Kevin J. Donovan, CPA, MSPA Pinnacle Plan Design, LLC. Compensation Uses

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Determine HCE status Allocations or benefit accruals 415 limits Top

1 Compensation Concerns Monday, April 29, 2013 Kevin J. Donovan, CPA, MSPA Pinnacle Plan Design, LLC Compensation Uses Determine HCE status Allocations or benefit accruals 415 limits Top Heavy minimums Non-discrimination testing Deduction limits May be different for different purposes 2 1

2 415 Compensation These sections/regs specifically refer to 415 compensation maximum benefits/allocations 416 top-heavy 414(q) HCE status 5%/7.5% max minimum allocation gateways Compensation element of catch-up limit Deduction limits Compensation 3 Alternative definitions Current includible compensation Simplified definition Reg (c)-2(a); 1.415(c)-2(d)(2) Wages for income tax withholding Reg (c)-2(d)(3) W-2 definition Reg (c)-2(d)(4) 4 2

3 415 Compensation Current includible compensation Wages, salaries, fees, other amounts received by employee for personal services rendered, but only to extent includible in income Includes bonuses, overtime, commissions, tips, fringe benefits and reimbursement or other expense allowances Earned income for self-employed persons Reg (c)-2(b)(1)-(2) Compensation Current includible compensation Amounts specifically included: Medical/disability benefits included in income Non-deductible moving expenses Stock options if included in income in the year of grant Amounts realized due to Section 83 election Deferred comp. plan amounts includable in income due to 409A or 457(f)(1)(A) Reg (c)-2(b)(3)-(7) 6 3

4 415 Compensation Current includible compensation Amounts specifically excluded: Employer contributions to deferred compensation plan or SEP But elective deferrals included Distributions from deferred comp plan But if from unfunded NQ plan may be included Amounts realized from exercise of stock options Amounts realized when restricted property becomes unrestricted Other amounts receiving special tax benefits E.g., premiums for group-term life insurance not includable in income Reg (c)-2(c) Compensation Simplified compensation May modify currently includible comp. definition by excluding amounts listed above as specifically included (as well as amounts specifically excluded) Must be in document Effectively reduces 415 limit for any participant with such compensation Reg (c)-2(d) 8 4

5 415 Compensation Wages for withholding Remuneration for services performed by an employee, unless specifically exempted under Code Section 3401(a) regardless of how the employer names the remuneration Earned income for SE persons Includes elective deferrals Basis or medium of payment not relevant Compensation W-2 compensation Wages and other payments for which employer must file W-2 Earned income for SE persons 10 5

6 Comparison of 415 Compensation Definitions Received from unfunded nonqualified plan Tips Fringe benefits includible in income Accident & health plan (if taxable) Taxable moving expense reimbursement Current Income Out (may elect in) In Income Tax Withholding In W-2 In Generally In. Noncash Out. Tips < $20/month Out. In Mostly In In In* Generally In. Self-insured medical Out. In* In In *Out if simplified method elected In 11 Comparison of 415 Compensation Definitions Group term life insurance > 50K Nonqualified stock option exercise Nonqualified option when granted Current Income Income Tax Withholding W-2 In Out In Out In In In* In In 83(b) election In* In In S. 83 property when nonforfeitable Out In In *Out if simplified method elected 12 6

7 415 Compensation Related employers 415 compensation includes comp. from all related employers (even where such employers don t sponsor plan) Reg (c)-2(g)(2) Similarly in prior reg (d)(6) 1998 greybook, Q&A 14 following slides Compensation Related employers 1998 greybook, Q&A 14 An individual operates a law practice as a sole proprietorship (SP) and has $100,000 of self employment income from such practice before the adjustment to subtract 1/2 of self employment tax (SECA) as provided under IRC section 164(f). The individual also operates another sole proprietorship where he has a loss of $95,000. Both trades involve personal services of the individual, but only the law firm has adopted the qualified plan. 14 7

8 415 Compensation Related employers 1998 greybook, Q&A 14 Is the individual's 415 annual addition limit based on the sum of earned income, if any, from the two trades, or is the loss from one trade netted against the gain from the other? To illustrate using the above example, is the 415 limit based on: 25% of the law practice's income as adjusted for 1/2 SECA and the plan contribution, or 25% of $5,000 ($100,000 income minus $95,000 loss) as adjusted for 1/2 SECA and the plan contribution? Compensation Related employers 1998 greybook, Q&A 14 IRS RESPONSE: The 415 limit is based on the lesser of the earned income from the law firm (the sole adopting entity) and the net earned income from the employer [the controlled group under Code section 414(c)]. Thus, the answer in this example is the lesser of (a) and (b). REBUTTAL I don t buy that it s the lesser of the two. i.e., the reg simply provides they are aggregated. So if the non-law entity had a positive amount 415 comp would be greater. 16 8

9 415 Compensation Related employers Assume corp and sole proprietorship related W-2 income of $100K from corporation and loss of $100K from sole proprietorship Does loss from sole prop zero out 415 comp? Compensation for SE persons defined as earned income under 401(c)(2) Definition of earned income begins with net earnings from self employment under 1402(a) Compensation Related employers Revenue Ruling section (a)-2(c) of the regulations requires net losses from self-employment to be aggregated only with net income from self-employment; and for purposes of section 219 of the Code, such losses do not reduce wages that an individual earns as an employee Ruling dealt with IRA deduction limit; however, definition of compensation under 219(f) points to 401(c)(2) so same logic would apply Further, 415 regs, as stated above, refer to earned income for SE persons Above ruling holds that such number cannot be a net negative 18 9

10 415 Compensation - Post-severance comp. 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 Reg (c)-2(e)(3)(i)/(ii) Compensation - Post-severance comp. May include amounts 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, deferred comp. payable at same time if employment had continued Must be paid by later of 2½ months of termination or by end of limitation year including severance Reg (c)-2(e)(3)(i)(A)-(B)/(iii) 20 10

11 415 Compensation - Post-severance comp. Compensation never includes: Amounts paid after severance payable solely because of severance: E.g., bona fide severance pay E.g., golden parachute payments Reg (c)-2(e)(3)(iv) May include salary continuation amounts to those who enter military if don t exceed normal pay Reg (c)-2(e)(4) Must be in document 21 Timing of Comp. Inclusion / First Few Weeks Rule Accrued comp. generally cannot be used Compensation must be actually paid or made available within limitation year to be counted in compensation for the year Final paycheck(s) of year: If compensation is paid early in next plan year due to timing of pay dates, can include in either year, but must be consistent Reg (c)-2(e)(2) 22 11

12 Compensation For Deduction Purposes Compensation used for deduction purposes same as 415 compensation Measured on employer s fiscal (tax) year Reg (a)-9(b) Reg. refers to compensation paid or accrued but 415 compensation uses cash basis other than the first few weeks rule Plan definition of compensation irrelevant E.g. full year compensation considered for deduction purposes even if participation comp. used to allocate Revenue Ruling Compensation - Measurement period Always limitation year (LY) for 415 limits Reg (c)-2(e)(1) In most cases Plan Year (PY) = LY Definition of compensation for allocation or accrual purposes does not impact 415 limit E.g., DBP might use comp. from calendar year ending in PY. If LY = PY then hi-3 for 415 % of comp. limit possibly won t equal plan hi

13 Code Section 401(a)(17) Limits comp. that can be taken into account $245,000 for 2011 $250,000 for 2012 $255,000 for 2013 Application of limit Cannot base allocations or accruals on compensation exceeding limit Cannot use compensation above limit in nondiscrimination testing Cannot use compensation above limit in computing maximum deductible contribution(s) 25 Code Section 401(a)(17) For fiscal years use limit in effect at beg. of PY Reg (a)(17)-1(a)(3) Applies on a year-by-year basis Example: DBP bases benefits on hi-3 years of compensation EE s compensation always above $250K Plan year ends June 30 For plan year base benefit on (245K [ ] + 245K [ ] + 250K [ ]) / 3 = $246,667 Reg (a)(17)-1(b)(2) 26 13

14 Code Section 401(a)(17) Short years Limit pro-rated where period for which compensation is used is short year Ex. Plan year ends September 30, Plan uses plan year compensation for allocations. Plan year shifts to calendar year. Will have three-month plan year from October 1, 2011, to December 31, 2011 Comp. limit is $61,250 (3/12 x $245,000) Reg (a)(17)-1(b)(3)(iii)(A) 27 Code Section 401(a)(17) BUT, pro-ration not required for mid-year entrant where plan uses compensation while participant Dr hired 5/1/11, earns $25K monthly comp. $200K so HCE in Enters plan 7/1/12 Receives bonus of $100K December of 2012 Plan counts compensation from date of participation Compensation from 7/1/12-12/31/12 = $250K (6 months at $25K plus $100K bonus) Full $250K can be counted and used in testing i.e., fact that only 6 months of compensation considered does not require limit to be reduced to $125K Reg (a)(17)-1(b)(3)(iii)(B) 28 14

15 414(s) Compensation Plan may use any definitely determinable definition of compensation, including an unreasonable or discriminatory definition, to allocate contributions or accrue benefits However, must use 414(s) definition in testing for non-discrimination Reg (s)-1(a)(2) Any 415 definition qualifies under 414(s) Reg (s)-1(c)(2) (s) Compensation Safe harbor modifications to 415 compensation for purposes of 414(s) May exclude fringe benefits, reimbursements or other expense allowances, moving expenses, deferred comp and welfare benefits (must exclude all for this safe harbor) Reg (s)-1(c)(3) 30 15

16 414(s) Compensation More safe harbor modifications to 415 comp May reduce 415 compensation by elective deferrals (must exclude all for this safe harbor) IRC 414(s)(2) This can be very useful in testing where HCEs well in excess of comp. limit as reduction reflected before limit applied Exclude any item of compensation applicable to HCEs only (can apply to some or all HCEs) Reg (s)-1(c)(5) (s) Compensation Other modifications Where other modifications made, compensation considered 414(s) compensation if modifications reasonable and compensation ratio test satisfied Reg (s)-1(d)(1) Modifications reasonable only if applied to category of comp. consistently to all employees Safe harbors for reasonable include bonuses, shift differential, overtime, call-in premium May exclude comp over threshold (e.g. over $100K) Reg (s)-1(d)(2) 32 16

17 414(s) Compensation For compensation ratio test compare average percentage of total comp. included for NHCEs with that included for HCEs HCE % cannot exceed NHCE % by more than de minimis amount Of course de minimis undefined Informally IRS has said within 3% OK 401(a)(17) compensation limit applied after reduction i.e. HCE with $300K of comp. and $50K of excludable bonus = 100% Reg (s)-1(d)(3) 33 Average NHCE Ratio = 88.10% Average HCE Ratio = 89.74% Total Comp Bonus Plan Comp Ratio HCE $190,000 $20,000 $170, % HCE $150,000 $15,000 $135, % NHCE $ 85,000 $10,000 $ 75, % NHCE $ 75,000 $10,000 $ 65, % NHCE $ 50,000 $ 5,000 $ 45, % NHCE $ 40,000 $ 5,000 $ 35, % Definition of compensation likely passes compensation ratio test 34 17

18 Average NHCE Ratio = 88.10% Average HCE Ratio = 95.00% Total Comp Bonus Plan Comp Ratio HCE $300,000 $50,000 $250, % HCE $150,000 $15,000 $135, % NHCE $ 85,000 $10,000 $ 75, % NHCE $ 75,000 $10,000 $ 65, % NHCE $ 50,000 $ 5,000 $ 45, % NHCE $ 40,000 $ 5,000 $ 35, % Definition of compensation likely fails compensation ratio test (s) Compensation Testing with imputing PD There s a special rule buried in the definition of 414(s) compensation in the 401(a)(4) regs. Under this rule, Permitted Disparity may not be imputed where compensation used for testing results in a significant underinclusion of compensation May occur where class(es) of comp. excluded even though otherwise acceptable 414(s) definition Similarly where elective deferrals excluded In such cases PD may not be imputed in testing Reg (a)(4)-12 definition of 414(s) Compensation, paragraph (3) 36 18

19 414(s) Compensation Some testing options When performing non-discrimination testing it s important to understand that s what ultimately being tested is not benefits but benefit rates i.e., the same benefit (allocation) can produce a different benefit rate depending upon the methods/data used in testing One piece of data used is compensation, and there are some options here that can make an otherwise failing test pass (s) Compensation Some testing options For example, non-discrimination testing may use Plan Year compensation (or comp. for 12- month period ending in PY) Reg (a)(4)-3(e)(2)(ii)(A) May limit to period of participation Reg (a)(4)-12 definition of Plan Year Compensation, paragraph (4) 38 19

20 414(s) Compensation Some testing options Or may use hi-3 (or greater) consecutive year average if testing on benefits basis Reg (a)(4)-3(e)(2)(i) Can be useful e.g. when cross testing a PS plan and HCE has low current compensation but has had higher amounts in prior years Must use same definition for all employees May change from year to year (s) Compensation Comp. while participant Consider cross tested PS plan. 43 year-old owner, compensation of $200,000, receives allocation of $50,000 Only other participant age 25, enters plan mid-year. Full year compensation $40,000; compensation while participant $20,000. PS allocation is top-heavy minimum of $1,200-3% of full-year comp. Recall TH min always on full-year compensation 40 20

21 414(s) Compensation Comp. while participant Test results based on Testing age = 65 Pre and post retirement interest 8.5% 1971 GAM mortality APR age 65 = 7.9 (annual) (s) Compensation Comp. while participant Owner s EBAR Equivalent benefit = $50,000 X (1.085^22) / 7.9 = $38,089 Accrual rate = $38,089 / $200,000 = 19.04% EE s EBAR Equivalent benefit = $1,200 X (1.085^40) / 7.9 = $3,970 Accrual rate = $ 3,970 / $40,000 = 9.92% OR (on compensation while participant) - Accrual rate = $ 3,970 / $20,000 = 19.94% 42 21

22 414(s) Compensation Comp. while participant Testing based on full-year comp. fails Owner EBAR 19.04%, EE 9.92% EE allocation (TH minimum) based on full year compensation; OK to test based on comp. while participant Gateway may also be tested on comp. while a participant and therefore passes i.e. $1,200 / $20,000 = 6% (s) Compensation Average comp. Consider cross tested PS plan. Owner age 43, compensation of $160,000, receives allocation of $50,000. Compensation was $245K for years Only other participant age 25, comp. of $60,000 (hi-3 year average $55,000). PS allocation $3,000 (5% gateway) 44 22

23 414(s) Compensation Average comp. Testing on current compensation fails Owner s EBAR Equivalent benefit = $50,000 X (1.085^22) / 7.9 = $38,089 Accrual rate = $38,089 / $160,000 = 23.81% EE s EBAR Equivalent benefit = $3,000 X (1.085^40) / 7.9 = $9,924 Accrual rate = $ 9,924 / $60,000 = 16.54% No NHC in HCE rate group (s) Compensation Average comp. Testing on average compensation passes Owner s EBAR Equivalent benefit = $50,000 X (1.085^22) / 7.9 = $38,089 Accrual rate = $38,089 / $245,000 = 15.55% EE s EBAR Equivalent benefit = $3,000 X (1.085^40) / 7.9 = $9,924 Accrual rate = $ 9,924 / $55,000 = 18.04% 46 23

24 414(s) Compensation - Average comp. When using average compensation in testing, average must be over at least a 3-year averaging period (or less if less than 3-years of history) Reg (a)(4)-3(e)(2)(i) Averaging period may begin at anytime and must end in current year Must use highest consecutive 3 (or more) years during averaging period (s) Compensation - Exclude deferrals Consider cross tested PS plan. 43 year-old owner, compensation of $300K, defers $17K Testing comp. w/o excluding deferrals = minimum of $300K or $250K = $250K Testing comp. excluding deferrals = minimum of $283K or $250K = $250K Only other participant age 25, compensation $40K, defers $5K Testing comp. w/o excluding deferrals = minimum of $40K or $250K = $40K Testing comp. excluding deferrals = minimum of $35K or $250K = $35K 48 24

25 414(s) Compensation - Exclude deferrals Ignoring details it s clear test results will be improved as benefit rate for NHC will go up when excluding deferrals (as compensation/denominator goes down) while that of HCE unchanged (s) Compensation- Gateway requirements If using 5% (7.5% if DB/DC combo) gateway must base minimum on 415 compensation Reg (a)(4)-8(b)(1)(vi)(B) (for DC only) Reg (a)(4)-9(b)(2)(v)(D)(2) (for combo) If using 1/3 (or similar combo rules) gateway minimum based on same definition used to compute HCE allocation rates Reg (a)(4)-8(b)(1)(vii)/1.401(a)(4)-2(c)(2)(i) Reg (a)(4)-9(b)(2)(v)(E)/1.401(a)(4)-9(b)(2)(ii)(A) / 1.401(a)(4)-2(c)(2)(i)/1.401(a)(4)-8(c)(2)(i) 50 25

26 414(s) Compensation- Gateway requirements So if reasonable exclusion/compensation ratio test used to determine 414(s) compensation for non-discrimination testing may base latter gateway on such compensation but 5%/7.5% gateways must be based on full 415 comp. In either case may use comp. while participant And must always use Plan Year compensation, even if otherwise testing on average (s) Compensation- Gateway requirements Example HCE 1 $200k comp, $50k commission, net $150k Comp ratio 75% HCE 2 $200k comp, $150k commission, net $50k Comp ratio 25% Average HCE comp ratio 50% NHCE 1 $40k comp, $20k commission, net $20k Comp ratio 50% NHCE 2 $40k comp, $20k commission, net $20k Comp ratio 50% Average NHCE comp ratio 50% 52 26

27 414(s) Compensation- Gateway requirements Compensation ratio % passed so net compensation acceptable 414(s) comp Consider cross tested DC plan Assume highest HCE allocation rate 20% Using 5% rule, gateway minimum for each NHC: 5% X $40,000 = $2,000 Using 1/3 rule, gateway minimum for each NHC: 20% / 3 = 6.67% 6.67% X $20,000 = $1, Reasonable Definition of Compensation Used in: Compensation used in average benefit percentage test under 410(b). Does not have to pass compensation ratio test, but cannot result in average benefit percentage that is significantly higher than it would have been had compensation ratio test been passed Reg (b)-5(e)(6) anyone ever used?? Safe harbor match plan can limit compensation an employee can defer to a reasonable definition of compensation (no compensation ratio test) Reg (k)-3(c)(6)(iv) 54 27

28 S Corporation Compensation Shareholders have two forms of income: Payroll Pass-through (dividends) Compensation = payroll Pass-through income may not be recognized for plan purposes Durando v. U.S., CA-9, 11/16/95 55 S Corporation Compensation Example Medical practice has net income of $400K before salary to Doctor CPA tells Dr. to take only $50K in salary to avoid payroll taxes on balance of earnings Balance of earnings will pass through to personal tax return on Schedule K-1 For plan purposes compensation is $50K 56 28

29 S Corporation Compensation Potential exists for IRS to challenge reasonableness of compensation Contributions to qualified plans are considered compensation when determining reasonableness Reclassification of dividends to compensation results in taxes, penalties and possible plan qualification/minimum funding issues 57 S Corporation Compensation Employer from previous example audited two years later and IRS determines that $150K of dividend distributions are to be reclassified as compensation. Dr s compensation therefore $200K instead of $50K. What if employer sponsors safe harbor 401(k) plan? SH contributions were based on $50K instead of $200K. Twelve month period to deposit SH contributions passed. VCP? Also elective deferrals not withheld when dividend payments made so operational failure 58 29

30 S Corporation Compensation Or employer sponsors DB plan where contribution influenced by current compensation. Additional $150K of compensation increases benefits and therefore funding requirement, resulting in possible funding deficiency 10% excise tax on failure to meet minimum funding requirement 59 Self-employed s Earned Income Earned income = net earnings from selfemployment (NESE) less: Deduction for employer contributions for owner But not elective deferrals ½ SE tax Only with respect to a trade or business in which personal services of the taxpayer are material income-producing factor IRC 401(c)(2) / 1402(a) 60 30

31 Self-employed s Earned Income When determining net earnings from SE (and therefore SE tax) Contribution for owner not deductible GCM Laflamme v. Comr, TCM /6/2012 Gale v. U.S., DC-Northern Ill., 6/27/91 Contribution for employees is deductible 61 Self-employed s Earned Income Calculation of deduction for ½ SE Tax First multiply NESE by 92.35% For 2012, tax is calculated as 10.4% up to the Social Security taxable wage base (TWB) for the year ($110,100 for 2012) plus 2.9% of all NESE Outside W-2 income serves to reduce SE tax Deduction for ½ SE tax is 10.4% portion X 59.6% plus 2.9% portion X 50% Basically same as 6.2% of amount subject to full tax plus 1.45% of amount subject to 2.9% only 62 31

32 Sole Proprietor Example Example (2012) Individual has W-2 income of $60,000 from regular employer Also has Schedule C income of $120,000 from outside consulting No other employees Wishes to maximize contribution to solo 401(k) plan 63 Sole Proprietor Example (cont d) Net earnings from SE $ 120,000 Multiply by ,820 Lesser this amount or TWB 110,100 Outside wages 60,000 Amount to tax at 10.4% 50,100 50,100 X 10.4% 5, ,820 X 2.9% 3,214 1/2 SE tax deduction 5,210 X.596 = 3,105 3,214 X.50 = 1,607 $4,

33 Sole Proprietor Example (cont d) Net Earnings from Self Employment $120,000 ½ SE tax 4,712 Pre-pension Earned Income 115,288 Maximum PS (20% of pre-contribution net) 23,058 Add 401(k) deferral 17,000 Total 40,058 Check PS: $120,000 4,712 - $23,058 = $92,230 (comp.) $ 92,230 x 25% = $23, Partner s Income Partner may be individual or corporation If individual: Net earnings from SE on Schedule K-1, line 14 Reduce by: Section 179 expense (line 12 of the K-1) only if used Unreimbursed business expenses of partner And proceed as above for sole prop Corporate partner income passed through to corporation and employees treated accordingly 66 33

34 Partner s Income Limited Partner Income generally not subject to SE tax If guaranteed payments for services, then these are reported on line 4 and 14 of K-1 and are subject to SE tax i.e. to extent of gty. payments LP treated as any other partner for plan purposes 67 LLCs / LLPs & Members If more than one member may be taxed as corporation or partnership If single member tax as corp or sole prop If taxed as partnership/sole prop treat as any other partner in partnership/sole prop Limited or general if multiple member Rely on CPA / tax atty Bottom line is look for SE income on K-1 / Sch C If taxed as corp treat as any other employee 68 34

Sole Props and Partnerships Issues for DB Plans

Sole Props and Partnerships Issues for DB Plans Kevin J. Donovan, CPA, EA, MSPA, Managing Member, Pinnacle Plan Design, LLC Kevin Donovan, CPA, EA, MSPA Managing Member, Pinnacle Plan Design, LLC Kevin