10/17/2016

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Connecting the Dots between

Plan Compensation

and

Plan Operation

10/17/2016

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Session Objectives

• Discuss various roles compensation plays

in qualified retirement plans

• Review definitions used as basis for plan

compensation

• Address common compensation errors

and available corrections

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Compensation Has Many Roles

• Contribution and benefit calculations

• Annual contribution/benefit limits--IRC §415

• Non-discrimination testing--IRC §§ 401(a)(4),

401(k), 401(m), and 414(s)

• Highly compensated employees (“HCEs”)

IRC §414(q)

• Key employees--IRC §416

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10/17/2016

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Compensation Definitions

• 415 compensation

• 414(s) compensation

• Plan compensation

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415 Compensation Uses

• HCEs--prior year 415 compensation exceeding *$120,000 (2016 and 2015)

• Key employees and top heavy contributions

• Annual contribution and benefit limits

• Cross-testing 5% gateway contribution

• Deductible contribution limit

*Retirement plan COLA chart: www.irs.gov/pub/irs-tege/cola_table.pdf

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415 Compensation

• 415 Compensation defined in Treasury Regulations

– “Currently Includible Compensation”

• Regulations provide 3 alternative definitions:

– Form W-2 (box 1)

– 3401(a) Comp (federal income tax withholding)

– 415 Safe Harbor Compensation (“Simplified”)

• All definitions adjusted to include pre-tax elective

deferrals under following IRC §§

– 401(k), 403(b), 408(k), 408(p), 457(b), 125, 132(f)

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415 Compensation

• Compensation paid by related employers is

included as 415 Comp

– Controlled groups

– Affiliated service groups

– Regardless of whether related employer participates

in plan

• Amounts paid during limitation year, including

comp paid while not an eligible participant

– 5 % gateway may exclude comp while not participant

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415 Compensation Compensation Type Form W-2,

Box 1 3401(a) 415 Safe

HarborCurrently Includible

Pre-Tax Elective Deferrals Included Included Included Included

Roth Contributions Included Included Included Included

Imputed Group Term Life Included Excluded Included Included

Taxable Moving Expenses Included Included Excluded Included

Nonqualified Plan Distrib Included Included *Excluded *Excluded

Taxable Medical/Disability Included Included Excluded Included

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*Excluded unless plan document includes.

415 Post-Severance

• Timing rule--certain post-severance 415 Comp

must be paid by the later of:

– End of Limitation Year, or

– 2 ½ months after employee termination

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415 Post-Severance

Post-Severance Pay Must Include

May Include

Subject to Timing Rule

Regular Pay √ √

PTO Cash-Outs √ √

Unfunded Deferred Comp only if

it would have been paid at same time regardless of employee termination

√ √

Disabled Salary Continuation √ N/A

Military Service Salary Cont. √ N/A

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414(s) Compensation Uses

• ADP/ACP testing

– Deferral and matching contributions

• General testing/cross-testing IRC §401(a)(4)

– Non-elective contributions

– Except 5 % gateway contribution

• Calculating employer contributions under

design-based safe harbor plan

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414(s) Compensation

• 414(s) compensation may use any 415 compensation definition

– W-2

– 3401(a)

– 415 safe harbor

– 415 currently includible

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414(s) Compensation

414(s) permits adjustments to 415 Compensation

1. Exclude elective deferrals:

– 401(k), 403(b), 408(k), 408(p), 457(b), 125, 132(f)

2. Exclude expense allowances/reimbursements, fringe benefits (cash or non-cash), moving expenses, deferred compensation, welfare benefit plans, etc.

3. Exclude pay while not a participant

414(s) safe harbor adjustments must treat all elective deferrals and all expenses in 1 and 2 above the same

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414(s) Compensation

• 414(s) compensation deemed nondiscriminatory

• Plan document may define specific 414(s) compensation to be used in testing or may permit any 414(s) compensation definition

– Check base document in pre-approved plans

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Plan Compensation Uses

• Calculate contributions and benefits

– Plan document will provide specific definition

– Plan compensation definition may not satisfy

414(s) compensation

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Plan Compensation

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*Excluded unless plan document includes.

Compensation Type Form W-2, Box 1

3401(a) 415 Safe Harbor

Pre-Tax Elective Deferrals *Excluded *Excluded Included

Roth Contributions Included Included Included

Imputed Group Term Life Included Excluded Included

Taxable Moving Expenses Included Included Excluded

Nonqualified Plan Distrib Included Included *Excluded

Taxable Medical/Disability Included Included Excluded

Plan Compensation

• Pre-approved plan documents

(Prototypes/Volume Submitters)

– Typically use 415 compensation alternative

as starting point

• Form W-2, box 1

• 3401(a) (federal income tax withholding wages)

• 415 safe harbor compensation

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Plan Compensation

• If using Form W-2 or 3401(a) compensation,

plan compensation may not automatically

include pre-tax elective deferrals

– Check base document if not stated on Adoption

Agreement

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Plan Compensation

PPA Adoption Agreement Excerpt:

Compensation with respect to any participant is defined as follows:

Base definition

– A. [ ] W-2 wages

– B. [ ] Section 3401(a) wages

– C. [ ] 415 safe harbor compensation

NOTE: Plan Sections 1.18(d) and 1.40 provide that the base

definition of Compensation includes deferrals that are not included

in income due to Code §§401(k), 125, 132(f)(4), 403(b),

402(h)(1)(B)(SEP), 414(h)(2), & 457.

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Plan Compensation Adjustments

• Common non-safe harbor adjustments to compensation

– Exclude bonuses

– Exclude commissions

– Exclude overtime

– Exclude shift differentials

• Non-safe harbor compensation adjustments may be

discriminatory. Requires testing unless exclusion applies

only to HCEs.

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Nondiscriminatory Plan Comp

• Non-safe harbor comp adjustments nondiscriminatory if

– Reasonable

– Do not favor HCEs

– Pass compensation ratio test

• Plan compensation is reasonable if based upon one of

415 compensation definitions

• Compensation ratio test passes if

– HCE average % included compensation does not exceed

NHCE average % by more than deminimis difference

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10/17/2016

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Compensation Ratio Test

• Included compensation % equals:

– Plan compensation / 415 compensation

• Employees included in average are employees who “benefit” for the specific contribution

– Deferrals – employees eligible to defer

– Matching – employees eligible to receive match

– Non-elective – employees who actually receive contribution

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Compensation Ratio Test

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415

Plan Comp Comp %

HCE 265,000 265,000 100%

HCE 163,000 175,000 93%

NHCE 87,000 95,000 92%

NHCE 61,500 65,000 95%

NHCE 75,000 75,000 100%

NHCE 63,500 65,000 98%

NHCE 60,000 60,000 100%

HCE average 96.5%

NHCE average 97%

HCE average does not exceed NHCE average

Compensation Ratio Test passes

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Nondiscriminatory Plan Comp

• What if Compensation Ratio Test fails?

– Must use 414(s) compensation when performing

ADP/ACP testing

– May require non-elective contributions to be tested

• General test or

• Cross test

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Maximum Plan Compensation

• Code §401(a)(17) annual compensation limit

(Plan must disregard compensation in excess of

limit)

– $265,000 for plan years beginning in 2016 and 2015

– Limit is prorated for any short plan year

– Limit is applied annually regardless of

• New participant entry dates

• Funding frequency

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Plan Compensation

• Issues in 401(k)/403(b) plans

– 401(k) & 403(b) plans may have different

entry for employee deferrals vs employer

contributions

– May use different comp definitions for

employee and employer contributions

– Requires employer to track multiple

compensation numbers

– Non-cash compensation must have

deferrals withheld, unless specifically

excluded in document

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Plan Compensation

• XYZ Manufacturing’s 401(k) Plan:

– Employee deferrals: Immediately eligible

– Employer matching: 6-months service

– Employer non-elective: 1-year service

• Requires tracking 3 different periods of comp on all new

participants

– New participants will have different compensation in:

• ADP test

• ACP test

• General test

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Plan Compensation

• Physician Practice’s 401(k) Plan defines plan comp as

Form W-2 wages plus all elective deferrals

• Certain employees receive non-cash comp:

• Imputed group term life insurance (> $50,000)

• Payment for business club memberships

• Automobile allowance (company auto personal use)

• Physician Practice must establish process to calculate

401(k) deferrals on non-cash comp

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Earned Income

• Self-employed individuals have earned income not W-2 comp

• Who is a self-employed individual?

– Sole-proprietor

– Partner in a partnership

– Member of an LLC

S Corp shareholders are not self-employed individuals. Only wages are compensation for plan purposes. S-Corp K-1 income is not earned income. IRC §415(c)(3)(b)

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Earned Income

• Earned income is “net earnings from self employment”

– Reduced by ½ of the allowed self-employment tax

deduction

– Reduced by retirement plan contributions deductible

under code §404

• Circular equation

• Contribution % ÷ (Contribution % + 100 %)

• Elective deferrals are not subtracted

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Earned Income

• Where to find net self-employment– Sole-proprietor -- Form 1040, Schedules C or F net income

– Partner -- Form 1065, Schedule K-1

– LLC member –

• Form 1065, Schedule K-1, or

• Form 1040, Schedules C or F

• For partners/LLC members, adjust above amount for:– Accelerated depreciation expense under Code § 179

– Oil and gas depletion

– Partner’s un-reimbursed expenses on Form 1040, Schedule E

• Partnership plan sponsors need to obtain partners’ unreimbursed

expense amounts each year

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Earned Income

• Sample calculation of 10% employer contributionPartner’s K-1 earnings from self-employment $ 100,000

Partner’s un-reimbursed expenses - 10,000

Net earnings from self-employment $ 90,000

½ self-employment tax deduction - 6,358

Calculation compensation $ 83,642

X 9.09% (10%/110%) 7,604

Plan Earned Income $ 76,038

Prove Circular Equation: $76,038 * 10% = $7,604

• 401(k) deferrals do not reduce earned income unless plan document excludes for employees

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Common Compensation Errors

Hometown Tech Co 401(k) Plan

• Plan comp is Form W-2 wages plus elective deferrals

• Match is 100% of deferrals up to 4% of pay

• Hometown paid employees $1,000,000 in bonuses; no 401(k) deferrals were withheld on bonuses

• Deferrals on bonuses would have totaled $32,000

• Matching contributions would have totaled $30,000

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Common Compensation Errors

• How much will it cost Hometown to correct

error?

A. $32,000 in deferrals; $30,000 in match; plus earnings

B. $16,000 in deferrals; $15,000 in match; plus earnings

C.$16,000 in deferrals; $30,000 in match; plus earnings

D.$16,000 in deferrals; $-0- match; plus earnings

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Common Compensation Errors

• Correction guidance

– Employee Plans Compliance Resolution System (EPCRS)

Rev. Procs. 2013-12; 2015-27; 2015-28

– QNEC equaling 50% of employees’ missed deferrals

(missed deferral opportunity) plus 100% employer

matching plus earnings on QNEC & match

– 50% QNEC may be avoided or reduced to 25% if certain

conditions met

– Corrections cannot cause participant to exceed annual

deferral limit

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Common Compensation Errors

• NFP Org sponsors money purchase plan

– Plan comp is Form W-2 wages plus elective

deferrals; fringe benefits are excluded

– Plan contribution formula is 10% of comp

– NFP paid $750,000 in fringe benefits to participants

– 2015 contribution based upon gross compensation,

including fringe benefits

– $75,000 was over-funded & allocated to participants

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Common Compensation Errors

• How does NFP correct the error?

A. No correction needed since all participants

received higher benefit

B. Retroactively amend the plan to include

fringe benefits

C. Forfeit incorrect contribution plus associated

earnings from affected participant accounts

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Common Compensation Errors

• ABC Distributors’ 401(k) plan

– Plan comp is 3401(a) wages plus elective deferrals

– ABC made 10% non-elective contributions

– In 2015, Jack received $200,000 in salary and $100,000 form a non-qualified executive comp plan

– Jack, age 52, made a 10% pre-tax deferral election

– ABC did not include non-qualified distributions as compensation for any plan purpose

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Common Compensation Errors

• How much is Jack’s missed deferral?

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A. $10,000 $100,000 X 10%

B. $ 4,000 $24,000 minus $20,000 from

salary deferrals

C. $ -0- $18,500 deferral limit

D. $ -0- 3401(a) wages do not include

distributions from non-qualified

deferred compensation plans

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Common Compensation Errors

• How much is Jack’s non-elective correction?

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A. $10,000 $100,000 X 10%

B. $15,000 $53,000 415 limit minus $38,000 ($18,000 salary deferrals + $20,000

non-elective on salary)

C. $ 500 $265,000 X 10% = $26,500 minus

$20,000 non-elective on salary

D. $ -0- 3401(a) wages do not include

distributions from non-qualified

deferred compensation plans

Key Take-Away(s)

• Excluding compensation (other than safe harbor

adjustments) requires non-discrimination testing

• Plans may have different 415, 414(s) and plan

compensation definitions

• Employers need procedures to insure correct

compensation used operationally & in testing

• Mistakes found early are usually cheaper to

correct

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Questions?

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