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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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Rollovers as Business Startups (ROBS)

Rollovers as business startups (ROBS)

“One of my clients, who participates in his employer’s 401(k) plan, asked me about an arrangement whereby he could use a tax-free rollover from the plan to start his own new business?  Are you aware of such a scheme?”

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

  • Your client is likely referring to “Rollovers as Business Start-Ups” (ROBS). The IRS has commented that promoters in the industry are aggressively marketing ROBS (described below) as a means for prospective business owners to access accumulated tax-deferred retirement funds, without paying applicable distribution taxes, in order to cover new business start-up costs. While the IRS does not consider all ROBS to be abusive tax avoidance transactions, it has found that some forms of ROBS violate existing tax laws and, therefore, are prohibited.
  • Anyone considering a ROBS transaction should consultant with a tax and/or legal advisor before proceeding as there are several issues the IRS has identified that must be considered on a case-by-case basis in order to determine whether these plans operationally comply with established law and guidance. These issues and guidelines for compliance are detailed in a 2008 IRS Technical Memorandum.
  • Here is an example of a common ROBS arrangement.  An individual sets up a C-Corporation and establishes a 401(k)/profit sharing plan for the business.  The plan allows participants to invest their account balances in employer stock. (At this point the business owner is the only employee in the corporation and the only participant in the plan.)  The new business owner then executes a tax-free rollover from his or her prior qualified retirement plan (or IRA) into the newly created qualified plan and uses the assets from the rollover to purchase employer stock. The individual next uses the funds to purchase a franchise or begin some other form of business enterprise. Note that since the rollover is moving between two tax-deferred arrangements, the new business owner avoids all otherwise assessable taxes on the rollover distribution.
  • The two primary issues that the IRS has identified with respect to ROBS that would render them noncompliant are 1) violations of nondiscrimination requirements related to the benefits, rights and features test of Treas. Reg. § 1.401 (a)(4 )-4; and 2) prohibited transactions resulting from deficient valuations of stock.
  • Other concerns the IRS has with ROBS relate to the plan’s permanency (which is a qualification requirement for all retirement plans, violations of the exclusive benefit rule, lack of communication of the plan when other employees are hired, and inactive cash or deferred arrangements (CODAs).
  • The Employee Plan Compliance Unit of the IRS completed a research project on ROBS in 2010. The research revealed that while some of the ROBS studied were successful, many of the companies in the sample had gone out of business within the first three years of operation after experiencing significant monetary loss, bankruptcy, personal and business liens, or having had their corporate status dissolved by the Secretary of State (voluntarily or involuntarily). The full project summary is accessible here.

 

Conclusion

Caution should prevail when considering a ROBS arrangement. Those interested should seek the guidance of a tax and/or legal advisor, and consider the guidance from the IRS’ 2008 Technical Memorandum.

 

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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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