Determining Retirement Plan Compensation-December 2015 Newsletter
In This Issue:
- Introduction
- Overview
- Pre-Participation Compensation
- Bonuses, Commissions and Overtime
- Taxable Fringe Benefits
- Reimbursements and Allowances
- Post-Severance Compensation
- Self-Employed Individuals
- Employees vs. Independent Contractors
- Conclusion
- IRS and Social Security Annual Limits
When it comes to operating your retirement plan, determining the compensation that should be used for each participant can be really confusing. It seems like it should be simple, but the reality is in fact quite different. In fact, the rules can be so confusing that using an incorrect definition of compensation is on the top ten list of mistakes the IRS sees in voluntary correction filings.
Since compensation is used not only to calculate contributions but also to apply limits, conduct nondiscrimination testing and determine tax deductions,the IRS is especially concerned that it be correct. While an exhaustive discussion of all the rules and exceptions would take up far more space than we have here, this article will cover some of the more common points of confusion.
For starters, no matter how a given plan determines compensation, the IRS
sets a cap on the maximum pay that can be counted each year. The limit for 2016
is $265,000, and the IRS adjusts this maximum each year based on the rate of
inflation.
The more standard definitions of compensation cast a wide net in terms of
what they include. There are four general definitions that serve as starting
points:
- W-2 compensation;
- Withholding wages;
- Current includible compensation; and
- Simplified compensation.
There are more similarities than differences among these definitions, and the
differences involve certain specific types of pay. For example, non-cash tips
are excluded in #1 and #2 but are included in #3 and #4. Distributions from
non-qualified plans are just the opposite—in for #1 and #2 but out for #3
and #4.
Examples of other differences include the value of group term life insurance
in excess of $50,000 as well as certain stock options. Because the differences
are so limited, all four definitions will yield an identical result for the
“average” employee.
If you want to disregard a certain form of pay that isn’t already excluded
under one of the above definitions, it must be clearly identified and
specifically excluded in the plan document. The trick is that if certain types
of compensation are excluded, it can trigger additional nondiscrimination
testing to ensure that non-highly compensated employees are not
disproportionately affected.
The so-called compensation ratio test divides included compensation by total
compensation to arrive at a ratio for each participant. The average ratio for
the highly compensated employees (HCEs) cannot exceed that of the non-HCEs
(NHCEs) by more than a de minimus amount. What does de minimus mean? Good
question. It’s not defined, but based on anecdotal information from IRS
representatives, a spread of three percentage points or less is usually deemed
acceptable.
Pre-Participation Compensation
Most plans have some sort of waiting period before new employees become
participants. Under all of the above definitions, that pay is counted for
testing as well as for calculating benefits. If the goal is to disregard
pre-participation compensation, the exclusion must be noted in the plan
document.
This particular exclusion does not trigger the compensation ratio test; however, there is an important point to note. If a plan is top-heavy (more than 60% of the plan benefits are for certain owners and officers), any minimum
required company contribution must be calculated using full compensation even if the plan otherwise excludes pre-participation pay.
Bonuses, Commissions and Overtime
Although not uncommon, these types of pay are also not necessarily regularly
recurring. As a result, some companies prefer to exclude them for plan purposes.
Again, the default under the four definitions is that all of these are included
unless otherwise noted in the plan document. This is where being specific can be
important.
Let’s use bonuses as an example. Assume that White Ocean, Inc. pays
performance bonuses, holiday bonuses and ad hoc merit bonuses. They want to
include performance bonuses but disregard the other two. If White Ocean sticks
with one of the standard definitions of pay, all bonus payments are in; however,
if they simply exclude “bonuses,” all three types are out. To accomplish its
goal, White Ocean would have to note in the plan document that holiday and ad
hoc merit bonuses are excluded.
In addition to the need for specificity, all three of these types of pay, if excluded, trigger additional testing, and it is important to monitor changing conditions from year to year. Consider this example:
The Lost Penguin 401(k) Plan excludes bonuses and overtime from its definition of pay. The company has several strong years in which it hires new employees and pays bonuses of 5% to 10% depending on position. Because they are well-staffed, very few of the hourly employees put in much overtime. Since the HCEs receive larger bonuses than the NHCEs, the plan easily passes the
compensation ratio test since bonuses are excluded.
Fast forward a couple of years when difficult economic times require Lost Penguin to cut its staff. The employees that are left put in a lot of overtime to get the work done, and company losses mean no bonuses are paid. Now, the exclusion of overtime means the plan’s definition of pay disproportionately impacts the NHCEs, and the compensation ratio test fails.
This type of pay includes items that might not be in the form of cash but
still provides something of value to an employee and must, therefore, be
reported as taxable income. One example might be allowing employees to use
company cars for their own personal business. Although included by default, a
plan can exclude taxable fringe benefits from its compensation definition. If
the plan excludes all taxable fringe benefits (and not just some), then the
compensation ratio test is not required.
The distinction between reimbursements and allowances can sometimes be a
tricky one and is more easily explained via an example. Wonderland, LLC provides
its CEO, Alice, with a monthly amount to cover automobile expenses. Alice
receives that amount regardless of the actual expenses she incurs, and she is
not required to provide any documentation. Lewis is a salesman for the company.
He tracks his mileage each month, submits documentation to the company and
receives a payment for each mile to cover the related expenses. Alice’s payment
is an allowance and Lewis’ is a reimbursement.
The difference is important, because a reimbursement is not taxable (and,
therefore, not included as plan compensation), while an allowance is taxable and
is included for plan purposes. An allowance is generally considered to be a
taxable fringe benefit, so it follows the rules noted above.
Post-severance compensation is any amount paid to an employee following his
or her severance from employment. It generally falls into four categories:
- Amounts earned but not yet paid at time of termination (bonuses,
commissions, etc.); - Payments for unused leave (sick leave, vacation, etc.);
- Distributions from deferred compensation plans; and
- Traditional severance pay.
The first three are amounts the employee would have been entitled to receive
even if he or she remained employed. The fourth is not…the employee is
essentially being paid to leave.
The default provision in most plans is that the first three types are counted
if they are paid before the later of:
- The last day of the plan year in which the employee terminated; or
- Two and a half months following the employee’s date of termination.
The fourth type can never be treated as plan compensation, so it is important
not to promise departing employees that they will receive retirement benefits
based on traditional severance payments.
So far, we’ve focused on amounts paid to employees, but there are some
important nuances that apply to owners and self-employed people. Owners of
corporations receive W-2 compensation, and any distribution of profits (either
dividends in a C corporation or S corporation distributions) is disregarded for
plan purposes.
Self-employed individuals, such as sole proprietors and partners in a partnership, on the other hand, receive earned income which is counted. The calculation used to determine the exact dollar amount of earned income for each self-employed individual is very complex and includes some circular calculations
and adjustments.
Employees vs. Independent Contractors
While somewhat beyond the scope of this article, this topic is worth mentioning at least in passing. The IRS, DOL and most states have strict rules for defining who is an employee and who is an independent contractor. Most of those requirements revolve around who controls the work and have very little to do with how the worker is paid.
In other words, simply reporting payments on a Form 1099 instead of a Form
W-2 does not make someone a contractor. This is important because if it is
determined a worker is an employee, the amount of payments reported on the Form
1099 must actually be recharacterized as compensation that must be considered
for plan purposes.
As you can see, something as seemingly simple as determining compensation can
become quite complicated, and this article has only scratched the surface.
Payroll is often a company’s most significant expense, so it is no surprise that
many companies devote a lot of time and energy to developing their compensation
strategies to attract and retain employees. Retirement benefits are an important
part of that strategy.
No matter how simple your pay structure may appear, the retirement plan rules
are complex enough that you can’t go wrong by consulting an expert to make sure
your plan defines compensation exactly as you intend and that all necessary
parties—from HR to finance to outside service providers—are on the
same page.
IRS and Social Security Annual Limits
Each year the U.S. government adjusts the limits for qualified plans and
Social Security to reflect cost of living adjustments and changes in the law.
However, the 2015 limits will remain unchanged for 2016 because the increase in
the cost-of-living index did not meet the statutory thresholds that trigger
their adjustment. Many of these limits are based on the “plan year.” The
elective deferral and catch-up limits are always based on the calendar year.
Here are the 2015/2016 limits as well as the 2014 limits for comparative
purposes:
| 2015/2016 | 2014 | |
| Maximum compensation limit | $265,000 | $260,000 |
| Defined contribution plan maximum contribution | $53,000 | $52,000 |
| Defined benefit plan maximum benefit | $210,000 | $210,000 |
| 401(k), 403(b) and 457 plan elective maximum elective deferrals | $18,000 | $17,500 |
| Catch-up contributions | $6,000 | $5,500 |
| SIMPLE plan elective deferrals | $12,500 | $12,000 |
| Catch-up contributions | $3,000 | $2,500 |
| IRA | $5,500 | $5,500 |
| Catch-up contributions | $1,000 | $1,000 |
| “Highly Compensated” employee threshold | $120,000 | $115,000 |
| “Key Employee” (officer) threshold | $170,000 | $170,000 |
| Social Security taxable wage base | $118,500 | $117,000 |
This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.
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