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Compensation and Benefits
University of Washington School of Law
Thorson, Lee A.

Thorson – Compensation & Benefits – Winter 2016
Unit I: Types of Plans
Defined Benefit Plans
– Participant receives specific output based on salary and years of employment
: (1) Deferred income provided on retirement, (2) provided in periodic payments, (3) collectively funded, (4) obligation to fund benefit lies with the employer
Funding Formulas: (1) Unit Benefit Formula – Employee credited with a “unit” of benefit for each year of service (% of salary) -> (2) Flat Benefit Formula – Contribution based on a constant annual amount (can be constant % of salary, flat $ amount)
Defined Contribution Plans – Participant contributes specific amount (usually % of salary each year) to individual account for further investment
Like a savings account -> Employer makes contribution to plan and employee benefits from back end account balance
Profit-Sharing Plans – Contribution to plan based on profits of the sponsor -> Discretionary employee contributions
Reg. §1.401-1(b)(1)(ii) – Plan must have set formula for contributions defined -> Amount of contribution left up to discretion of the board
Money Purchase Pension Plans – Employer makes a fixed contribution to employee’s account (typically a fixed % of employee’s compensation)
Tax deferred until distribution -> Cannot take money out early without a penalty
Cash or Deferred Arrangement (§401(k) Plans) – Employee opts to make a pretax contribution, deferring tax until time of withdrawal -> These are profit sharing plans with a 401(k) component (only what employee opts to defer)
Stock Bonus Plans – Contribution made in form of employer stock -> Allows employer to take a deduction without the use of money
Employee Stock Ownership Plans (ESOPs) – Stock bonus plans that invest in qualifying employer securities (at least 50% held as employer stock) -> Leveraged Plans – Requires related party guarantee, which would be barred by Prohibited Transaction rules but for ERISA exemption
ERISA 406(a) – ESOPs are exempted from Prohibited Transaction rules
Hybrid Plans
Cash Balance Plans – Defined benefit plan that mimics account balance of a DC plain -> Balance = Contribution and interest -> Creates hypothetical balance, and the employer must make up the difference
Age-Weighted DC Plans – Contribution based on participant’s age, not solely on compensation -> Contribution produces large benefit for younger employee, which allows greater contribution for older employees without violating non-discrimination policies
ERISA Development
Studebacher Incident – Company enters bankruptcy and is unable to pay back benefit that far exceeds plan funds -> Structured settlement at fraction of promised benefit -> Led to development of ERISA and PBGC to serve as “insurance” for employees
ERISA Coverage
– A Plan Covered by ERISA Is – Any employee benefit plan established and maintained by an employer, an employee organization (union) or both, which are engaged in any industry or activity affecting commerce
– Employee Benefit Plan -> §3(1) – Employee Welfare Benefit Plan -> §3(2) – Employee Pension Benefit Plan
Funds Flow:
(Sponsor) -> Deductible Contributions -> Tax Qualified Plan – Mismatch between deduction and income recognition is permitted -> Tax Deferred Earnings -> Tax Exempt Trust Holding Plan Assets (§501 – Gain from interest not taxed to benefit compounds) -> Taxable Distribution (Taxed as Ordinary Income Under §1(c)) -> Participant
Regulatory Schemes
Code Only Requirements: Restrictions based on tax qualification -> Failure results in loss of favorable treatment (tax penalties)
Overlapping Requirements: Both in code and ERISA -> Failure to meet results in tax penalties and civil penalties under ERISA
ERISA Only Requirements: Results only in non-tax civil or criminal penalties for failure to meet requirements
Qualification Requirements Under ERISA and the Code
IRC §401(a), Reg. §1.401-1(a)(12), ERISA §402(a)(1) – Written Plan Requirement – Plan must be set out in writing -> Can be used as a sword (participant can bring suit for failure to maintain plan in writing), but not as a shield (sponsor cannot use lack of written plan as a defense)
IRC §404(a)(1)(3), ERISA §403(a)(1) – Trust Requirement – Plan must maintain plan assets in a trust separate from general accounting
Who are the players? (1) Sponsors – Employer who sets up retirement plan, which is not required, but once set up ERISA applies -> (2) Participants – Employees once they become eligible to participate (enroll) (for 401(k) plans employee is a participant if they have a right to participate whether they do or not) -> (3) Third Party Administrators – No Discretion, only apply the terms of the plan to participate
Key Principles of Regulation: (1) Tax Subsidy, (2) Protective Pension Policies, (3) Voluntariness
Pensions v. Social Security
Social Security
Qualified Pensions
Benefits not weighted by compensation
Benefits weighted by compensation
Fully portable (Some cities can opt out)
Limited portability
Inflation indexed benefits
Benefits generally not indexed
Benefits not taxed
Benefits taxable
ERISA Plan Types
Defined Benefit Plans
Defined Contribution Plans
Income deferred until retirement
Income deferred for a period of time
Allocation + Contribution Formula
Definitely determinable benefit and allocation formula
Determinable allocation, not necessarily fixed contribution formula
Form of Payment
Benefits paid as annuity
Benefits in lump sum or installments
Collective funding of benefits
Each employee’s benefit funded separately
Responsibility for Shortfall
Employer responsible to make up benefit shortfall (exception for insolvency)
Employee suffers loss of investment on shortfall
Unit II: Participation and Coverage
Minimum Participation Standards (§410(a))
Age and Service Rules
§410(a)(1)(A) / ERISA 202(a)(1)(A) – Minimum age a plan can impose as a participation requirement is 21
§410(a)(1) / ERISA 202(a)(1) – Cannot postpone eligibility based on service by period of more than one year for eligibility (can postpone participation)
: 410(a)(1)(B)(ii) / 202(a)(1)(B)(ii) – Educational institutions with 100% vesting can use minimum age of 26 ->
– All service with current employer must be counted unless specific exception exists in both Code and Plan
– No requirement that service from predecessor employer be credited -> may be credited in non-discriminatory fashion -> Exclusions that require full recognition: Collective bargaining plan, multiple employer plan, or affiliated service group
New Employer Will Become Successor If: (1) adopts plan, (2) stock acquisition, or (3) merger -> must credit service in these situations, otherwise it is optional -> If successor employer is given option and chooses to adopt the plan, it must credit all employees of predecessor
Year of Service: §401(a)(3) / 202(a)(3) – Year of Service – 12 month period (ending with Anniversary Date) with 1000 or more hours of service -> Start with first performance of services
Hours of Service: DOL Reg. 2530.2006-2 – Hour of Service – Each hour for which employee is paid for performance of duties, or no duties are performed for which payment is made
Crediting Policy – Plan can adopt any reasonable crediting policy as long as it does not result in a substantial understatement of service hours
: (1) 410(a)(3)(D) / 202(a)(3)(D) – Maritime – 125 Days of Service = 1000 hours; (2) DOL Reg. 2530.2006-3 – 10 hours per “day,” 45/weeks, 190/month minimum; (3) 2530.2006-3(c) – Can create categorical equivalencies by work type as long as no discrimination or understatement
Breaks in Service – Start from premise that all years of service count unless statute allows otherwise
: 410(a)(5) / 202(b) – Plan can disregard service occurring during a “break in service”
“One Year Break” – 411(a)(6)(A) / 203(b)(3)(A) – 12 month period with less than 500 hours
“One Year Hiatus” – 12 month period with more than 500 hours, but less than 1000 -> No credit for the year, but no break in service either
One-Year Hold Out – Temporary delay with retroactive admission
IRC 410(a)(5)(B) – One year break in two year service requirement forces employee to start over in crediting service
IRC 410(a)(5)(C) – Employee becomes a participant and then suffers a break in service, plan may require another year of service following re-hire to re-enter the plan -> On re-entry, the entry is retroactive to date of rehire -> Retroactivity may conflict with 401(k) rules
Maternity and Paternity Absences – IRC 410(a)(5)(E) – Special rule for maternity / paternity – Plan must credit person with sufficient hours to prevent break in service in first year following commencement of the leave -> 501 Hours resulting in a Hiatus -> This hiatus does not count toward satisfying vesting requirements or benefit accrual
Special Service Rules
Two Year 100% Vesting Rule: 410(a)(1)(B)(i) / 202(a)(1)(B)(i) – Plan with 100% vesting can require 2 years of service, but cannot determine vesting schedule (does not apply to 401(k) plan)
Rule of Parity: IRC 410(a)(5)(D) – Post-participation, pre-vesting – If break exceeds GREATER Of: (i) 5 1-year breaks or (ii) aggregate years of service of employee prior to break (made largely irrelevant by requirement that some vesting be awarded by year 5), then pre-break service can be disregarded -> BUT this rule does not apply if the employee is vested at all
Eligibility Computation Periods: Plan Year – Commence with plan year beginning with anniversary year -> (1) If employee does not attain 1000

vices performed substantially full time for at least on year and (2) performed “under primary direction or control by the recipient”
– Treasury has authority to prescribe regulations to prevent use of separate organizations, employee leasing, or “other arrangements” to avoid coverage requirement
Disaggregation Rule – Plan specific or statutorily mandated provision that requires/permits separate testing of plan types, employers within a multi-employer plan, collectively bargained versus non-collectively bargained -> Need a positive source of authority permitting disaggregation
Acquisitions and Dispositions: 410(b) permits a one year transitional rule that suspends coverage testing following a merger or acquisition
Employees Benefiting Under the Plan: Employee counts as benefiting from a plan if: (1) for DB, the employee accrues a benefit, or (2) DC plan, the employee receives an allocation or contribution or forfeitures
: Reg. 1.410(b)-3(a)(2) – Participant who has more years in service than a plan covers is treated as benefiting from the plan -> 410(b)(6)(E) – As long as employee is eligible for 401(k) plan, they count as benefiting whether or not they make a contribution
Excludable Employees: Certain provisions permit the exclusion of employees when calculating minimum coverage ratios
Minimum Age and Service Exclusion – 410(b)(2)(D)(i) / 401(a)(26)(B)(i) – If a plan has a minimum age or service requirement, then employees not meeting the requirement can be excluded for all minimum coverage tests except average benefit test
Reg. 1.410(b)-6(f) – Employee who previously met minimum age and service requirements must be counted even if they do not accrue a benefit in the given year, unless Certain Terminated Employees – The employee was terminated during the year with not more than 500 hours of service can be excluded
Collective Bargaining Exclusion – 410(b)(3)(A) / 401(a)(26)(B)(i) – Employees covered by collective bargaining agreement are excluded as long as there is evidence that the agreement involved good faith bargaining
Independent Contractors – Vizcaino v. Microsoft Corp. – Company can included contract provision stating that individual who is not classified as an employee will not be eligible for plan participation -> IRS Position: Amount of discretion determines whether worker is an employee or independent contractor -> Consequences of employee misclassification can be plan disqualification (unless plan addressed this issue)
IRS Announcement 2011-64 – Employer can re-classify with only a one year penalty assessed by IRS -> Applies because Average Benefit test can be satisfied retroactively after reclassification
Nationwide Mutual Ins. Co. v. Darden – “Common Law Test” – Does hiring party have right to control manner and means by which product is accomplished
House Ways and Means Committee Report No. 104-586 – Primary Direction and Control Test
Minimum Participation Rule (§401(a)(26)) – Each qualified defined benefit plan must benefit at least the lesser of (1) 50 employees or (2) 40% of all employees -> Must be met on each day of the year -> Really a minimum coverage rule, no requirement that all receive the same benefit
Reg. 1.401(a)(26)-1(b)(1) – Exceptions: (1) Collectively bargained plans, (2) transition after merger (have up to end of following year), (3) plan subject to disaggregation rules
Qualified Separate Lines of Business: 414(r)(2) – To be treated as a separate line of business, the sponsor must (1) have at least 40 employees, (2) notify IRS that line is separate, and (3) meet IRS guidelines -> 414(r)(3) – Sponsor can automatically qualify for IRS guidelines if % of highly compensated falls within safe harbor percentage -> Separate Line of Business – Each separate line can be tested independently of other lines under same employer
Very hard to satisfy test for QSLOB, but if you do qualify then test each line separately