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. Robert manages the consulting department and is instrumental in authoring and supporting SunGard Corbel's retirement plan documents. He is a frequent lecturer and author on matters involving qualified retirement plans and cafeteria plans. Robert is President-Elect of the American Retirement Association and has held numerous positions within the American Society of Pension Professionals and Actuaries (ASPPA), including President from October 2011 to October 2012 and President-Elect. He is a Fellow of the American College of Employee Benefits Counsel and is a member of the Florida Bar as well as other organizations. Robert received a B.S., with a major in Finance, from the University of Florida, a J.D. from Florida State University, and an LL.M. in taxation from the University of Florida. 1
Avaneesh Bhagat, Group Manager, IRS Avaneesh is the Group Manager for the Voluntary Compliance Group in El Monte, California. His responsibilities include assisting with the resolution of applications made under VCP, assisting with the development of the revenue procedure relating to the correction programs for qualified plans, providing information on correction programs, and responding to inquiries relating to plan corrections and potential VCP applications. Avaneesh has worked with the examination, determination letter and voluntary compliance functions of the IRS' Employee Plans Division since 1988. What We ll Cover 415 Compensation Post-severance compensation 414(s) Nondiscriminatory Compensation 401(a)(17) Compensation Limit How Compensation Is Used Compensation in Controlled Groups and Multiple Employer Plans 2
3 Definitions 415 Compensation 415 limits Top-heavy minimums 414(s) Compensation Nondiscrimination testing Plan Compensation Benefits/allocations The Foundation 415 Compensation 3
415 Compensation 3 alternatives: 415 Compensation (current income) Federal Income Tax Withholding W-2 Compensation Plus mandatory inclusions of certain amounts not subject to taxes For self-employed (including partners) use Earned Income (we will not cover) Mandatory Inclusions Must add back elective deferrals to: 125 cafeteria plans 401(k) plans 403(b) plans SIMPLE SARSEP 457 Qualified transportation fringe benefit plan 4
Never Include in Compensation Employer contributions (other than elective deferrals) to deferred compensation plan or SEP Retirement plan distributions 415 Regulatory Definition (Current Income) 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).... 5
415 Simplified Definition* Excludes Taxable fringes (IRS Publication 15-B) Taxable moving expenses Taxable nonqualified options Taxable property under IRC 83(b) 457(f) and amounts under 409(A) Definitional Differences Current Income Income Tax Withholding W-2 Received from unfunded nonqualified plan Out* In In Tips In Generally In. Noncash Out. Tips < $20/month Out. Fringe benefits includible in income Accident & health plan (if taxable) Moving expense reimbursement In Mostly In In Out* Generally In. Self-insured medical Out. Out* Out if deductible. In In 6
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 Accrued Compensation Generally, cannot use accrued compensation Can elect to include accrued compensation paid in first few weeks of following year For example, a plan can elect to include payments in January that are for work performed in the prior December as being paid in the prior year Determination period for purposes of applying 415 limits = limitation year Generally a 12 month period regardless of length of participation Only short if change in limitation year (mid-year plan termination is considered a change) 7
Post-Severance Compensation 415 Regulations set forth what must be included, what may be included, and what can t be included Limit on how long post-severance compensation can be included: 2 ½ months after severance The end of the limitation year including the date of severance Exception to time limit for disability payments if only recognized for NHCEs or if recognized for all participants but for a set period of time Post-Severance Compensation Mary is paid trailing commissions after she severs employment 1. Mary severed employment on July 1, 2015 Amounts paid through December 31, 2015 are included 2. Mary severed employment on November 1, 2015 Amounts paid through January 15, 2016 are included 8
Post-Severance Compensation Must include regular pay Compensation for services outside the employee s regular working hours (such as overtime, shift differential, commissions, bonuses and other similar compensation) May include: Leave cash-outs = payments for 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 Nonqualified unfunded deferred compensation Post-Severance Compensation The following are never compensation if paid after severance (even if within 2½ months) Severance pay Golden parachute payments What exactly is severance pay Bonus paid prior to termination isn t severance pay Bonus paid after termination? 9
Compensation for Nondiscrimination Testing IRC 414(s) Structure Can use safe harbor definition Definition deemed to be nondiscriminatory Can use alternative definition and test each year to show that it is nondiscriminatory 10
414(s) Safe Harbors 415 compensation (any of the three base definitions) Can be gross or net of elective deferrals (all or none) Can exclude all of the following (all or none - but can be for all EEs or just for HCEs): Reimbursements or other expense allowances, Fringe benefits (cash and noncash) (IRS Publication 15-B), Moving expenses, Deferred compensation, and Welfare benefits What is a Fringe Benefit See Publication 15-B Achievement awards Athletic facilities Employer provided cell phones Group-term life insurance Meals Retirement planning services Commuting benefits 11
Other Safe Harbor Adjustments Can exclude military differential pay (Notice 2010-15) Not clear if all post-severance payments can be excluded as a safe harbor adjustment Include/Exclude Deferrals Pat and Chris both earn $100,000 and each defers $10,000 but Pat s is pre-tax and Chris is Roth 414(s) regulations permit exclusion of amounts excluded from income due to 401(k) Sponsor elects to not include these amounts Pat s compensation is $90K What is Chris compensation? No IRS guidance on this 12
414(s) Alternative Definitions Reasonable Not discriminatory by design in favor of HCEs Must pass compensation ratio test annually 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., exclude compensation over $100K) Can exclude any fringe benefit items Impermissible exclusions: Compensation = 75% of Compensation 2016 Compensation = December 2015 compensation 13
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 Total compensation = safe harbor definition (i.e., 415 compensation which can be adjusted for deferrals and fringe benefits) 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 14
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 David s gross pay was $300,000 and he had a $10,000 bonus His 2016 compensation limit is $265,000 (lesser of $265,000 or $290,000) His inclusion ration for 414(s) testing is 100% NHCE ratio =88.10%; HCE ratio =95.00% Total Comp Bonus Plan Comp Ratio Kirk* $190,000 $0 $190,000 100.00% Spock* $150,000 $15,000 $135,000 90.00% McCoy $ 85,000 $10,000 $ 75,000 88.24% Scotty $ 75,000 $10,000 $ 65,000 86.67% Uhura $ 50,000 $ 5,000 $ 45,000 90.00% Sulu $ 40,000 $ 5,000 $ 35,000 87.50% Definition of compensation fails compensation ratio test. HCE ratio exceeds NHCE ratio by more than de minimis amount 15
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, then plan must adjust earned income Multiply earned income by NHCE compensation ratio Example Plan excludes bonuses and inclusion ratio for NHCEs is 90% Cathy s earned income is $300,000 For 2016 the plan must limit Cathy s compensation to $238,500 265,000 (EI limited to 401(a)(17)) x 90% = $238,500 16
Annual Limit on Compensation IRC 401(a)(17) Compensation Limitation Limits compensation in 4 ways: For allocations or benefit accruals For nondiscrimination testing (414(s) compensation) 415 compensation For computing 404 deduction Year Limit 2014 $260,000 2015 $265,000 2016 $265,000 17
Annual Limitation For fiscal plan years, 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 $300,000 per year Plan year ends June 30 For 2016 plan year John s benefit is based on (260K + 265K + 265K)/3 = $263,333 Limit Prorated for Short Period Prorate for determination period of less than 12 months Example: Plan year ends September 30, 2015 Employer decides to shift to calendar year Will have 3 month PY of October 1, 2015 to December 31, 2015 401(a)(17) limit is $66,250 (3/12 X Limit) Determination period is a plan level definition Do not prorate limit for a part-year participant if plan uses compensation while a participant 18
New Plan Problem Employer wants to begin elective deferrals 7/1/2016 Employer wants profit sharing allocation based on full year comp (i.e., does not want to prorate 401(a)(17) limit) Can the plan be designed to accomplish this? Solutions Make effective date of plan 1/1/2016 with special effective date for deferrals (7/1/16) What if ER didn t exist until 7/1/16? Make effective date of plan 7/1/2016 and measure comp for allocation purposes as the CY ending within the PY For PS contribution, do not exclude compensation prior to date of entry No proration because CY is not short determination period No issue for 415 compensation because there isn t a short limitation year 19
Comp Limit Doesn t Affect Deferrals Suppose Sue earns $50,000/month ($600,000) Can she defer after June 2016 (2016 comp limit is $265,00 and her comp as of June exceeds $265,000)? Preamble to 414(s) regulations says YES; deferrals don t have to come from the first dollars in Issues raised by IRS in prior years centered on interpretation of deferral election forms If plan imposes a limit on deferrals then must apply the compensation limit Example: Participants may only defer up to 6% of compensation Be Careful on Matching Contributions Compensation limit applies to matching contributions and is applied on an annual basis (does not need to be prorated throughout the year) Example: Plan has monthly match of 100% on deferrals up to 4% of compensation Mary defers 4% of $50,000 monthly compensation Match for 2016 cannot exceed 4% X $265,000 = $10,600 If plan does not apply pro-rated limit when depositing the match this limit could be exceed Mary s deferrals and match are $2,000/month if limit not applied In June she will have received maximum permissible matching contribution 20
Putting the Definitions to Work Uses of 415 Compensation Gross, full-year compensation Used for: IRC 415 limits IRC 416 (top-heavy) IRC 414(q) (HCE determination) 5% gateway for cross-testing (401(a)(4) regulations) IRC 414(v) (100% limit on catch-up contributions) IRC 404 Compensation limit for deductions IRC 409 ESOP allocation limits IRC 414(n) safe harbor leasing plan 21
414(s) compensation Safe harbor (gross or net) or alternative definition IRC IRC 401(a)(4) and (5) nondiscrimination testing IRC 401(k) ADP testing IRC 401(m) ACP testing ADP/ACP test safe harbors (except cannot exclude compensation above threshold) IRC 401(l) permitted disparity Nondiscrimination Testing 401(a)(4) For nondiscrimination purposes, determination period can be: 414(s) Compensation for plan year 414(s) Compensation for specified 12 month period ending in plan year May exclude 414(s) Compensation while not a participant Must follow this rule fairly consistently from year to year Can t shift to benefit HCEs 22
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 ADP/ACP Testing Compensation For ADP/ACP testing, determination period can be: 414(s) Compensation for plan year 414(s) Compensation for calendar year May exclude 414(s) Compensation while not a participant ADP Safe Harbor - Compensation cannot exclude compensation over a limit other than 401(a)(17) 23
Consistency Plan must use same definition for all employees in applying a particular provision Can use different definitions for different purposes (e.g., ADP test vs. general 401(a)(4) test) Can change definition from year to year Can use different definitions in different plans as long as not aggregating for testing Allocations/Benefits A plan can use any definitely determinable definition of compensation, including an unreasonable or clearly discriminatory definition, to allocate employer contributions The plan must test for 401(a)(4) nondiscrimination based on a nondiscriminatory definition of compensation 401(a)(17) limit applies 24
Effect of Discriminatory Definition FastNLoose Enterprise, Profit Sharing Plan defines compensation as W-2 compensation less overtime The plan allocates to each participant 20% of compensation Compensation ratio test results: Pass Plan is uniform allocation safe harbor plan Fail Plan must pass general nondiscrimination test Non-uniform allocation Total Comp Bonus Plan Comp Comp. Ratio Allocate Alloc. Rate Kirk $190,000 $0 $190,000 100.00% $38,000 20.00% Spock $150,000 $15,000 $135,000 90.00% $27,000 18.00% McCoy $85,000 $10,000 $75,000 88.24% $15,000 17.65% Scotty $75,000 $10,000 $65,000 86.67% $13,000 17.33% Uhura $50,000 $5,000 $45,000 90.00% $9,000 18.00% Sulu $40,000 $5,000 $35,000 87.50% $7,000 17.50% Every participant has a different allocation rate based on a nondiscriminatory definition of compensation Plan fails uniform allocation safe harbor and must perform general nondiscrimination test 25
Safe Harbor 401(k) Plan Plan provides for SH nonelective contribution = 3% of compensation Compensation is W-2 wages excluding bonuses For 2015 the definition does not satisfy 414(s) (higher inclusion ratio for HCEs) How do you correct? Elective Deferrals 26
Elective Deferrals General rule: Plans have flexibility in determining what compensation is eligible for deferrals 1.401(a)(4)-4(e)(3) provides that the rate of elective deferrals permitted must be nondiscriminatory and a rate is based on compensation regardless of whether it satisfies 414(s) ADP Safe Harbor plan can limit compensation an employee can defer to a reasonable definition of compensation (no compensation ratio test) QACA Regulations provide that compensation for purposes of determining default contributions means safe harbor compensation as defined in 1.401(k)-3(b)(2) 414(s) except cannot exclude comp over $ limit Gross vs Net Compensation Always use gross compensation (i.e., do not exclude deferrals) for deferral purposes Pete elects to defer 4% of plan compensation if net is used then how do you determine his deferral? Beware of using net compensation for matching purposes Plan has 100% match on deferrals up to 4% of compensation Pete wants to defer the maximum amount that is matched If plan uses net compensation, how does Peter figure out how much to defer? If he defers 4% of gross then he has over contributed since match is only on 4% of net 27
Fun With Matching Contributions A plan excludes bonuses for deferral purposes (only needs to be reasonable) but does not exclude bonuses in applying a limit on matching contributions Match is 100% of deferrals up to 3% of compensation and is on a payroll basis Jim makes $10,000/month ($5K semi-monthly pay) and has elected to defer 4% of compensation per pay check Match is normally $150 per pay period Jim receives a bonus of $10,000 in March 2016 payroll Match is now $400 - even though he can t defer, it s part of compensation for the matching contribution What if bonus is paid as separate payroll? Bonus is Paid as Separate Payroll Jim makes $10,000/month ($5K semi-monthly pay) and has elected to defer 4% of compensation per pay check Match is normally $150 per pay period Jim receives a bonus of $10,000 in a separate payroll Match is now $0 because no deferral can be made What if match is determined on an annual basis instead of payroll? Annual match does not mean match can t be deposited earlier True-up would be required if Jim had deferrals during the year that were not matched due to 4% of comp limit 28
Benefits, Rights and Features Right to make each rate of deferrals or after-tax contributions, based on plan s comp definition (whether or not it is nondiscriminatory) Different rates exists if different comp definitions or other requirements differ Right to each rate of matching contributions, based on plan s compensation definition Different rates exist if based on years of service or different compensation definitions or other requirements differ Determined after ADP/ACP corrections In other words, if you have different rates of match, you must apply two tests: ACP test and the availability of rights and features test Irregular Compensation Irregular compensation can result in operational errors with respect to deferrals Suppose plan does not exclude bonuses for deferral purposes A participant has elected to defer 3% of compensation What happens with respect to a bonus that is paid? No deferral taken out unless special election is made 3% is taken out unless special election is made 3% is taken out because no special election is permitted 29
The Election may be the Key What did the participant elect to defer? Plan does not exclude any compensation for deferral purposes How much should the plan withhold based on the following elections? I elect to defer $10,000 I elect to defer 5% of my base pay I elect to defer 5% of compensation Cash Tips Once an employee has the tips in hand (cash), deferrals cannot be made out of those amounts Not an issue if tips are pooled A deferral election can technically be based on these amounts as long as the contribution does not come from these amounts Example: I elect to defer 3% of total compensation More than 3% of regular pay will need to be contributed Almost impossible to know what it will be because tips for end of the year won t be known until after the end of the year 30
Partners and Self-Employed Earned income is currently available as of the last day of the taxable year of the individual Deferral elections must be made by that date If a draw is based on a reasonable estimate of earned income, then a deferral can be made if an election is made prior to payment of the draw Related Employers and Multiple Employer Plans 31
Related Employers Related = Controlled group of corporations or affiliated service group If an employee receives pay from more than one member of a related employer then a plan must aggregate all pay from all group members for purposes of 415 compensation 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 IRC 410(b) The plan covers Alice When the plan computes Alice s 415 compensation, it must include the Tweedledum pay, just as it must include the hours of service Alice performs for Tweedledum 32
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 Multiple Employer Plan Aggregate compensation from all sponsors to demonstrate compliance with IRC 415 Each sponsor counts only its own compensation for all other purposes, such as: Nondiscrimination testing (including testing an alternative definition of compensation to determine if it is nondiscriminatory) Determining HCE status Applying the top-heavy rules Applying the IRC 401(a)(17) limit Determining the deduction limit, unless the plan was adopted before 1989 (this also applies to affiliated service group plans) 33
Questions 34