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Deferrals from Third Party Sick Pay


BTG

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Taxable third party sick/disability pay (e.g., where the premiums are employer paid or are treated as such because they are made pre-tax through a cafeteria plan) would be included in a W-2 definition of plan compensation.  As a practical matter, how are deferrals on these amounts handled where the amounts are paid by the third party insurer directly to the participant?  Do any insurers actually withhold deferrals and forward to plan sponsors for deposit in the plan?  I have seen this issue discussed on a number of threads, but I haven't found any that reached a conclusion.

Thanks!

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10 minutes ago, BTG said:

Taxable third party sick pay (e.g., where the premiums are employer paid or are treated as such because they are made pre-tax through a cafeteria plan) would be included in a W-2 definition of plan compensation.

Not sure that I agree here. 3rd party sick pay is reported on the W-2, yes, but it is not "compensation paid by the employer to the employee" and therefore would not be compensation for plan purposes.

Free advice is worth what you paid for it. Do not rely on the information provided in this post for any purpose, including (but not limited to): tax planning, compliance with ERISA or the IRC, investing or other forms of fortune-telling, bird identification, relationship advice, or spiritual guidance.

Corey B. Zeller, MSEA, CPC, QPA, QKA
Preferred Pension Planning Corp.
corey@pppc.co

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13 hours ago, C. B. Zeller said:

Not sure that I agree here. 3rd party sick pay is reported on the W-2, yes, but it is not "compensation paid by the employer to the employee" and therefore would not be compensation for plan purposes.

And not sure I agree with you (actually, I am SURE I don't agree! ? ).  Third party sick pay IS compensation paid ON BEHALF of the employer and in all aspects is treated as if paid by the employer. 

For retirement plan purposes, we include it in the compensation.  

As to 401(k), here is some commentary that I found that matches my own opinion:

The most common definitions of compensation in plan documents are tied to amounts reported on Form W-2 or amounts used to determine income tax withholding. Although there can be some nuances that separate these two definitions, both include bonuses, commissions, and overtime.

While important parts of an overall compensation strategy, all can wreak havoc on the operation of a 401(k) plan. In most instances, employee deferral elections should be applied to these amounts just like any other payroll. If included with regular paychecks, it doesn’t create much, if any, additional effort; however, if paid in a separate check outside of payroll, it can be easy to overlook them. In addition to withholding 401(k) deferrals, these forms of compensation must also be considered when calculating matching and profit sharing contributions, and performing compliance testing.

There are some exceptions, but they must be spelled out in the plan document. In other words, the plan must be written in a manner that specifically excludes these compensation “extras” if that is your intent.

Contestant beware! The exclusion of these types of irregular compensation requires special nondiscrimination testing each year. If you exclude a greater percentage of compensation from your lower paid employees than your higher paid employees, you may not be able to exclude that compensation after all, and you may have to make some additional corrective contributions to the plan.

So, you need to work with the insurance company to handle 401(k) deferrals (I bet they have a procedure for that) or you have to modify your definition of compensation in the  plan to say that no 401(k) deferrals will come out of third party disability payments (but then you will have to test your compensation definition).

Lawrence C. Starr, FLMI, CLU, CEBS, CPC, ChFC, EA, ATA, QPFC
President
Qualified Plan Consultants, Inc.
46 Daggett Drive
West Springfield, MA 01089
413-736-2066
larrystarr@qpc-inc.com

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Larry, I appreciate the feedback. Cunningham's Law at work, perhaps?

However I'd like to dig a little deeper. The W-2 safe harbor definition of compensation comes from 1.415(c)-2(d)(4) which says "amounts that are compensation under the safe harbor definition of paragraph (d)(3) of this section, plus all other payments of compensation to an employee by his employer (in the course of the employer's trade or business) for which the employer is required to furnish the employee a written statement under sections 6041(d), 6051(a)(3), and 6052."

(d)(3) says sec. 3401(a) wages, plus deferrals.

6041(d) describes who is required to furnish a statement, and the information required to be reported on it.

6051(a)(3) says "the total amount of wages as defined in section 3401(a)." Notably, third party sick pay is explicitly required to be reported on the statement by 6051(f). However, since the safe harbor definition of compensation under 415 refers only to 6051(a)(3), and not to 6051(f), I understand that to mean that third party sick pay is not compensation under this definition.

6052 refers to payment of wages in the form of group-term life insurance.

Free advice is worth what you paid for it. Do not rely on the information provided in this post for any purpose, including (but not limited to): tax planning, compliance with ERISA or the IRC, investing or other forms of fortune-telling, bird identification, relationship advice, or spiritual guidance.

Corey B. Zeller, MSEA, CPC, QPA, QKA
Preferred Pension Planning Corp.
corey@pppc.co

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Thank you all for the responses.  They caused me to go back and re-examine my original premise.  Upon further review, I have concluded that such third party sick payments may or may not be included in plan compensation for plans that use W-2 compensation (as well as plans that use 3401(a) withholding compensation).  The answer depends upon whether the third party is acting as the employer's agent (as well as whether the employer and third party have entered into a binding agreement to shift the responsibility).  There is a great discussion on this topic in IRS Publication 15-A.

However, in some situations (such as where the third party is acting as the employer's agent), these third party payments are included in both 3401(a) and W-2 wages.  Therefore, my question remains:  How are 401(k) deferrals withheld from these third party payments and deposited in the plan?  Has anyone seen this done successfully?

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Many documents have language that can help you out in such a situation. FIS, for example (my emphasis):

"Regardless of the definition of Compensation selected in the Adoption Agreement, the Administrator may adopt a uniform policy for purposes of determining the amount of a Participant's Elective Deferrals of excluding "non-cash Compensation." For purposes of this Section, "non-cash Compensation" means tips, fringe benefits, and other items of Compensation not regularly paid in cash or cash equivalents, or for which the Employer does not or may not have the ability to withhold Elective Deferrals in cash for the purpose of transmitting the Elective Deferrals to the Plan pursuant to the Participant's Salary Deferral Agreement. Additionally, the Employer may, on a uniform and nondiscriminatory basis, permit different salary deferral elections for different items of Compensation (e.g., a separate salary deferral election for bonuses), and may exclude for purposes of calculating Elective Deferrals one or more items of irregular pay (e.g., car allowance)."

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Thanks Belgarath.  That approach had occurred to me (we use FIS for our documents).  Unfortunately, this particular client uses a different document, and I was unable to locate any similar language.

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I had added an edit to my response, but evidently I hit a wrong button or something before "accepting" the edit. While I can''t remember the exact wording, it was something to the effect of, if you WANT to deduct , see Larry's comments. But not all insurance companies necessarily have such a procedure or are willing to help out on this.

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BTG - I can respond to this from a practical standpoint :)  My husband broke his ankle several months ago while hiking in WY and has been receiving short term disability payments from AFLAC.  His premiums are deducted from his paycheck on a pre-tax basis, so the disability income payments will be reported on his W2 from his employer (actually, the employer failed to do this on the original W2 so is in the process of redoing the 2019 W2 now).  When applying  for the disability payments from  AFLAC, we were not given any opportunity to make any sort of withholding elections.  AFLAC automatically withheld  for FICA but that is it.  No federal, state or 401k withholdings were taken from his payments, nor was that an option.  So in our case, and to answer your question - No, the insurer does not withhold for 401k.  

Of course, this is just our experience with AFLAC, and may not be true with other insurers.  

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5 hours ago, AKconsult said:

BTG - I can respond to this from a practical standpoint :)  My husband broke his ankle several months ago while hiking in WY and has been receiving short term disability payments from AFLAC.  His premiums are deducted from his paycheck on a pre-tax basis, so the disability income payments will be reported on his W2 from his employer (actually, the employer failed to do this on the original W2 so is in the process of redoing the 2019 W2 now).  When applying  for the disability payments from  AFLAC, we were not given any opportunity to make any sort of withholding elections.  AFLAC automatically withheld  for FICA but that is it.  No federal, state or 401k withholdings were taken from his payments, nor was that an option.  So in our case, and to answer your question - No, the insurer does not withhold for 401k.  

Of course, this is just our experience with AFLAC, and may not be true with other insurers.  

FWIW, I would  never use AFLAC as an example of a company that knows what it is doing.

Lawrence C. Starr, FLMI, CLU, CEBS, CPC, ChFC, EA, ATA, QPFC
President
Qualified Plan Consultants, Inc.
46 Daggett Drive
West Springfield, MA 01089
413-736-2066
larrystarr@qpc-inc.com

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  • 6 months later...

just saw your discussion on disability payments by third party and thought logic might apply here.  Employer pays employee credit card tips in cash to employee at end of shift with no deductions.  Employee elects for 20% deferral into 401(k).  Employer defers from regular wages but falls short of 20% of plan compensation.  Compensation defined as W-2 comp.  Is this a problem and is employer required to make up shortfall?

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