Employers in need of reporting injuries to OSHA are quickly approaching an important date  – March 2, 2020. Download our Occupational Health & Safety Bulletin for detailed information and helpful links to ensure your company stays in compliance.

Deadline for Electronic Reporting of OSHA 300A Data

Employee benefits compliance is a complex year-round process.  Benefits professionals are grappling with year three of Covid-19, and ever-changing legislation.  The Consolidated Appropriations Act of 2021 (CAA) has created additional compliance responsibilities that may be under the radar for most employers.   

The CAA has three deadlines coming up very quickly:

Notice Regarding Patient Protections Against Surprise Billing:  All employers that maintain a public website for their group health plan need to post the new version of the Notice on that site by the first day of the plan year beginning on or after January 1, 2023.  Employers without a public group health plan website should ensure the insurance carrier or TPA makes the Notice available on the carrier’s or TPA’s public website for the plan.  The model Surprise Billing Notice is located within the CMS No Surprises Act website.  

For more details see our blog: The New CAA Surprise Billing Notice



CAA Prescription Drug Data Collection:  All employer-sponsored medical plans, whether fully insured or self-insured are subject to a new annual prescription drug and health care spending data submission requirement commonly referred to as the Prescription Drug Data Collection (RxDC) report.  Reporting for the 2020 and 2021 calendar years is due December 27,2022, and then reporting will be due each June 1, for subsequent calendar years.  Absent any further extensions, the 2022 report will be due June 1, 2023.  

Employers with fully insured plans will rely on their insurance carrier to submit the report but should confirm this with the insurance carrier.  Self-insured employers (including level funded plans) should confirm with their third-party administrator (TPA) or pharmacy benefit manager (PBM) that they will complete the report on the plan’s behalf.      

For more details see our blog: Additional Health Plan Price Transparency Disclosures Coming Soon



Participant-Level Transparency in Coverage (TiC): Health plans must begin offering an internet-based price comparison tool disclosing an initial list of 500 shoppable items effective the first plan year beginning on or after January 1, 2023.  Employers will rely on their insurance carrier for fully insured plans or TPA for self-insured plans to provide this tool.  

Employers can enter into a written agreement with the insurance carrier or TPA to provide that they will comply with the TiC requirements.  

For more details see our blog: Additional Health Plan Price Transparency Disclosures Coming Soon

Other frequently overlooked items include: 

ACA Reporting:  Applicable Large Employers (ALEs) and self-insured employers of any size, must report group health plan offer and coverage information to the IRS and to employees annually.  The forms must be distributed by March 2, 2023 to employees and filed with the IRS by March 31 if filing electronically (required for employers that filed 250 or more returns with the IRS).  If filing by paper, the forms must be furnished by February 28, 2023.   

An employer is an ALE in the current year if it employed on average at least 50 full-time employees (including full-time equivalent employees) on business days during the preceding calendar year.

For more details see our Newfront Office Hours Webinar: The ACA Employer Mandate & ACA Reporting



Imputed Income for Domestic Partners: Employers must report imputed income on the Form W-2 for employees who cover non-tax dependent domestic partners and/or domestic partner’s children under the health plan.  

For more details see our Newfront Office Hours Webinar: Health Benefits for Domestic Partners



Nondiscrimination Testing (NDT) for Cafeteria Plans:  All cafeteria plans must undergo annual non-discrimination testing.  While most employers will pass most of the required tests easily, some dependent care FSA plans which have a large number of highly compensated employees (HCEs) participating may fail the 55% average benefits test.  In that case, the employer must make adjustments to the HCEs elections by year-end to preserve at least a portion of the HCEs’ pre-tax benefit.  

For more details see our Newfront Office Hours Webinar: Section 125 Cafeteria Plans

There are many more employee benefits compliance items that need to be considered – not just at year-end.  To help with compliance, Newfront provides its clients with an internet-based reminder system tailored to each client’s plan year, funding arrangement, and other relevant characteristics.  

The Consolidated Appropriations Act of 2021 (CAA) has created additional compliance responsibilities that may be under the radar for most employers.  

Year End Compliance Review:  What Are You Missing?

Newell joins Newfront at a time of industry-leading growth and national expansion as it modernizes the insurance industry through technology

Newfront, the tech-driven insurance brokerage firm based in San Francisco, today announced the addition of industry veteran John Newell as Chief Commercial Officer. Newfront reached an inflection point this year as a top 40 broker based on revenue, with close to 1,000 employees across the US. Given this key milestone, Newfront hired John Newell to lead the insurance, benefits, and retirement services as it continues to transform the insurance brokerage industry. 

“John’s decision to join Newfront is another example of our company vision and results attracting the best talent in the industry as well as validation of our mission to modernize our industry for clients, colleagues, and trading partners,” said Newfront President Brian Hetherington. “I look forward to working closely with John and welcome his expertise as an insurance professional and leader.”

Newell brings more than 20 years’ experience to Newfront as a leader focused on delivering excellent client experiences and building culture. Prior to joining Newfront, Newell spent two decades at Marsh, where he began his career as a producer before moving up the ranks to a top leadership position. Most recently, he oversaw the central US, a region of nearly 2,000 employees and prominent clients, which has consistently delivered outpaced growth at the company.

“Throughout my career I’ve focused on recruiting elite talent, building diverse teams, and advocating on behalf of clients of all sizes – from Fortune 500 companies to small, privately held firms,” said Newell. “As I thought about the evolution of our industry and the opportunity for technology to benefit clients and colleagues, I knew I needed to be a part of this company’s mission.”

Newfront is transforming the delivery of risk management, employee experience, insurance, and retirement solutions by building the modern insurance platform. Transparent data delivered real-time translates into a lower total cost of risk and greater insights. Newfront makes insurance work for you. Headquartered in San Francisco, Newfront has offices throughout the country and is home to more than 850 employees who serve clients across the United States and globally.

Traci Johnson
Newfront
press@newfront.com 


Natasha Koleas
PAN Communications 
949-397-7582
nkoleas@pancomm.com 

Newfront announced the addition of industry veteran John Newell as Chief Commercial Officer.

Newfront Welcomes John Newell as Chief Commercial Officer

Question: How should employers address the many challenges associated with the 55% average benefits test component of the dependent care FSA nondiscrimination testing?

Short Answer: The best practice approach is to test early, consider using the top-paid group election (top 20%) to avoid or mitigate a testing failure, and correct any failures by reducing highly compensated employees’ dependent care FSA elections to a passing level prior to the end of the plan year.

General Rule: Section 125 Cafeteria Plan Nondiscrimination Testing

Employees’ elections to pay the employee-share of the premium for health and welfare plan coverage on a pre-tax basis or make pre-tax FSA contributions are governed by Section 125 of the Internal Revenue Code. The Section 125 cafeteria plan rules include nondiscrimination testing (“NDT”) requirements designed to ensure that the plan does not discriminate in favor of highly compensated employees.  

There are multiple components of the cafeteria plan NDT and multiple definitions of which employees qualify as highly compensated.  This post focuses on the most (and only) commonly failed test, which is the 55% average benefits test (“ABT”) component of the dependent care FSA NDT under Section 129.

Newfront Office Hours Webinar: Section 125 Cafeteria Plans

The Cafeteria Plan Nondiscrimination Tests

The Dependent Care FSA 55% Average Benefits Test: Why It’s So Difficult to Pass

Although the ABT is just one component of a wide variety of cafeteria plan-related NDT, it is by far the most notorious.  This is because of the practical reality that virtually every other cafeteria plan-related NDT under Section 125 (POP), Section 105(h) (health FSA), or Section 129 (dependent care FSA) does not present a practical concern that the typical plan approach could result in a failed NDT.

In other words, the ABT is the only component of cafeteria plan NDT that employers have any significant chance of failing based on a quantitative analysis of utilization rates.  All other components are either based on a) structural plan design (as opposed to utilization rates) that can easily be addressed by making the plan available on a nondiscriminatory basis, or b) utilization rates that are essentially never in jeopardy of failing.  So, while employers still need to perform all of the other NDTs to confirm a passing result, there generally is no drama or suspense tied to the result.

The design of the ABT, on the other hand, conveys the sense that Congress intended for a large swath of employers to fail the test.  Employers await their ABT results back from their FSA TPA with bated breath, knowing that even a dependent care FSA made available on completely equal terms to both highly and non-highly compensated employees still has a high chance of failure based on utilization rates.

The reason the ABT is so difficult to pass is that the test requires at least 55% of the dependent care FSA benefits be for non-highly compensated employees (“NHCEs”).  The test looks to the average benefit received by highly compensated employees (“HCEs”) as a ratio compared to the average benefit received by NHCEs, requiring that the NHCE average be at least 55% of the HCE average.  HCEs tend to disproportionately participate at higher levels and make higher dependent care FSA elections, which is exactly what the ABT is designed to prevent.  That makes the ABT very hard to pass without adjustments to reduce HCE elections.

Who Qualifies as a HCE for Purposes of the Dependent Care FSA?

Individuals are considered highly compensated as an HCE for purposes of the dependent care FSA NDT if they are:

A more-than-5% owner of the employer in the current or preceding plan year; or

An employee who earned more than $135,000 (2023 testing) or $150,000 (2024 testing) in the prior plan year.

Employers will generally look to Box 1 of the Form W-2 to determine compensation levels for the prior year.  Employees hired mid-year in the prior year may have an annualized salary in excess of the applicable limit but still not qualify as an HCE because they did not earn over that limit in their initial partial year of employment.

The Section 125 NDT rules direct employers to use current-year compensation for new hires not employed in the prior year, but it is not clear whether this special current-year-hire rule applies to dependent care FSA testing.  Many FSA TPAs reasonably take that employers can simply exclude all current-year hires from HCE status unless they are more-than-5% owners.

Alternative HCE Determination Method: The Top-Paid Group Election (Top 20%)

Many employers face particularly difficult ABT prospects because a large amount of their population are employees who earn more than the applicable annual threshold.  These employers will have an unusually high number of HCEs, making it even more difficult to pass the ABT.  In other words, the more HCEs in the population, the more unlikely it is that 55% of the dependent care FSA benefits will accrue to the (smaller) NHCE population.

Fortunately, many such employers do have an alternative approach available through an option to use the “top-paid group election” that may alleviate this predicament.  The top-paid group election determines HCE status by reference to whether employees are in the top 20% highest-paid employees instead of the specific annual compensation level under §414(q) ($135,000 for 2023 testing).  

This can result in significantly fewer employees meeting HCE status because employees who earned $135,000 (2023 testing) in the prior year but are not in the top 20% highest paid employees (and are not more-than-5% owners) will be moved from HCE to NHCE status.  The more NHCEs in the employer’s population, the better the chance employers have to pass the ABT.  

Important Limitation to the Top-Paid Group (Top 20%) Election: Must Also Apply to 401(k) Plan

The top-paid group election cannot be used for the dependent care FSA NDT unless it is also applied to the employer’s other employee benefit plans that rely on the §414(q) HCE definition, which includes the employer’s retirement plan.   

Accordingly, employers seeking to utilize the top-paid group election must coordinate with their 401(k) plan nondiscrimination testing to confirm that the top-paid group election is also in place for the 401(k) plan for that plan year.

Action Item: Employers that fail the ABT pre-test should work with the FSA TPA to run the pre-test again utilizing the top-paid group election—provided that election is also in place for the 401(k) plan.  The top-paid group approach may move the plan from a failing to passing level.  However, even where the top-paid group election does not move the plan to a passing level (at or above 55%), it often will reduce the degree of the failure by moving the result closer to 55%.  The degree of the failure is still meaningful because the closer the test results are to 55%, the less severe the reductions needed to HCE elections to pass the ABT.

When to Test: The Advantages of Performing Nondiscrimination Testing Early

As a technical matter, the NDT results that matter are only those as of the last day of the plan year.  In other words, the cafeteria plan NDT rules look to the last day of the plan year to determine whether the plan passes.

However, it is best for employers to run a pre-test mid-year to determine whether the plan is on track to pass or fail as of the last day of the plan year.  For example, a mid-year pre-test might show the plan’s ABT is running at a failing result of 45%, and that the employer needs to reduce HCE elections by 20% to pass.  In that situation, the employer would need to cap HCEs who elected the full $5,000 at a reduced $4,000 limit.  Reducing HCE elections ensures that the plan will pass the ABT as of the last day of the plan year—which, again, is the key date for all the cafeteria plan NDT requirements. 

The earlier the employer runs the cafeteria plan NDT pre-test, the more likely the employer will discover any ABT failure before the HCEs have reached the reduced limit needed to ensure a passing result.  It is far simpler to correct a failed ABT result before HCEs reach the reduced cap by stopping HCE contributions at the reduced amount indicated by the pre-test (as opposed to the alternative of having to correct excess contributions, as discussed below).  This is generally as easy as informing HCEs of the reduced limit and directing payroll to implement the reduced cap on HCE contributions.

Action Item: Engage with the FSA TPA early in the year to run a pre-test and determine the direction of the plan’s ABT results, preferably prior to the last quarter of the plan year.  For example, consider running the pre-test in summer for a calendar plan year.  This early testing approach will greatly simplify the process if corrections are needed.

Correcting an ABT Failure Where HCEs Have Already Exceeded the Reduced Limit

In some situations, employers will not discover an ABT failure in time to impose a reduced HCE contribution limit prior to HCEs contributing to the dependent care FSA in excess of that limit.  

For example, suppose the ABT pre-test results show that HCE elections must be reduced by 20%, resulting in HCEs who elected the $5,000 maximum having to drop to $4,000.  If those HCEs have already contributed $4,375, there is a $375 excess that must be made taxable income before the last day of the plan year.

There are two basic approaches to converting excess HCE dependent care FSA contributions to taxable income:

Refund/Return: The employer can distribute the excess contributions back to the HCEs through payroll as taxable income subject to withholding and payroll taxes by the end of the year, thereby reducing the amount available in the HCEs’ dependent care FSA account balance.  Note that this approach will not work for HCEs that have already received reimbursement of the excess amount.

Recharacterize: The employer can recharacterize the excess contributions as taxable income subject to withholding and payroll taxes without directly refunding the excess to HCEs.  The downsides of this approach are that the employer will need to a) take the withholding and payroll taxes from other income, and b) inform the HCEs that they may take a distribution of the excess contributions (which no longer have pre-tax status) from the FSA without the need to submit qualifying dependent care expenses. 

With either approach, the employer will need to coordinate with the FSA TPA to ensure proper administration of the correction.  As always, the employer will need to take action before the end of the year to ensure a passing result as of the last day of the plan year.

Relying on Pre-Test Results and Corrections: The General Industry Standard

By running a mid-year pre-test and making any corrections needed to address failures, the employer can be confident that the result as of the last day of the plan year will reflect a passing grade.  

Although it is not entirely clear in official IRS guidance, the typical FSA TPA approach has essentially set the industry standard that if the IRS were to audit an employer’s NDT results, pre-test results showing a clear passing score—including any adjustments made to reduce HCE contributions—should always be sufficient.  If the IRS was not willing to rely on pre-test results (including, if applicable, any necessary corrections), the employer should still be able to perform an after-the-fact NDT as of the last day of the plan year to confirm the passing result.

Many FSA TPAs do not perform a second year-end NDT as of the last day of the plan year for this reason.  The additional NDT is viewed mostly as an unnecessary formality.

Employers that are concerned about demographic and participation changes potentially affecting the result after the pre-test is performed can consider a) closing the dependent care FSA to new HCE participation for the remainder of the year for new hires and mid-year permitted election change events, and/or b) correcting the pre-test results up to a level higher than 55%, such as 57.5% or 60% to provide additional buffer to serve as a margin for error.

Corrections Required by the Last Day of the Plan Year (December 31 for Calendar Plan Year)

Employers must correct any NDT failure, including ABT results below 55%, by the last day of the plan year.  Once the plan year closes, there is no option to correct because the plan will have failed as of the last day of the plan year—the only relevant date for NDT purposes.

For example, employers with a calendar plan year cannot wait until January’s Form W-2 preparation process to address any testing failure through an after-the-fact recharacterization process.  HCEs must have their pre-tax contributions reduced to the passing level through payroll as of December 31 to pass the ABT.

Where the employer fails to make corrections before the end of the year to result in a passing ABT as of the last day of the plan year, all the dependent care FSA contributions for all HCEs must be recharacterized as taxable income.  In other words, HCE elections must be reduced to “0” because the entire pre-tax contribution amount becomes taxable.  The Form W-2 would accordingly reflect “0” in Box 10 for dependent care benefits (because the full amount would have to be moved to standard Box 1, 3, 5 income).

For example, suppose the ABT pre-test results show that HCE elections must be reduced by 20%, resulting in HCEs who elected the $5,000 maximum having to drop to $4,000.  If the employer fails to correct HCE elections by the last day of the plan year, the HCEs will not receive any dependent care FSA benefit.  Those HCEs who elected $5,000 will not receive a $4,000 reduced benefit, but rather the complete elimination of their benefit down to zero (because the full amount will have to be recharacterized as taxable income).

Action Item: The ABT cannot be satisfied through corrections made after year-end.  Make sure all corrections required to HCE elections are implemented and processed through payroll prior to the last day of the plan year.  Employers must reduce HCE elections prior to the end of the plan year to preserve the reduced tax-advantaged benefit for all HCEs.

Strategies to Avoid ABT Failures: The Good, the Bad, and the Ugly

Employers clearly become frustrated with failing the ABT year after year, and in many cases they overcompensate with approaches that unnecessarily harm HCEs.  The following are a few of those strategies:

The Good: Offer an Employer Matching Contribution to Non-HCEs

The only approach to reducing the risk of testing failure that is recommended is to incentivize NHCEs to participate in greater numbers and to a greater degree.  Although it is uncommon because of the increased employer cost, a few employers have taken the smart approach of offering NHCEs additional employer contributions as a carrot to encourage greater participation.

One particularly effective approach is to offer an employer matching contribution to the dependent care FSA for NHCEs that operates in a similar manner as a 401(k) plan matching contribution.  For example, the employer might offer a dollar-for-dollar matching contribution for NHCEs of up to $500.  This will entice greater participation and higher elections from NHCEs, which will in turn significantly improve the employer’s chances of passing the ABT.

The Bad: Limit HCE Contributions to a Reduced Level from the Outset

A common approach that is not recommended is for employers to simply cap HCE elections from the beginning at a reduced level.  For example, HCEs may elect only up to $3,000 instead of the standard $5,000 limit available to NHCEs.

Although this approach does improve the chances of passing the ABT because it will decrease HCE dependent care FSA benefits by design, it does so in a very haphazard manner.  In that example, allowing HCEs full elections and pre-testing may have resulted in a required reduction of $5,000 HCE elections to $4,000 to reach a passing 55% level.  However, by capping HCE elections at $3,000, the employer would have effectively preemptively precluded HCEs from enjoying an additional $1,000 pre-tax contribution.

This approach is therefore not recommended because it will always either a) cause HCEs not to be able to take advantage of the maximum permitted pre-tax election, or b) require only a slightly smaller correction to HCE contributions than would have otherwise been required if they initially could have elected up to the full $5,000 maximum.

The Ugly: Permit Only NHCEs to Participate in the Dependent Care FSA

This approach has the advantage of guaranteeing the plan will pass the ABT because 100% of the benefits will be for NHCEs.  However, needless to say this approach does not go over well with the HCEs who are blocked entirely from dependent care FSA participation.

Employers should not preemptively cap HCE elections at the outset, but instead run an early pre-test (e.g., summer for a calendar plan year) to determine any reduced contribution limit required to pass the ABT.  This approach ensures that HCEs receive the maximum pre-tax benefit that can be made available.

Although it is common for employers not to pass the ABT in pre-test results, running the test early will typically catch the issue before HCEs have contributed up to the reduced limit needed to achieve 55%.  The administrative burden is relatively minor where the adjustment simply requires a payroll contribution cap for HCEs.

Mid-Year Reduction to HCE Limit May Permit Spouse to Enroll/Increase Dependent Care FSA

The IRS has informally stated that the spouse’s employer may permit the spouse to enroll in (or increase an existing election in) the dependent care FSA sponsored by the spouse’s employer mid-year in response to an HCE being informed their contribution limit must be decreased to satisfy the ABT.  

If the spouse’s cafeteria plan permits this mid-year adjustment approach, it will in some cases allow a married couple affected by a failed ABT to still achieve the maximum $5,000 in combined dependent care FSA contributions.

Should ABT be Performed Based on All Employees or Only Those Participating?

There is debate among benefits professionals and the FSA TPA industry as to whether the ABT averages for HCEs and NHCEs are based on only those employees participating in the dependent care FSA, or based all employees regardless of participation.

The dependent care FSA rules refer to “the average benefits provided to employees” (emphasis added) who are NHCEs vs. HCEs, rather than the average benefits provided to eligible employees or participants.  Therefore, the best practice approach is to include all HCEs and NHCEs in the average regardless of participation or eligibility.  

Some FSA TPAs offer employers the ability to choose how to perform the ABT based on these different approaches, which can be reasonable for employers to consider based on their risk tolerance.

What Happens if Employers Fail to Perform the ABT?

The reason employers run the NDT for cafeteria plans, including the dependent care FSA ABT, is not for the sake of testing itself.  There are no penalties for failure to perform the testing.

The reason employers perform the NDT annually is to know whether HCEs are permitted to retain their full pre-tax cafeteria plan elections, and to be able to prove to the IRS that they treated the taxation of HCE elections correctly in case of IRS audit.

In other words, the NDT is performed simply to determine whether HCEs are permitted to retain the full exclusion from income for their elections.  Not running the NDT is a bad practice because if the employer fails to complete the NDT, the employer will not be able to verify that they passed (or the required corrections needed by the end of the plan year to reach a passing level).  

Employers that fail the ABT unknowingly have a Form W-2 reporting issue for the affected HCEs.  Those HCEs should have received no tax-advantaged dependent care FSA benefits for the year of the failure.  That generally creates a potential liability of $290 for the Form W-2 to the employee, and $290 for the copy of the Form W-2 to the IRS, for a general total of $580 per return in 2023.

Most FSA TPAs incorporate full cafeteria plan NDT into their standard service offering for the plan.  In situations where the FSA TPA does not offer NDT services, the employer should engage with a vendor that will offer the NDT services on a stand-alone basis for a fee.

The 55% Average Benefits Test is a regular pain point for employers who often express frustration with the frequent need to address ABT failures by reducing dependent care FSA elections for highly compensated employees.  However, employers can take three simple steps to alleviate at least some of these frustrations:

Consider using the top-paid group election (top 20%); and

Catch and correct testing failures before HCEs reach the reduced contribution cap.

Admittedly, the process will always cause some level of small headaches in working with payroll to implement the reduced contribution limit and communicating the reduction to the affected HCEs.  However, consistently taking this approach has the benefit of avoiding the more burdensome administrative work, more restrictive preemptive limitations, and the last-minute recharacterizations before the end of the year that can put a damper in anyone’s holiday spirit.

For more details on cafeteria plan compliance considerations, see our Newfront Office Hours Webinar: Section 125 Cafeteria Plans.

How should employers address the many challenges associated with the 55% average benefits test component of the dependent care FSA nondiscrimination testing?

The Dependent Care FSA 55% Average Benefits Test

Plan compensation is one of the most difficult topics in understanding retirement plan operation.  The topic can be confusing for both human resource professionals and retirement plan practitioners.  This blog will review compensation that is paid to an employee upon separation from service with the employer.   

Before diving into categories of compensation paid after an employee terminates employment, let’s review some compensation basics. There are three base definitions of compensation used as the starting point in qualified retirement plans: 

Section 415 Safe Harbor (Gross compensation including pre-tax deferrals) 

Section 3401(a) Wages (Compensation subject to Federal tax withholding) 

The Form W-2 wage definition is commonly used for plan allocation purposes because it can be readily obtained.  If using either the Form W-2 or the 3401(a)-wage definition, plans typically add back pre-tax deductions that reduce the amounts reported in Box 1 to arrive at gross compensation.  Any of the above definitions can be further adjusted by including or excluding some post-severance (post termination date) compensation. 

Best Practices: Elect a definition of eligible plan compensation that your organization will be able to easily support.   

Severance Pay: “Go Away Pay” is Never 401(k) Eligible Compensation 

The key distinction between severance compensation and post-severance compensation is that true severance compensation is never eligible plan compensation.  I like to refer to true severance compensation as the “go away pay.”  Simply put, the employer is paying the employee a stated amount of money over a specific period NOT to work for the employer.  Severance compensation is not payment for services performed by that employee and is always excluded from eligible plan compensation.   

“Go away pay” is simply a shorthand phrase to distinguish between severance compensation and post-severance compensation.  According to the Department of Labor, “Severance pay is often granted to employees upon termination of employment.  It is usually based on length of employment for which an employee is eligible upon termination… and is a matter of agreement between an employer and an employee (or the employee’s representative).”   

The distinction is that severance pay is not based on services performed by the employee nor would it have been paid to the employee had the employee remained an employee of the employer.  Severance pay is typically associated with a layoff or dismissal (not a temporary furlough).  This type of compensation is never eligible plan compensation.  Therefore, employee deferrals may not be withheld from severance pay and employer contributions may not be allocated on severance pay. 

Severance Pay: What About When It’s Paid Pre-Termination of Employment? 

Recently, we have seen a trend in severance compensation being paid to an employee before the last day of service performed by the employee.  The regulations are very clear that true severance pay (generally paid after an employee is dismissed from service with the employer), is never eligible plan compensation.   There are different applications for compensation in retirement plans.  For example, the compensation used for the contribution basis (allocations) may be different from compensation that is used in the nondiscrimination testing. Specific definitions apply in determining who is a highly compensated employee that are not the same as the definition used for allocations. 

How the pre-paid severance compensation is treated in your retirement plan will depend on the base definition of compensation specified in your plan document and specific inclusions or exclusions elected in that document.  Pre-paid severance is not defined in the regulations, and there are differing opinions in the industry as to whether this compensation is a “bonus” rather than severance compensation.  If the intent is to include (or exclude) the pre-paid severance compensation for purposes of your retirement plan, you will need to make sure that your plan document is very clear as to that election so as not to create operational failures applicable to deferrals and employer provided contributions. 

Best practices: Consult with your plan document provider and ERISA legal counsel regarding compensation that is intended to be severance compensation.  Ultimately, it is the plan sponsor’s responsibility to ensure that the plan’s definition of compensation is clearly defined, does not discriminate in favor of highly compensated employees, and is uniformly applied to all employees. 

Post-Severance Pay: Regular Pay After Termination May Be 401(k) Eligible Compensation 

On the other hand, post-severance compensation is compensation paid to an employee after the employee’s termination of employment with the employer.  In many cases, the compensation is paid after termination because of a short timing issue due to the employer’s payroll cycle.  In some cases, such as bonuses and commissions, the pay is regularly scheduled for distribution at certain points of the year, which may occur post-termination.  This type of post-severance compensation may be eligible 401(k) compensation. 

Post-severance compensation is eligible compensation if it meets the timing restrictions and is an amount paid to an employee for "regular” pay for services.  “Regular” pay is compensation that would have been paid prior to termination had the employee continued employment with the employer.  For example, an employee terminates on March 21st and the next payroll date is not until March 31st.  The amount paid on March 31st is compensation earned before the employee terminated employment but is paid after date of termination.     

“Regular” pay includes hourly wages, salary, overtime, bonuses, commissions, and other regular payments that the employee would have been paid had there been no termination of employment. 

There is a payment timing requirement for post-severance compensation which will determine whether the post-severance regular pay is eligible plan compensation (i.e., eligible for deferrals and other employer contributions).  The post-severance compensation must be paid by the later of: 

2.5 months after termination of employment, or 

the end of the limitation year in which the employee terminated employment (in most plan documents the limitation year is the same 12-month period as the plan year). 

Note that for a calendar plan year, the 2 ½ month period will be relevant only for terminations after mid-October. 

Irregular post-severance compensation is not required to be included in eligible plan compensation and is subject to the same timing requirements as regular post-severance compensation.  Irregular post-severance compensation includes items such as unused vacation or sick pay (PTO) and amounts paid from a deferred compensation plan.  The provisions in the plan document will indicate which irregular post-severance payments will be included or excluded.  It is important to understand what items are included because the compensation may be subject to salary deferral elections and employer contributions. 

Severance and Post-Severance Pay Case Studies – Calendar Plan Year 

Frank has been an employee of Big Tech for more than 10 years.  Unfortunately, Big Tech is reorganizing the company and Frank will be dismissed on November 17, 2022.  Big Tech and Frank reach a severance package agreement that states Frank will receive an amount equal to 6 months of his salary after November 30, 2022.  Because this is true severance pay, the compensation will not be eligible for any retirement plan contributions.  Frank may not elect to make salary deferrals from the severance compensation and will not receive any employer contributions on the severance compensation. 

Case #2 – Pre-Paid Severance Compensation

Same facts as in Case #1, except that Big Tech includes 6 months of Frank’s salary on his November 15, 2022 paycheck.  Is this eligible plan compensation?  Well, it depends.  Big Tech should review the terms of the plan document to determine if severance compensation paid before termination is specifically addressed and whether it is included or excluded for plan purposes.  If the plan document is silent, could the additional compensation be treated as a bonus?  Are bonuses included (default position) or excluded (explicit in plan terms)?  In this scenario, Big Tech should ensure that the plan document is carefully drafted to not leave any ambiguity regarding pre-paid severance compensation.  Big Tech may have intended to count this payment as severance compensation (which is excluded for plan purposes); however, the IRS could disagree with that classification upon audit if it was not clearly spelled out in the plan document. 

Case #3 – Post Severance Compensation 

Same facts as Case #1, except that Frank is not offered a severance package and his final paycheck will be issued on November 30, 2022.  His final paycheck will include his unused vacation and sick pay and the amount he earned before terminating employment.  Are all amounts included on his final paycheck considered eligible plan compensation?  The compensation that is attributable to amounts he earned for his services is always counted as plan compensation.  Whether the amounts paid to Frank attributable to his unused vacation and sick pay are counted will depend on the specific plan provisions. 

Case #4 – Post Severance Compensation Timing 

Same facts as Case #3, except that Frank is a commissioned sales employee.  He receives his final regular paycheck on November 30, 2022 but his commissions will be paid monthly after that date.  Any commission checks paid on or before February 2, 2023 (2.5 months after his date of termination) would be eligible plan compensation (assumes that plan compensation does not exclude all commission payments).  Any commission payments paid after February 2, 2023 would be excluded because they were not paid within 2.5 months following termination and were not paid before the end of the plan year in which he terminated. 

Case #5 – Post Severance Compensation Timing 

Same facts as Case #4, except that Frank terminates employment on February 15, 2023. Frank continues to receive commission payments through December 31, 2023.  If the plan document does not exclude commissions from eligible plan compensation, any payments of commission paid to Frank through December 31, 2023 would be eligible plan compensation because they are paid by the end of the limitation year (calendar year 2023) that includes his date of termination. 

Note: Compensation is a plan document provision and may vary from plan to plan.  It is extremely important that the plan sponsor know and understand the compensation definition in its plan document.  The application of eligible plan compensation is one of the most common mistakes in plan operation and requires plan correction pursuant to EPCRS if misapplied. 

All contributions provided in an employer sponsored retirement plan are related to compensation paid to the employees.  Therefore, it is critically important that plan sponsors and their human resource professionals understand the definitions applicable to their specific retirement plan.  Understanding and following the rules will keep the plan in operational compliance.  Newfront’s Retirement Services team is available to assist you with questions regarding complex compensation matters or other retirement plan questions that may arise. 

IRS Fix-It-Guide Incorrect Compensation Used 

Severance compensation is a term that may have a different meaning for the purpose of your qualified retirement plan than how it is used in your workplace.  Using an incorrect determination of plan compensation for allocating contributions is an operational failure that may jeopardize the tax favored status of your retirement plan. 

401(k)ology –“Post-Severance” vs. “Severance” Compensation

As California goes, so does the nation. As the fifth largest economy on the planet, California sets the tone and tempo for the rest of the country - quite often the world. As such, it is important to analyze why AB257 has garnered so much attention, especially due to its possible far-reaching implications beyond the Golden State and for all business owners. 

There are a number of issues that have been challenging the restaurant industry as of late including COVID, inflation, the dramatically rising cost of protein, produce, paper goods, and labor shortages, just to name a few.  Now there is a new challenge on the horizon, the Fast Recovery Act, signed by California Governor Gavin Newsom on September 5, 2022. 

Beginning January 1, 2023, a council will be established consisting of workers, corporate representatives, franchises, and state officials tasked with setting industry minimum wages, working hours and other conditions.  The law will apply to workers who are employed by fast food restaurants with at least 100 locations nationwide.  The minimum wage for groups at this size could rise as high as $22 next year, currently minimum wage is $15 an hour in California, with annual increases on the cap tied to inflation.

Many franchise owners are vehemently opposed to the bill as it significantly increases the cost to do business in the state, upends the franchise business model, and allows for a council of 10 unelected political appointees to run the fast-food restaurant industry. The act has an intended consequence of making the big box retailer responsible for reported wage theft instead of the individual franchise owner; similar to legislation that was passed previously in the garment industry. Ultimately, this could potentially result in the franchisee becoming an employee of the larger corporation instead of being an independent business owner. 

Alternatively, Union proponents argue that the fast-food industry is rife with labor violations and 85% of fast-food workers in California are experiencing wage theft, with 57% of workers experiencing multiple forms of wage theft. Per their estimates, approximately 425,000 workers are not being compensated correctly. Further, they argue, that the current model of franchise owners does too much to protect the global big box brand and often siphon off profits to evade liability. 

Regardless of which side of the argument you fall on, and with labor costs running between 20-30% of gross revenue, this can be a significant increase to the cost base with the inevitable result of food price increases and of course, cost to customers. With a recession looming, there are questions about how much can be absorbed with price increases.  Current estimates range from 2.3% to 20%.  It may appear, at first glance, that if you are under that 100-store mark this may not affect you, but it will as you will now be competing for employees earning a higher wage somewhere else.

There are definitive implications to the workers compensation marketplace, which is rated on payroll so an increase in wages translates into an identical increase in premium. For example, San Diego minimum wage is going from $15 per hour to $16.25 on January 1, which corresponds to an 8.3% increase in direct labor costs, but also an 8.3% increase in your workers compensation basis.  If you are subject to the FAST act, and your wages land on $22 an hour, that increase is 47%.

The council will also have the ability to establish new safety standards for workers which will require additional compliance issues for the employer.

Make certain handbooks are up to date, you have proper training in place, scheduling policies, and timekeeping.  

Either obtain or maintain an Employment Practices Liability insurance policy to protect yourself against allegations of discrimination, harassment, retaliation and more.  

Make a general review of all your cost centers to identify and moderate any waste in an effort to offset increase in labor costs.

Research technology: the tools available to the fast-food restaurant are constantly growing, such as kiosks and automated frying technology.

Stay informed. Restaurant groups and associations, such as the California Restaurant Association (CRA), are great resources for information for navigating the intricacies and evolution of the bill.  

In conclusion, AB 257 will impose an additional strain to the fast-food industry already plagued with challenges.  With a little planning and that incredible resilience I have come to know from the fast-food industry, the industry can continue to thrive.  Reach out to your trusted advisors now, in the insurance industry or otherwise, to start planning for all of the changes coming this January.

Beginning January 1, 2023, a council will be established consisting of workers, corporate representatives, franchises, and state officials tasked with setting industry minimum wages, working hours and other conditions for food service workers in California.

Fast Recovery Act (AB257): Facing $22 Minimum Wage in California Food Service

Deadline for Electronic Reporting of OSHA 300A Data

Megan O'Toole

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401(k)ology –“Post-Severance” vs. “Severance” Compensation

Fast Recovery Act (AB257): Facing $22 Minimum Wage in California Food Service