Compensation Part I: Allowable Definitions and When to Use Them. Ilene H. Ferenczy, Managing Partner Ferenczy Benefits Law Center

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1 Compensation Part I: Allowable Definitions and When to Use Them Ilene H. Ferenczy, Managing Partner Ferenczy Benefits Law Center

2 Ilene H. Ferenczy, Managing Partner Ferenczy Benefits Law Center Ilene Ferenczy is the managing partner of Ferenczy Benefits Law Center LLP in Atlanta, Georgia. Ilene particularly focuses her practice on qualified retirement plans, benefits issues in mergers and acquisitions, and advising third-party administrators of employee benefit programs on technical and practice issues. Ilene became an attorney after more than ten years as a third-party administrator, and she brings a unique and practical approach to her advice to clients. She is a member of the State Bars of Georgia and California, and holds designations as a Certified Pension Consultant from the American Society of Pension Professionals and Actuaries ( ASPPA ) and Accredited Pension Administrator from the National Institute of Pension Administrators. She is a nationally known speaker on benefits issues and has authored more than 85 articles and five books. She is a member of ASPPA s Leadership Council, a former co-chair of ASPPA s Government Affairs Committee, the 2007 recipient of ASPPA s Educator of the Year Award, and is also a Fellow in the American College of Employee Benefits Counsel, the highest honor awarded to ERISA lawyers. 1

3 Consider This: Complex Corp. has a safe harbor 401(k) plan (3% employer contribution) with a cross-tested profit sharing contribution Excludes employees in the Cucamonga office and uses the average benefit test to pass coverage requirements Participants can defer from regular salary only (not bonus or overtime) The plan accepts catch-up contributions 50% match on deferrals up to 8% of comp The plan is top-heavy 2

How Does Complex Corp. Plan Use Compensation? 1. To determine HCEs 2. To calculate average benefit percentage for coverage 3. To allocate 3% safe harbor QNEC 4.

To allocate the cross-tested PS contribution 9. To determine if minimum gateway is passed 10. To perform general nondiscrimination testing (cross-testing) 11.

4 How Does Complex Corp. Plan Use Compensation? 1. To determine HCEs 2. To calculate average benefit percentage for coverage 3. To allocate 3% safe harbor QNEC 4. To determine deferrable compensation 5. To determine the catch-up contribution limit 6. To allocate matching contributions 7. To calculate the ACP test 8. To allocate the cross-tested PS contribution 9. To determine if minimum gateway is passed 10. To perform general nondiscrimination testing (cross-testing) 11. To impute permitted disparity for testing 12. To ensure no violation of the 415 limits 13. To make sure the contribution is within deduction limits 14. To determine top-heavy minimum contributions (i.e., the amount of key employee contribution; and each employee s minimum contribution) 3

5 Types of Compensation Compensation used for statutorily-based determinations E.g., HCEs, top-heavy determinations, 415 Compensation used for nondiscrimination testing E.g., ADP/ACP, cross-testing Other uses of compensation E.g., deferrable compensation 4

6 Compensation for Statutorily-Based Determinations 5 5

7 The Foundation: 415 Compensation These Code sections refer to 415 compensation: Plan benefit and contribution limits ( 415, of course!) Top-heavy rules ( 416, for determination of compensation thresholds, amount of contribution received by keys, amount of TH minimum for nonkeys) HCE determination ( 414(q)) 5% minimum allocation gateway for cross-testing ( 1.401(a)(4)-8(b)(1)(vi)(B)) 100% of compensation catch-up limit ( 414(v)) Compensation limit on deductions ( 404) 6

8 What Is 415 Compensation? IRC 415(c)(3): For purposes of paragraph (1) (A) In general. The term participant s compensation means the compensation of the participant from the employer for the year. Well, that was helpful! 7

9 Check the Regulation: Seems to Include Everything! Treas. Reg (c)-2(b): The employee s wages, salaries, fees for professional services, and other amounts received (without regard to whether or not an amount is paid in cash) for personal services actually rendered in the course of employment with the employer maintaining the plan to the extent that the amounts are includible in gross income (including, but not limited to, commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, bonuses, fringe benefits, and reimbursements or other expense allowances under a nonaccountable plan)... 8

10 Additional Inclusions Under the Regulation Remuneration that is subject to: The foreign earned income exclusion under IRC 911 (i.e., money earned by US citizens or residents living abroad) The exclusion under IRC 931 (i.e., income from sources within Guam, American Samoa, or the Northern Mariana Islands); and The exclusion under IRC 933 (income from sources within Puerto Rico) These exclusions prevent these amounts from being income taxed, but they are still includible 9

11 Additional Inclusions Under the Regulation Medical or disability benefits that are includible in gross income (e.g., disability benefits paid through insurance purchased by the employer) Moving expenses that are not reasonably believed to be deductible by the employee Amounts includible in income in relation to a nonqualified stock option in the year granted Amounts includible in income in relation to a 83(b) election Nonqualified plan amounts includible in income due to constructive receipt under IRC 409A or 457(f) 10

12 The Regulation Specifically Excludes Treas. Reg (c)-2(c): Contributions made by the employer to a plan that are not includible in gross income Distributions from retirement plans Stock options: Amount realized from exercise of a nonqualified stock option Amount realized from sale, exchange, or disposition of qualified stock option Amounts realized when restricted stock becomes freely transferrable or no longer subject to a substantial risk of forfeiture Other amounts that receive special tax benefits (such as group term life insurance 11

13 Can Use 415 Definition or One of Two Other Safe Harbors 415 Definition commonly called the Current Includible Compensation Alternative Safe Harbors: W-2 Compensation (reportable under 6041, 6042, and 6054) May include or exclude amounts paid/reimbursed by the employer for moving expenses, but only to the extent that it is reasonable to believe that those amounts are deductible by the employee Federal Income Tax Withholding ( 3401(a) wages) Must ignore limits based on the nature and location of the employment or services 12

14 W-2 Compensation Fine Points Includes wages that must be reported under IRC 6041(d), 6051(a)(3), and 6052, i.e.,: Compensation to an employee of the employer Wages under IRC 3401(a); and Employer-provided group term life insurance, to the extent includible in income under IRC 79 Also includes: Cash value of noncash payments; Earned income for services rendered outside the US if usually excluded under IRC 911; and Distributions from unfunded nonqualified plans 13

15 W-2 Compensation Fine Points Excluded: Reimbursements if treated as paid under an accountable plan i.e., a plan that requires employees to substantiate their expenses and to return any advance in excess of actual expenses Moving expenses paid to a third party or furnished in kind to the employee, and qualified reimbursements for moving expenses that will be deductible by the employee Workers compensation payments Housing allowances for ministers 14

excepted Includes payments under unfunded deferred compensation plans

16 Federal Withholding Comp Fine Points Generally includes anything that is remuneration for services performed by an employee unless specifically excepted Includes payments under unfunded deferred compensation plans Includes noncash payments Includes vacation pay and employer-funded disability pay 15

17 Federal Withholding Comp Fine Points Excludes: Reimbursements if treated as paid under an accountable plan; Nontaxable fringe benefits (no-additional cost services; qualified employee discounts; working condition benefits; de minimis benefits; qualified transportation benefits; on-site gym or other athletic facilities; qualified tuition reduction) Includes qualified transportation benefits if purchased through salary reduction Housing allowances for ministers 16

18 For All Three Safe Harbor Definitions Use gross compensation plus elective deferrals (including catch-up contributions) to: 125 cafeteria plans 401(k) plans 403(b) plans SIMPLE SARSEP 457 Qualified transportation fringe benefit plan 17

19 What s the Diff? Received from unfunded nonqualified plan Tips Fringe benefits includible in income Accident & health plan (if taxable) Moving expense reimbursement Current Income Income Tax Withholding W-2 Out* In In In Generally In. Noncash Out. Tips < $20/month Out. In Mostly In In Out* Out* *may be included if desired 18 Generally In. Self-insured medical Out. Out if deductible. In In*

20 What s the Diff? Current Income Income Tax Withholding W-2 Group term life insurance > 50K Nonqualified stock option exercise Qualified stock option exercise Nonqualified option when granted In Out In Out In In Out Out Out Out* In In 83(b) election Out* In In *may be included if desired 19

21 Using W-2 Compensation Reasoning: it s easiest Is that true? Possibly not: still have adjustments to make Add back deferrals Post-termination compensation (see discussion below) Very inclusive If company has stock option plan, awards of restricted stock, or expense reimbursements, probably not desirable 20

22 Post-Termination (Severance) Compensation Type 1 Must include compensation earned during employment that is paid after severance if paid by the later of: 2½ months after severance; or The end of the limitation year including the date of severance e.g., trailing commission or bonus 21

23 Post-Termination (Severance) Compensation Type 2 May include amounts that are payable after severance but that would have been paid or usable had the participant continued in employment E.g., accumulated unused sick, vacation, or other leave Must be paid by later of 2½ months of termination or by end of limitation year including severance e.g., unused sick leave or PTO 22

24 Post-Termination Compensation - Type 3 Compensation never includes bona fide severance pay (regardless of timing): Paid after severance of employment; and Payable solely because of severance: E.g., You re fired, take this two weeks pay and GET OUT E.g., golden parachute payments Salary continuation amounts to those who enter the military are considered to be compensation if the payments do not exceed normal pay and plan so provides 23

25 Differential Wage Payments Defined: Amounts paid voluntarily by an employer to true up compensation earned by a service member while on active duty Must be on active duty for more than 30 days Must represent all or a portion of the wages the individual would have received had s/he been working for the employer Part of HEART legislation Always includible in 415 compensation 24

26 Timing of Compensation Inclusion Generally cash basis Final paycheck of the year: If compensation is paid in the next plan year but within a few days due to timing of pay dates, can include in either year, but must be consistent 25

27 For ALL Statutory Uses Must use compensation for entire year E.g., if calculating top-heavy minimum, must provide allocation equal to 3% of the full year s compensation (even if normal allocations are based on compensation while a participant) Exception: One Third Test gateway calculations: If using one third test, can use same definition of compensation as is used for allocations to the HCEs (i.e., this could be compensation while a participant) Note: if using 5% gateway, must use full year compensation (i.e., not an exception) 26

28 Compensation for Nondiscrimination Testing ( 414(s)) 27 27

compensation definition Can use alternate definition

29 Structure Can use a safe harbor definition for nondiscrimination testing Deemed to be permissible compensation definition Can use alternate definition and test compensation to show that it is not discriminatory 28

414(s) Safe Harbors 415 compensation (any of the three definitions) Can be gross or net of elective deferrals Can exclude all of the following (either for all

30 414(s) Safe Harbors 415 compensation (any of the three definitions) Can be gross or net of elective deferrals Can exclude all of the following (either for all employees or just for HCEs): Reimbursements or other expense allowances; Fringe benefits (cash and noncash); Moving expenses; Deferred compensation; and Welfare benefits 29

31 Alternative Definitions Must: Be reasonable Not discriminate by design in favor of HCEs Pass compensation ratio test annually 30

, Compensation = comp up to $100,000) Can exclude any fringe benefit items Impermissible

32 Reasonable Definition Safe harbor minus items of irregular or additional compensation: Bonus Overtime Shift differential Call-in premium Can exclude compensation over a threshold (e.g., Compensation = comp up to $100,000) Can exclude any fringe benefit items Impermissible exclusions: Compensation = 75% of Compensation 2016 Compensation = December Compensation x 12 31

33 Compensation Ratio Test Exclusions must knock out as much for the HCEs as they do for the NHCEs Compare the percentage of total compensation included for the NHCEs with the percentage included for the HCEs The HCE percentage cannot exceed the NHCE percentage by more than a de minimis amount 32

34 What Is Total Compensation? Safe harbor definition (see slide #28) If there is a special definitional adjustment that applies to some, but not all, HCEs, you must apply that adjustment in determining total compensation 33

35 What Is De Minimis? Facts and circumstances Informal IRS indication is that <3% is de minimis Can look at prior periods to determine de minimis An isolated instance of a more than de minimis difference between the compensation percentages that is due to an extraordinary unforeseeable event (such as overtime payments to employees of a public utility due to a major hurricane) will be disregarded if the amount of the difference in prior determination periods was de minimis. 34

36 Average NHCE Ratio = 88.10% Average HCE Ratio = 88.06% Total Comp Bonus Plan Comp Ratio Harry $190,000 $20,000 $170, % Ron $150,000 $20,000 $130, % Hermione $ 85,000 $10,000 $ 75, % Fred $ 75,000 $10,000 $ 65, % George $ 50,000 $ 5,000 $ 45, % Ginny $ 40,000 $ 5,000 $ 35, % Definition of compensation passes compensation ratio test 35

37 Average NHCE Ratio = 88.10% Average HCE Ratio = 93.33% Total Comp Bonus Plan Comp Ratio Harry $190,000 $0 $190, % Ron $150,000 $20,000 $130, % Hermione $ 85,000 $10,000 $ 75, % Fred $ 75,000 $10,000 $ 65, % George $ 50,000 $ 5,000 $ 45, % Ginny $ 40,000 $ 5,000 $ 35, % Definition of compensation fails compensation ratio test. HCE ratio exceeds NHCE ratio by more than de minimis amount.

401(a)(4) General Nondiscrimination Testing For nondiscrimination testing purposes, a plan can base compensation for all employees on: 414(s) compensation for

38 401(a)(4) General Nondiscrimination Testing For nondiscrimination testing purposes, a plan can base compensation for all employees on: 414(s) compensation for the plan year 414(s) compensation for a specified 12 months ending in plan year 414(s) compensation while a participant Cannot shift definition to benefit HCEs 37

39 38 401(k) ADP Testing For nondiscrimination testing purposes, plan can base compensation for all employees on: 414(s) compensation for plan year 414(s) compensation for calendar year ending in plan year 414(s) compensation while a participant Safe harbor compensation cannot exclude compensation over a limit other than 401(a)(17)

40 Consistency Plan must use same definition for all employees in applying a particular provision (e.g., nondiscrimination testing under 401(a)(4)) Can change definition from year to year Can use different definitions in different plans 39

41 Annual Limit on Compensation for Plan Purposes 40

42 Code 401(a)(17) Limitation Limits compensation taken into account for plan purposes $270,000 for 2017 $265,000 for 2015 and 2016 $260,000 for

43 Compensation Limitation Applies three ways: 1. Cannot base allocations or benefit accruals on compensation exceeding limit 2. Cannot use compensation above limit in doing nondiscrimination testing 3. Cannot use compensation above limit in computing 404 deduction limitation 42

44 What About Deferrals? Mortimer earns $300,000 per year (not catch-up eligible) He has elected to defer 6% of pay per paycheck Mortimer s monthly paycheck is $25,000 He defers $1,500 per paycheck Must deferrals stop when total pay exceeds $270,000 (i.e., in November)? Answer: no, unless there is something in the plan document that limits deferrable compensation to the IRC 401(a)(17) limit 43

years compensation John s salary is $270,000 each year of high three-year period Plan year ends June 30 For 2015-2017

45 Annual Limitation and Average Compensation For fiscal plan years, use limitation in effect at beginning of year Applies on a year-by-year basis for compensation averaging Example: Defined benefit plan bases benefits on high three years compensation John s salary is $270,000 each year of high three-year period Plan year ends June 30 For plan year beginnings, plan bases John s benefit on (265K [ ] + 265K[ ] + 270K[ ])/3 = $266,667 44

Will have three-month plan year October 1, 2017, to December 31, 2017.

46 Limit Prorated for Short Years Plan year ends September 30. Employer decides to shift to calendar year. Will have three-month plan year October 1, 2017, to December 31, (a)(17) limit is $67,000 (3/12 x $270,000) Do not have to prorate limit for a mid-year entering participant if plan uses compensation while a participant 45

47 Apply 401(a)(17) Limit After Other Adjustments First determine compensation without regard to limit. Then apply the limit Example: Plan defines compensation as W-2 compensation minus bonus Mary s gross pay was $280,000 and she had a $12,000 bonus Calculation: First determine compensation without limit ($280,000 minus $12,000 bonus or $268,000) Then apply limit: $268,000 comp vs. $270,000 limit 46

48 Compensation Limitation and the Compensation Ratio Test Limit applies to both plan compensation and total compensation in doing compensation ratio Example: Plan defines compensation as W-2 minus bonus Mary s 2017 gross pay was $290,000, which included a $30,000 bonus Her total compensation is $270,000 ($290K, limited to $270 max) Her plan compensation is $260,000 (the $290K compensation is reduced by the bonus, and then the limit is applied) Her compensation ratio is 96.3% ($260K/$270K) 47

49 Questions?? 48

50 Contact Information Ilene H. Ferenczy Ferenczy Benefits Law Center 2200 Century Parkway, Suite 560 Atlanta, Georgia (678) (V) (866) (toll free) (404) (F) Follow us on 49

Compensation Quandary

Compensation Quandary Robert M. Richter, FIS Relius Avannesh K. Bhagat, IRS Robert M. Richter, FIS Relius Robert M. Richter, JD, LL.M. is a Vice President with FIS (formerly SunGard) in Jacksonville, Florida.