Answer: This is the second of three articles dealing with the Who's the Employer aspects of the proposed 415 regulations. The first dealt with the erroneous treatment of Code §415(h). The final article will deal with predecessor employers.
This is an area that's long needed formal guidance, so I'm delighted the IRS has provided it. Let me set the stage.
One of the most important rules relating to qualified plans is the exclusive benefit rule of section 401(a). Qualified plans can benefit only the employees of the employer sponsoring the plan. But one's status as an "employee," especially in this day and age, isn't a lifetime status. Sooner or later, employees walk, are pushed, or are carried out the door. Logically this means that once somebody stops being an employee, that person should stop accruing benefits. Once the worker's back clears the doorway, compensation should be over, right?
But wait a minute. What about the worker's final paycheck? If the worker quits on Tuesday but gets paid on Friday for work through Tuesday, shouldn't the worker get credit for that? Of course. How about accrued but untaken vacation pay? Most folks would credit that as well. But it can get murkier. What about a TV performer who is not only paid for performances but receives residuals, often long after the series is over? Or an insurance salesperson whose commission stream might run for quite some time? Or a bonus check that comes out after the books are closed for the prior year? Anybody up for severance pay that goes on for 6 months after the employer fires the worker?
These are tough issues, but I like the way the proposed regulations address them. The regulations provide us with a nice, clear line in the sand (which beats a "facts and circumtances" test hands-down). The proposals start with a rule that if the compensation is paid after severance of employment, it isn't compensation for plan purposes. But then the rules make two exceptions: the 2-1/2 month rule and the military rule.
The 2-1/2 month rule says that compensation includes payments made to the employee within 2-1/2 months after severance of employment for either of two purposes:
- Payments the worker would have received-- had he or she not left-- for performing services, including regular pay, overtime, shift differential, bonuses, commissions, etc.
- Payments for accrued bona fide sick leave, vacation pay or other leave that the worker would have been entitled to take had he or she remained in employment.
What does that leave out? The proposed regs specifically list severance pay, unfunded nonqualified deferred compensation, and parachute payments as never being qualified plan compensation if paid after severance of employment. It also leaves out bonuses, commissions, and residuals paid more than 2-1/2 months after severance.
The military pay exception is easier to understand. If a worker leaves for active U.S. military duty and the employer decides to continue his or her pay (or the differential between what the employer pays and what the military pays), that's considered compensation for plan purposes. There's no 2-1/2 month rule here.
These regulations were issued as part of the 415 regulations. The definition of 415 compensation is used not only for section 415 limits but also for 416 top-heavy minimums, 401(a)(4) gateway minimums, 414(q) HCE determinations and 404 deduction limits.
Perhaps even more important, 415 compensation is the basis of nondiscriminatory compensation under 414(s). 414(s) compensation starts with 415 compensation and then excludes items. Plans must use a 414(s) definition in all nondiscrimination testing, including the ADP and ACP tests, and the ADP and ACP safe harbors. Most plans try to use a 414(s) definition for making allocations or accruing benefits. Even if they choose not to do so, the plan document almost always starts with a 415 definition and pares down from there.
The proposed regulations raise another issue that will use this definition of compensation. They modify the 401(k), 403(b), and 457 regulations to say that a plan cannot accept post-severance deferrals from amounts that aren't compensation under the new definition. Of course, this implies that the employee can defer out of military pay and out of payments that constitute compensation under the 2-1/2 month rule.
Perhaps my most frequently asked question in this arena concerns a participant in a calendar year plan who quits December 15, 2006 (a poor choice in my book), and receives commissions and bonuses February 28, 2007 (within the 2-1/2 months but during another plan year).
When do you count such a participant's compensation? The proposed regulations do not change the timing rules. We don't base compensation on accrued compensation. It comes in the year when paid or made available (absent application of the "first few weeks" rule). So the 2007 payment is 2007 compensation. And the rules don't make much sense unless the plan can provide benefits based on that compensation.
Suppose the plan is a 3% safe harbor 401(k) plan. Can the participant (who is an NHCE) defer from the 2007 paycheck? Apparently yes.
Does the employer therefore have to provide the former employee with a 3% safe harbor QNEC? Absolutely, yes, if the employee can defer.
What if the employer makes a profit sharing contribution without allocation conditions? The participant shares in it.
What if the profit sharing contribution is conditioned on employment on the last day of the year? The worker is out in the cold for 2006 and 2007.
(IMPORTANT CAVEAT: These are my conclusions. They aren't official. It would be really handy if the final regulations, perhaps in the "pre-ramble," addressed these issues.)
Can an employer choose to disregard post-severance compensation in calculating benefits and allocations? As it stands right now, the answer looks like "Yes, but..." An employer can use any definition of compensation it wishes for allocation or accrual purposes, but the plan must test using a nondiscriminatory definition. It looks to me like disregarding post-severance compensation under the new rules is a nonstandard definition-- an alternative definition of compensation. That means the definition would have to be tested every year to see if it is nondiscriminatory, before the plan could use it to test benefits. So I'm concered that some employers might stop military continuation pay because of the additional pension costs that come with it for workers who don't end up returning under USERRA.
One of the most fascinating points about these new rules is their proposed effective date. The 415 regs as a whole are proposed to go into effect for limitation years starting in 2007. But we are told that taxpayers can rely on these post-severance compensation rules now. Mr. Marty Pippins, Manager of EP Technical Guidance, is quoted as saying "This portion of the regulations is proposed effective for limitation years beginning on or after January 1, 2005." This is fascinating because I cannot find that date anywhere in the proposed regulations. But apparently it behooves practitioners to assume the rules are in effect now.
For more information about the proposed 415 regulations, join my for my July 19 SunGard Corbel webcast on the topic. For details, please see their website.