Recent IRS Guidance Addresses Contribution of Unused Paid Time Off, Automatic Enrollment and Tax Notices
During his weekly address over this past Labor Day weekend, President Obama announced several new initiatives with the goal of providing American workers additional avenues to save for retirement. The details of those initiatives were subsequently published in several Internal Revenue Service (“IRS”) rulings and notices, which are summarized below.
Contribution of Unused Paid Time Off to Qualified Retirement Plans
Revenue Ruling 2009–31 provides guidance relating to the annual contribution to qualified profit sharing plans of the cash-equivalent of unused paid time off (“PTO”), and Revenue Ruling 2009–32 provides guidance relating to the contribution to qualified profit sharing plans of the cash-equivalent of unused PTO at termination of employment. Both the annual contribution and the contribution at termination of employment may be designed either to:
- require the contribution of unused PTO in the form of an employer nonelective contribution; or
- permit the contribution of unused PTO in the form of an employee’s elective contribution.
The rulings describe several plan designs that provide for contributions of unused PTO to profit sharing plans. In each example, the following facts exist:
- All employees of the employer are eligible to participate in the PTO plan on substantially the same terms and conditions
- The PTO plan qualifies as a bona fide sick and vacation leave plan for purposes of Section 409A of the Internal Revenue Code (the “Code”) and Treasury Regulations section 1.409A–1(a)(5)
- All payments for PTO (whether paid for used or unused time off) are made from the general assets of the employer
- For purposes of the contribution of unused PTO at termination of employment, the payments under the PTO plan constitute payment for unused accrued bona fide sick, vacation or other leave for purposes of Treasury Regulations section 1.415(c)–2(e)(3)(iii)(A), i.e., the employee would have been entitled to use the leave in the event employment had continued
Nonelective Contribution of Unused PTO
Under the nonelective structures described in the rulings, the PTO plan and the profit sharing plan provide that, for the annual contribution structure, at the end of the plan year an amount equal to the dollar equivalent of any unused PTO that is not eligible to be carried over to the next year shall be contributed to the profit sharing plan. In the case of contribution at termination of employment, the PTO plan and the profit sharing plan provide that an amount equal to the dollar equivalent of any unused PTO at the time of termination shall be contributed to the profit sharing plan.
Contributions of unused PTO that are structured to be employer nonelective contributions must, in combination with other contributions and forfeitures allocated for the year, satisfy the nondiscrimination requirements of Section 401(a)(4) of the Code. Because the PTO contributions will likely vary for each participant based on the amount of unused time off each participant has, it is not likely that the arrangement would satisfy a design-based safe harbor under Section 401(a)(4) of the Code, and nondiscrimination testing will generally be required. In addition, the contribution, when combined with all other annual additions for the year, must not exceed the limitation under Section 415 of the Code. To the extent the amount of unused PTO would cause the limits of Section 415 of the Code to be exceeded, the excess would be paid to the participant in cash rather than contributed to the profit sharing plan.
Elective Contribution of Unused PTO
Under this plan design, participants are given the opportunity to make an election under a 401(k) plan to defer the dollar equivalent of any unused PTO at the end of a year, or upon termination of employment. Any amounts contributed in this arrangement are subject to the same withdrawal restrictions as regular salary deferrals. These contributions are also taken into consideration for the annual ADP test, and are subject to the limitations of Sections 402(g) and 415 of the Code.
While these rulings provide a valuable roadmap for employers wishing to implement a method for employees to contribute unused PTO to a profit sharing plan, there are several issues not addressed in the rulings. For instance, the guidance does not address whether or not the contribution of unused PTO is subject to FICA taxes. While employer nonelective contributions are exempt from FICA taxes, the cash-out of unused PTO is not exempt from FICA. In the absence of further guidance from the IRS, it is reasonable to conclude that the contribution of the cash equivalent of unused PTO to a qualified profit sharing plan should be treated in the same manner as any other nonelective contribution, and should therefore be exempt from FICA.
The rulings only address federal income tax laws, and do not provide any guidance for complying with any particular state laws governing PTO plans. Before adopting plan amendments to require or permit the contribution of unused PTO, an employer should analyze the consequences of any applicable state laws governing PTO.
More Guidance on Automatic Contribution Increases under Automatic Contribution Arrangements
In our April 2009 issue, we discuss the final regulations governing automatic contribution arrangements and, in particular, the uniformity requirement applicable to an eligible automatic contributions arrangement (“EACA”) and a qualified automatic contribution arrangement (“QACA”). The final regulations clarified that a mid-year escalation (e.g., from 3% to 4% deferral rate) did not run afoul of the uniformity rule as long as the application of the escalation is uniform. The clarification was requested by employers who indicated a desire to time escalation of deferral rates to salary increases that may occur mid-year.
In Revenue Ruling 2009–30 the IRS provides examples of how the escalation of deferral rates can be structured in light of the regulations. The first example involves an automatic increase structure for a plan that has a basic automatic contribution arrangement (“ACA”). Because the regulations governing ACAs do not contain a uniformity requirement, there is a good deal of flexibility in how automatic increases may be structured. In the example, automatic contribution increases occur at the time an employee receives a pay increase on the employee’s employment anniversary date. Further, the amount of the increase in the contribution rate is a formula tied to the amount of the pay increase received by the employee. The IRS notes that while this structure is not uniform with respect to all eligible employees, because it is an ACA, and not an EACA or a QACA, the nonuniformity is permissible.
The second example describes how an automatic increase feature can be structured for an EACA or a QACA. In the example, the employer provides an annual pay increase for its employees effective for the first pay period beginning on or after April 1 each year. For plan years after the first plan year of the eligible employee’s participation in the automatic contribution arrangement, the default contribution percentage is automatically increased on the date of the annual pay increase. The increase in the default contribution percentage is equal to 1%, subject to a 10% maximum default contribution percentage. The IRS explains that the increases described are eligible for an exception to the uniformity requirement because they apply in the same manner to all eligible employees for whom the same number of years have elapsed since default contributions were first made for them under the automatic contribution arrangement.
Sample Amendments for Addition of an Automatic Enrollment Feature to a 401(k) Plan
The IRS further eased the process for adding an automatic enrollment feature to an existing 401(k) plan by providing sample amendments in Notice 2009–65. Plan sponsors are not required to adopt the amendment verbatim and, in fact, the IRS notes that modifications may be necessary to properly reflect a plan’s desired administrative procedures. Two sample amendments are provided; one for an ACA, and one for an EACA.
New Safe Harbor Rollover Notice
In Notice 2009–68 the IRS provided two new safe harbor explanations that a plan sponsor can provide to participants who receive an eligible rollover distribution from a qualified plan. The new notices satisfy the requirements of Section 402(f) of the Code and describe the rollover rules and the tax treatment applicable to these distributions. One safe harbor explanation applies to an eligible rollover distribution that is not from a designated Roth account. The other safe harbor explanation applies to an eligible rollover distribution from a designated Roth account. Prior to Notice 2009-68, safe harbor explanations were last published in Notice 2002–3. The new safe harbor explanations reflect changes to the law since the earlier publication and also present the required information in a simpler manner than the older explanations.