee benefits:
• Supplement retirement income through benefits paid by plan
• Benefits con be designed specifically foreach participant
• No reportable income until benefits received
• Moy provide survivorship benefits

Additional considerations:
• Moy provide survivorship benefits
• Employer deduction is delayed until benefits ore actually paid
• Survivorship benefits ore taxable income to employee's family
• Funding vehicle used must be subject to company creditors
• Employees must not hove rights to specific assets because it's on unfunded promise to pay.

Premium payor:
• Business

Owner and beneficiary:
Business is owner and beneficiary

Income tax:
• Employer premium not deductible
• Employer contributions not taxable to employee
• Loons and withdrawals ore taxed to the employer
• Death benefits taxable to employee and/or beneficiary when paid out
• Benefit payments deductible by corporation
• Before policy is issued, insured must sign consent and be given written notice of the policy to obtain on income-tax-free death benefit to the business
• Taxable to employee once benefits ore received

Highlights: Protects business against financial loss in case of a key person's death
Purposes: Tax-free money to reimburse business so it con recruit, hire, and train a replacement

Appropriate business entity:
• Sole Proprietorship
• Partnership
• C & S Corporation
• Limited Liability Company

Owner/Employer Benefits:
• Helps offset financial loss
• Cash value accumulation potential may offset cost of premium

Employee benefits:
If employee retires, business con use policy to fund non-qualified plan at retirement for employees, or fund a death benefit plan for employee's family

Additional considerations:
Premium paid with after-tax employer money

Premium payor:
• Business

Owner and beneficiary:
Business is owner and beneficiary

Income tax:
• Premium not deductible by employer
• Premium not taxable to employee
• Income-tax-free death benefit to the business
• Distributions to employee or family may be subject to income tax
• Before policy is issued, insured must sign consent and be given written notice of the policy to obtainon income-tax-free death benefit to the business

Highlights: A life insurance benefit a business provides to a key employee. The insured on the policy is the key employee, and the business pays all or some of the policy premiums. At the employee's death, the life insurance proceeds are split according to a previously executed agreement by the business and the key employee.

Purposes: This is an arrangement between two parties, the employer and a key employee, in which they share and split a life insurance policy according to a previously executed agreement by the business and employee. The policy can be used as an incentive or as a form of deferred compensation.

Appropriate business entity:
• Partnership
• C & S Corporation
• limited liability company

Owner/Employer Benefits:
Retain key employees

Employee benefits:
Provide survivor income to beneficiaries, help address estate-tax concerns

Additional considerations:
There are two options for split-dollar arrangements: the endorsement method and collateral assignment method

Premium payor:
Business

Owner and beneficiary:
Depends on type of split-dollar agreement; owner could be the business or key employee.
• Endorsement method: employer owned
• Collateral assignment method: employee owned

Income tax:
The tax results depend on which method of split-dollar is used -the endorsement method or the collateral assignment method.

Highlights: Each owner purchases life insurance on the other owner(s) to buy and sell their respective business interests
Purposes: Insurance proceeds used to buy business interest from deceased owner's estate

Appropriate business entity:
• Partnership
• C & S Corporation
• Limited Liability Company

Owner/Employer Benefits:
• Helps prevent forced liquidation of business
• Fair market value for business guaranteed
• Keeps ownership of business from heirs or outsiders
• Helps ensure continuation of business

Employee benefits:
• Provides a ready market for business upon death
• Discounted money used to fund ownership obligations
• Buyers of the business interest receive new basis

Additional considerations:
• Generally, a cross-purchase agreement works best with three or fewer partners. If there ore more than three partners, they could explore on entity purchase agreement
.• The number of policies increases with each additional owner
• Wide age differences among owners will create disparity in premium

Premium payor:
Each partner or shareholder is owner and beneficiary of policy on the life of the other owner partner(s) or shareholder(s)

Owner and beneficiary:
Each partner or shareholder is owner and beneficiary of policy on the life of the other owner partner(s) or shareholder(s)

Income tax:
• Premium not deductible
• Upon death of owner, appreciated ownership interests in business receive a stepped-up basis, with no income tax to decedent's family
• Surviving business owners get basis for the purchase of deceased owner's interest
• Death benefit received income-tax-free to the business

Highlights: Business purchases life insurance on the owners to redeem deceased owners' business interests
Purposes: Insurance proceeds used to buy business interest from deceased owner's estate

Appropriate business entity:
• Partnership
• C & S Corporation
• Limited Liability Company

Owner/Employer Benefits:
• Helps prevent forced liquidation of business
• Fair market value for business guaranteed
• Keeps ownership of business from heirs or outsiders
• Only purchase one policy per owner
• Business pre-funds its obligations with discounted money

Employee benefits:
• Provides a ready market for business upon death
• Value of stock (not the basis) owned by surviving owner(s) increases if corporation retires stock

Additional considerations:
• There may be no increase in cost basis for surviving owner(s)
• Failure to follow the terms of a redemption agreement may cause the value of the death benefit to be included in the value of the business interests being redeemed for estate tax purposes

Premium payor:
Business

Owner and beneficiary:
Business is owner and beneficiary

Income tax:
• Premium not deductible
• Upon death of owner, appreciated ownership interests in business receive a stepped-up basis, with no income tax to decedent's family
• Before policy is issued, insured must sign consent and be given written notice of the policy to obtain an income-tax-free death benefit to the business
• Death benefit received income-tax-free to the business

Highlights: Existing C or S corporation with 3 or more owners establishes a new partnership (or LLC taxed as a partnership) to purchase cash value life insurance for business continuation purposes

Purposes: Insurance death benefits distributed from partnership to surviving partners are used to purchase C or S corporate stock and the partnership interest of deceased owner. Insurance policy is transferred to an owner upon retirement for personal use of policy and cash values.

Appropriate business entity:
• C & S Corporation

Owner/Employer Benefits:
• Helps prevent forced liquidation of business
• Fair market value for business guaranteed
• Keeps ownership of business from heirs or outsiders
• Only purchase one policy per owner

Employee benefits:
• Buyers of business interest upon insured's death receive a stepped-up basis
• Distribution of life insurance policy from partnership toa retiring partner is not a taxable event
• Tax-deferred cash value accumulation for retirement when policy is distributed

Additional considerations:
• For existing C or S corporation with more than 3owners, a new partnership (or new LLC taxed as a partnership) is used to own the life insurance policies
• For existing partnership or LLC taxed as a partnership, the existing entity is used to own the life insurance. See buy-sell entity purchase column.

Premium payor:
Existing C or S corporation pays the premium on behalf of the partnership. Premium is considered a taxable bonus to the owners and a contribution by the owners to the partnership

Owner and beneficiary:
Partnership or LLC taxed as a partnership is owner and beneficiary of the life insurance policies

Income tax:
• Payment of premium by existing C or S corporation is taxable income to the insured owner
• Insured owner makes a contribution to the partnership or LLC taxed as a partnership equal to policy premium• Before policy is issued to obtain an income-tax-free death benefit, the new partnership or LLC taxed as a partnership must give insured written notice and obtain written consent from insured
• If insured owner lives until retirement, his/her life insurance policy is transferred from the partnership or LLC taxed as a partnership to the insured, income-tax-free