compensation part i: allowable definitions and when to use
TRANSCRIPT
Compensation Part I: Allowable Definitions and When to Use Them
Ilene H. Ferenczy, Managing Partner
Ferenczy Benefits Law Center
Ilene H. Ferenczy, Managing Partner
Ferenczy Benefits Law Center
Ilene Ferenczy is the managing partner of Ferenczy Benefits Law Center
LLP in Atlanta, Georgia. Ilene particularly focuses her practice on qualified
retirement plans, benefits issues in mergers and acquisitions, and advising
third-party administrators of employee benefit programs on technical and
practice issues. Ilene became an attorney after more than ten years as a
third-party administrator, and she brings a unique and practical approach to
her advice to clients. She is a member of the State Bars of Georgia and
California, and holds designations as a Certified Pension Consultant from
the American Society of Pension Professionals and Actuaries (“ASPPA”)
and Accredited Pension Administrator from the National Institute of Pension
Administrators. She is a nationally known speaker on benefits issues and
has authored more than 85 articles and five books. She is a member of
ASPPA’s Leadership Council, a former co-chair of ASPPA’s Government
Affairs Committee, the 2007 recipient of ASPPA’s Educator of the Year
Award, and is also a Fellow in the American College of Employee Benefits
Counsel, the highest honor awarded to ERISA lawyers.
1
Consider This:
• Complex Corp. has a safe harbor 401(k) plan
(3% employer contribution) with a cross-tested profit
sharing contribution
• Excludes employees in the Cucamonga office and
uses the average benefit test to pass coverage
requirements
• Participants can defer from “regular” salary
only (not bonus or overtime)
• The plan accepts catch-up contributions
• 50% match on deferrals up to 8% of comp
• The plan is top-heavy
2
How Does Complex Corp. Plan
Use “Compensation”?1. To determine HCEs
2. To calculate average benefit percentage for coverage
3. To allocate 3% safe harbor QNEC
4. To determine deferrable compensation
5. To determine the catch-up contribution limit
6. To allocate matching contributions
7. To calculate the ACP test
8. To allocate the cross-tested PS contribution
9. To determine if minimum gateway is passed
10. To perform general nondiscrimination testing (cross-testing)
11. To impute permitted disparity for testing
12. To ensure no violation of the §415 limits
13. To make sure the contribution is within deduction limits
14. To determine top-heavy minimum contributions (i.e., the amount of
key employee contribution; and each employee’s minimum
contribution)
3
Types of Compensation
• Compensation used for statutorily-based
determinations
• E.g., HCEs, top-heavy determinations, §415
• Compensation used for nondiscrimination testing
• E.g., ADP/ACP, cross-testing
• Other uses of compensation
• E.g., deferrable compensation
4
Compensation for Statutorily-Based
Determinations
55
The Foundation:
§415 Compensation
• These Code sections refer to §415
compensation:
• Plan benefit and contribution limits (§415, of course!)
• Top-heavy rules (§416, for determination of compensation
thresholds, amount of contribution received by keys, amount of
TH minimum for nonkeys)
• HCE determination (§414(q))
• 5% minimum allocation gateway for cross-testing (§1.401(a)(4)-8(b)(1)(vi)(B))
• 100% of compensation catch-up limit (§414(v))
• Compensation limit on deductions (§404)
6
What Is §415 Compensation?
• IRC §415(c)(3): “For purposes of paragraph (1)
– (A) In general. The term ‘participant’s
compensation’ means the compensation of the
participant from the employer for the year.”
• Well, that was helpful!
7
Check the Regulation:
Seems to Include Everything!
8
• Treas. Reg. §1.415(c)-2(b): 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). . .”
Additional Inclusions Under
the Regulation
• Remuneration that is subject to:
• The foreign earned income exclusion under IRC §911
(i.e., money earned by US citizens or residents living
abroad)
• The exclusion under IRC §931 (i.e., income from
sources within Guam, American Samoa, or the
Northern Mariana Islands); and
• The exclusion under IRC §933 (income from sources
within Puerto Rico)
• These exclusions prevent these amounts from
being income taxed, but they are still includible
9
Additional Inclusions Under
the Regulation• Medical or disability benefits that are includible in
gross income (e.g., disability benefits paid through
insurance purchased by the employer)
• Moving expenses that are not reasonably believed to
be deductible by the employee
• Amounts includible in income in relation to a
nonqualified stock option in the year granted
• Amounts includible in income in relation to a §83(b)
election
• Nonqualified plan amounts includible in income due
to constructive receipt under IRC §409A or 457(f)
10
The Regulation Specifically
Excludes
• Treas. Reg. §1.415(c)-2(c):• Contributions made by the employer to a plan that are not
includible in gross income
• Distributions from retirement plans
• Stock options:
• Amount realized from exercise of a nonqualified stock option
• Amount realized from sale, exchange, or disposition of
qualified stock option
• Amounts realized when restricted stock becomes freely
transferrable or no longer subject to a substantial risk of
forfeiture
• Other amounts that receive special tax benefits (such as
group term life insurance
11
Can Use §415 Definition or
One of Two Other Safe Harbors
• §415 Definition commonly called the “Current
Includible Compensation”
• Alternative Safe Harbors:
• W-2 Compensation (reportable under §6041, 6042,
and 6054)
• May include or exclude amounts paid/reimbursed by the
employer for moving expenses, but only to the extent that it is
reasonable to believe that those amounts are deductible by
the employee
• Federal Income Tax Withholding (§3401(a) wages)
• Must ignore limits based on the nature and location of the
employment or services
12
W-2 Compensation Fine Points
• Includes wages that must be reported under IRC
§§6041(d), 6051(a)(3), and 6052, i.e.,:
• Compensation to an employee of the employer
• Wages under IRC §3401(a); and
• Employer-provided group term life insurance, to the
extent includible in income under IRC §79
• Also includes:
• Cash value of noncash payments;
• Earned income for services rendered outside the US if
usually excluded under IRC §911; and
• Distributions from unfunded nonqualified plans
13
W-2 Compensation Fine Points
• Excluded:
• Reimbursements if treated as paid under an
“accountable plan” – i.e., a plan that requires
employees to substantiate their expenses and to
return any advance in excess of actual expenses
• Moving expenses paid to a third party or furnished in
kind to the employee, and qualified reimbursements
for moving expenses that will be deductible by the
employee
• Workers’ compensation payments
• Housing allowances for ministers
14
Federal Withholding Comp
Fine Points
• Generally includes anything that is remuneration
for services performed by an employee unless
specifically excepted
• Includes payments under unfunded deferred
compensation plans
• Includes noncash payments
• Includes vacation pay and employer-funded disability
pay
15
Federal Withholding Comp
Fine Points
• Excludes:
• Reimbursements if treated as paid under an
accountable plan;
• Nontaxable fringe benefits (no-additional cost
services; qualified employee discounts; working
condition benefits; de minimis benefits; qualified
transportation benefits; on-site gym or other athletic
facilities; qualified tuition reduction)
• Includes qualified transportation benefits if purchased through
salary reduction
• Housing allowances for ministers
16
For All Three Safe Harbor
Definitions
• Use gross compensation plus elective deferrals (including catch-up contributions) to:
• §125 cafeteria plans
• 401(k) plans
• 403(b) plans
• SIMPLE
• SARSEP
• §457
• Qualified transportation fringe benefit plan
17
Current
Income
Income Tax
WithholdingW-2
Received from
unfunded
nonqualified planOut* In In
Tips InGenerally In. Noncash Out.
Tips < $20/month Out.
Fringe benefits
includible in
incomeIn Mostly In In
Accident &
health plan (if
taxable)Out*
Generally In.
Self-insured
medical Out.
In
Moving expense
reimbursementOut*
Out if
deductible.In*
18
*may be included if desired
What’s the Diff?
Current IncomeIncome Tax
Withholding W-2
Group term life
insurance > 50KIn Out In
Nonqualified stock
option exerciseOut In In
Qualified stock
option exerciseOut Out Out
Nonqualified
option when
grantedOut* In In
83(b) election Out* In In
19
*may be included if desired
What’s the Diff?
Using W-2 Compensation
• Reasoning: it’s easiest
• Is that true?
• Possibly not: still have
adjustments to make
• Add back deferrals
• Post-termination compensation
(see discussion below)
• Very inclusive
• If company has stock option plan, awards of restricted stock,
or expense reimbursements, probably not desirable
20
Post-Termination (Severance)
Compensation – Type 1
• 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
21
e.g., trailing
commission
or bonus
Post-Termination (Severance)
Compensation – Type 2
• May include amounts that are 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
• Must be paid by later of 2½ months
of termination or by end of limitation
year including severance
22
e.g., unused
sick leave or
PTO
Post-Termination
Compensation - Type 3
• Compensation never includes bona fide
severance pay (regardless of timing):
• Paid after severance of employment; and
• Payable solely because of severance:
• E.g., You’re fired, take this two weeks’ pay and
GET OUT
• E.g., golden parachute payments
• Salary continuation amounts to those who
enter the military are considered to be
compensation if the payments do not exceed
normal pay and plan so provides
23
Differential Wage Payments
• Defined: Amounts paid voluntarily by an
employer to “true up” compensation earned by a
service member while on active duty
• Must be on active duty for more than 30 days
• Must represent all or a portion of the wages the
individual would have received had s/he been working
for the employer
• Part of HEART legislation
• Always includible in §415 compensation
24
Timing of Compensation
Inclusion
• Generally “cash basis”
• Final paycheck of the year:
• If compensation is paid in the next plan year but within a
few days due to timing of pay dates, can include in either
year, but must be consistent
25
For ALL Statutory Uses
• Must use compensation for entire year
• E.g., if calculating top-heavy minimum, must provide
allocation equal to 3% of the full year’s compensation
(even if normal allocations are based on
compensation while a participant)
• Exception: “One Third Test” gateway
calculations:
• If using “one third test,” can use same definition of
compensation as is used for allocations to the HCEs
(i.e., this could be compensation while a participant)
• Note: if using 5% gateway, must use full year
compensation (i.e., not an exception)
26
Compensation for
Nondiscrimination Testing
(§414(s))
2727
Structure
• Can use a safe harbor definition for
nondiscrimination testing
• Deemed to be permissible
compensation definition
• Can use alternate definition and
test compensation to show that it
is not discriminatory
28
§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 (either for all
employees or just for HCEs):
• Reimbursements or other expense allowances;
• Fringe benefits (cash and noncash);
• Moving expenses;
• Deferred compensation; and
• Welfare benefits
29
Alternative Definitions
• Must:• Be reasonable
• Not discriminate by design in
favor of HCEs
• Pass compensation ratio test
annually
30
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.,
Compensation = comp up to $100,000)
• Can exclude any fringe benefit items
• Impermissible exclusions:• Compensation = 75% of Compensation
• 2016 Compensation = December
Compensation x 12
31
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
32
What Is Total Compensation?
• Safe harbor definition (see slide #28)
• If there is a special definitional adjustment that
applies to some, but not all, HCEs, you must apply
that adjustment in determining total compensation
33
What Is De Minimis?
• “Facts and circumstances”
• Informal IRS indication is that <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
Average NHCE Ratio = 88.10%
Average HCE Ratio = 88.06%
Total
Comp Bonus Plan Comp Ratio
Harry $190,000 $20,000 $170,000 89.47%
Ron $150,000 $20,000 $130,000 86.67%
Hermione $ 85,000 $10,000 $ 75,000 88.24%
Fred $ 75,000 $10,000 $ 65,000 86.67%
George $ 50,000 $ 5,000 $ 45,000 90.00%
Ginny $ 40,000 $ 5,000 $ 35,000 87.50%
• Definition of compensation passes compensation ratio test
35
Average NHCE Ratio = 88.10%
Average HCE Ratio = 93.33%
Total
Comp Bonus Plan Comp Ratio
Harry $190,000 $0 $190,000 100.00%
Ron $150,000 $20,000 $130,000 86.67%
Hermione $ 85,000 $10,000 $ 75,000 88.24%
Fred $ 75,000 $10,000 $ 65,000 86.67%
George $ 50,000 $ 5,000 $ 45,000 90.00%
Ginny $ 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.
§401(a)(4) General
Nondiscrimination Testing
• For nondiscrimination testing purposes, a plan
can base compensation for all employees on:
• §414(s) compensation for the plan year
• §414(s) compensation for a specified
12 months ending in plan year
• §414(s) compensation while a
participant
• Cannot shift definition to benefit
HCEs
37
401(k) ADP Testing
• For nondiscrimination testing 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)
38
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
39
Annual Limit on Compensation
for Plan Purposes
40
Code§401(a)(17) Limitation
• Limits compensation taken into account for
plan purposes
• $270,000 for 2017
• $265,000 for 2015 and 2016
• $260,000 for 2014
41
Compensation Limitation
Applies three 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
42
What About Deferrals?
• Mortimer earns $300,000 per year (not catch-up
eligible)
• He has elected to defer 6% of pay per paycheck
• Mortimer’s monthly paycheck is $25,000
• He defers $1,500 per paycheck
• Must deferrals stop when total pay exceeds $270,000
(i.e., in November)?
• Answer: no, unless there is something in the plan
document that limits deferrable compensation to the
IRC §401(a)(17) limit
43
Annual Limitation and
Average Compensation
• For fiscal plan years, use limitation in
effect at beginning of year
• Applies on a year-by-year basis for
compensation averaging
• Example:
• Defined benefit plan bases benefits on
high three years’ compensation
• John’s salary is $270,000 each year of high three-year period
• Plan year ends June 30
• For 2015-2017 plan year beginnings, plan bases John’s benefit
on (265K [2015-2016] + 265K[2016-2017] + 270K[2017-2018])/3
= $266,667
44
Limit Prorated for Short Years
• Plan year ends September 30. Employer
decides to shift to calendar year. Will have
three-month plan year October 1, 2017, to
December 31, 2017. §401(a)(17) limit is
$67,000 (3/12 x $270,000)
• Do not have to prorate limit for a mid-year
entering participant if plan uses “compensation
while a participant”
45
Apply §401(a)(17) 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 $280,000 and she had a $12,000
bonus
• Calculation:
• First determine compensation without limit ($280,000 minus
$12,000 bonus or $268,000)
• Then apply limit: $268,000 comp vs. $270,000 limit
46
Compensation Limitation and
the Compensation Ratio Test
• Limit applies to both plan compensation and total
compensation in doing compensation ratio
• Example: • Plan defines compensation as W-2 minus
bonus
• Mary’s 2017 gross pay was $290,000,
which included a $30,000 bonus • Her total compensation is $270,000 ($290K, limited to $270
max)
• Her plan compensation is $260,000 (the $290K
compensation is reduced by the bonus, and then the limit is
applied)
• Her compensation ratio is 96.3% ($260K/$270K)
47
Questions?
48
?
Contact Information
Ilene H. FerenczyFerenczy Benefits Law Center
2200 Century Parkway, Suite 560
Atlanta, Georgia 30345
(678) 399-6602 (V)
(866) 515-5140 (toll free)
(404) 320-1105 (F)
Follow us on Twitter: @ferenczylaw
49