compensation and contribution … of nonqualified stock option yes yes no disqualifying disposition...

berrydunn.com | GAIN CONTROL

COMPENSATION AND CONTRIBUTION ALLOCATIONS

Adam Lomas Bill Enck, CPA, CPC, APA

SESSION OBJECTIVES

• Definitions

• Common errors identified during audits

• Methods to correct plan errors

• Best practices and how to prevent future plan errors

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TYPES OF ERRORS

• Operational error Plan operations do not match the plan document Significant vs. Insignificant

• Plan document error Plan document is incorrectly stated and does not match the intention of how the plan is supposed to be designed

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TYPES OF ERRORS - EXAMPLES

Operational Error or Plan Document Error?

• Employer notified employees that matching contribution was being eliminated but plan document was never amended

• Employer has been excluding certain types of compensation when allocating employer nonelective contributions

• Plan document does not exclude any employees from participating in the plan and there are no eligibility requirements but, employer has been excluding per diem employees from the plan.

• Not-for-profit employer did not timely adopt amendment conforming plan documents to final 403(b) plan regulations

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HOW DO I FIX THE ERROR?

General Rule: Make the plan whole again Correct all affected plan years

Methods for correction: • Self-Correction – No filing with the IRS is required

Generally available for operational errors only

• Voluntary Correction Program – Must file with the IRS Available for operational and plan document errors

• Audit Closing Agreement Program (CAP) – Not good! Used when errors are discovered in an IRS audit

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PLAN COMPENSATION

PLAN COMPENSATION

Most common errors – Operations do not match document

• Plan document definitions of compensation Can be defined in either the plan document or adoption agreement

• Handling of special types of compensation Beware of the off-cycle, manual paycheck!

• IRS compensation limits

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COMPENSATION DEFINED

The most common forms of plan compensation are:

• Form W-2 wages – broadest definition

• Section 3401(a) wages – compensation base used for calculation of income tax withholding

• Simplified Section 415 definition that only includes wages, fees for professional services and other amounts received for personal services to the extent that the amounts are includible in gross income

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Type of Compensation W-2 Wages 3401(a) 415

Taxable group-term life insurance Yes No Yes

Distributions from deferred compensation plan Yes Yes No

Exercise of nonqualified stock option Yes Yes No

Disqualifying disposition of qualified stock option Yes No No

Amount taxable on 83(b) election Yes Yes Maybe


Common Exclusions

• Overtime

• Bonuses

• Fringe Benefits e.g., imputed income for domestic partner benefits

• Severance Pay

• Earned-time cash-in

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Why is compensation excluded?

• Pre-entry compensation

• Contribution cost savings

• Equal contribution based on base pay

• If excluding compensation, are you performing the 414(s) nondiscrimination test?

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Example #1: Compensation defined in the Plan Document

W-2 wages or 3401(a) wages?

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Example #1 (cont’d): Clarification in the Plan Document that compensation is the basis for determining contributions


Example #1 (cont’d): Compensation further defined in the Adoption Agreement

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Example #2: Plan document defers to the Adoption Agreement


Example #2 (cont’d): Plan document defers to the Adoption Agreement


Example #2 (cont’d): Compensation defined in the Adoption Agreement

WHAT WENT WRONG?

Management Letter Comments to Avoid:

Participant Salary Deferral Contributions Relating to Special Payroll Events As part of our testing of participant deferral contributions, we noted that the Plan Sponsor did not appropriately withhold participant salary deferral contributions on certain special payroll events, specifically holiday bonus compensation and retroactive salary increase compensation, in accordance with the Plan Document. The Plan Document indicates that there are no income exclusions with respect to participant salary deferral contributions.

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WHAT WENT WRONG?


Earned Time Payout Issue In our testing of contributions, earned time (vacation) payouts were treated as an excludable source of compensation with respect to participant contributions for two participants. Per review of the Plan Document such compensation should not have been considered excludable compensation for participant contributions.

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WHAT WENT WRONG?


Excess Matching Contributions The amount of participant compensation that can be taken into account when determining employer contributions is limited. The compensation limitation is $245,000 for 2011 and $250,000 for 2012.

When the staff performed the true-up calculation for December 31, 2011, the eligible compensation for two employees was not limited to $245,000. The result was that one of the two participants received an excess matching contribution.

…and then in the following year…

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WHAT WENT WRONG?


Review of Employer Matching Contribution True-up Calculation Per discussion with the Vice President of Compensation and Benefits, the employer matching contribution true-up calculation was outsourced to the custodian for the 2012 plan year. When reviewing the calculation, we noted that the custodian used the incorrect compensation – gross compensation rather than Plan eligible compensation – in determining the amount of the true-up contribution. The error in the calculation was not identified by Management prior to funding the contribution.

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COMPENSATION ISSUES

• Improper treatment of non-standard forms of compensation

• Overtime

• Bonus

• Commissions

• Fringe benefits

• Off-cycle/Manual payroll checks – ensure controls are in place to process like typical payroll runs

• Holiday present/bonus pay

• Retro-active incentive compensation increases – can have large dollar impact

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COMPENSATION ISSUES

Common audit response to these findings: “Well, the participant probably would have wanted to receive the full payment anyway…”

Perhaps, but still considered an operational error and requires some form of correction

OTHER CONSIDERATIONS

• IRS compensation limit with respect to EMPLOYER contributions $255,000 for 2013 $260,000 for 2014

• Different definitions of compensation for different sources of contributions

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EMPLOYER MATCHING CONTRIBUTION ALLOCATIONS

How can a plan allocate employer matching contributions?

• Pre-approved allocations

• Same formula applies to all participants

• Discretionary or fixed

• Allocations that may require additional nondiscrimination testing

• Tiered formula based on salary deferrals

• Formula based on years of service

• Formula based on employee status

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EMPLOYER NONELECTIVE CONTRIBUTION ALLOCATIONS

How can a plan allocate employer nonelective contributions?

• Pre-approved allocations

• Equal percentage of compensation

• Integrated with social security wage base (aka permitted disparity)

• Allocations that require additional nondiscrimination testing

• Age-weighted

• Grouping by classification

• Length of service

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HOW DO WE FIX THIS?

NOW WHAT DO WE DO?

Help! We underfunded the employee!

• Make the employee AND plan whole again

• Recalculate contributions for all affected employees, for all affected plan years

• Employee contributions – employer funds minimum of 50%

• Employer contributions – employer funds 100% of lost contributions

• Adjust for lost earnings – Generally not the DOL rate!

• Correct operations prospectively to prevent future mistakes

• Adjust payroll such that plan wages agree to plan document, OR

• Amend the plan document to restate the definition of compensation

NOW WHAT DO WE DO?

…but wait…there is an exception!

Small Delivery of Benefits Exception

Generally, employer can forgo additional contribution to the employee, if:

1. Employer discovers participant underfunded by $75 or less, and

2. Participant has terminated and taken full distribution, and

3. Administrative costs of additional contribution exceed participant’s benefit.

BUT – the plan itself must be made whole! Employer must still make corrective contribution to the plan, which will be allocated to current participants in the plan.

NOW WHAT DO WE DO?

Help! We overfunded the employee!

• Recalculate contributions for all affected employees, for all affected plan years

• Employee contributions – refund 100%, plus applicable earnings

• Same plan year – correct outside of the plan (through payroll)?

• Employer contributions – forfeit 100%, plus applicable earnings Do NOT refund from plan to employer

• Correct operations prospectively as previously noted

• Is it material? Does it matter? Is there an exception?

NOW WHAT DO WE DO?

Recovery of Small Overpayments Exception

Generally, employer is not required to seek repayment from participant, if:

1. Employer discovers participant overfunded by $100 or less, and

2. Participant has terminated and taken full distribution.

BEST PRACTICES

• Maintain list of annual plan limits each year

• Summarize plan document provisions

• Maintain common location (i.e., binder or folder on network drive) for signed documents, amendments, etc.

• Perform self-audits by randomly selecting employees and recalculating their contributions

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2013 2014

Compensation Limit for employer contributions only $ 255,000 $ 260,000

Salary Deferral Contributions 17,500 17,500

Catch-up Contributions for employees 50 or older 5,500 5,500

Annual Additions Limit 51,000 52,000

Full list of limits can be obtained from IRS.gov

BEST PRACTICES

• Assign oversight responsibilities to an individual or group

• Review service organization reports (SSAE 16, SOC 1)

• Review tasks outsourced to 3rd party

• Review and approve plan amendments

• Ensure there is more than one person to perform necessary functions

• Prepare checklist with important filing dates and deadlines

• Consider an independent plan review every three to five years

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compensation and contribution … of nonqualified stock option yes yes no disqualifying disposition...

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