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Compensation - The Backbone of Retirement Plan Testing

Robert M. Richter, J.D., LL.M.

VP FIS Relius

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3 Definitions

• 415 Compensation• 415 limits

• Top-heavy minimums

• 414(s) Compensation• Nondiscrimination testing

• Typically not defined in the plan document

• Plan Compensation• Benefits/allocations

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The Foundation

415 Compensation

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415 Compensation

• 4 alternatives:• Federal Income Tax Withholding

• Reportable W-2 Compensation

• 415 Regulatory Definition (referred to as current income)

• Simplified alternative of current income

• For self-employed (including partners) must use Earned Income (we will not cover)

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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)

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415 Compensation

• Must add back elective deferrals, cafeteria plan contributions and qualified transportation fringes

• For self-employed (including partners) use Earned Income (we will not cover)

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Definitional DifferencesCurrent Income

Income Tax

WithholdingW-2

Received from

unfunded

nonqualified

plan

Out* In In

Tips InGenerally 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

reimbursementOut* Out if deductible In

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More Differences

Current IncomeIncome Tax

WithholdingW-2

Group term life

insurance > 50KIn Out In

Nonqualified

stock option

exercise

Out In In

Qualified stock

option exerciseOut Out Out

Nonqualified

option when

granted

Out* In In

83(b) election Out* In In

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415 Compensation

• Must add back elective deferrals, cafeteria plan contributions and qualified transportation fringes

• For self-employed (including partners) use Earned Income (we will not cover)

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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

• Limit does not apply to disability payments

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Post-Severance Compensation

• Must include regular pay

• May include:• Leave cash-outs (e.g., cash-out of unused vacation)

• Nonqualified unfunded deferred compensation

• May not include severance pay

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Related Employers

• Related employers = Controlled group of corporations or affiliated service groups

• Must aggregate all pay from all related employers

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Compensation for Nondiscrimination TestingIRC §414(s)

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414(s) Safe Harbors

• 415 compensation (any of the base definitions)

• Can be gross or net of elective deferrals (all or none)

• Can exclude:• Reimbursements or other expense allowances,

• Fringe benefits (cash and noncash) (IRS Publication 15-B),

• Moving expenses,

• Deferred compensation, and

• Welfare benefits

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What is a Fringe Benefit?

• Achievement awards

• Athletic facilities

• Country club dues

• Cell phones

• Group-term life insurance

• Health coverage

• Meals

• Retirement planning services

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Other Safe Harbor Adjustments

• Can exclude military differential pay (IRS Notice 2010-15)

• Not clear if all post-severance payments can be excluded as a safe harbor adjustment

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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?

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414(s) Alternative Definitions

• Must be reasonable

• Must pass compensation ratio test annually

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Compensation Ratio Test

• 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

• Informally <3% is de minimis

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Apply Limit After Other Adjustments

• First determine “Compensation” without regard to 401(a)(17) 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 2018 compensation limit is $275,000 (lesser of $275,000 or $290,000)

• His inclusion ration for 414(s) testing is 100%

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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

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Example

• Plan excludes bonuses and inclusion ratio for NHCEs is 90%

• Cathy’s earned income is $300,000

• For 2018 the plan must limit Cathy’s compensation to $247,500• $275,000 (EI limited to 401(a)(17)) x 90% = $247,500

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• Annual Limit on CompensationIRC §401(a)(17)

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Limit Prorated for Short Period

• Prorate for “determination period” of less than 12 months

• 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 6/1/2018

• Employer wants profit sharing allocation based on full year comp (i.e., does not want to prorate 401(a)(17) limit)

• Can be plan be designed to accomplish this?

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Solutions

• Make effective date of plan 1/1/2018 with special effective date for deferrals (6/1/18)

• Make effective date of plan 6/1/2018 and measure compensation for allocation purposes as the CY ending within the PY• For PS contribution, do not exclude compensation prior to date of entry

• No issue for 415 compensation because there isn’t a short limitation year

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Annual Limit

• If there is a plan imposed limit on deferrals or matching contributions, the 401(a)(17) is not required to be pro-rated

• Example: Plan has monthly match of 100% of deferrals up to 4% of compensation• Mary defers 4% of her monthly compensation of $50,000

• Match for 2018 cannot exceed 4% X $275,000 = $11,000

• If plan does not apply pro-rated limit Mary’s deferrals and match are $2,000/month

• In June she will have received maximum matching contribution

Putting the Definitions to Work

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Uses of 415 Compensation

• Gross, full-year compensation

• Primary uses: • IRC §415 limits

• IRC §416 (top-heavy)

• IRC §414(q) (HCE determination)

• 5% gateway for cross-testing (401(a)(4) regulations)

• IRC §404 Compensation limit for deductions

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414(s) compensation

• Primary uses:• IRC §IRC 401(a)(4) and (5) nondiscrimination testing

• ADP and ACP testing

• ADP/ACP test safe harbors (except cannot exclude compensation above threshold)

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Special Rules For 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

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Cross-tested Gateways

• For 5% gateway, must use 415 compensation

• For 1/3 gateway may use same definition used to compute the HCE allocation rates

• For both gateways a plan can exclude compensation while not a participant

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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 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

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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

• Employer A’s 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

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Safe Harbor 401(k) Plan

• Plan provides for SH match of 100% of elective deferrals up to 4% of compensation

• Compensation is W-2 wages excluding bonuses

• For 2018 the definition does not satisfy 414(s) (higher inclusion ratio for HCEs)

• How do you correct?

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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)

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Exception

• 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

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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?

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Matching Contributions

• Best Practice – use the same definition of compensation for matching contributions that you use for elective deferrals• Plan has 100% match on deferrals up to 4% of compensation

• Match is based on net compensation and deferrals are based on gross compensation

• Pete elects to defer 4% of gross compensation but will not receive a match on all deferrals

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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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Other Irregular Compensation

• How do you handle cash tips that are reported?

• How do you handle the spot bonus (e.g., a gift card) or a surprise holiday bonus?