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4/9/2018
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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?