Payroll period crosses plan years, participant terms mid-pay-period

[BG5150]

I have a participant whose termination date is 12/28/06. That is the last day he worked. The payroll ending date for his last paycheck was 1/5/07. SO he has compensation and deferrals on his 2006 W2.

Should he be in the 2007 test? He did not work one single day in '07, and the pay he received was for work in 2006.

[rcline46]

You would think he must be in SOME test. Under the old regs for 2006 this pay was after severance date and would not be included (depending on the document of course)

[Tom Poje]

what does the document say? the new 401(k) regs say:

Attributable to services performed, would have been received as compensation except for the fact deferral election was made, and would have been received with 2 ½ months after close of plan year – but only if plan provides that such deferrals that relate to compensation that would have been received after the close of the plan year to be allocated to the prior year rather than the year the compensation would have been received. (1.401(k)-2(a)(4)(i)(B))

the problem is consistency. suppose your plan had immediate eligibility, and to replace this fellow who quit 12/28/06 they hired a replacement that day. If you were being consistent, this fellow certainly worked on 2006, so why wouldn't you include him on the test in 2006 (even though he received no money until 2007?)

just like a 401(k) plan makes no sense to use rule of parity for rehires, I think some of this stuff with last day, etc makes no sense in dealing with a 401(k). I tend to look at things based on the W-2 pay period rather than actual dates. thus, for me, someone who quit 12/28 but who's last paycheck is in 2007, shows deferrals in 2007 for tax purposes and I would include them in the 2007 test. Note, under this method, someone who starts in 2006 but doesn't have a paycheck until 2007 would not show up in the 2006 test.

[Guest dbvail]

This is a fun one that comes up every now and then. I was speaking with a local CPA yesterday on the same subject. Seems like no clear answer is available.

I recall (maybe) that "no hours, not in test" was a quote on one of these boards a while ago. So no hours in 2007 means not in any test for 2007.

Extending that, we should revise the 2006 to now include the accruals? Redoing a test perhaps 14 months later for a single persons one week of pay seems a stretch. I am of the opinion that termination date rules. I seem to recall Relius uses the same logic, i.e. if term date in 2006, not in tests for 2007.

Just some random thoughts.

[Guest Sieve]

I don't think that "no hours, not in test" makes a lot of sense (not having read the prior posts you refer to), especially if the individual is an HCE. How could you let a terminating HCE defer $10,000 from his/her last paycheck--which just so happened to be in the next plan year--without testing that deferral at all. I'd agree with Tom Poje--absent a plan provision which would move a deferral back into a prior year, the deferral should be in the test for the year in which the deferral occurs. What about the fact that this person was not an "employee" in the year of the deferral, you say? Well, the reg (Treas. Reg. Section 1.401(k)-2) talks in terms of an "eligible employee" with regard to ADP aned ADR, and an "eligible employee" is "an employee who is directly or indirectly eligible to make a cash or deferred election . . . for all or a portion of the plan year". (Treas. Reg. Section 1.401(k)-6.) I would say that an employee in 2006 is, by definition, "indirectly" eligible to defer for a portion of 2007, just because of the manner in which payroll is paid--and that would make that eligible employee's deferral in 2007 subject to the 2007 ADP test.

[ERISAnut]

Why is an elective deferral being withheld by someone who is no longer employed? You must actually be employed in order to make an elective deferral; not have been employed but actually employed at the time the compensation is to be received in cash or deferred into the plan. Therefore, if the participant terminated in 2006, but received pay in 2007, he shouldn't have had a deferral. Even though he is a participant in the plan, he is not an employee at the time the compensation is paid.

It would be a good practice for your payroll department not to withhold elective deferrals after the participants have severed employment.

[Guest Sieve]

Clearly, ERISAnut, it is normal practice for a payroll paid after an employee terminates employment to have salary deferrals taken from it just as if that payroll was paid while the employee was still working. This is especially true after issuance of the final Section 415 regs, which revised the 401(k) regs to permit deferrals from post-severance compensation representing regular payroll or accrued vacation time. (Treas. Reg. Section 1.401(k)-1(e)(8)). Deferrals are not required to cease as soon as severance form employment occurs. The only reason it would make sense NOT to defer from post-termination payroll would be to protect against deferrals coming from true severance payments.

[Blinky the 3-eyed Fish]

The phrase in question, is "no compensation, not in the test", uttered by Jim Holland repeatedly.

[ERISAnut]

Clearly, ERISAnut, it is normal practice for a payroll paid after an employee terminates employment to have salary deferrals taken from it just as if that payroll was paid while the employee was still working. This is especially true after issuance of the final Section 415 regs, which revised the 401(k) regs to permit deferrals from post-severance compensation representing regular payroll or accrued vacation time. (Treas. Reg. Section 1.401(k)-1(e)(8)). Deferrals are not required to cease as soon as severance form employment occurs. The only reason it would make sense NOT to defer from post-termination payroll would be to protect against deferrals coming from true severance payments.

Terms like 'permit deferrals' and 'are not required to cease' would suggest that there is another choice available to the employer. That choice is to operate the plan to avoid this issue by ensuring no deferrals are made from amounts receive after the employee has severed employment with the company. Wouldn't that be the reasonable choice given the current circumstances? This would clearly qualify as another reason to NOT defer from post-termination payroll.

[Tom Poje]

Blinky:

Holland's comments don't apply. he never said "no hours (but has a check) not in test"

or put another way, I can look at the guy's W-2 for 2007 - and he does indeed have comp. he might not have worked in 2007, but beacuse of when checks are paid, he does indeed have a check and therefore comp. If he fully retired and never worked in 2007, do you ignore his W-2 for the 2007 tax filing because he never worked in 2007?

as I said earlier if a plan has immediate eligibility then a person hired on 12/28/06 should be on the 2006 test because they did indeed work in 2006, even though they have no W-2. but you can't tell me they were working for free. It is just that the check doesn't show up until 2007. You want to be consistent.

[Blinky the 3-eyed Fish]

I opined to nothing other than the phrase is not, "no hours, not in the test" but rather "no compensation, not in the test".

[ERISAnut]

To add a little emphasis to Tom's statement; whatever you do, consistency is very important. You typically want the process to flow smoothly by being designed as consistent. When you get into the world of 'include this one in the test for new year because he made a deferral, even though he was terminated in prior year' you have now opened the door to including everyone who received a final paycheck (and was eligible to defer) but didn't defer because they elected not to.

[Guest 410b]

We had this situation in our last test.

We had an employee who terminated in the last week of the previous plan year and received a final check in the first week of the plan year being tested. Deferrals and employer match were made on compensation in the final check.

Our third party testing service initially told me that this employee should not be in the test for that most recent plan year, because, since he terminated prior to that year, he was not eligible to be in the plan. However, I noticed that when they sent the test results, this employee was included in the census, so they must have decided that the compensation and deferrals were the controlling element.

[Guest dbvail]

I knew this would be fun.

Blinky, thanks for the correction. I sometimes I fail to record the good comments of Mr. Holland correctly.

Tom, without guidance I might argue this as follows: the compensation and deferrals for testing shall be in the plan year that hours and compensation were earned. This results in testing on an 'accrual' basis rather than "cash". This may not stand up to standards I am unaware of, but if done on a consistant basis it may be accepted.

As mentioned by ERISAnut, this may result in a more reasonable result. Otherwise there could be many people in the test for 2007 that in fact distort the result, if they terminated in Dec 2006 and only had a check date in 2007.

ASPPA in DC in October could be a place to look at this further?

[Guest 410b]

I'm not sure about this testing data, but in accounting when you do an accrual, you create extra work - forever.

The controller needs a way to enhance the revenue for a given month. Eureka, we can accrue this income figure. Technically correct - not illegal - but for consistency, the person doing the work is now stuck with reversing that entry and making a new one for all months following. Not fun.

In my system at least, I think an hours basis would be difficult, Tom's W2 data approach is easy. I like easy (or maybe in the case of this stuff - just easier!).

[ERISAnut]

I think it is important to note that you are dealing with a imperfect process due to rules being written to allow things that are not adminstratively feasible. When this is the case, then the key is to not ponder what is legal, but instead adjust your process to operate within the framework of what it administratively feasible.

There is not a recordkeeping system developed that accounts for this. Why not? Because it shouldn't be an issue. If you make the argument that because the new Regs allow it we will do it, then be prepared to spend additional hours addressing these issue with your clients. Simply avoid deducting deferrals from the last payroll after severance. This doesn't even require a change in the plan's language since the plan adminstrator may reasonably interpret the plan's provisions to say you are no longer an employee and therefore ineligible to defer. In such instance when this is CONSISTENTLY applied to all employees, the standard is that the interpretation may not be 'arbitrary and capricious'; and the IRS will never touch that one.

[Guest Sieve]

I would ask ERISAnut whether it truly would be practical for an employer to stop a payroll deferral from a paycheck paid after termination of employment? First, it would require the employer to stop the presses and immediately notify the payroll provider or the payroll department to make this one single adjustment--and not all employers are that focused. Secondly, it may, in fact, be too late to stop the presses by the time the employee leaves. Not every employee remains on the job 2 or 3 weeks after deciding to leave--and, when someone is escorted out the door 2 days before payday (especially in late December) changing the amount of the paycheck may be impossible.

[Kevin C]

ERISAnut,

I see you haven't changed. Where have you been hiding the last two years?

http://benefitslink.com/boards/index.php?s...mp;#entry133128

[Mike Preston]

Having been gone for a few days it is interesting to come back to a thread like this one. erisaNUT is up to his/her old tricks, I see and by that I mean suggesting something which really has no basis in the law or regs, whether we are talking about the new 415 regs or the old ones.

Caution to anyone who decides that regular paychecks delivered after termination of employment should just "not count." I wonder if that is why California has a rule that one's final paycheck must be made available within a very short period of time after termination of employment?

http://lawzilla.com/content/ca-emp-005.shtml

In practice, however, final paychecks are sometimes significantly delayed and, rumor has it, that there are other states in the USA besides California. I note that even in California a voluntary quit on 12/30 doesn't require that the final paycheck be cut until the next year.

With all that said, anybody who interprets their plan to completely exclude regular compensation merely because it is paid in a subsequent plan year is just plain wrong. Strong letter to follow.

You can, if you choose, by plan provision, or, if you can believe it, just by wiggling your nose, include it in the year during which the quit took place. If you don't have a plan provision, and choose not to wiggle your nose, it is compensation in the subsequent year and would be included in the ADP test, 401(a)(4) non-discrimination testing, etc, etc, for that year. Any other treatment is, how did I put it earlier? Oh, yeah, WRONG.

Nose wiggle provision: 1.415-2(d)(5)(ii).

[K2retire]

Mike,

Thanks for that information! I was beginning to wonder if what I'd learned over the past 9 years had somehow been horribly misinformed.

[ERISAnut]

Interesting,

Mike, I see you have come to understand that a position you have taken previously turned out to be false. If memory serves, you stated at the mere use of an average benefits test allowed exemption from the gateway requirement, which was not true. Now, to suggest that I am up to some type of trick is beneath me. I, unlike others, enjoy and opportunity to share a wealth of knowledge that inspire others to think about why things work they way they do and apply this reasoning to make their processes flow a little smoother.

Apparently, there seems to be some other motive for certain individuals who seem to have their egos challenged with individuals break down situations into easily understood components and overcome these challenges through sound reasoning. This is one of the joys of being an educator. What is your objective?

I notice that sometime questions are asked that go unanswered. Then, when I chime in to provide guidance, someone else comes in with the pure intent to antagonize. Well, if that is the case, then why not jump in an answer the question first; don't let it just sit there. Madison has an interesting issue attempting to calculate an integrated allocation formula in another post, why not give this a shot. Better yet, why not antagonize me on my answer there? Maybe its because your values are misaligned with a pure objective of providing a little understanding to seeming complex issues. Quite hilarious; but sad.

[ERISAnut]

With all that said, anybody who interprets their plan to completely exclude regular compensation merely because it is paid in a subsequent plan year is just plain wrong. Strong letter to follow.

Nose wiggle provision: 1.415-2(d)(5)(ii).

One interesting concept about breaking down equations is to not add concepts that were never discussed. I never made mention about how compensation is being defined. My mention was only regarding an interpretation of who is willing to make elective deferrals under the plan. My argument was explicitly focused on the deferral, and who has a right under the plan to make one. So, why a nose wiggle?

If a plan administrator states that even though you receive a lagging paycheck, you are no longer eligible to defer because you are no longer an employee, how can that be construed as being arbitrary or capricious if consistently applied? Perhaps you missed that in your haste.

[Mike Preston]

Interesting,

Mike, I see you have come to understand that a position you have taken previously turned out to be false. If memory serves, you stated at the mere use of an average benefits test allowed exemption from the gateway requirement, which was not true.

Huh? Please point out the thread where I said that. I *think* what I said was: the mere use of an average benefits test which utilizes cross-testing does not result in a gateway requirement. Only if the "regular" test (under 401(a)(4)) uses cross testing is there a gateway requirement. What you say I said makes no sense.

[Mike Preston]

Madison has an interesting issue attempting to calculate an integrated allocation formula in another post, why not give this a shot. Better yet, why not antagonize me on my answer there?

If it is the thread I think I just read, it is because your formulas and calculations were correct.

[Mike Preston]

If a plan administrator states that even though you receive a lagging paycheck, you are no longer eligible to defer because you are no longer an employee, how can that be construed as being arbitrary or capricious if consistently applied? Perhaps you missed that in your haste.

Didn't miss it at all. It is just plain wrong. Are you really saying, with a straight face, that every final check should have the deferral election reset to zero because there no longer exists an employee/employer relationship? Besides being blatantly discriminatory, I think your comment about defining (or not dealing with) compensation is the real issue. By definition, if it is not compensation under the plan then you can't defer from it. The opposite is also true: if it *IS* compensation under the plan, you must be able to defer from it.

Let's take your position: it isn't compensation under the plan. Great. Talk to me about top-heavy benefits. See any qualification issues? I knew you could.

Look, your position that a final check, of regular wages, can be ignored is just plain ludicrous. It isn't that it is just "not arbitrary and capricious", it disqualifies the plan.

[Mike Preston]

Mike,

Thanks for that information! I was beginning to wonder if what I'd learned over the past 9 years had somehow been horribly misinformed.

We aim to please.

[BG5150]

From my good friends at TAG. It looks like it would count in '06. Which is bad news if we are not getting this information until 2008 and the 06 test failed.

The IRS position had been that a deferral cannot be made by someone who

is not an employee as of the payroll date that the deferral relates to;

elective deferrals could only be made by an employee. The final 415

regulations allow certain post severance compensation payments to be

included in compensation, if the plan document so provides. This comp

must be paid within 2 1/2 months following severance, or the end of the

plan year of severance, if later. If the terminated participant is paid

in the plan year following severance, the compensation is included for

the prior plan year (not the plan year when paid), if at all. Therefore,

the deferral would also be included in the prior year's ADP testing.

§1.415©-2(e)(3) provides that “...in order to be taken into account for

a limitation year, compensation...must be actually paid or made available

to an employee...within the limitation year....” and “In addition, the

plan may provide that amounts...are included in compensation

...if...those amounts are paid by the later of 2 ½ months after

severance...or the end of the limitation year that includes the date of

severance...; “

[Guest 410b]

It seems to me that the consistency issue relates to month of termination and month of payment, rather than the plan year issue.

If an employee terminates/is terminated in the last week of a month, is paid final pay in the following month and deferrals are allowed, then changing that procedure for the few times when those two actions occur in separate plan years would create inconsistencies in an otherwise consistent set of procedures.

[Guest Sieve]

I agree with Mike, and I think TAG got it wrong. Where does this TAG statement come from: "If the terminated participant is paid in the plan year following severance, the compensation is included for the prior plan year (not the plan year when paid), if at all"? Yes, you can elect, in the plan, to count certain compensation paid in one year as being paid in the prior year, but it is not automatic without the plan document language--and that is rarely chosen. (See Treas. Reg. Section 1.401(k)-2(a)(4)(i)(B)(2).) You also can elect in the plan document that compensation paid after severance from employment is taken into account--which, I would venture, is what nearly all plans will provide--but that simply means it is compensation from which deferrals can be made, NOT that it is treated as compensation in the earlier year. And, compensation is defined, as TAG notes, as what is paid or made available during the limitation year. The last paycheck we are talking about was neither paid nor made available during the prior year, so how could it not be compensation in the year it is actually paid?

Great minds differ, and will continue to do so. Glad to see, however, that none of us truly holds our opinions strongly . . .

[Kevin C]

I recall hearing informal IRS statements about not being able to defer after the employment relationship ends. But, those comments predate the final 401(k) regs. If that was the IRS’s intent, they had ample opportunity to include it in their final regulations. Instead, they specify that only an employee can make a deferral election and that the election only applies to compensation that is not currently available at the time of the election. None of that prohibits deferrals from the final paycheck as long as the election was made while still employed.

If the plan document says that deferral elections do not apply to a paycheck paid after termination of employment, that would be different.

1.401(k)-1(a)(2) (i) Definition of cash or deferred arrangement. --Except as provided in paragraphs (a)(2)(ii) and (iii) of this section, a cash or deferred arrangement is an arrangement under which an eligible employee may make a cash or deferred election with respect to contributions to, or accruals or other benefits under, a plan that is intended to satisfy the requirements of section 401(a) (including a contract that is intended to satisfy the requirements of section 403(a)).

1.401(k)-1(a) (3) (i) Definition of cash or deferred election. --A cash or deferred election is any direct or indirect election (or modification of an earlier election) by an employee to have the employer either --

(A) Provide an amount to the employee in the form of cash (or some other taxable benefit) that is not currently available; or

(B) Contribute an amount to a trust, or provide an accrual or other benefit, under a plan deferring the receipt of compensation.

Then, look at 1.401(k)-1(e)(8) that was added by the final 415 regs. It specifically mentions deferrals from post-severance amounts.

(8) Section 415 compensation required. --With respect to compensation that is paid (or would have been paid but for a cash or deferred election) in plan years beginning on or after July 1, 2007, a cash or deferred arrangement satisfies this paragraph (e) only if cash or deferred elections can only be made with respect to amounts that are compensation within the meaning of section 415©(3) and §1.415©-2. Thus, for example, the arrangement is not a qualified cash or deferred arrangement if an eligible employee who is not in qualified military service (as that term is defined in section 414(u)) and who is not permanently and totally disabled (as defined in section 22(e)(3)) can make a cash or deferred election with respect to an amount paid after severance from employment, unless the amount is paid by the later of 2 1/2months after severance from employment or the end of the year that includes the date of severance from employment and is described in §1.415©-2(e)(3)(ii) or (iii).

Some items of compensation paid after termination of employment are required to be counted as 415 comp, others are optional. A final paycheck would normally be required to be counted as 415 compensation. Accrued vacation is one of the optional items.

1.415©-2(e)(3) Compensation paid after severance from employment

(i) In general. --Any compensation described in paragraph (e)(3)(ii) of this section does not fail to be compensation (within the meaning of section 415©(3)) pursuant to the rule of paragraph (e)(1)(ii) of this section merely because it is paid after the employee's severance from employment with the employer maintaining the plan, provided the compensation is paid by the later of 2 1/2months after severance from employment with the employer maintaining the plan or the end of the limitation year that includes the date of severance from employment with the employer maintaining the plan. In addition, the plan may provide that amounts described in paragraph (e)(3)(iii) of this section are included in compensation (within the meaning of section 415©(3)) if --

(A) Those amounts are paid by the later of 2 1/2months after severance from employment with the employer maintaining the plan or the end of the limitation year that includes the date of severance from employment with the employer maintaining the plan; and

(B) Those amounts would have been included in the definition of compensation if they were paid prior to the employee's severance from employment with the employer maintaining the plan.

(ii) Regular pay after severance from employment. --An amount is described in this paragraph (e)(3)(ii) if --

(A) The payment is regular compensation for services during the employee's regular working hours, or compensation for services outside the employee's regular working hours (such as overtime or shift differential), commissions, bonuses, or other similar payments; and

(B) The payment would have been paid to the employee prior to a severance from employment if the employee had continued in employment with the employer.

(iii) Leave cashouts and deferred compensation. --An amount is described in this paragraph (e)(3)(iii) if the amount is either --

(A) Payment for unused accrued bona fide sick, vacation, or other leave, but only if the employee would have been able to use the leave if employment had continued; or

(B) Received by an employee pursuant to a nonqualified unfunded deferred compensation plan, but only if the payment would have been paid to the employee at the same time if the employee had continued in employment with the employer and only to the extent that the payment is includible in the employee's gross income.

(iv) Other post-severance payments. --Any payment that is not described in paragraph (e)(3)(ii) or (iii) of this section is not considered compensation under paragraph (e)(3)(i) of this section if paid after severance from employment with the employer maintaining the plan, even if it is paid within the time period described in paragraph (e)(3)(i) of this section. Thus, compensation does not include severance pay, or parachute payments within the meaning of section 280G(b)(2), if they are paid after severance from employment with the employer maintaining the plan, and does not include post-severance payments under a nonqualified unfunded deferred compensation plan unless the payments would have been paid at that time without regard to the severance from employment.

[Guest dbvail]

As I said before, this would be fun!

From my perspective (however warped) I would treat the income and deferrals in the year of termination. The concept of including all the employees who had 'cross-over' or 'accruals' in the following year is tough to justify administratively.

I agree that deferrals can not be stopped just because of termination. But which year we include them in testing is vague enough for me to use a practical approach.

More fun?

[Guest Sieve]

I just can't reach that conclusion, since the 401(k) regs say that you can include amounts in a prior year ONLY if the document permits it. Absent that type of provision--and I've never seen one like that--I just don't see the regulatory basis for the approach you suggest. Does anyone know what Sal says?

[Tom Poje]

in case you haven't seen the new document language. (I assume other providers have similar language)

the Corbel amendment for the Final 415 regulations is worded as follows:

Definition:

Administrative delay ("the first few weeks") rule.

415 compensation for a limitation year shall NOT INCLUDE, unless otherwise elected in Section 2.2 of this Amendment, amounts earned but not paid during the limitation year solely because of pay periods and pay dates. However, if elected in Section 2.2 of this Amendment, 415 Compensation for a limitation year shall include amounts earned but not paid during the first few weeks of the next limitation year, the amounts are inlcuded on a uniform and consistent basis with respect to all similarily situated participants, and no compensation is included in more than one limitation year.

emphasis mine

[Guest Sieve]

Tom --This requires that "amounts are included on a uniform and consistent basis with respect to all similarily situated participants". Do you think that means if you elect the first few weeks rule that you'd have to apply it to all participants, or do you think you could apply that rule only to those whose last paycheck came in another limitation year?

I was just thinking (an activity I've been known to perform on rare occasions) that a closely-related issue applies with respect to PS contributions. Assume a participant terminates employment on 12/28/07 and the last paycheck is paid on January 5, 2008. If there are no end-of-year or year of service conditions on the allocation of an employer non-elective contribution, should this individual receive an allocation of the PS contribution for 2008? Does the answer depend on the "first few weeks" rule of Section 415?

[Tom Poje]

at this point in the game I am going to beg off your question. A similar one has been submitted for the 2008 IRS Q and A. I get to sit in with the agents in Sept beforehand (fools like me get 'selected' to do stuff like that), so I will have an idea on the answer before the official meeting in Oct at the fall conference.

[Guest Sieve]

Which question--the "similarly situated" consistent use of the first few weeks rule, or the question about the allocation of a PS contribution to a termianted employee with a lagging payroll in a new plan year?

[Tom Poje]

allocation to a terminated ee