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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.

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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

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3 Definitions

• 415 Compensation

• 415 limits

• Top-heavy minimums

• 414(s) Compensation

• Nondiscrimination testing

• Plan Compensation

• Benefits/allocations

The Foundation

415 Compensation

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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

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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). . . .‖

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• 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)

415 Simplified Definition*

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 In Mostly In In

Accident &

health plan (if

taxable) Out*

Generally In.

Self-insured

medical Out.

In

Moving expense

reimbursement Out* Out if deductible. In

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More Differences

Current Income Income Tax

Withholding W-2

Group term life

insurance > 50K In Out In

Nonqualified

stock option

exercise Out In In

Qualified stock

option exercise Out Out Out

Nonqualified

option when

granted 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)

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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

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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?

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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

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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

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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

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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

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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‖

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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

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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

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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

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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‖

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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

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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 pro-

rated 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

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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

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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

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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)

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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)

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Questions