Tag Archive for: Compensation

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Plan Establishment and “Compensation”

“My client is a shareholder in an S-Corporation. Can the business still set up a retirement plan for 2022 and can she contribute to the plan based on her S-Corporation distributions?”

ERISA consultants at the Retirement Learning Center (RLC) 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 Georgia is representative of a common inquiry related to setting up and contributing to qualified retirement plans.

Highlights of the Discussion

Because this question deals with specific tax information, business owners and taxpayers should always seek the guidance of a tax professional for advice on their specific situations.  What follows is general information based on IRS guidance and does not represent tax or legal advice, and is for informational purposes only.

With respect to setting up a plan for 2022, the short answer is, yes, provided the S-Corporation has an extension to file its 2022 tax return. Regarding contributions for your client, she could not base plan contributions on her S-Corporation distributions for 2022. She could only receive a contribution if she also had wages as an employee, which were reported on Form W-2, Wage and Tax Statement. (Please refer to Retirement Plan FAQs Regarding Contributions – S Corporation.)

Now for a bit of background. Under the SECURE Act 1.0, for 2020 and later tax years, a business has until its tax filing deadline, plus extensions for a particular tax year, to set up a plan. The plan establishment deadline is tied to the type of business entity and its associated tax filing deadline as illustrated below. [Note: Simplified employee pension (SEP) plans have historically followed the below schedule; and special set-up rules apply for SIMPLE and safe harbor 401(k) plans.]

Business Tax Status IRS Business Tax Filing Form Filing Deadline (and deadline to establish a retirement plan unless an extension to file applies) Extended Filing Deadline (and latest deadline to establish a retirement plan) Starting Point for Compensation or Earned Income for Plan Contributions
S-Corporation (or LLC taxed as S-Corp) Form 1120-S, U.S. Income Tax Return for an S Corporation

 

March 15 September 15 Form W-2, Wage and Tax Statement

 

Partnership (or LLC taxed as a partnership) Form 1065, U.S. Return of Partnership Income

 

March 15 September 15 Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc. *

See adjustments below

C-Corporation (or LLC taxed as C-Corp) Form 1120, U.S. Corporation Income Tax Return

 

April 15 October 15 Form W-2, Wage and Tax Statement

 

Sole Proprietorship (or LLC taxed as sole prop) Form 1040, U.S. Individual Income Tax Return with Schedule C

 

April 15 October 15 Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship)

 

Schedule F (Form 1040), Profit or Loss From Farming

See adjustments below

*Not to be confused with Schedule K-1 for Forms 1120s or 1041

The definition of compensation for contribution purposes for unincorporated business owners (i.e., sole proprietors or partners) is unique  [IRC 401(c)(2)(A)]. It takes into consideration earned income or net profits from the business [reported on Schedule C (Form 1040), Schedule F (Form 1040) or Schedule K-1 (Form 1065)], which then must be adjusted for self-employment taxes. The result is the individual’s “adjusted net business income (ANBI).” A retirement plan uses ANBI to allocate plan contributions. Please see the worksheets for self-employed individuals in IRS Publication 560, Retirement Plans for Small Businesses.

And here’s something owner-only businesses can look forward to because of the SECURE Act 2.0 of 2022 (SECURE 2.0). Effective for plan years beginning after December 29, 2022, Section 317 of SECURE 2.0 allows sole proprietors or single member LLCs to make retroactive first year elective deferrals up to the date of the employee’s tax return filing date for the initial year. Currently, this is an issue as explained in a prior Case of the Week Establishing a Solo 401(k) Plan.

Conclusion

Pass-through businesses, including sole proprietorships, partnerships, limited liability companies and S-corporations have several special considerations with respect to setting up and contributing to retirement plans. Tax advisors and other financial professionals with expertise in this area can really add value and set themselves apart from the comp

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“How is a lump-sum payout of unused vacation treated for plan purposes–is it compensation?”

How is a lump-sum payout of unused vacation treated for plan purposes–is it compensation?”

ERISA consultants at the Retirement Learning Center (RLC) 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 an advisor in Massachusetts is representative of a common question compensation for plan purposes.

Highlights of Discussion

  • To answer this question, we need to consider two issues—ideally with the help of a tax advisor. First, how does the IRS treat a lump-sum payout of unused vacation for tax purposes and, second, what is the definition of compensation for plan purposes according to the governing plan document?
  • The following is not tax advice, but a general explanation of the rules based on IRS source materials. With respect to the first question, the IRS treats a lump-sum payout of unused vacation as “supplemental wages” subject to Social Security and Medicare taxes according to the IRS Publication 15, (Circular E), Employer’s Tax Guide. Any federal income tax withheld will be at the IRS supplemental wage tax rate, depending on whether the supplemental payment is identified as a separate payment from regular wages or combined with regular wages. (For more information, please see Publication 15 and Treasury Decision 9276.)
  • Regarding question number two, as supplemental wages, a lump-sum payout of unused vacation would be included in the definition of compensation for plan purposes—unless it is explicitly excluded under the terms of the plan document. Therefore, be sure to check the wording of the plan document carefully.

Conclusion

The IRS treats the lump-sum payout of unused vacation as supplemental wages for tax purposes. As supplemental wages, a lump-sum payout of unused vacation would be included in the definition of compensation for plan purposes—unless it is explicitly excluded under the terms of the plan document. For specific tax advice, please see the guidance of a tax professional.

 

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Definition of Compensation When Safe Harbor Match Eliminated Mid Year

“The company is a safe harbor 401(k) match plan and they pay the match in a lump sum after the plan year.  The company amended the plan to remove the safe harbor matching contribution mid-year. What definition of compensation should the plan use to determine the amount of match to make—full year or partial year?”

ERISA consultants at the Retirement Learning Center (RLC) 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 Ohio is representative of a common inquiry related to the definition of compensation.

Highlights of the Discussion

The IRS has provided guidance in treasury regulations  as follows.

“A plan that is amended during the plan year to reduce or suspend safe harbor contributions (whether nonelective contributions or matching contributions) must pro rate the otherwise applicable compensation limit under section 401(a)(17) in accordance with the requirements of § 1.401(a)(17)–1(b)(3)(iii)(A).”

Consequently, when a safe harbor 401(k) reduces or suspends the matching contribution mid-year via amendment, the plan would use prorated compensation to determine the amount of match to make for the shortened period of time the match is given.

However, because the plan is no longer a safe harbor plan, it must be amended to provide that the actual deferral percentage (ADP) test and actual contribution percentage (ACP) tests will be satisfied for the entire plan year in which the reduction or suspension occurs using the current year testing method described in §1.401(k)–2(a)(2)(ii).  Therefore, the plan would be required to use full year compensation to run the ADP and ACP tests [see Treas. Reg. Sections 1.401(k)-3(g)(1)(iv) ].

Conclusion

Using the correct definition of compensation for plan purposes is one of the top compliance concerns of the IRS. This hurdle is confounded even further when plans realize more than one definition of compensation may apply depending on the circumstance.

 

 

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Company Reimbursements—Employee Pay or Not?

“Are reimbursements that an employee receives from his or her employer for business expenses counted as income on Form W-2?”

ERISA consultants at the Retirement Learning Center (RLC) 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 Texas is representative of a common inquiry related to what items constitute wages for plan purposes.

Highlights of the Discussion

Generally, reimbursements that an employee receives from his or her employer for business expenses count as pay or income on Form W-2 (box 1) only if the reimbursements are treated as paid under a “nonaccountable plan” as opposed to an “accountable plan” [See IRS Publication 15 (Circular E)] and Publication 463, Travel, Gift and Car Expenses]. Conversely, reimbursements paid from an accountable plan are not treated as employee pay or income, and are not reported on Form W-2. An employer makes the decision whether to reimburse employees under an accountable plan or a nonaccountable plan.

Accountable Plan

To be an accountable plan, an employer’s reimbursement or allowance arrangement must satisfy all of the following rules.

  1. Employee expenses must have a business connection; meaning, an employee must have paid or incurred deductible expenses while performing services as an employee of the employer;
  2. An employee must adequately account to his or her employer for these expenses within a reasonable period of time; and
  3. An employee must return any excess reimbursement or allowance within a reasonable period of time.

Nonaccountable Plan

A nonaccountable plan is a reimbursement or expense allowance arrangement that does not meet one or more of the three criteria listed above. Be aware, however, that even if an employer has an accountable plan (as described above), the IRS will treat the following payments as being paid under a nonaccountable plan:

  • Excess reimbursements an employee fails to return to the employer, or
  • Reimbursement of nondeductible expenses related to the employer’s business.

An employer will combine the amount of any reimbursement or other expense allowance paid under a nonaccountable plan with an employees wages, salary, or other income, and report the total in box 1 of Form W-2.

Conclusion

Whether reimbursements to an employee for business expenses count as pay or income for the recipient depends on whether the employer pays such amounts from an accountable or a nonaccountable plan.

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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.

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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

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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.

 

 

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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

 

 

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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.

 

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