8/12/2008
The Final 415 Regulations: Post Severance Compensation and Post Year End Compensation - What are They and What Do They Mean?
Few concepts are more confusing than how post severance compensation and post year end compensation actually work in a defined contribution plan. The concepts were introduced in the proposed section 415 regulations and included in the final 415 regulations released in April of 2007. This article will define and compare each term and apply the definitions to a plan with a participating employee terminating in December. Finally, the implications of each definition of compensation on employee elective deferral elections, employer contributions and reporting will be discussed.
Post Severance Compensation
There are two types of compensation to be counted after severance under the final 415 regulations. The final 415 regulations require some post severance compensation to be included in compensation. The required type of post severance compensation will be referred to as the "final paychecks rule" for purposes of this article. There is an additional type of optional post severance compensation allowed under the final 415 regulations, which will simply be referred to as "post severance compensation". The difference between the two (beyond whether each is required) is the type of compensation that is included.
Compensation under the "final paychecks rule" must include other compensation paid by the later of: (1) 2-1/2 months after an employee's severance from employment with the employer maintaining the plan or (2) the end of the limitation year that includes the date of the employee's severance from employment with the employer maintaining the plan 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 (e.g., 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.
This should be contrasted with optional post severance compensation. "Post severance compensation" means compensation paid by the later of: (1) 2-1/2 months after an Employee's severance from employment with the employer maintaining the plan, or (2) the end of the limitation year that includes the date of the employee's severance from employment with the employer maintaining the plan if: (a) the payment is for unused accrued bona fide sick, vacation or other leave that the employee would have been able to use if employment had continued; or (b) the payment is received by the employee pursuant to a nonqualified unfunded deferred compensation plan and would have been paid at the same time if employment had continued, but only to the extent includible in gross income.
So while similar in timing of the compensation counted (paid before the later of the end of the limitation year or 2-1/2 months after severance), the type of compensation included under either rule is different. Please note that actual severance pay is never counted under the "final paychecks rule" or as post severance compensation. Note also that the plan may specify whether to include payments to a disabled participant or a participant performing qualified military service.
Post Year End Compensation
In contrast to post severance compensation, post year end compensation (defined below), is a timing rule of when compensation is counted. "Post year end compensation" means amounts earned during a year but not paid during that year solely because of the timing of pay periods and pay dates if: (i) these amounts are paid during the first few weeks of the next year; (ii) the amounts are included on a uniform and consistent basis with respect to all similarly situated Employees; and (iii) no compensation is included in more than one year. Essentially the question is: do you want to include December pay that is actually paid in January or just include amounts in compensation when paid?
Under a plan that includes post year end compensation, Compensation earned in one year but actually paid early in the following year will be counted as Compensation in the year it was earned.
Application of the definitions
Let's assume that a plan includes both post severance compensation and post year end compensation (both for 415 limits and for determining benefits under the plan) and a participating employee terminates on December 31, 2008 (limitation year is the calendar year). December pay is regularly paid in the first week of January. This employee has commissions that are collected and paid in February of 2009 (most employees get commissions paid semi-annually) and the employer also pays out unused vacation to terminating employees at that time. The terminating employee also receives six weeks severance pay. (The plan year and the limitation year both end on December 31.)
- The plan must include compensation paid up through 2-1/2 months after severance (March 15, 2009) under the "final paychecks rule". The regular paycheck paid out in the first week of January and the commissions paid in February would be included in compensation under this rule.
- Since the plan includes post year end compensation, compensation includes regular December pay that is actually paid during the next few weeks of 2009. Therefore the regular paycheck paid out in the first week of January would be included in the 2008 plan year under the post year end compensation election. The commissions paid in February of 2009 under the "final paychecks rule" would be counted in the 2009 plan year since it is not considered post year end compensation (it is not paid during the first few weeks of the next year and is not included on a uniform and consistent basis with respect to all similarly situated employees).
- Since the plan includes optional post severance compensation as well, compensation would also include payments for sick leave, vacation or similar items paid before 2-1/2 months after severance (March 15, 2009). The pay for the unused vacation time paid in February would be included in compensation and would be included in the 2009 plan year since it is not post year end compensation (it is not paid during the first few weeks of the next year and is not included on a uniform and consistent basis with respect to all similarly situated Employees).
- The severance pay is not included in 2008 or 2009 pay.
If the plan did not include post year end compensation, all the post severance compensation described above would be included in the 2009 plan year. Even if the plan includes post year end compensation, any compensation that is paid after more than a few weeks into a new year or outside a regular pay period is included in the 2009 plan year.
Implications for the Plan Sponsor
Since the employee described above continues to have compensation under the plan into 2009, the employee may have rights to change his or her elective deferrals (many plans offer the option to change elections at the beginning of a new year). In addition, if there are no hour requirements for matching/safe harbor contributions, the plan will likely need to provide a safe harbor or match for the terminated employee in the 2009 plan year.
Under this scenario, even if the plan excluded optional post severance compensation, there will be compensation under the "final paychecks rule" that is counted in the 2009 plan year (the commissions paid in February of 2009).
Conclusion
It is difficult to say which definition of compensation will work best for a particular employer. The choice will depend on the employer's payroll methods and the employer's priorities. The most important concept to keep in mind is that even if the plan does not include optional post severance compensation and post year end compensation, the "final paychecks rule" will still apply and regular compensation paid out before the end of the limitation year or 2-1/2 months after severance will always need to be included as compensation for terminated employees.
If you have any questions please feel free to contact us at support@ftwilliam.com or call 800.596.0714.