Connecting The Dots Between Plan Compensation And Plan Operation

10/17/2016 Connecting the Dots between Plan Compensation and Plan Operation 1

10/17/2016 Session Objectives Discuss various roles compensation plays in qualified retirement plans Review definitions used as basis for plan compensation Address common compensation errors and available corrections 3 Compensation Has Many Roles Contribution and benefit calculations Annual contribution/benefit limits--IRC §415 Non-discrimination testing--IRC §§ 401(a)(4), 401(k), 401(m), and 414(s) Highly compensated employees (“HCEs”) IRC §414(q) Key employees--IRC §416 4 2

10/17/2016 Compensation Definitions 415 compensation 414(s) compensation Plan compensation 5 415 Compensation Uses HCEs--prior year 415 compensation exceeding * 120,000 (2016 and 2015) Key employees and top heavy contributions Annual contribution and benefit limits Cross-testing 5% gateway contribution Deductible contribution limit *Retirement plan COLA chart: www.irs.gov/pub/irs-tege/cola table.pdf 6 3

10/17/2016 415 Compensation 415 Compensation defined in Treasury Regulations – “Currently Includible Compensation” Regulations provide 3 alternative definitions: – Form W-2 (box 1) – 3401(a) Comp (federal income tax withholding) – 415 Safe Harbor Compensation (“Simplified”) All definitions adjusted to include pre-tax elective deferrals under following IRC §§ – 401(k), 403(b), 408(k), 408(p), 457(b), 125, 132(f) 7 415 Compensation Compensation paid by related employers is included as 415 Comp – Controlled groups – Affiliated service groups – Regardless of whether related employer participates in plan Amounts paid during limitation year, including comp paid while not an eligible participant – 5 % gateway may exclude comp while not participant 8 4

10/17/2016 415 Compensation Compensation Type Form W-2, Box 1 3401(a) 415 Safe Harbor Currently Includible Pre-Tax Elective Deferrals Included Included Included Included Roth Contributions Included Included Included Included Imputed Group Term Life Included Excluded Included Included Taxable Moving Expenses Included Included Excluded Included Nonqualified Plan Distrib Included Included *Excluded *Excluded Taxable Medical/Disability Included Included Excluded Included *Excluded unless plan document includes. 9 415 Post-Severance Timing rule--certain post-severance 415 Comp must be paid by the later of: – End of Limitation Year, or – 2 ½ months after employee termination 10 5

10/17/2016 415 Post-Severance Post-Severance Pay Must May Subject to Include Include Timing Rule Regular Pay PTO Cash-Outs it would have been paid at same time regardless of employee termination Disabled Salary Continuation N/A Military Service Salary Cont. N/A Unfunded Deferred Comp only if 11 414(s) Compensation Uses ADP/ACP testing – Deferral and matching contributions General testing/cross-testing IRC §401(a)(4) – Non-elective contributions – Except 5 % gateway contribution Calculating employer contributions under design-based safe harbor plan 12 6

10/17/2016 414(s) Compensation 414(s) compensation may use any 415 compensation definition – W-2 – 3401(a) – 415 safe harbor – 415 currently includible 13 414(s) Compensation 414(s) permits adjustments to 415 Compensation 1. Exclude elective deferrals: – 401(k), 403(b), 408(k), 408(p), 457(b), 125, 132(f) 2. Exclude expense allowances/reimbursements, fringe benefits (cash or non-cash), moving expenses, deferred compensation, welfare benefit plans, etc. 3. Exclude pay while not a participant 414(s) safe harbor adjustments must treat all elective deferrals and all expenses in 1 and 2 above the same 14 7

10/17/2016 414(s) Compensation 414(s) compensation deemed nondiscriminatory Plan document may define specific 414(s) compensation to be used in testing or may permit any 414(s) compensation definition – Check base document in pre-approved plans 15 Plan Compensation Uses Calculate contributions and benefits – Plan document will provide specific definition – Plan compensation definition may not satisfy 414(s) compensation 16 8

10/17/2016 Plan Compensation Compensation Type Form W-2, Box 1 3401(a) 415 Safe Harbor Pre-Tax Elective Deferrals *Excluded *Excluded Included Roth Contributions Included Included Included Imputed Group Term Life Included Excluded Included Taxable Moving Expenses Included Included Excluded Nonqualified Plan Distrib Included Included *Excluded Taxable Medical/Disability Included Included Excluded *Excluded unless plan document includes. 17 Plan Compensation Pre-approved plan documents (Prototypes/Volume Submitters) – Typically use 415 compensation alternative as starting point Form W-2, box 1 3401(a) (federal income tax withholding wages) 415 safe harbor compensation 18 9

10/17/2016 Plan Compensation If using Form W-2 or 3401(a) compensation, plan compensation may not automatically include pre-tax elective deferrals – Check base document if not stated on Adoption Agreement 19 Plan Compensation PPA Adoption Agreement Excerpt: Compensation with respect to any participant is defined as follows: Base definition – A. [ ] W-2 wages – B. [ ] Section 3401(a) wages – C. [ ] 415 safe harbor compensation NOTE: Plan Sections 1.18(d) and 1.40 provide that the base definition of Compensation includes deferrals that are not included in income due to Code §§401(k), 125, 132(f)(4), 403(b), 402(h)(1)(B)(SEP), 414(h)(2), & 457. 20 10

10/17/2016 Plan Compensation Adjustments Common non-safe harbor adjustments to compensation – Exclude bonuses – Exclude commissions – Exclude overtime – Exclude shift differentials Non-safe harbor compensation adjustments may be discriminatory. Requires testing unless exclusion applies only to HCEs. 21 Nondiscriminatory Plan Comp Non-safe harbor comp adjustments nondiscriminatory if – Reasonable – Do not favor HCEs – Pass compensation ratio test Plan compensation is reasonable if based upon one of 415 compensation definitions Compensation ratio test passes if – HCE average % included compensation does not exceed NHCE average % by more than deminimis difference 22 11

10/17/2016 Compensation Ratio Test Included compensation % equals: – Plan compensation / 415 compensation Employees included in average are employees who “benefit” for the specific contribution – Deferrals – employees eligible to defer – Matching – employees eligible to receive match – Non-elective – employees who actually receive contribution 23 Compensation Ratio Test Plan Comp 415 Comp % HCE HCE 265,000 163,000 265,000 175,000 100% 93% NHCE NHCE NHCE NHCE NHCE 87,000 61,500 75,000 63,500 60,000 95,000 65,000 75,000 65,000 60,000 92% 95% 100% 98% 100% HCE average NHCE average 96.5% 97% HCE average does not exceed NHCE average Compensation Ratio Test passes 24 12

10/17/2016 Nondiscriminatory Plan Comp What if Compensation Ratio Test fails? – Must use 414(s) compensation when performing ADP/ACP testing – May require non-elective contributions to be tested General test or Cross test 25 Maximum Plan Compensation Code §401(a)(17) annual compensation limit (Plan must disregard compensation in excess of limit) – 265,000 for plan years beginning in 2016 and 2015 – Limit is prorated for any short plan year – Limit is applied annually regardless of New participant entry dates Funding frequency 26 13

10/17/2016 Plan Compensation Issues in 401(k)/403(b) plans – 401(k) & 403(b) plans may have different entry for employee deferrals vs employer contributions – May use different comp definitions for employee and employer contributions – Requires employer to track multiple compensation numbers – Non-cash compensation must have deferrals withheld, unless specifically excluded in document 27 Plan Compensation XYZ Manufacturing’s 401(k) Plan: – Employee deferrals: – Employer matching: – Employer non-elective: Immediately eligible 6-months service 1-year service Requires tracking 3 different periods of comp on all new participants – New participants will have different compensation in: ADP test ACP test General test 28 14

10/17/2016 Plan Compensation Physician Practice’s 401(k) Plan defines plan comp as Form W-2 wages plus all elective deferrals Certain employees receive non-cash comp: Imputed group term life insurance ( 50,000) Payment for business club memberships Automobile allowance (company auto personal use) Physician Practice must establish process to calculate 401(k) deferrals on non-cash comp 29 Earned Income Self-employed individuals have earned income not W-2 comp Who is a self-employed individual? – Sole-proprietor – Partner in a partnership – Member of an LLC S Corp shareholders are not self-employed individuals. Only wages are compensation for plan purposes. S-Corp K-1 income is not earned income. IRC §415(c)(3)(b) 30 15

10/17/2016 Earned Income Earned income is “net earnings from self employment” – Reduced by ½ of the allowed self-employment tax deduction – Reduced by retirement plan contributions deductible under code §404 Circular equation Contribution % (Contribution % 100 %) Elective deferrals are not subtracted 31 Earned Income Where to find net self-employment – Sole-proprietor -- Form 1040, Schedules C or F net income – Partner -- Form 1065, Schedule K-1 – LLC member – Form 1065, Schedule K-1, or Form 1040, Schedules C or F For partners/LLC members, adjust above amount for: – Accelerated depreciation expense under Code § 179 – Oil and gas depletion – Partner’s un-reimbursed expenses on Form 1040, Schedule E Partnership plan sponsors need to obtain partners’ unreimbursed expense amounts each year 32 16

10/17/2016 Earned Income Sample calculation of 10% employer contribution Partner’s K-1 earnings from self-employment Partner’s un-reimbursed expenses Net earnings from self-employment ½ self-employment tax deduction Calculation compensation X 9.09% (10%/110%) Plan Earned Income 100,000 - 10,000 90,000 - 6,358 83,642 7,604 76,038 Prove Circular Equation: 76,038 * 10% 7,604 401(k) deferrals do not reduce earned income unless plan document excludes for employees 33 Common Compensation Errors Hometown Tech Co 401(k) Plan Plan comp is Form W-2 wages plus elective deferrals Match is 100% of deferrals up to 4% of pay Hometown paid employees 1,000,000 in bonuses; no 401(k) deferrals were withheld on bonuses Deferrals on bonuses would have totaled 32,000 Matching contributions would have totaled 30,000 34 17

10/17/2016 Common Compensation Errors How much will it cost Hometown to correct error? A. 32,000 in deferrals; 30,000 in match; plus earnings B. 16,000 in deferrals; 15,000 in match; plus earnings C. 16,000 in deferrals; 30,000 in match; plus earnings D. 16,000 in deferrals; -0- match; plus earnings 35 Common Compensation Errors Correction guidance – Employee Plans Compliance Resolution System (EPCRS) Rev. Procs. 2013-12; 2015-27; 2015-28 – QNEC equaling 50% of employees’ missed deferrals (missed deferral opportunity) plus 100% employer matching plus earnings on QNEC & match – 50% QNEC may be avoided or reduced to 25% if certain conditions met – Corrections cannot cause participant to exceed annual deferral limit 36 18

10/17/2016 Common Compensation Errors NFP Org sponsors money purchase plan – Plan comp is Form W-2 wages plus elective deferrals; fringe benefits are excluded – Plan contribution formula is 10% of comp – NFP paid 750,000 in fringe benefits to participants – 2015 contribution based upon gross compensation, including fringe benefits – 75,000 was over-funded & allocated to participants 37 Common Compensation Errors How does NFP correct the error? A. No correction needed since all participants received higher benefit B. Retroactively amend the plan to include fringe benefits C. Forfeit incorrect contribution plus associated earnings from affected participant accounts 38 19