Compensation Consternation S. Derrin Watson. Copyright 2010, SunGard, all rights reserved

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2 Consider This: Safe harbor 401(k) plan 3% QNEC Cross-tested profit sharing contribution. Catch-ups OK Employees in the Cucamonga office can t participate Plan uses the average benefit test to pass 410(b) Participants can defer from regular salary only Not bonus or overtime Match = 50% of deferrals 8% of compensation Top-heavy

3 How the plan uses Compensation 1. Determine HCEs 2. Coverage (average benefit % test) 3. Allocate 3% safe harbor QNEC 4. Deferrable compensation 5. Catch-up limit 6. Allocate matching contributions 7. ACP test 8. Allocate cross-tested PS contribution 9. Allocate minimum gateway 10.General nondiscrimination test 11.Imputing permitted disparity limits 13.Deduction limits 14.Top heavy minimum contributions (key employee; minimum contribution)

4 415 COMPENSATION The foundation

5 415 Comp seemingly includes everything Amounts (whether or not paid in cash) paid for personal services actually rendered in the course of employment with the employer maintaining the plan, includible in gross income: Wages Salaries Fees for professional services Commissions to salesperson or on insurance premiums Comp paid based on % of profits Tips Bonuses Fringe benefits Reimbursements under nonaccountable plan

6 3 Definitions Alternatives: 415 Compensation (current income) Simplified version of 415 compensation Federal Income Tax Withholding W-2 Compensation Use gross compensation; add back elective deferrals to: 125 cafeteria plans 401(k) plans 403(b) plans SIMPLE SARSEP 457 Qualified transportation fringe benefit plan

7 Definitional differences 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* Generally In. Self-insured medical Out. Out* Out if deductible. In* In

8 More differences 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

9 Never include in compensation Employer contributions (other than elective deferrals) to deferred compensation plan or SEP 1099-R plan distributions

10 Can t count accrued comp Since 1992, 415 compensation is based on amounts paid or made available. Cannot use accrued compensation. Plan can elect to include accrued compensation paid in first few weeks of following year. Includes compensation for entire year, regardless of length of participation.

11 Location irrelevant Count all compensation: Regardless of where earned Regardless of form of payment Example: Multinational corporation pays workers in Japan in Yen Does not issue W-2 It s still compensation

12 POST-SEVERANCE COMPENSATION And military differential wage payments

13 Post-severance rule 415 Compensation must be paid prior to severance of employment with employer maintaining the plan Also 401(k)/457(b) definition 3 exceptions 2 ½ month rule Military Disability Use 401(k) definition of severance But use 415(h) controlled group rules

Military Exception The rule on post-severance compensation doesn t apply to payments to a former employee who enters the US military So long as the payments don t exceed what

14 Military Exception The rule on post-severance compensation doesn t apply to payments to a former employee who enters the US military So long as the payments don t exceed what the employee would have been paid as compensation had he or she remained employed This is optional You don t have to count it for 415 So you don t have to count it for 414(s), etc.

15 HEART Definition: Differential Wage Payment HEART adds new rules for differential wage payments for years after 2008 DWP: Employer s payment to an individual with respect to service in the uniformed services Must be for active duty Minimum: 30 days All or a portion of the wages the individual would have received from the employer if the individual continued to work for the employer

16 Employment Status Plan must treat employee receiving differential wage payments as still employed No severance But see distribution exception Employed on last day of year Post-severance comp rules are irrelevant while employee receives differential wage payments Example: Employee receives renewal commission after 2 years in military It s compensation for plan purposes

17 Differential Wage Payments Are Compensation The differential wage payment shall be treated as compensation by the retirement plan Notice : Plan doesn t have to count as allocation compensation What it seems to include: 415 Benefit/annual addition limit 416 Top heavy 404 Deduction limit 414(q) 414(v)(2) Reg 1.401(a)(4)-8(b) HCE determination Catch-up contribution limit Cross-testing gateways

18 Disability exception Post-severance comp rule optionally doesn t apply to participant who is totally and permanently disabled Unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected: to result in death or to last for a period of not less than 12 months Can count comp employer would have paid if employee had stayed Contributions nonforfeitable Either Paid to NHCE (before disability) Disability comp given to all disabled EEs

19 2½ month rule Compensation counts if two conditions are both met: 1. It is paid no later than the later of 2½ months after severance of employment The last day of the limitation year of severance 2. Permitted purpose Wages for services To the extent otherwise counted as comp and plan provides: Leave cash-out Unfunded deferred compensation payments

20 Wages for services It is a payment that would have been made while the employee continued in employment as: Regular compensation for services during the employee s regular working hours Compensation for services outside the employee s regular working hours (such as overtime or shift differential) Commissions Bonuses Other similar compensation

21 Leave cash-out Payment for unused accrued bona fide sick, vacation, or other leave, but only if: The employee would have been able to use the leave if employment had continued The plan would have counted the payment as compensation if employment had continued The plan chooses to count it as 415 comp

22 Unfunded deferred compensation Payments to employee from unfunded deferred compensation plan that satisfy all the following requirements: The plan would have counted the payment as compensation if employment had continued The payment is included in income Payment would have been made at same time if employee had continued in employment The plan chooses to count it as 415 comp

23 Can t count post-severance The following are never compensation if paid after severance (even if within 2½ months) Severance pay Unfunded nonqualified deferred compensation (409A, 457(f)) except as above Parachute payments

24 Effect of post-severance comp rules 415 comp doesn t include severance payments or payments after 2½ months/end of year Neither does nondiscriminatory comp Plan can t accept deferrals on post-severance comp unless the comp complies with the new rules Only post-severance comp that plan MUST count for 415 purposes is normal payment for work done

25 Examples Example 1: Jose was fired June 10, 2011 He received his final paycheck June 15, 2011 Includes His salary through June 10 One week s unused vacation Jose s 415 compensation includes the June 15 check Example 2: Jose s check also includes 4 weeks of severance pay Jose would not have been entitled to receive the severance pay had Jose continued working The severance pay is not 415 compensation, even though the rest of the check is

26 414(S) COMPENSATION Nondiscriminatory Used in testing

27 414(s) Safe Harbors 415 compensation (any of the three definitions) Can be gross or net of elective deferrals Can exclude all of the following: Reimbursements or other expense allowances, Fringe benefits (cash and noncash), Moving expenses, Deferred compensation, and Welfare benefits Can exclude items just for HCEs Notice : Can exclude differential wage payments

28 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.

29 Alternative Definitions Reasonable Not discriminate by design in favor of HCEs Must pass compensation ratio test annually

30 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. What s de minimis?

31 NHCE ratio =88.10%; HCE ratio =89.74% Status Total Comp Bonus Plan Comp Ratio Kirk HCE $190,000 $20,000 $170, % Spock HCE $150,000 $15,000 $135, % McCoy NHCE $ 85,000 $10,000 $ 75, % Scotty NHCE $ 75,000 $10,000 $ 65, % Uhura NHCE $ 50,000 $ 5,000 $ 45, % Sulu NHCE $ 40,000 $ 5,000 $ 35, % Definition of compensation passes compensation ratio test

32 NHCE ratio =88.10%; HCE ratio =95.00% Total Comp Bonus Plan Comp Ratio Kirk $190,000 $0 $190, % Spock $150,000 $15,000 $135, % McCoy $ 85,000 $10,000 $ 75, % Scotty $ 75,000 $10,000 $ 65, % Uhura $ 50,000 $ 5,000 $ 45, % Sulu $ 40,000 $ 5,000 $ 35, % Definition of compensation fails compensation ratio test. HCE ratio exceeds NHCE ratio by more than de minimis amount.

33 De Minimis Facts and circumstances Informally <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

34 401(a)(4) Plan Year For nondiscrimination purposes, plan can base compensation for all employees on: 414(s) Compensation for plan year 414(s) Compensation for specified 12 months ending in plan year 414(s) Compensation while a participant Must follow this rule fairly consistently from year to year Can t shift to benefit HCEs

35 401(k) Compensation For nondiscrimination 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).

36 401(A)(17) COMPENSATION LIMITATION

37 Compensation Limitation Year Limit 2003 $200, $205, $210, $220, $225, $230, $245, $245,000 Applies four 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 4. Limits 415 comp (per final regs) 2011 $245,000

38 Annual Limitation For fiscal year plan, use limitation in effect at beginning of year. Applies on a year by year basis. Example: DB plan bases benefits on high 3 years comp John s salary is $250,000 per year Plan year ends June 30 For plan year, plan bases John s benefit on (225K + 230K + 245K)/3 = $233,333

39 Nondiscrimination Testing Limit 401(a)(17) limit applies: 401(a)(4), (5) nondiscrimination test 401(k) ADP; safe harbor 401(m) ACP; safe harbor 401(l) permitted disparity 403(b)(12) TSA nondiscrimination 404(a)(2) employee annuity 410(b) coverage (average benefit % test)

40 Limit prorated for short years Example: Plan year ends September 30 Employer decides to shift to calendar year Will have 3 month plan year October 1, 2011 to December 31, (a)(17) limit is $61,250. Do not have to prorate limit for a part-year participant if plan uses compensation while a participant.

41 Apply 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 $300,000 and she had a $10,000 bonus Her 2011 plan compensation is the lesser of $290,000 or $245,000

42 Compensation Limitation and the Compensation Ratio Test Limit applies both to total compensation and to plan compensation in doing compensation ratio. Example: Plan defines compensation as W-2 minus bonus. Mary s gross pay was $300,000, with a $10,000 bonus. For 2011 her total compensation and her plan compensation is $245,000. Her compensation ratio is 100%.

43 Comp limit doesn t affect deferrals 401(a)(17) compensation limit ($245,000 for 2010) applies now for 415 Potentially big issue for DB, not 401(k) 401(k) can t accept deferrals from funds that aren t compensation So, suppose Sue has earns $50,000/month ($600,000) Can she defer after May (comp to date $250K)? Preamble to final regs says YES; your deferrals don t have to come from the first dollars in

44 EARNED INCOME FOR THE SELF-EMPLOYED

45 Earned Income Compensation for owners who don t receive a W-2 Applies to sole proprietors, partners, and owners of entities taxed as partnerships Foundation: Net Earnings from Self-Employment (NESE) from a trade or business in which the owner s services are a material income producing factor

46 Net Earnings from Self- Employment See Schedule SE for a trade or business Many exclusions Rental income not NESE unless services provided Interest and dividends aren t NESE except for securities dealers There is no NESE from S Corporation K-1 S Corporation shareholders are not selfemployed individuals

47 Earned Income Adjustments Earned income also includes gains and earnings (other than capital gain) from property sale or licensing, other than goodwill, by the individual who created that property, even if those gains would not ordinarily be considered NESE. Reduce earned income by ½ SE tax. Nontaxable income (and deductions relating thereto) aren t NESE. Reduce earned income by IRC 404 retirement plan deduction. Gross up comp for elective deferrals.

48 Earned Income Example Sam owns his own business and his work materially contributes to this business His 2010 Schedule C income is $171,417 SE tax $17,834 Sam has a 401(k) plan Deferrals = $16,500 PS Contribution = $32,500 Sam s 415 comp is $130,000 = $171,417 ($17,834/2) - $32,500

49 414(s) and Earned Income Earned income is exclusive basis for 414(s) compensation of self-employed No alternative definition If the plan uses an alternative definition of compensation for common law employees to test nondiscrimination, plan must adjust earned income compensation Multiply earned income by NHCE compensation ratio

50 PUTTING THE DEFINITIONS TO WORK Don t put a square peg in a round hole!

51 415 Compensation Gross, full-year compensation Used in: 415 limits 404 deduction limits 414(q) HCE determination 414(v) catch-up limit 416 top heavy minimums; key employee 401(a)(5)(D) defined benefit integration 409 ESOP allocation limits 414(n) safe harbor leasing plan

52 414(s) compensation Safe harbor (gross or net) or alternative definition 401(a)(4),(5) nondiscrimination testing 401(k) ADP testing 401(m) ACP testing 401(k),(m) safe harbor (except cannot exclude compensation below threshold) 401(l) permitted disparity

53 Reasonable definition 410(b) average benefit percentage test (doesn t have to pass compensation ratio test but HCE disparity can t be significantly higher ) Safe harbor match plan can limit compensation an employee can defer to a reasonable definition of compensation (no compensation ratio test)

54 Cross-tested gateways If plan uses 5% gateway, then the plan must base the minimum contribution on gross 415 compensation If the plan uses the 1/3 gateway, then the plan can base the minimum contribution on the same definition used to compute the HCE allocation rates In either case, the plan can use compensation while a participant

55 Any definition A plan can use any definitely determinable definition of compensation, including an unreasonable or clearly discriminatory definition, to allocate employer contributions. However, the plan must test for nondiscrimination based on a nondiscriminatory definition.

56 CONTROLLED GROUPS

57 Aggregate If the Employee receives pay from more than one member of a controlled group, group under common control, or affiliated service group, the plan must aggregate all pay from all group members for purposes of 415 compensation and likely for 414(s) nondiscriminatory compensation

58 Alternative Definition If a controlled group plan excludes compensation from a group member, that is an alternative definition of compensation Plan must test Is it a reasonable definition? Does it pass compensation ratio test? Total compensation (including all group members) is in the denominator

59 Controlled Group Example Alice works for both Tweedledee and Tweedledum, two members of a controlled group Tweedledee sponsors a plan for its employees only, and the plan passes 410(b) The plan covers Alice When the plan computes Alice s 415 compensation, it must include the Tweedledum pay It also includes the hours of service Alice performs for Tweedledum

60 Loss in controlled group Jen owns 100% of: Corporation A; W-2 compensation $200,000 Sole prop B; Net loss $50,000 A sponsors a plan What is Jen s 415 compensation? No guidance My answer: Compensation from B is $0 Total compensation is $200,000

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.