Make Whole Payment to HCE for Tax on Excess Contributions?

[casey72]

Plan fails ADP testing for 2016 plan year.

Company distributes HCEs' excess contributions in February 2017.

Excess contributions are subject to tax in year of distribution (2017).

Company provides a make whole payment to HCEs to account for the tax owed on the distributed excess contribution.  (Idea being that if the plan had passed ADP testing, the excess contributions would have stayed in the plan and would not have been subject to tax.)  

Payment to the HCEs is made outside of the plan -- structured as a bonus essentially.

Anyone see a problem with this?  I tend to think this is okay...

[ETA Consulting LLC]

This does not pertain to the plan, so it cannot possibly be a problem. This is merely the company deciding how (and what) to pay their employees.

Good Luck!

[jpod]

This may be a very conservative concern, but could it possibly be an "other benefit" problem, i.e., a cash payment conditioned upon the employee making elective deferrals?  In other words, but for the elective deferrals being made at the level necessitating a refund, there would be no tax bonus.

 

 

[My 2 cents]

For what it's worth, I see no moral, ethical or legal obligation to "make whole" the HCEs whose 401(k) contributions were at a high enough level for the plan to fail ADP testing.  It looks to me just like another effort to take care of the HCEs.  Had there been more timely efforts to hold down the HCE contributions, the HCEs would have been on the hook for higher 2016 taxes instead of higher 2017 taxes.  The entire regulatory structure is intended to keep HCEs from deriving too big a tax benefit from the 401(k) plan when the level of contributions from non-HCEs is on the low side.  Why should there be any pressure on the sponsor to make anything up for the HCE's?

 

[Tom Poje]

I like the line

"would not have been subject to tax"

does that mean you know in the future there will be no tax on any withdrawals?

 

[casey72]

Thanks, jpod, that's what I was thinking too -- this might be an issue under the contingent benefit rule. (1.401(k)-1(e)(6).) Agree that it's a conservative answer.

 

[401_noob]

So the company pays the HCEs taxable compensation to compensate them for the taxes that they have to pay? That seems rather circular. 

[Luke Bailey]

It's probably OK. The argument is that it is not a "benefit, right or feature" for purposes of 1.401(a)(4)-4 because it is outside the plan, not "under" it, as would be required for the BRF reg to apply. I know of no written guidance on point, and I understand this could sound shaky to some, but a similar practice of long standing exists at every large professional firm that I am aware of of reimbursing partners (typically lateral hires) who have paid for their own matching and nonelective contributions through a reduction of their K-1 earnings and who leave with insufficient service to be fully vested in those amounts. The firm will typically make up the forfeited amount (including earnings at the time of departure) from firm assets, as a taxable special allocation of firm earnings in the year the partner departs, or in the next year. The firm then pays itself back by using the forfeitures to offset future required matching or nonelective contributions. Similar separation bonuses may be negotiated for executive departures from corporations, although in my experience that does not seem to occur as much. Years ago I received informal advice from someone at IRS that they were aware of these practices and thought they were not a qualified plan issue because done outside and apart from plan, albeit in connection with plan. Obviously nothing you can take to the bank. Just saying it's done, is not unknown to many at IRS, and to best of my knowledge has not been objected to by IRS.

[jpod]

This is not a benefit, right or feature issue.  The contingent benefit rule in the reg which KEC9 cited is very broad and definitely encompasses benefits provided OUTSIDE the plan.  The issue is whether this scenario is shoe-horned into that prohibition.    

[Luke Bailey]

jpod, I see your point regarding the contingent benefit rule, i.e. that it encompasses benefits outside plan, but the cash payment here is contingent on making or not making an elective contribution only in a remote way. The payment from the employer is contingent on whether, and if so by how much, the elective contribution exceeds the amount permitted by ADP. Maybe would depend on facts and circumstances. At one extreme, if the make whole payment is a little-publicized afterthought and was not taken into account by the HCEs in making their deferral decisions, it would be hard to say that the benefit was linked in the sense contemplated by 1.401(k)-1(e)(6). On the other hand, if the HCEs knew that the plan was not going to pass ADP and all they had to do to trigger the payment was elect to defer an amount they knew would not stick in the plan, it would look like the payment is factually "contingent" on the deferral and amount, although that is not likely to be consistent with the rule's purpose.

[jpod]

I stated at the beginning that I thought this was a concern only if one is very conservative.  Yet, it's a bit of an open question and I wasn't anxious to attempt to provide an answer on a message board. 

[Luke Bailey]

Right. Frankly, the purpose and exact scope of the contingent benefit rule have never been clear to me.

[XTitan]

It was supposed to be an anti-abuse provision. "I'll give you $x if you don't participant in this plan".

[Luke Bailey]

OK. Makes sense that way. I wish the regs just said that. Thanks, XTitan.

[jpod]

Arguably, it is broad enough to include, "I will cover your taxes if you contribute but then have to take a taxable distribution because of an ADP failure," but as I said that is a conservative interpretation and maybe or maybe not warranted.   

[JamesK]

The regulation cited above (Treas. Reg. 1.401(k)-1(e)(6)) provides that "increases in salary, bonuses or other case remuneration" are benefits for purposes of the regulation.  This seems pretty clear to me, but I suppose that there remains an issue of proof. 

In other words, the HCEs receive a small bonus.  How will the IRS prove that it was received as a contingent benefit?  The answer to that depends on whether the employer maintains a record of how the bonus was calculated. 

In any case, is it worth risking the qualification of the company's plan just to ease the tax pain of a few HCEs?  Honestly, I think the answer is no.  On the other hand, if the employer can show that the bonus is paid without regard to the refund of excess deferrals, then there should be no problem.  But those weren't the facts we were given. 

[casey72]

Thanks, jpod and JamesK. The bonus would have been calculated based on how much $ was returned to the HCE.  I think it technically fits into the scope of the contingent benefit rule and in the end why risk it.  And if you're going to do it anyway, don't document it!

 

[Bird]

IMO this is clearly an over-reading of the contingent benefits reg.  Yes it says "... increases in salary, bonuses or other cash remuneration (other than the amount that would be contributed under the cash or deferred election) are benefits..." but remember that the beginning says "...only if no other benefit is conditioned (directly or indirectly) upon the employee's electing to make or not to make elective contributions under the arrangement." 

These bonuses are triggered by refunds, not by making or not making the deferral elections.  It's a few steps removed and I think Luke Bailey made the case pretty well.

At the end of the day, it's perfectly ok to pay anyone what you want as taxable income. 

[jpod]

Can you give us an example of when an impermissible benefit is "indirectly" conditioned upon the election to contribute that can be distinguished from this scenario?  I'm not saying you can't, but I can't think of one.  

[Bird]

3 hours ago, jpod said:

Can you give us an example of when an impermissible benefit is "indirectly" conditioned upon the election to contribute that can be distinguished from this scenario?  I'm not saying you can't, but I can't think of one.  

I can't but remember that the regs say "...only if no other benefit is conditioned (directly or indirectly) upon the employee's electing to make or not to make elective contributions under the arrangement."   (My emphasis)

I'm not a law/reg expert by any means but I suspect the point of this is more about the scenario where an employer says "if you contribute to the 401(k) then you don't get..."something, health insurance, whatever.

[My 2 cents]

Not a lawyer, not a 401(k) expert, but this situation (HCE contributes $X, but some has to be returned due to ADP testing) seems to me not to be a "conditioned on" contribution, even if the employer is on record as promising to boost their earnings to make up for the taxes on a piece of contribution that must be returned. 

Let us not forget that they could solve the problem without having to disgorge the excess HCE amounts by (as if) making a special contribution to the non-HCEs sufficient to have the ADP test passed.

[JamesK]

I feel like I am back in law school discussing the chain of causation in Palsgraf v. Long Island Railroad Co., 248 N.Y. 339, 162 N.E. 99 (1928). 

I think Luke, Bird, and My 2 cents have all made a reasonable argument that the payment is too far removed from the election to make elective contributions.  On the other hand, the facts we were given seem to make it clear that those payments would not be made but for the election.  

In the end, the client will always prefer to hear their advisor say "yes" if there is a reasonable basis and the argument that a payment two steps removed is not one that is conditioned on the election may well meet that threshold.  

[jpod]

Yes, this is a brain teaser.  Playing devil's advocate, two factors go the opposite way.  First, there is no indication that there was a promise of a gross-up if the HCE did not contribute, only if he did contribute.  Second, the word "indirectly" is used in the regulation, and it has to mean something; perhaps it means there need not be Palsgraf-like proximate cause.