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What is a Long-Term Incentive Plan?

“My client says she has a Long-Term Incentive Plan (LTIP). What is an LTIP, and is it a type of qualified retirement plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from New York is representative of a common inquiry related to compensation programs.

Highlights of the Discussion

A Long-Term Incentive Plan or LTIP is a type of compensation incentive program designed to reward executives for achieving the sponsoring company’s strategic objectives while maximizing shareholder value. It in not an IRC Sec. 401(a) qualified retirement plan [e.g., profit sharing or 401(k)], but rather, a way of compensating executives for reaching specified company performance goals.

An LTIP may be one components of a senior executive’s pay package, which may include:

  • Base salary;
  • Performance based annual incentive (e.g. annual bonus);
  • Performance based long-term incentive;
  • Benefits (e.g., Social Security, Medicare, Workers Compensation, and Unemployment Insurance, life and health insurance, 401(k), defined benefit, nonqualified deferred compensation plans, etc.);
  • Executive perquisites or “perks” (e.g., drivers to and from work, convenient parking, installation of home communications systems, financial planning, use of company airplanes for personal travel, etc.) and/or
  • Contingent Payments (e.g., payments to executives in the case of involuntary termination resulting from a merger or acquisition).

According to the Center for Executive Compensation, an LTIP can take the form of stock-based compensation, such as stock options, restricted stock, performance shares, cash, or stock-settled performance units. Usually, LTIPs are a mix of types of equity and may include a cash component. The performance period for an LTIP typically runs between three and five years. The executive does not receive any pay from the incentive program until the end of the performance period and the performance measure is met. Long-term incentive goals vary by company but the most prevalent are focused on Total Shareholder Return (TSR), operational measures such as earnings per share and return measures, such as return on assets.

Conclusion

An LTIP is a general name for a type of compensation for executives, the form of which may vary, depending on the company’s specific pay program. An LTIP can have material impact on an investment client’s overall finances. Therefore, reviewing the documentation associated with such arrangements and understanding their impact can go a long way to achieving a client’s goal of financial wellness.

© Copyright 2019 Retirement Learning Center, all rights reserved
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Definitions of compensation for plan purposes

What definition of compensation does a 401(k) plan use in plan administration?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Washington D.C. is representative of a common inquiry related to the definition of compensation for plan purposes.

Highlights of the Discussion
The term “compensation” has several different applications in qualified retirement plan operations, depending on the particular compliance goal. For example, a plan may use one definition of compensation to allocate employer contributions and a separate, distinct one for testing whether employee salary deferrals are nondiscriminatory. One of the top plan compliance concerns identified by the IRS is a plan sponsor’s failure to identify and apply the correct definition of compensation in a particular scenario. What follows is a general description of the various definitions of compensation that plan sponsors are required or permitted to use for various plan purposes.

The definitions of compensation used for the plan must be specified in the governing plan documents. Plan documents that are preapproved by the IRS simplify the process of selecting the various definitions of compensation. Plan sponsors are, ultimately, responsible for making sure the party administering the plan (e.g., CPA, record keeper, or third-party administrator) is using the appropriate definition of compensation.

At a high level, there are two primary definitions of plan compensation from the Internal Revenue Code (IRC) that apply in plan operations, one is found in IRC Sec. 415(c)(3) and the other is in IRC Sec. 414(s). Other IRC sections and regulations refer to one or the other of these definitions, and specify which of the compensation definitions a plan can or must use for a particular purpose.

IRC Sec. 415(c)(3) compensation

There are four different definitions of compensation in the regulations under IRC Sec. 415(c)(3) from which a plan sponsor may choose: 1) statutory; 2) simplified; 3) W-2; or 4) 3401 withholding wages. Please refer to the chart on pages 47-48 of the IRS’s material on Compensation for a comparison of the definitions.

A plan must use an IRC Sec. 415(c) definition of compensation when determining the following:

  • Annual limits on contributions and benefits;
  • Which employees are highly compensated employees and key employees;
  • A top-heavy minimum contribution, when needed;
  • The minimum “gateway” contribution for plans using a cross-tested contribution allocation method; and
  • A sponsor’s maximum tax deductible contribution for a year.

IRC Sec. 414(s) compensation

With respect to IRC. Sec. 414(s) compensation, any definition of compensation that satisfies IRC Sec. 415(c)(3) will automatically satisfy IRC Sec. 414(s). In addition, the regulations under IRC Sec. 414(s) also provide for a safe harbor alternative definition. Under the alternative safe harbor, a plan starts with a definition of compensation that satisfies IRC Sec. 415(c)(3), and reduces it by all of the following categories of compensation:

  1. Reimbursements or other expense allowances;
  2. Cash and noncash fringe benefits;
  3. Moving expenses;
  4. Deferred compensation; and
  5. Welfare benefits.

A plan must use a definition of compensation that meets the requirements of IRC Sec. 414(s) when determining the following:

  • Contributions for a design-based safe harbor plan[1] or a safe harbor 401(k) plan;
  • A participant’s actual deferral ratio and actual contribution ratio used in performing the actual deferral percentage (ADP) and actual contribution percentage (ACP) nondiscrimination tests in a 401(k) plan;
  • Whether contributions and benefits are nondiscriminatory under Sec. 401(a)(4) (other than the minimum contribution component of the gateway test mentioned previously);
  • Contributions under a design-based safe harbor plan with permitted disparity provisions[2].

Finally, a sponsor has some leeway in choosing a definition of compensation, provided it is reasonable and does not unduly favor highly compensated employees, when determining the following:

  • Contributions (if the plan is not a design-based safe harbor);
  • The maximum permitted deferrals within a 401(k) plan; and
  • The plan sponsor’s matching contributions for participants.

Conclusion

Applying the proper definition of plan compensation for a particular compliance purpose is one of the trickiest parts of administering a plan correctly. Sponsors and their CPAs, record keepers, and/or TPAs must always refer to the plan document for the correct definition of compensation to apply based on the function being performed.

[1] A design-based safe harbor plan is designed to demonstrate nondiscrimination with a uniform method of allocating contributions.

[2] Allocation formula integrated with Social Security

© Copyright 2019 Retirement Learning Center, all rights reserved
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Plan Compensation and Imputed Income

“What is imputed income and how does it affect a 401(k) plan, if at all?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Virginia is representative of a common inquiry related to compensation.

Highlights of Discussion

Imputed income relates to group term life insurance (GTLI). Offering GTLI may affect the administration of an employer’s qualified retirement plan, depending on the definition of compensation selected for plan purposes.

The first $50,000 of employer-provided GTLI is excludable from an employee’s taxable income pursuant to Internal Revenue Code Section (IRC) §79. Once the amount of coverage exceeds $50,000, the imputed cost of coverage, based on the IRS Premium Table, is subject to income, Social Security and Medicare taxes (see IRS Publication 15-B). The imputed income is considered a taxable fringe benefit to the employee.

An employer must report the amount as wages in boxes 1, 3, and 5 of an employee’s Form W-2, and also show it in box 12 with code “C.” At an employer’s discretion, it may withhold federal income tax on the amount.

As taxable income, the amount may be included in the definition of compensation that is specified in the governing documents of an employer’s retirement plan. For example, with respect to the safe harbor definitions of compensation that plans may use, treatment of imputed income is as follows.

Compensation Type Form W-2 3401(a) 415 Safe Harbor
Taxable premiums for GTLI Included Excluded Included

 

Conclusion

Imputed income from GTLI coverage may be includible compensation for retirement plan administrative purposes. Employers and plan administrators must always refer to the specific definition of compensation elected in the plan document to know when to include or exclude imputed income.

 

 

© Copyright 2019 Retirement Learning Center, all rights reserved
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Non Statutory Stock Options and 401(k) Deferrals

“My client has participants in his company’s 401(k) plan who are receiving cash as a result of exercising their stock options. The client is going to report the income on the participants’ IRS Form W-2 for the year. Is this eligible/included as compensation for purposes of withholding salary deferrals? ”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans.

Highlights of discussion

  • Whether income from the exercise of stock options is includable as W-2 income as defined in 1.415(c)-2(d)(4) income for purposes of making salary deferrals to a 401(k) plan depends on whether the stock options are statutory or nonstatutory.
  • W-2 income includes income from the exercise of nonstatutory stock options for the year the options are exercised.
  • In contrast, income from the exercise of statutory stock options is excludable from W-2 income.
  • Therefore, when a participant exercises nonstatutory stock options, he or she will have additional taxable income, reported on IRS Form W-2, which can increase the amount of money the individual has available for making 401(k) employee salary deferrals.
  • The IRS has several publications with helpful information regarding the taxation of stock options: Topic 27, Publication 525, IRS CPE Compensation, Instructions Form W-2.

Conclusion

  • Income from the exercise of nonstatutory stock options is included in W-2 income, and is eligible for deferral into a 401(k) plan up to the maximum annual limit.

 

© 2017 Retirement Learning Center, LLC, a subsidiary of Retirement Literacy Center

 

 

© Copyright 2019 Retirement Learning Center, all rights reserved
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What is the Definition of Compensation for HCEs

What is the definition of compensation for determining HCEs?

“What definition of compensation is used to determine who is considered an HCE for nondiscrimination testing in a 401(k) plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

A plan must use an Internal Revenue Code Section (IRC §) 415 definition of compensation when determining which employees are HCEs under IRC §414(q).

  • More specifically, according to  Temporary Treasury Regulation 1.414(q)-1T, Q&A 13, the term “compensation” for HCE determination means compensation within the meaning of IRC §415(c)(3) without regard to §§125, 402(a)(8), and 402(h)(1)(B) and, in the case of employer contributions made pursuant to a salary reduction agreement, without regard to § 403(b). Thus, compensation for this purpose includes elective or salary reduction contributions to a cafeteria plan, cash or deferred arrangement or tax-sheltered annuity.

 

  • Only compensation an employee received during the “applicable period” is considered in determining HCE status.  HCE status based on compensation (not on ownership) is determined using compensation earned during the preceding year or 12-month period, referred to as the “look-back year.” If the year for which HCE status is being determined is not a calendar year, the sponsor may make a calendar year election so that HCE status is determined based on compensation earned during the calendar year beginning with or within the look-back year.

 

  • A compensation threshold applies for determining HCE status. This amount is subject to indexing.  When the amount is indexed, the new dollar amount applies to the year in which the compensation is earned, not the year in which HCE status is determined.  For example, when determining HCE status for 2017 based on compensation, plans must use the indexed amount for 2016, which was $120,000.  When determining HCE status for 2018 based on compensation, plans must use the indexed amount for 2017, which is $120,000.

Conclusion

Plans must follow a specific definition of compensation as defined in the IRC and supporting Treasury regulations when determining whether an employee is or is not an HCE.

 

© Copyright 2019 Retirement Learning Center, all rights reserved