COMPENSATION CONUNDRUMS ASPPA Virtual …asppavirtual.commpartners.com/files/2016/Tripoldi Session 2 Handout...COMPENSATION CONUNDRUMS ASPPA Virtual Conference April 21, 2016 Presented

COMPENSATION CONUNDRUMS

ASPPA Virtual Conference

April 21, 2016

Presented by:

Sal TripodiTRI Pension Services

1550 Larimer St., #423Denver, CO

[email protected]

http://www.cybERISA.com

mailto:[email protected]

Compensation Conundrums (Table of Contents)

Table of Contents

COMPENSATION CONUNDRUMS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Section 415 compensation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Current includible income definition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Simplified compensation rule.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

W-2 definition.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Wages for income tax withholding definition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Elective Deferral Gross-Up. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

What’s deemed section 125 compensation?.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4Self-employed individuals: earned income definition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Self-employment tax deduction under §164(f) is taken into account. . . . . . . . . . . . . . . . . . . 6Reduction of earned income for self-employed individual's qualified plan deduction. . . . . . 6

Fringe benefits for 2% shareholders of S corporations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7Post-severance compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

General rule: post-severance compensation is not counted. . . . . . . . . . . . . . . . . . . . . . . . . . . 8Inclusion of certain payments received after severance from employment. . . . . . . . . . . . . . . 8Military service/disabled participants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9Other post-severance payments are excluded from section 415 compensation. . . . . . . . . . . 10

Which section 415 compensation definition applies to the plan?/What are the differences among thedefinitions?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10Differences among the definitions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10Comparison Table. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Section 414(s) compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Table: Uses of Compensation under Qualified Plans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Determining whether section 415 limits have been exceeded. . . . . . . . . . . . . . . . . . . . . . . . . . . 17Allocating employer contributions in DC plan (other than match), or determining accrued benefits

in DB plan. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Calculating plan-imposed limit on 401(k) deferrals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18Compensation from which employees may defer under 401(k) arrangement. . . . . . . . . . . . . . . 20Calculating the employer's matching contribution. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21Identifying highly compensated employees (HCEs) under the "compensation test". . . . . . . . . . 22ADP/ACP testing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23Nondiscrimination testing under IRC §401(a)(4). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24Identifying key employees under IRC §416(i). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25Computing an employee's top heavy minimum benefit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26Employer's deduction limit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Plan Design “Red Flags” Relating To Compensation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28Different definitions used for different purposes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28Using only partial-year compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28Excluding categories of compensation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

EPCRS Corrections Relating To Compensation Mistakes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30Improper allocations due to compensation errors.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30Elective Deferral Failures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31Testing errors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

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Compensation Conundrums

IRC §415 violations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32Top heavy error.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32Overstatement of deduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

COMPENSATION CONUNDRUMS

# Section 415 compensation

A reference to "section 415 compensation" is a reference to compensation as defined for purposes ofapplying the limitations under IRC §415. There are three prescribed definitions: current includiblecompensation definition, W-2 definition, and wages for income tax withholding definition.

Current includible income definition. Under this definition, compensation includes all wages, salaries, feesand other amounts received by the employee for personal services rendered in the course of employment withthe employer, but only to the extent includible in gross income (but see 1.a.4) below regarding Indian tribalfishing rights). See Treas. Reg. §1.415(c)-2(b)(1). This definition includes overtime, bonuses, commissions,tips, fringe benefits (e.g., taxable use of a company automobile), and reimbursements or other expenseallowances under a nonaccountable plan (as described in Treas. Reg. §1.62-2(c)).

k Simplified compensation rule. Under a simplified compensation rule, a plan may modify thisdefinition of section 415 compensation by excluding the amounts listed in Treas. Reg. §1.415(c)-2(b)(3)through (7), as well as the amounts in Treas. Reg. §1.415(c)-2(c). See Treas. Reg. §1.415(c)-2(d)(2). Thisrule is one of three safe harbors prescribed by Treas. Reg. §1.415-2(d), the other two of which are theW-2 and Wages for federal income tax withholding definitions discussed below.

W-2 definition. Under this definition, section 415 compensation is defined as wages (as determined underIRC §3401(a)), as described below, and other payments for which the employer must file a written statement(i.e., Form W-2) under IRC §6041(d) (but only with respect to items of compensation to an employee of theemployer), §6051(a)(3) (referring to wages under §3401(a)) and §6052 (referring to employer-provided grouplife insurance to the extent it is includible in gross income under §79). See Treas. Reg. §1.415(c)-2(d)(4).The W-2 definition is similar to the wages definition below, but would be more inclusive because it listsother included items besides those described in IRC §3401(a). Any rules that limit the remuneration includedin wages based on the nature or location of the employment or the services performed are disregarded. Forexample, non-cash compensation for agricultural labor (sometimes referred to as “commoditycompensation”) is excluded from the definition of wages under IRC §3401(a)(2), but is included in section415 compensation under the W-2 definition. The IRS permits the plan to state this definition by referencingamounts reported as "wages, tips or other compensation" on Form W-2.

Plan’s terminology might differ. Some plan documents refer to this definition as “§6051 compensation” orsome similar designation that incorporates the tax code sections used to make the determination.

Wages for income tax withholding definition. Under this definition, section 415 compensation is defined aswages under §3401(a) for purposes of income tax withholding at the source. See Treas. Reg. §1.415(c)-2(d)(3). Any rules that limit the remuneration included in wages based on the nature or location of theemployment or the services performed are disregarded (e.g., noncash compensation for agricultural labor isexcluded from wages, pursuant to IRC §3401(a)(2), but would be included in this definition). IRS Publication


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15, Circular E, Employer's Tax Guide, and Publication 15-A provide helpful instructions on the treatmentof compensation as wages for income tax withholding purposes. All amounts included in this definitionwould also be included in the W-2 definition described above, so this definition is a less inclusive definitionthan the W-2 definition.

Plan’s terminology might differ. Some plan documents refer to this definition as “§3401 compensation”or some similar designation that incorporates the tax code section used to make the determination.

Elective Deferral Gross-Up. All three definitions above are grossed up for the following: (1) 401(k) deferrals,(2) 403(b) salary reduction contributions, (3) elective deferrals under SARSEPs and SIMPLE-IRA plans, (4)elective deferrals under a section 457(b) plan, (5) salary reduction contributions under an IRC §125 plan(cafeteria plan), and (6) salary reduction amounts to purchase qualified transportation fringe benefits (IRC§132(f)(4)). Note that Roth contributions already would be reflected in the three definitions, so only pre-taxelective deferrals would increase the amount of an employee’s 415 compensation that would otherwise bedetermined under one of the above three definitions.

k What’s deemed section 125 compensation? This rule treats a salary reduction contribution for healthcoverage as if it is section 125 compensation, even though the employee is unable to elect a cash optionbecause the employee lacks other health coverage. To do so, however, the coverage must be automaticthrough salary reduction, and other coverage information is not requested or collected at the time ofenrollment.

Example #1. An employer offers health coverage for its employees. Coverage of the employee underthe company’s health plan is automatic unless the employee elects out. However, an employee whocannot certify to other health coverage is not permitted to elect out. A portion of the health coverageis deducted from the employee’s pay through salary reduction. There are 50 employees who areeligible for the company’s defined contribution plan. You have the following information aboutthese 50 employees.

Number automatically enrolled in self-only coverage - 45Number who have elected cash - 5

Suppose the plan includes the deemed 125 compensation rule. The employer does not know howmany of the 45 have other coverage and thus, would be eligible to elect cash. Of course, the 5 whoelected cash had to demonstrate coverage under another health plan.Q: Is the salary reduction amount for the 45 employees covered by the company’s health planincluded in section 415 compensation?A: Yes because (1) the plan uses the deemed 125 rule, and (2) the employer is not aware of whichof the 45 employees are actually eligible to elect out of coverage since other health coverageinformation was not solicited.

Example #2. Suppose in Example #1 that the plan does not use the deemed 125 compensation rule.Q: Is the salary reduction amount for the 45 employees covered by the company’s health planincluded in section 415 compensation?A: Only the salary reduction amount for those employees who are actually eligible to elect cashinstead (i.e., opt out of coverage) is included in section 415 compensation. Thus, the employer willneed to inquire of each employee whether he/she has other health coverage.


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Example #3. Suppose in Example #1 that the plan includes the deemed 125 compensation rule, butthe employer asks at the time of enrollment in the health plan whether the employee has other healthcoverage.Q: Is the salary reduction amount for the 45 employees covered by the company’s health planincluded in section 415 compensation?A: Only the salary reduction amount for those employees who are actually eligible to elect cashinstead (i.e., opt out of coverage) is included in section 415 compensation. The deemed 125 rule willnot allow inclusion of the salary reduction amount for the employees who cannot demonstrate otherhealth coverage, because the employer inquires of each employee at the time of enrollment whetherhe/she has other health coverage. If the employer is going to proceed in this manner, there is noreason to have the deemed 125 compensation rule stated in the plan.

Example #4. In the above examples, an employee may elect an additional salary reduction amountto purchase health coverage for his/her spouse or for his/her family.Q: Is the addition salary reduction amount deducted from an employee’s pay for spousal or familyhealth coverage included in section 415 compensation?A: Yes. All employees eligible to elect this additional coverage have the right to cash by not electingsuch coverage, and thus, such amounts are treated as 125 compensation for section 415 purposesregardless of whether the deemed 125 compensation rule is used and regardless of whether theemployee must provide coverage under another health plan to decline coverage under the company’shealth plan.

Self-employed individuals: earned income definition. For self-employed individuals covered by the plan (e.g.,sole proprietor or partner), section 415 compensation means earned income as defined in IRC §401(c)(2).However, the Elective Deferral Gross-Up is applied to earned income to determine section 415compensation. An individual's earned income is his or her net earnings from self-employment (as definedin IRC §1402(a)) with the modifications described in IRC §401(c). All adjustments taken into account inarriving at net earnings from self-employment are taken into account, even if the self-employed individualseparately reports such items.

How to compute. The starting point for determining net earnings from self-employment will be the ScheduleC (line 31) or Schedule C-EZ (line 3), in the case of most sole proprietors, or the Schedule K-1 (the linereferencing “self-employment earnings (loss)”), in the case of partners of partnerships (or entities, such asLLCs, which are taxed as partnerships). In the case of a farming operation, self-employment income mightbe reportable on Schedule F, in which case the amount in line 36 is the starting point. Then make anyadjustments required by IRC §401(c)(2). IRC §179 expense deduction. To arrive at earned income for a general partner, the depreciation allowanceunder IRC §179 is subtracted from the self-employment earnings reported on the Schedule K-1. Seeinstructions to the Schedule K-1.Other Schedule K-1 adjustments. The instructions to the Schedule K-1 also require the amount reported asself-employment earnings for a general partner to be reduced by unreimbursed partnership expenses claimedby the partner, as well as by depletion on oil and gas properties. These are the same additional expenseswhich are subtracted from self-employment earnings to determine the amount reported on line 1 or line 2of the Schedule SE.


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a. Self-employment tax deduction under §164(f) is taken into account. Earnings are reduced by thededuction allowed under IRC §164(f) for one-half of the individual's self-employment tax. See IRC§401(c)(2)(A)(vi).

a.1) IRC §1402(a)(12) deduction does not apply for qualified plan purposes. IRC §1402(a)(12)provides for a deduction equal to the net earnings from self-employment (determined before thisdeduction) times one-half of the sum of the tax rates under IRC §1401(a) and (b). The IRS positionis that the IRC §1402(a)(12) applies solely for calculating the self-employment tax on the self-employed individual, and is in lieu of the IRC §164(f) deduction. The IRC §164(f) deduction appliesin determining the individual's net-earnings from self-employment for income tax purposes, and theIRC §1402(a)(12) deduction is not taken in addition to the IRC §164(f) deduction for these purposes.This position is stated in a memorandum from the Assistant Chief Counsel (Employee Benefits andExempt Organizations) at the IRS National Office to the Associate District Counsel (Louisville),dated July 7, 1997. The income tax definition (which takes into account the IRC §164(f) deductionrather than the IRC §1402(a)(12) deduction) is the one that is applicable to determining earnedincome for qualified plan purposes (i.e., plan allocations, section 415 limits, deduction limits underIRC §404). The IRS alludes to this in its audit guidelines on qualified plan deduction calculationsfor self-employed individuals, which were published in Announcement 94-101.

SIMPLE-IRA uses different definition. Note that "compensation" of a self-employed individual forpurposes of determining contributions under SIMPLE-IRA plans does not include the §164(f)deduction, and apparently does not include the §1402(a)(12) either. See IRC §408(p)(6)(A).

b. Reduction of earned income for self-employed individual's qualified plan deduction. Earnings arereduced by the deductions allowed to the individual under IRC §404 for contributions to a qualified plan,including contributions allocated for the benefit of the individual. See IRC §401(c)(2)(A)(v). When theemployer is a sole proprietorship, the entire IRC §404 deduction for the year will reduce the earnedincome of the sole proprietor. When the employer is a partnership, the IRC §404 deduction is allocableamong the partners. Thus, for each partner, the IRC §404 deduction taken into account under IRC§401(c)(2)(A)(v) is the partner’s allocable share of the IRC §404 deduction relating to the common lawemployees (see b.3) below) and the portion of the IRC §404 deduction attributable to contributions madeon behalf of the partner.

b.1) Example - discretionary employer contribution. A self-employed individual, who is a soleproprietor, participates in a profit sharing plan maintained by the sole proprietorship. Theindividual’s net earnings, after the adjustment for one-half of the self-employment taxes, asdescribed above, is $60,000. A discretionary contribution is made to the plan, on behalf of the self-employed individual, in the amount of $10,000. The individual’s earned income under IRC§401(c)(2) is $50,000, because it must reflect the deduction taken for the $10,000 discretionarycontribution. The $50,000 amount must be used to determine whether the contribution allocationexceeds any limitations, such as the §415 limitation or the deduction limitation under §404. The$50,000 amount is also used to determine whether the contribution satisfies the nondiscriminationrequirements of §401(a)(4), in the event that there are nonhighly compensated employees of the soleproprietorship who also participate in the plan.


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b.2) Status of elective deferrals under IRC §401(k). Although elective deferrals made by the self-employed individual to a section 401(k) arrangement are treated as employer contributions, and thusare deductible under IRC §404 as well, the elective deferrals will not have the same impact on theindividual’s earned income. In the example in 3.a. above, suppose that, in addition to the $10,000discretionary contribution allocated on behalf of the self-employed individual, the individual alsocontributes $15,000 of elective deferrals, pursuant to a 401(k) arrangement offered under the sameplan. Although the total amount of contributions made on behalf of the self-employed individual is$25,000, the $15,000 of elective deferrals do not reduce the individual’s compensation for twoimportant calculations: (1) the individual’s section 415 compensation, and (2) the individual’scompensation for purposes of calculating the deductible limit.

b.3) Plan contributions for common law employees. If the sole proprietorship or partnership hascommon law employees who are covered by the plan, the qualified plan deduction under IRC §404that is taken into account to compute earned income includes the contributions made on behalf ofsuch employees (or, in the case of a partner, the partner’s allocable share of the deductionattributable to such contributions), including the elective deferrals made by such common lawemployees to a 401(k) arrangement maintained by the employer. The “gross up” rule discussed inb.2) above pertains to the elective deferrals made by the self-employed individual for purposes ofdetermining his/her compensation for certain purposes. The elective deferrals made by the commonlaw employees are part of the employer contributions deducted by the employer (i.e., the soleproprietor, or the partnership, as the case may be) under IRC §404.

b.4) More than one plan maintained by sole proprietor or partnership. If the sole proprietorshipor partnership maintains more than one plan, the combined qualified plan deduction allowed to theemployer is taken into account in determining the self-employed individual’s earned income. Theearned income so determined is used by all the plans.

Fringe benefits for 2% shareholders of S corporations. IRC §1372 provides that, for purposes of the tax codeprovisions relating to fringe benefits (including health and welfare benefits), an S corporation is treated asa partnership and a 2% shareholder of the S corporation is treated as a partner in a partnership. A 2%shareholder means a person who, after application of the attribution rules under IRC §318, owns more than2% of the S corporation. The effect of this provision is to deny a 2% shareholder an exclusion from grossincome with respect to fringe benefits that fall under the reach of IRC §1372. Where this can affectcompensation under the plan is with items such as employer-provided health insurance and employercontributions to a Health Savings Account (HSA) on behalf of the 2% shareholder. This is because IRC §106,which provides for an exclusion from gross income with respect to employer-provided coverage under anaccident or health plan, applies only to employees, and not to partners (or 2% shareholders treated as partnersfor this purpose). Some practitioners believe that, although these amounts are includible in gross income that,if the 2% shareholder is eligible to deduct the amount in full on his/her personal income tax return, that theyshould not be included in compensation for IRC §415 purposes. This is not true. What happens to the incomeon a personal tax return is not relevant to the plan’s treatment of the amounts. Accordingly, our conclusionis that these amounts should be included in IRC §415 compensation for a 2% shareholder. Also note that,since the amounts attributable to fringe benefits included in a 2% shareholder’s compensation is subject tofederal income tax withholding (see IRS Publication 15), and such amounts appear on Box 1 of the Form W-2 issued to the 2% shareholder, these amounts would still be included if the plan uses the W-2 definition orthe wages for income tax withholding definition.


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Post-severance compensation. The 2007 regulations clarify the manner in which compensation paid afterseverance from employment is treated for purposes of determining section 415 compensation. See Treas.Reg. §1.415(c)-2(e)(3), (4) and (5).

a. General rule: post-severance compensation is not counted. As a general rule, compensation paid ina limitation year may not be treated as section 415 compensation unless it is paid (or treated as paid)prior to the employee’s severance from employment. See Treas. Reg. §1.415(c)-2(e)(1)(ii).

a.1) Definition of severance from employment. A severance from employment is determined inthe same manner as under Treas. Reg. §1.401(k)-1(d)(2) (relating to permissible distribution eventsunder 401(k) arrangements), except that, an employee’s employer is determined by reference to themodified definition of a controlled group under IRC §415(h). See Treas. Reg. §1.415(a)-1(f)(5)(i).However, under a multiemployer plan, a participant is not treated as having a severance fromemployment with an employer maintaining the plan if the participant continues to be an employeeof another employer maintaining the plan. See Treas. Reg. §1.415(a)-1(f)(5)(ii).

b. Inclusion of certain payments received after severance from employment. Under this rule, anypayment of compensation described in b.2) below is included in section 415 compensation, but only ifthe general conditions described in b.1) below are satisfied.

b.1) General conditions (“2½-month rule”). Payments described in b.2) below are not includedin section 415 compensation unless the following two conditions are satisfied:

(1) the payment is actually made by the later of: (i) 2½ months after severance fromemployment, or (ii) the last day of the limitation year in which the severance occurs, and(2) the amounts would have been included in section 415 compensation if they were paid priorto the employee’s severance from employment.

See Treas. Reg. §1.415(c)-2(e)(3)(i). Condition (1) is often referred to as the 2½-month rule, eventhough payments may be made more than 2½ months after severance if made by the end of thelimitation year in which the severance occurs.

b.2) Types of post-severance compensation that may be included under the 2½-month rule. Thereare three types of compensation that are eligible for inclusion as section 415 compensation.Compensation described in b.2)a) below is required to be included in section 415 compensation.Compensation described in b.2)b) and b.2)c) below are permitted to be included in section 415compensation, but only if the plan provides for the inclusion of such amounts.

b.2)a) Regular compensation paid after severance (“trailing compensation”). If the generalconditions in b.1) above are satisfied, section 415 compensation must include any post-severancepayment that represents “regular compensation for services” during the employee’s regularworking hours, or compensation for services outside regular working hours (e.g., overtime, shiftdifferential pay), commissions, bonuses, or other similar payments, but only if, in the absenceof a severance from employment, the payment would have been made anyway. See Treas. Reg.§1.415(c)-2(e)(3)(ii). We refer to this type of post-severance compensation as “trailing”compensation.


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b.2)b) Unused leave cashouts. If the general conditions in 1) above are satisfied, the plan mayprovide that section 415 compensation includes any payment for unused accrued bona fide sick,vacation, or other leave, but only if the employee would have been able to use the leave ifemployment had continued. See Treas. Reg. §1.415(c)-2(e)(3)(iii). Rev. Rul. 2009-32 addressesvarious scenarios where post-severance payments under a paid time off (PTO) plan are deferredinto a qualified plan, either on an elective basis, through a 401(k) arrangement, or as anonelective employer contribution.

b.2)c) Nonqualified deferred compensation payments. If the general conditions in b.1) aboveare satisfied, the plan may provide that section 415 compensation includes any payment receivedby an employee pursuant to a nonqualified unfunded deferred compensation plan, but only if thepayment would have been made at the same time if the employee had continued in employmentwith the employer, and only to the extent that the payment would have been includible in grossincome. See Treas. Reg. §1.415(c)-2(e)(3)(iii).

c. Military service/disabled participants. If the plan so provides, payments described in c.1) or c.2)below may (but are not required to) be taken into account as section 415 compensation. See Treas. Reg.§1.415(c)-2(e)(4). The “2½-month rule” described in b.1) above does not apply to the timing of thesepayments. Thus, compensation paid by the employer during the employee’s period of military service,as described in c.1) below, may be treated as section 415 compensation, regardless of the length of themilitary service.

c.1) Military service. Under this rule, salary continuation payments or other compensation madeto an individual who does not currently perform services for the employer by reason of qualifiedmilitary service (as defined for USERRA purposes under IRC §414(u)(1)) may be treated as section415 compensation, but only to the extent such payments do not exceed the amounts the individualwould have received if the individual had continued to perform services for the employer rather thanentering qualified military service.

c.1)a) Effect of the HEART Act. For plan years beginning after December 31, 2008, anindividual who receives differential wage payments from an employer is treated as an employeefor retirement plan purposes, and such payments are treated as compensation. See IRC§414(u)(12)(A), as added by the Heroes Earnings Assistance and Relief Tax Act of 2008(HEART Act). To the extent an individual receiving differential wage payments is treated as anemployee under this rule, the post-severance compensation rules described above would notapply, and the payments would simply be treated as included under the normal definitions ofsection 415 compensation.

Practical effect. As a practical matter, virtually all salary continuation payments for militaryservice will fall under the HEART Act definition of differential wage payments, and so willgenerally be included in section 415 compensation as compensation to an active employee.However, the post-severance compensation rule discussed in c. above, where inclusion in section415 compensation is optional, would apply to a salary continuation payment that falls outsideof the differential wage payment definition (e.g., salary continuation for individuals who are onactive military duty for periods of less than 30 days).


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c.2) Disabled participants. Under this rule, salary continuation or other compensation paid to aparticipant who is permanently and totally disabled (as defined in IRC §22(e)(3)) may be treated assection 415 compensation even if paid after severance from employment, but only if the conditionsprescribed by Treas. Reg. §1.415(c)-2(g)(4)(ii)(A) are satisfied (i.e., either the participant is not anHCE immediately before becoming disabled, or the plan provides for the continuation ofcompensation on behalf of all participants who are permanently and totally disabled for a fixed ordeterminable period).

d. Other post-severance payments are excluded from section 415 compensation. All other post-severance payments (other than back pay awards described in 4.f. below), even if made within thetimeframe of the 2½-month rule described in b.1) above, are excluded from the definition of section 415compensation. See Treas. Reg. §1.415(c)-2(e)(3)(iv). For example, severance pay, and parachutepayments (as defined in IRC §280G(b)(2)) are excluded. In addition, payments under a nonqualifieddeferred compensation plan, except as described in b.2)c) above, are excluded.

Which section 415 compensation definition applies to the plan?/What are the differences among thedefinitions? The plan document will determine which definition of section 415 compensation applies. If theIRC §415 limits may be applied in more than one manner, but there is a statutory or regulatory default rule,the default rule applies if the limits are incorporated by reference. See Treas. Reg. §1.415(a)-1(d)(3)(ii). Onthe other hand, if a limitation may be applied in more than one manner, but there is no default rule thatapplies in the absence of contrary plan provisions, the plan must specify the manner in which the limitationis to be applied, even if the plan otherwise incorporates IRC §415 by reference. How do these rules applyto the compensation definition. It can be argued that the regulations contain a default rule. Treas. Reg.§1.415(c)-2(d)(1) states that the three safe harbor alternatives provided in that section, the simplified methoddefinition, the W-2 compensation definition, and the wages subject to income tax withholding definition,satisfy the definition of section 415 compensation if specified in the plan. Thus, if the plan is silent, the planwould apply the standard regulatory definition (current includible compensation definition).

Caution: prototype users. The fact that an employer’s adoption agreement under a prototype document failsto specify a definition of section 415 compensation does not necessarily mean that the document has failedto define such compensation. Check the basic plan document. In some cases, the prototype’s basic plandocument will provide a default, which might be W-2 compensation, for example, as the definition of section415 compensation in the absence of a contrary election in the adoption agreement.

a. Differences among the definitions. For the typical employee, whose compensation is paid entirelyin the form of wages, salary, overtime, bonuses and/or commissions, the three definitions produce thesame amount of compensation. Certain forms of compensation are specifically addressed in a.1) througha.5) below because of special income issues relating to such forms of compensation or because suchitems might be treated differently under the three definitions of section 415 compensation. Also see thecomparison table in b. below.

a.1) Tips. The current includible compensation definition includes all tips, whereas the W-2definition and the wages for income tax withholding definition exclude noncash tips and cash tipsless than $20 per month. The exclusion of noncash tips is found in IRC §3401(a)(16)(A). Theexclusion of cash tips that are less than $20 per month is found in IRC §3401(a)(16)(B). IRSPublication 531 discusses the reporting of tip income. Also see the instructions for Box 8 of FormW-2, the description of tips in IRC §3402(k), and the instructions to IRS Form 8027, Employer'sAnnual Information Return of Tip Income and Allocated Tips. FICA treatment of tips is addressed


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in Rev. Rul. 2012-18. The IRS also has two programs to facilitate compliance with tip reporting: theTip Rate Determination and Education Program (TRD/EP), under which the employer enters intoa tip reporting agreement under which the IRS agrees not to challenge the manner in which tips arereported pursuant to such agreement, and the Attributed Tip Income Program (ATIP), under whichtips are reported at a deemed rate, as prescribed by Rev. Proc. 2006-30 (as modified by Rev. Proc.2009-53 to extend the ATIP program). Tips reported under these programs are included in W-2wages that are subject to income tax withholding.

a.1)a) When are tips treated as paid? IRC §3401(f) treats tips as wages when a writtenstatement including such tips is furnished by the employee to the employer, pursuant to IRC§6053(a). If no statement is furnished, then tips are treated as wages when received by theemployee. An employer's liability for withholding with respect to tips is addressed in IRC§3401(k). Generally withholding on tips that are treated as wages can be taken from non-tipwages. If the non-tip wages are not sufficient to cover the withholding liability, the employer isnot required to withhold, unless the employee turns over sufficient funds to cover thewithholding, pursuant to IRC §3102(c)(2) or IRC §3202(c)(2).

Credit-card tips. Note that tips received by credit card can be used by the employer to satisfywithholding, and the employer would simply reduce the amount of cash it pays the employee forsuch tips. This can be useful in making salary reduction contributions under a 401(k) plan, too.

a.1)b) Allocated tips. IRC §6053(c) provides for the allocation of tips to employees of "largefood or beverage establishments." These allocated tips are reported in a separate box on FormW-2. The purpose of allocated tips is to ensure a reasonable portion of tip income is reported tothe Treasury. The amount of allocated tips is affected by the amount of tips reported by theemployees to the employer. If the reported tips, which would show up as wages, exceed 8% ofgross receipts, there are no allocated tips. Since allocated tips are not reported in Box 1 of theW-2, it is assumed that allocated tips are not included as part of section 415 compensation, atleast under the W-2 compensation definition, or under the wages for income tax withholdingdefinition. In addition, since the allocated tips are not really “received” by the employee, itshould be a reasonable interpretation that the current includible compensation definition alsowould not include the allocated tips.

a.2) Medical benefits. Amounts paid under accident and health plans that are includible inincome are generally included in the W-2 definition and the wages for income tax withholdingdefinition, but may be (although not required to be) excluded under the current includiblecompensation definition.

a.3) Group term life insurance. Group term life insurance provided by the employer, to the extentit is includible in the employee's gross income, is included in the current includible compensationdefinition and in the W-2 definition. However, IRC §3401(a)(14) exempts such amounts from thewages for income tax withholding definition.

a.4) Stock options. The exclusion with respect to nonqualified stock options, which is found inthe current includible compensation definition in the regulations, does not apply to the W-2definition nor to the wages for income tax withholding definition. However, amounts realized from


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the sale, exchange or disposition of stock acquired under a qualified stock options (e.g., incentivestock options) are excluded under all three definitions.1

a.5) Nonqualified plan distributions. Distributions from an unfunded nonqualified plan areincluded in the W-2 definition and the wages for income tax withholding definition. The currentincludible compensation definition normally excludes these amounts but the plan may provide forthe inclusion of these amounts.

a.5)a) Contributions to unfunded plans. All three definitions treat contributions to unfundedplans in the same manner. Contributions to an unfunded nonqualified plan (e.g., to a rabbi trust)would be compensation (reportable on W-2 and subject to federal income tax withholding) whenthey are actually or constructively received by the employee. This is true even though thecontributions might be subject to FICA at an earlier time. FICA on unfunded nonqualifieddeferred compensation is required when the contributions are no longer subject to a substantialrisk of forfeiture. See IRC §3121(v)(2).

a.5)b) Contributions to funded plans. All three definitions also treat contributions to fundednonqualified plans in the same manner. These contributions are compensation (reportable on W-2 and subject to federal income tax withholding) when they are no longer subject to a substantialrisk of forfeiture, under the principles discussed in IRC §83 and §402(b).

b. Comparison Table. The table below indicates whether each listed item is included or excluded ineach of the 4 possible definitions: current includible compensation definition, simplified compensationrule under the current includible compensation definition, W-2 compensation definition, and wages forincome tax withholding definition.

Item ofcompensation

Current includiblecompensation

Simplified comp.definition W-2 compensation

Federalwithholding wages

Salary Included Included Included IncludedOvertime Included Included Included IncludedBonuses Included Included Included Included

Commissions Included Included Included Included

1 The exclusion of amounts realized in a sale, exchange or other disposition of stock acquired under a statutory stockoption, in the context of the W-2 and wages for income tax withholding definitions does not necessarily reach adisqualifying disposition of stock acquired pursuant to the exercise of a statutory stock option, which results in ordinaryincome and generally will result in a reporting obligation on the Form W-2. See Notice 2002-47. Treas. Reg. §1.415(c)-2(c)(3) contains a very broad exclusion for all amounts received in such a sale, exchange or other disposition, sopresumably that definition would still result in exclusion from section 415 compensation under the currently includibleincome definition. However, Treas. Reg. §1.415(c)-2(d)(3) and (4), which describes the W-2 and federal income taxwithholding wages does not contain sweeping language for dispositions of stock acquired in a statutory stock option.Thus, if the disposition results in gross income inclusion (e.g., a disqualifying disposition, as discussed in Notice 2002-47), there is generally reported in Box 1 of W-2, resulting in inclusion in the W-2 wages definition, although if federalincome tax withholding is not required on the disposition, such amounts would still be excludable under the wages forincome tax withholding definition.


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Item ofcompensation




Tips Included, butallocated tips are

arguably excepted

Same as currentincludible

compensation

Exclude allocatedtips, noncash tips,tips under $20 per

month

Same as W-2

Elective deferrals Included Included Included IncludedExpense

reimbursements -accountable plan

Excluded Excluded Excluded Excluded

Expensereimbursements -nonaccountable

plan

Included Included Included Included

Fringe benefits to2% shareholders of

S corporations


“Qualified” movingexpense

reimbursements


“Nonqualified”moving expensereimbursements

Included Excluded Included Included

Nontaxable fringebenefits


Taxable fringebenefits


“Excess” groupterm life insurance

Included Included Included Excluded

Taxable medical ordisability benefits


Worker’scompensation


IRC §83 propertythat become freelytransferable or nolonger subject tosubstantial risk of

forfeiture

Excluded Excluded Included Included

Income attributableto IRC §83(b)

election


Nonqualified plancontributions

excludable in yearof contribution


Nonqualified plandistributions

Excluded unlessplan provides

otherwise

Excluded unlessplan provides

otherwise

Included Included


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Item ofcompensation




Statutory stockoptions - grant or

exercise;disposition of stock

acquired understatutory stock

option

Excluded Excluded Excluded (but seediscussion in

footnote to 5.a.4)above)

Excluded

Nonstatutory stockoption includible in

income in yeargranted


Nonstatutory stockoption - income

includible in year ofexercise

Excluded Excluded Included Included

Differential wagepayments (as

defined in IRC§3401(h)(2), added

by HEART Act)


Medical Loss Ratiorebates attributableto salary reductioncontributions under

cafeteria plan


Post-severancecompensation that

is “trailingcompensation” thatmeets the 2½-month

rule


Post-severancecompensation that

is unused leavecashout that meetsthe 2½-month rule

Included only ifplan provides




Post-severancecompensation

relating tononqualified

deferred comp.payable without

regard to severanceand that satisfies the

2½-month rule





Post-severancesalary continuation

for disabledparticipants






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Item ofcompensation




Post-severancesalary continuationfor military service

(other thandifferential wagepayments coveredby HEART Act)





Any other post-severance

compensation


# Section 414(s) compensation

Safe harbor definitions.(1) 415 compensation (includes Elective Deferral Gross-Up)2

(2) 415 compensation without Elective Deferral Gross-Up(3) 415 compensation without Special Compensation Items(4) 415 without Elective Deferral Gross-Up and without Special Compensation Items(5) Any additional subtraction from compensation that affects only HCEs.

The modifications to section 415 compensation, as described in (2), (3), (4) and (5) are safe harbormodifications are deemed to satisfy the definition of compensation under IRC §414(s), even if NHCs aremore negatively affected by the definition than are HCEs.

Special Compensation Items. The Special Compensation Items in alternatives (3) and (4) of the safe harbordefinitions are: (1) taxable fringes (cash or noncash), (2) expenses reimbursements (i.e., amounts includibleincome because they are paid under a nonaccountable plan), (3) moving expenses, (4) deferred compensation(e.g., payments from nonqualified plan), and (5) welfare benefits (e.g., taxable disability benefits, severancepayments under a severance pay plan that qualifies as a welfare benefit plan).

Non-safe harbor definition must satisfy compensation ratio test. If the definition of compensation being usedto satisfy nondiscrimination testing does not meet one of the safe harbor definitions, the administrator mustrun the definition through the compensation ratio test, or the definition cannot be used for demonstrating thatnondiscrimination testing is passed. The compensation ratio test is passed if the compensation ratio of the

2 Designated Roth contributions. Presumably, elective deferrals under a 401(k) arrangement or under a section403(b) plan are treated in the same manner for this purpose, regardless of whether the deferrals are made on apre-tax basis or are designated as Roth contributions, pursuant to IRC §402A. However, the IRC §414(s)regulations refer only to elective deferrals that are not included in gross income. Obviously, this language reflectsthe law at the time the regulations under IRC §414(s) were issued, which predates the enactment of the Roth401(k) provisions. A literal reading of the regulations would permit a safe harbor definition under IRC §414(s)to include Roth contributions but to exclude all pre-tax elective deferrals, including 401(k) contributions that aredesignated to be pre-tax. Treasury and IRS personnel have stated informally that the intention is to treat all401(k)/403(b) elective deferrals the same, whether they are pre-tax or Roth.


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NHCs satisfies one of two tests: (1) the ratio equals or exceeds the compensation ratio of the HCEs, or (2)the ratio is not less than the HCE ratio by more than a de minimis amount.

Calculation of compensation ratios. Compensation ratios are calculated by averaging the individualcompensation percentages of each person in the group (HCE or NHC)Compensation ratio of an individual. An individual’s compensation ratio is the amount of compensationtaken into account under the plan divided by the section 415 compensation (or “net” section 415compensation, meaning section 415 compensation except for the elective deferrals).

Related employers. Related employers (see IRC §414(b), (c) and (m)) are aggregated for nondiscriminationtesting purposes. Therefore, an employee's section 414(s) compensation includes his compensation from allrelated employers, regardless of whether the employers maintain a single plan or separate plans. This sameprinciple applies to the section 415 compensation definition.

Consequences of failing the compensation ratio test on a non-safe harbor definition. Suppose the definitionof compensation is not a safe harbor, but also fails the compensation ratio test. What are the consequences?

(1) The definition cannot be used to run the ADP test or the ACP test.

(2) If employer nonelective contributions are allocated on the basis of such definition of compensation,the plan may not be treated as a design-based safe harbor under IRC §401(a)(4), even if the allocationmethod would otherwise satisfy the safe harbor rules (i.e., “uniform allocation” requirement). Thus, therate group testing method will have to be used to demonstrate compliance with IRC §401(a)(4). Whenallocation rates or equivalent benefit rates are determined under the rate group testing method, adefinition of compensation that satisfies IRC §414(s) must be used. However, the allocation that wasdetermined on the basis of the non-414(s) definition of compensation is not modified.

Alternative to (2). In lieu of following (2) above, additional contributions could be made within thecorrection period allowed under Treas. Reg. §1.401(a)(4)-11(g), so that the allocation satisfies thedesign-based safe harbor under Treas. Reg. §1.401(a)(4)-1(b) (using a 414(s) definition ofcompensation).


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# Table: Uses of Compensation under Qualified Plans

References to sections of The ERISA Outline Book are included in the table below.

IssueUse of section 415

compensationUse of non-415compensation Measuring period

1. Determining whethersection 415 limitshave been exceeded

Chapter 5, Section II (PartA) and Section III (PartA); section 415compensation is defined inPart A. of thecompensation definition inChapter 1A

Mandatory Not permitted Limitation year

Partial period. Not permitted.Compensation for the entirelimitation year is counted,even if employee is not aneligible participant for entireyear. See Chapter 5, SectionII, Part A.5.

2. Allocating employercontributions in DCplan (other thanmatch), or determiningaccrued benefits inDB plan, where theapplicable formula iswholly or partly basedon a participant'scompensation

Chapter 3A, Section II,Part A.2. (DC plans);Chapter 3A, Section III,Part A (DB plans)

Permitted, but notrequired. Dependson the terms of theplan.

Permitted. The plandocument must define howcompensation is determinedfor purposes of theallocation formula orbenefit formula. Anydefinition is permissible, butthe definition used by theplan could affect how theplan satisfies thenondiscriminationrequirements under§401(a)(4) (see below).

Nondiscrimination testingissue. If employer intendsallocation formula underDC plan to satisfy safeharbor testing rules under§1.401(a)(4)-2, or ifemployer intendsbenefit/accrual formulasunder DB plan to satisfysafe harbor testing rulesunder §1.401(a)(4)-3,compensation definitionmust satisfy IRC §414(s).(See Issue 8)

Generally the plan year.

Plan may specify other 12-month period for measuringcompensation (e.g., calendaryear ending in plan year)

DB plan usually determinescompensation as an averagecompensation (e.g., 3-yearaverage, 5-year average,career average)

Partial period. DC plan (oraccumulation-type DB plan)might limit compensation toportion of plan year (or othermeasuring period) thatemployee is an eligibleparticipant.


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k If the definition useddoes not satisfy§414(s), then generaltesting (also known as"rate group testing") onthe employercontributions orbenefits, as prescribedby §1.401(a)(4)-2(c)(DC plans) or§1.401(a)(4)-3(c) (DBplans), is required.

Nonelective contributionsmade to safe harbor 401(k)plans. To the extent anonelective contribution ismade to satisfy the ADPsafe harbor under IRC§401(k)(12) or 401(k)(13),the compensation definitionused to calculate suchcontribution must satisfyIRC §414(s).

3. Calculating plan-imposed limit on401(k) deferrals (e.g.,15% of compensation)

A 401(k) might limit aparticipant’s annualdeferrals (other than catch-up contributions under IRC§414(v), if applicable) to apercentage ofcompensation. The planmust defined whatcompensation means forthis purpose.

See Chapter 3A, SectionII, Part D.5.c.

Don’t confuse with theIRC §402(g) limit. The§402(g) limit is a dollarlimit, and is not based onan employee’scompensation. Also, the§402(g) limit is measured


Permitted. The plandocument must define howcompensation is determinedfor this purpose. Anydefinition is permissible.

A non-415 definition usedby the plan is not requiredto satisfy IRC §414(s)

k If the definition doesnot satisfy §414(s), thecompensation used toapply the plan-imposedlimit on deferral ratescould not be used todetermine deferral ratesfor ADP testing (seeIssue 7 and thediscussion in Chapter11, Section VI, PartC.2.e.) Section 414(s)compensation must beused for ADP testing.

Example. Plan limitsdeferrals to 15% of

Plan year, because the plan islimiting the employee’sdeferrals for the plan year.

Partial periods. The planmight limit an employee'sdeferral rate to a percentageof compensation paid: 1)while the employee was aneligible participant, or 2)while the employee wasactually deferringcompensation under the401(k) arrangement.

Example. Employeebecomes first eligible toparticipate in a 401(k)arrangement on July 1 in aplan year which endsDecember 31. The planlimits deferrals to 15% ofcompensation. The employeedoes not elect to startdeferring until October 1 ofthat year. The employee's


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for the calendar year,whereas any plan-imposedlimits on deferrals aremeasured on a plan yearbasis.

compensation (excludingbonuses). Melanie's totalcomp. for plan year is$70,000, $10,000 of whichis a bonus. So hercompensation for purposesof limiting her deferrals is$60,000. Melanie's deferralfor the plan year is limitedto $9,000 (i.e., 15% x$60,000). Suppose Melaniedefers $9,000. If thecompensation definitionfails to meet §414(s),Melanie's deferralpercentage for ADP testingmust take into account hercompensation attributable tobonuses. Therefore, her$9,000 deferral will betreated as a 12.86% (i.e.,$9,000/$70,000) fornondiscrimination testingpurposes, rather than 15%,even though the plan treats$9,000 as reaching the plan-imposed limit of 15%because for that purposeMelanie’s compensation is$60,000.

Availability of permittedrates of deferral must benondiscriminatory, but ratesof deferral are determinedwithout regard to whetherthe definition satisfies§414(s) (see §1.401(a)(4)-4(e)(3)(iii)(D))

Example. A 401(k) planallows employees to deferfrom all currentcompensation exceptbonuses, not to exceed 15%of such compensation. The15% rate of deferral isconsidered to be availableon a nondiscriminatorybasis to all eligible

compensation is as follows:Jan-June: $20,000July-Sept: $11,000Oct-Dec: $12,000Total for year: $43,000If plan applies 15% limit forentire year, regardless ofperiod of eligibility,employee's deferrals for theplan year are limited to$6,450 (i.e., 15% x $43,000).If limit is applied for periodof eligibility, employee'sdeferrals for the plan year arelimited to $3,450 (i.e., 15% x$23,000 comp. for July-Dec).If limit is applied for periodof actual deferral, employee'sdeferrals for the plan year arelimited to $1,800 (i.e., 15% x$12,000 comp. for Oct-Dec).


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participants, even if theexclusion of bonuses causesthe comp. definition to failto satisfy §414(s).

The rate of deferralavailable to each participantdoes not fail to benondiscriminatory merelybecause the definition ofcompensation used for thispurpose does not satisfy§414(s). See Chapter 11,Section XII, Part E.2.

4. Compensation fromwhich employees maydefer under 401(k)arrangement

This is a different issuefrom the one in 3. Here weare concerned with thesources of compensationfrom which an employee’sdeferral election mayapply, not the maximumpercentage ofcompensation that can bedeferred. For example, ifan employee has filed adeferral election of 3% ofcompensation, butcompensation is definedfor this purpose as notincluding overtime pay,then the 3% deferralelection will apply only tothe employee’s regulartime pay.

See Chapter 3A, SectionII, Part D.2.a.4).


Permitted (e.g., plan mightpreclude employees fromdeferring out of bonuses)except the plan may notallow deferrals from post-severance compensationthat is not included in thedefinition of section 415compensation. Thedefinition that applies is theone specified in the plandocument.

Non-415 definition ofcompensation is notrequired to satisfy §414(s),but if §414(s) not satisfied,the definition ofcompensation used for thispurpose could not be usedto determine deferral ratesfor ADP testing (see Issue7). See the example in 3.above and the discussion inChapter 11, Section VI, PartC.2.e. However, if the planis a qualified automaticcontribution arrangement(QACA) under IRC§401(k)(13), compensationfrom which deferrals aremade must satisfy IRC§414(s) for post-2009 planyears. See Chapter 11,Section XIV, Part A.2.a.6).

Plan year.

However, employee mayonly defer out ofcompensation that has notbeen paid or made currentlyavailable to the employeebefore the deferral election isin effect (see §1.401(k)-1(a)(3) and the discussion inSection II, Part D.2.a.1) ofChapter 3A)


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5. Calculating theemployer's matchingcontribution (e.g.,100% match on thefirst 3% ofcompensationdeferred)

See Chapter 3A, SectionII, Part D.8.


Permitted. The plandocument will control indetermining whichdefinition of compensationapplies.

Non-415 definition ofcompensation not requiredto satisfy IRC §414(s),unless the matchingcontribution is intended tosatisfy the ADP safe harborunder IRC §401(k)(12) or401(k)(13), or the ACP safeharbor under IRC§401(m)(11) or 401(m)(12).

k If definition does notsatisfy §414(s), thecompensation used todetermine theemployer's match couldnot be used todetermine contributionrates for ACP testing(see Issue 7)

Example. Plan limits matchto 4% of compensation(excluding bonuses).Melanie's total comp. forplan year is $70,000,$10,000 of which is abonus. So her compensationfor purposes of determiningthe match is $60,000.Melanie's match for the planyear is limited to $2,400(i.e., 4% x $60,000). If thecompensation definitionfails to meet §414(s),Melanie's contributionpercentage for ACP testingmust take into account hercompensation attributable tobonuses. In other words, ifMelanie’s match was$2,400, the plan could nottreat that match as equal to4% of compensation forACP purposes, even though,

Plan year.

Partial periods. The planmight determine anemployee's match on thebasis of compensation paid:1) while the employee was aneligible participant, or 2)while the employee wasactually deferringcompensation under the401(k) arrangement.

Example. Employeebecomes first eligible toparticipate in a 401(k)arrangement on July 1 in aplan year which endsDecember 31. The planprovides a $1-for-$1 matchon the first 4% of comp.deferred by employee. Theemployee does not elect tostart deferring until October1 of that year. Theemployee's compensation isas follows:Jan-June: $20,000July-Sept: $11,000Oct-Dec: $12,000Total for year: $43,000If plan determines match onbasis of comp. for entireyear, regardless of period ofeligibility, match will be onthe first $1,720 of deferrals(i.e., 4% x $43,000). If matchis determined on comp. forperiod of eligibility, thematch will be on the first$920 of deferrals (i.e., 4% x$23,000 comp. from July toDec). If match is determinedon comp. for period of actualdeferral, the match will be onthe first $480 (i.e., 4% x$12,000 comp. from Oct-Dec).


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to limit her match, the plantreats the match as equal to4% because Melanie’scompensation is only$60,000 for that purpose.

Availability of each rate ofmatch must benondiscriminatory, but ratesof match are determinedwithout regard to whetherthe definition satisfies§414(s) (see §1.401(a)(4)-4(e)(3)(iii)(G) and thediscussion in Chapter 11,Section XII, Part E.3.)However, if employees aresubject to differentcompensation definitions,that would result in differentrates of match.

6. Identifying highlycompensatedemployees (HCEs)under the"compensation test"

(Need to identify HCEs forcoverage testing andnondiscrimination testing)

See the highlycompensated employeedefinition in Chapter 1A.

Mandatory Not permitted Lookback year (see Part C.of the highly compensatedemployee definition inChapter 1A)

12-month period precedingthe current plan yearNoncalendar year plan maymeasure period as thecalendar year which ends inthe plan year (e.g., plan yearending June 30, 2010, mayuse calendar year 2009 as thelookback year, rather thanJuly 1, 2009-June 30, 2010)

Partial periods. Notpermitted. Employee'scompensation for entirelookback year is taken intoaccount, even if employeewas not eligible for the planfor all or any part of thatlookback year.


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7. ADP/ACP testing(i.e., to determine aneligible employee'sdeferral percentageunder the ADP test orto determine aneligible employee'scontributionpercentage under theACP test)

ADP test applies toelective deferrals under401(k) arrangement (otherthan catch-upcontributions, as describedin IRC §414(v))

ACP test applies to: 1)matching contributions,and 2) after-tax employeecontributions

See Chapter 11: SectionVI, Part C. (ADP), SectionVII, Part C. (ACP)

Permitted, but notrequired.

Permitted, but only if thenon-415 definition ofcompensation satisfies IRC§414(s). The plan documentwill not necessarily definecompensation for thispurpose. Instead, it maygrant the plan administratordiscretion to determine whatdefinition of compensationto use on a year-by-yearbasis. If that is the case, theadministrator may chooseany definition whichsatisfies §414(s). If, instead,the plan specifically defineswhat compensation meansfor ADP/ACP purposes, theplan administrator mustfollow that definition.

Section 415 compensationautomatically satisfies§414(s), so it is permissibleto use section 415compensation for thispurpose

Definition that reflects only"safe harbor modifications"to the section 415definition, as described in§1.414(s)-1(c),automatically satisfies§414(s)

Other definitions than thosedescribed above, mustsatisfy the compensationratio test under §1.414(s)-1(d) in order to satisfy§414(s) and be used todetermine deferralpercentages andcontribution percentages forADP/ACP testing purposes.Therefore, thecompensation used tocompute percentages underADP/ACP might have be

Generally, the plan year

May use the calendar yearending in the plan year, butnot any other measuringperiod

Partial periods. Anemployee's compensationmay be limited to the portionof the measuring period thatthe employee was eligible toparticipate in the 401(k)arrangement (ADP test) or inthe 401(m) arrangement(ACP test).

May not limit compensationto just the portion of themeasuring period in whichthe employee was actuallydeferring


Page 23




different from thecompensation used tocompute limits on deferralsor match, as described inIssues 3, 4 and 5 of thistable.

8. Nondiscriminationtesting under IRC§401(a)(4) (i.e.,requirement to providenondiscriminatorycontributions orbenefits)

Does not apply todetermine whether amountof matching contributionsis nondiscriminatory.Instead, ACP test appliesfor that determination. SeeIssue 7.

See Chapter 9 for adiscussion of §401(a)(4)testing.

Permitted, but notrequired

Caution:“gateway”contribution.Under§1.401(a)(4)-8(b),a DC plan mayneed to provide aminimumcontribution to theNHCs who benefitunder the plan inorder for the planto be allowed touse “cross-testing”(also known as“benefits” testingor “newcomparability”testing) to prove itsatisfies IRC§401(a)(4). Thegatewaycontribution hastwo components: a5% safe harbor testor a one-thirdallocation rate test.For the 5% safeharbor test, theplan must usesection 415compensation.

Permitted (except as notedin the second column withrespect to the 5% safeharbor “gateway” test), butonly if the non-415definition of compensationsatisfies IRC §414(s) (seethe explanation in Issue 7).

To satisfy the safe harbortesting rules under§1.401(a)(4)-2(b) (DCplans) or §1.401(a)(4)-3(b)(DB plans), the definitionused to allocate employercontributions under a DCplan or to determineaccrued benefits under a DBplan must satisfy IRC§414(s). The safe harborrules are discussed inChapter 9, Section III (DCplans) and Section VI (DBplans)

k Permitted disparityformulas under IRC§401(l) are safe harborformulas, so §414(s)comp. must be used tocalculatecontributions/benefits.The permitted disparityformulas are discussedin Chapter 10.

If employer is relying ongeneral test (also known as"rate group" test) todemonstrate thatcontributions or benefits arenondiscriminatory, thecomp. used to allocateemployer contributions ordetermine accrued benefits

Generally, the plan year.

May use any 12-monthperiod ending in the planyear (see Plan yearcompensation definition in§1.401(a)(4)-12)

Partial periods. May limit tocompensation paid forportion of measuring periodin which employee was aneligible participant (even forthe “gateway” contributiontest described in the secondcolumn)

Average compensation forDB plans. Unless a DB planis an accumulation plan, mustuse an averaging period todetermine averagecompensation, as prescribedby §1.401(a)(4)-3(e)(2), toapply the §401(a)(4) testingrequirements.


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is not required to satisfy§414(s). However, underthe rate group test, a DCplan must calculateallocation rates (orequivalent benefit rates, ifthe plan is cross-tested), anda DB plan must calculateaccrual rates (or equivalentallocation rates, if the planis cross-tested), by using a§414(s) definition ofcompensation. Thus, if adefinition of compensationis used to determineallocations or benefits (seeIssue 2), and that definitionfails to satisfy §414(s), thenthat definition may not beused to calculate the ratesused to apply the §401(a)(4)rate group test.

k The definition ofcompensation used torun the general test(rate group test) under§401(a)(4) does nothave to be stated in theplan document.

9. Identifying keyemployees under IRC§416(i) (i.e., the 1%owner, top 10 owner,and officer tests takeinto account anemployee'scompensation)

See the key employeedefinition in Chapter 1A.

The top 10 owner test isrepealed for plan yearsbeginning on or afterJanuary 1, 2002

Mandatory. Not permitted. 1-year testing period for planyears beginning on or afterJanuary 1, 20025-year testing period for planyears beginning beforeJanuary 1, 2002Use 1-year rule to identifykey employees for a topheavy determination beingmade for a post-2001 planyear, even if thedetermination date fallswithin the 2001 plan year

1-year testing period is theplan year in whichdetermination is made

If 5-year testing periodapplies, also include the 4


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plan years preceding the planyear in which thedetermination occurs

Partial periods. Notpermitted. For any plan yearincluded in the testingperiod, an employee'scompensation for that entireplan year is counted, even ifemployee was not eligible forthe plan for all or any part ofthat plan year.

10. Computing anemployee's top heavyminimum benefit (i.e.,top heavy minimumcontribution under atop heavy DC plan ortop heavy minimumaccrued benefit undera top heavy DB plan)

See Chapter 3B, SectionIV.

Mandatory. Not permitted. Plan year.

Highest averagecompensation used in DBplan. Years of service used tocalculate averagecompensation might bemeasured on a basis otherthan the plan year. See§1.416-1, M-2, for moredetails.

Partial periods. Notpermitted. Employee'scompensation for entire planyear must be taken intoaccount to determine the topheavy minimum benefit, evenif employee was not eligiblefor the plan for part of thatplan year.

11. Employer's deductionlimit under IRC§404(a)(3), IRC§404(a)(7) or IRC§404(a)(9)

See Chapter 7, SectionXVI, Part B.

Not applicable to§404(a)(1) limit(applicable only to definedbenefit plans for post-2001taxable years, but to allpension plans for pre-2002taxable years). The

For taxable yearsbeginning on orafter January 1,2002, required toinclude electivedeferrals anddeemed-compensation forcertain disabledparticipants, asdescribed in IRC§415(c)(3)(C) and(D)(For all practicalpurposes, thismeans the section

For pre-2002 taxable yearsonly: Regulatorycompensation definitioncontrols, which is totaltaxable compensation (see§1.404(a)-9). See theexplanation in the secondcolumn for the section 415compensation definitionused in post-2001 taxableyears.

The regulatory definition ineffect for pre-2002 yearswas essentially the same assection 415 compensation,

Employer's tax year forwhich the deduction is beingclaimed.

This might not coincide withthe plan year.

Partial periods. Notpermitted. An eligibleemployee's compensation forthe entire tax year is takeninto account, even if theemployee was eligible for theplan for only part of the year.


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§404(a)(1) limit, includingthe limit under IRC§404(o) which applies tosingle-employer definedbenefit plans in post-2007taxable years, is based onfunding requirements,which might be affected bycontribution/benefitformula and thecompensation used forsuch formula (see Issue 2.in this table). Thecompensation used for thecontribution/benefitformula might be section415 compensation.

415 compensationdefinition is usedto calculate thesededuction limits,although the§404(a) limit canbe based onaccruedcompensation thatmight not becounted in thecurrent year for§415 purposes)

For taxable yearsbeginning beforeJanuary 1, 2002,use of section 415compensation was not permitted tocalculate thesededuction limits,and was the onlyitem in this tablefor which section415 compensationwas not permitted.

with the exception thatelective contributions under§401(k) plans, cafeteriaplans (IRC §125), SEPs andSIMPLE plans weredisregarded ("netted" out)and deemed-compensationused to calculate the IRC§415 limits for a disabledparticipant was notincluded.

Example. An employee'stotal annual compensation is$50,000. For the currentyear, he defers $1,500 to theemployer's 401(k) plan, and$2,500 to pay for healthinsurance premiums underthe employer's cafeteriaplan. The employee's "net"compensation is $46,000(i.e., $50,000 - $1,500 -$2,500), which is thecompensation used todetermine the employer'sdeduction limit under the401(k) plan. However, theemployee's section 415compensation for thisperiod would be $50,000.


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# Plan Design “Red Flags” Relating To Compensation

a. Different definitions used for different purposes: a plan might use different definitions ofcompensation to perform different functions

' 1) Section 415 limits (also used to calculate top heavy minimum)' 2) Allocation of employer contributions under DC plan (other than match) or determination ofaccrued benefit under DB plan' 3) Calculating plan-imposed limit on 401(k) deferrals (e.g., 15% of compensation)' 4) Compensation from which 401k deferrals can be made' 5) Compensation used to calculate matching contributions (e.g., match applies to first 3% ofcompensation deferred)' 6) Compensation used to determine whether employees are highly compensated' 7) Compensation used for ADP/ACP testing (must satisfy IRC §414(s))' 8) Compensation used for nondiscrimination testing under IRC §401(a)(4) (must satisfy §414(s))' 9) Compensation used to determine whether employees are key employees (1% owner test, top10 owner test, officer test)' 10) Calculation of top heavy minimum benefit' 11) Calculation of employer’s deduction limit under IRC §404(a)(3), (7) or (9)

Check to see how many of the above apply to the plan design. Section 415 compensation must be usedfor items 1), 6), 9), 10) (although, the measuring period is different for each determination). All of theother items can be defined to be section 415 compensation to simplify administration. However, for pre-2002 taxable years, Item 11) requires a definition that is almost the same as section 415 compensation,except it does not include elective deferrals (e.g., 401k deferrals, cafeteria plan deferrals, salary reductionfor qualified transportation fringe benefits) and deemed-compensation for certain disabled participants.

b. Using only partial-year compensation: in some cases, less than the full plan year (or other 12-monthmeasuring period) is used to determine a participant’s compensation for a particular plan function

Cross-reference tip. The table in Part G. of this Section IV also identifies whether compensation canbe measured for less than a 12-month period. That table also provides cross-references into otherparts of the book.

1) Use of less than a full 12-month period of compensation might apply to:' Determining allocation of employer contribution for new participant who becomes eligible forthe plan on a date other than the first day of the plan year' Calculating matching contribution, where employee is eligible or participates for only part of theyear' Calculating a plan-imposed limitation on 401k deferrals' Determining compensation for ADP/ACP purposes where employee is eligible for only part ofthe year' Determining compensation for §401(a)(4) discrimination testing purposes


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2) Use of less than a full 12-month period of compensation may not apply to:' Compensation used to calculate the top heavy minimum' Compensation for purposes of determining whether an employee is a HCE or a key employee' Compensation used to calculate the employee’s section 415 limit for a 12-month limitation year(if there is a short limitation year, due to a plan amendment, for example, compensation for that shortlimitation year would be used to calculate the section 415 limit)' Calculate deduction limits under IRC §404 that are based on compensation (e.g., the deductionlimit under IRC §404(a)(3)) (if there is a short tax year (i.e., less than 12 months), compensation forthat short tax year would be used to calculate any deduction limit that is based on compensation)

c. Excluding categories of compensation (e.g., exclusion of bonuses, overtime and/or commissions)

' May be used to allocate employer contributions or determine benefits (creates a discriminationtesting issue - if definition does not satisfy IRC §414(s), rate group testing under §401(a)(4) will benecessary)' May be used to determine compensation from which 401k deferrals may be made; limits on 401kdeferrals (does not have to satisfy §414(s) for this purpose)' May be used to calculate limits on matching contributions' May use for ADP/ACP testing and/or §401(a)(4) testing, but only if the definition ofcompensation satisfies IRC §414(s)' Not allowed for permitted disparity formulas unless §414(s) is satisfied (many prototypedocuments prohibit, regardless of whether §414(s) could be satisfied)' Not used for section 415 purposes, top heavy minimum calculations, determining whetherindividuals are HCEs or key employees, calculating employer deduction limits


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# EPCRS Corrections Relating To Compensation Mistakes

k Improper allocations due to compensation errors

One area where there may be more than one correction method is when the allocation formula under adefined contribution plan has been misapplied. For example, suppose the employer contributions under aprofit sharing plan were allocated under a pro rata allocation method based on W-2 compensation. However,there were errors in compensation determinations, resulting in some participants having too muchcompensation included and others having too little compensation included. How should correction behandled? This is an example of an error for which no suggested correction method is prescribed in AppendixA or Appendix B of the EPCRS Procedure. We see two alternative theories for fashioning a correctiveallocation under these circumstances.

Alternative #1: Reallocation of the contribution. Under this alternative, the contributions are reallocatedin accordance with the terms of the plan. In the case of the example above, where the plan provides fora pro rata allocation method based on W-2 compensation, but in operation the allocation was made withcompensation data errors, Alternative #1 will result in a shift of some of the contribution that wasincorrectly allocated. The participants who had too much compensation taken into account will receiveless, the participants who had too little compensation taken into account will receive more, andparticipants who had the correct amount of compensation taken into account will receive less or more,depending on how the corrected compensation as a whole compares to each individual’s compensation.Is the reallocation of the contribution considered to be a reduction of accrued benefits, in violation ofIRC §411(d)(6), for those participants who would have received a greater allocation under the permitteddisparity method? We would argue no. A participant’s accrued benefit is the amount that he or she wasentitled to under the terms of the plan, not the amount the participant was incorrectly allocated due toa misapplication of the plan’s allocation formula. The incorrect allocation to a participant due to a failureto follow the terms of the plan is similar to a bank’s incorrectly crediting a deposit to a customer’schecking account. Nonetheless, there may be some practical considerations regarding the use of thiscorrection method. First, statements may have gone out to plan participants showing the incorrectallocation. Fixing the allocation and amending the statement may present an employee-relations issuethat the employer might prefer to avoid if possible. Second, if participants individually-directinvestments, the corrective allocation will have to take into account whether any participants sufferedan investment loss because of the incorrect allocation of part of their share of the employer contributionto other participants, and the employer will have to make up the difference. Third, some participants whoreceived too much of the employer contribution under the incorrect allocation method may have beenpaid those amounts in a distribution from the plan. The employer will need to assess the feasibility ofcollecting the overpayments. If it moves forward with reallocating the contribution anyway, and is unableto collect any of the overpayments, the plan sponsor will need to make restorative contributions for theparticipants in the plan who would have received the allocation of those overpayments.

IRS has adopted this correction method in a different context. The IRS has formally approved thisreallocation method in Appendix B of the EPCRS Procedure, in the context of a profit sharing plan orstock bonus plan that excludes an eligible employee the allocation of the employer contribution. Althoughthe issue discussed above pertains to the allocation of an employer contribution using impropercompensation data, the correction principles set forth in Appendix B of the EPCRS Procedure shouldbe considered reasonable in this situation as well.


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Alternative #2: Employer makes up difference. Under this alternative, the plan sponsor contributes anadditional amount so that the resulting allocation is where it should be under the pro rata allocationmethod. In the situation described above, where the plan provides for a uniform allocation method butin operation, improper compensation data is used for some participants, this Alternative #2 wouldidentify the allocation rate that applied to each participant whose correct compensation was used.Suppose that was 8.25%. For participants whose incorrect compensation amount was taken into account,the allocation is adjusted upward (if the compensation was understated) to 8.25% of the propercompensation amount, or adjusted downward (if the compensation was overstated) to 8.25% of theproper compensation amount. The overcontribution amounts can be used to satisfy the employer’scontribution obligation for the undercontribution amounts. The employer would need to make a netcontribution amount if the upward adjustments exceed the downward adjustments.

U This approach still involves some reallocations (i.e., from those participants who received toomuch)U The employer might choose to decline to fix over-allocations to NHCs, or at least those that havealready been forfeited or distributed to an NHC who has terminatedU The employer’s contribution liability will increase to the extent it chooses not to correct over-allocationsU The employer also will have to ensure that Earnings are include with any make-up contributions.To the extent over-allocations are used to satisfy part of the liability for under-allocations, any lossesin the account from which the over-allocation is taken may result in additional employer contributionliabilities to properly make up Earnings for the participant who was under-allocated.

Deductions. Note that, if the employer makes an additional contribution under Approach #1 or #2, thededuction for that contribution will not be available for the year to which the contribution relates unlessit is contributed within the time frame prescribed by IRC §404(a)(6). If the contribution is not timely forthe prior year deduction, it will be deductible in the year made, which may affect the maximumdeduction remaining for such year with respect to current-year contributions made by the employer.

k Elective Deferral Failures

The use of improper compensation may result in an Elective Deferral Failure.U Too little might have been deferred from an employee’s paycheck due to an understatement ofcompensationU Too much might have been deferred from an employee’s paycheck due to an overstatementofcompensation

Missed deferral/matching opportunities. Use the guidance in Rev. Procs. 2013-12 and 2015-28 to correctthese Elective Deferral Failures. For an employee who had too little deferred, the employer might onlyhave to make up the match if the conditions are met for either the “3-month failure” rule under Rev. Proc.2015-28 or the “9½-month rule” under Rev. Proc. 2015-28 available to automatic contributionarrangements. Otherwise the employer might owe the employee, in addition to any make-up match, a25% or 50% QNEC for the missed deferra opportunity, depending on the applicable conditions and thetiming of the correction.

Excess Allocation. For the employee who had deferred too much, the error can be treated as an ExcessAllocation and distributed with earnings (with any corresponding match forfeited).


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k Testing errors

Use of improper compensation data can result in errors in:U the ADP and/or ACP testU “rate group” testing under IRC §401(a)(4)

If not enough refunds were made to cure a failed ADP or ACP test that takes into account propercompensation data, use the correction methods in Appendix A and B of Rev. Proc. 2013-12. Can use theone-to-one correction method to distribute additional excess contributions or excess aggregatecontributions to the HCEs, or make additional QNECs under the QNEC correction method.

If any HCE was refunded too much, treat as an Overpayment.

Use Treas. Reg. §1.401(a)(4)-11(g) to correct a “rate group” test that fails once correct compensationis taken into account, if you are still within the regulatory correction period (i.e., 9½ months after theclose of the plan year). Otherwise, use VCP.

k IRC §415 violations

Overstating compensation may have resulted in a violation of IRC §415(c). In such case, treat as anExcess Amount and correct accordingly. In the case of a defined benefit plan, properly adjust the accruedbenefit. If improperly allocated amounts have been distributed, there has been an Overpayment.

k Top heavy error

Understatement of compensation might have resulted in a non-key employee receiving an insufficienttop heavy minimum under a defined contribution plan. The employer should make up the under-contribution with Earnings.

k Overstatement of deduction

Taking into account may mean that the employer determined that its deduction limit under IRC§404(a)(3) an/or IRC §404(a)(7) was higher than it actually was. Will require amendment of take returnif the employer claimed too much of a deduction for employer contributions. May also result in excisetaxes under IRC §4972.


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Documents

COMPENSATION CONUNDRUMS ASPPA Virtual …asppavirtual.commpartners.com/files/2016/Tripoldi Session 2 Handout...COMPENSATION CONUNDRUMS ASPPA Virtual Conference April 21, 2016 Presented