The regulations add specific rules regarding when amounts received following severance from employment are considered compensation for purposes of Section 415 and when such amounts may be deferred to Section 401(k), 403(b) or eligible 457(b) plans. (The Section 403(b) provisions will be also incorporated into the final Section 403(b) Regulations, when they are ultimately released. The rumor currently circulating is June of 2007, however, we had previously heard June 2006 and it didn't happen so who knows.)

Specific Provisions of the Regulations

Annual additions to defined contribution plans (§1.415(c)-1)
Annual additions to a defined contribution plan may not exceed the lesser of $40,000, (as adjusted for inflation) or 100 percent of the participant's compensation for the limitation year. The limit for years ending in 2007 is $45,000. The term “annual additions” generally means the sum of employer contributions, employee contributions, and forfeitures allocated in the limitation year. This limitation also applies to Section 403(b) annuity arrangements, SEPs, mandatory employee contributions to qualified defined benefit plans, and contributions to certain medical benefit accounts.

Restorative payment issues clarified
The regulations provide that a restorative payment that is allocated to a participant's account will not be treated as an annual addition. Restorative payments are defined as payments that are made to restore some or all of a plan's losses due to an action (or a failure to act) of a fiduciary that creates a reasonable risk of liability for such a breach under Title I of ERISA or under another applicable federal or state law. The regulations specifically list certain payments that satisfy this rule. Examples include payments made pursuant to a Department of Labor order or court approved settlement or payments made pursuant to the DOL's Voluntary Fiduciary Correction Program (VFCP) to restore losses to a qualified defined contribution plan on account of a breach of fiduciary duty.

The final regulations also provide that the IRS Commissioner may determine, based on facts and circumstances, that certain transactions between the plan and the employer, or certain allocations to participants' accounts may result in annual additions. For example, an employer's or other party's payment to a plan to make up for losses resulting from market fluctuations or other payments, but not made on account of a reasonable risk of liability for breach of a fiduciary duty will be treated as a contribution that creates annual additions. This may commonly occur in situations where an employer attempts to make participants whole for “back-end” fees or commissions charged against participant accounts when the plan leaves an investment provider.

Contribution Timing
For taxable employers, these regulations retain the rule that an employer contribution is not treated as credited to a participant's account for the limitation year unless the contribution is actually made to the plan no later than 30 days after the end of the tax filing deadline plus extensions for the taxable year -- with or within which the particular limitation year ends.

Correction of Excess Annual Additions
As with the proposed regulations, these regulations do not specify the correction methods for excess annual additions. The prior acceptable correction methods include reallocating excess annual additions to other participants, using suspense accounts or distributing employee contributions.

These methods are generally permitted under the Employee Plans Compliance Resolution System (EPCRS). In section 2.02(2) of Rev. Proc. 2006-27, comments were requested on whether the correction methods, including the maintenance of suspense accounts, should be retained as options under EPCRS. Until future guidance is released, plans eligible for the Self-Correction Program may implement corrections using these methods, but only if the requirements of section 9 of Rev. Proc. 2006-27 are satisfied. Such corrections will be taken into account for purposes of EPCRS's Voluntary Correction and Audit Closing Agreement Programs.

Definition of compensation (§1.415(c)-2)

Post-severance payment issues
The final regulations reflect a number of statutory changes to Section 415(c)(3), which defines compensation, made after the 1981 regulations were issued. Among these changes are the inclusion in the definition of compensation of certain deemed amounts for disabled participants, nontaxable elective deferrals to Section 401(k), 403(b), and 457 plans, pre-tax cafeteria plan elections, and qualified transportation fringe elections under Section 132(f)(4).

The proposed regulations provided specific guidelines regarding when amounts received after severance from employment would be considered compensation for 415 purposes. Under the proposal, post-severance payments are included in “compensation” if they were paid within 2 ½ months following severance from employment and they were either (1) payments that would have been paid to the employee had the employee continued in employment with the employer and were regular compensation for services during the employee's regular working hours, compensation for services outside the employee's regular working hours (such as overtime or shift differential), commissions, bonuses, or other similar compensation; or (2) payments for accrued bona fide sick, vacation, or other leave, if the employee would have been able to use the leave if employment had continued.

The final regulations add a new concept to the deadline for making post-severance payments. For retirement plan purposes, post-severance payments must be made by the later of 2½ months after the severance from employment or by the end of the limitation year that includes the date of severance from employment. In addition, a governmental plan may provide that the calendar year that includes the date of severance from employment be substituted for the limitation year that includes the date of severance from employment for this purpose. Unlike payments for vacations and sick leave (which are discussed below), under the final regulations, ”regular” compensation amounts are automatically included in the definition of compensation if paid within the appropriate time frame. (The proposal implied the need for the employer to elect this as an option in a plan.)

MHC Comment: This change may potentially result in administrative burdens especially if the payments are received in the next plan year. There are also potential discrimination issues when testing includable compensation if these amounts are kept out of the plan. Given the IRS's previous position that post-severance payments should never count, retaining the election would have been more sensible.

However, post-severance payments of accrued bona fide sick, vacation, and other leave that are paid within the above timeframe are not included in compensation for plan purposes unless the plan specifically includes such payments.

Election to include compensation paid by a nonqualified plan
Under the final regulations, for the first time, a plan may elect to include a post-severance payment from a nonqualified unfunded deferred compensation plan in compensation. Such payment must be made by the later of 2 ½ months after the severance from employment or the end of the limitation year that includes the date of severance, and must be the type that would have been distributed at the same time had the employee continued employment. Finally, it will be taken into consideration only to the extent the payment is includible in the employee's gross income. Since under normal rules, nonqualified plans only benefit a select group of management and highly compensated employees, this was an unexpected benefit.

Coordination with USERRA
The general rule excluding post-severance payments from compensation also will not apply to payments to an individual who is not currently performing services for the employer by reason of qualified military service (as defined in Section 414(u)(1) (this concept is known as differential pay). This exception applies to the extent such payments do not exceed the amounts the individual would have received had the individual continued to perform services for the employer, rather than entering qualified military service.

Coordination with 401(k) and 457 Rules
The final regulations also amend the 401(k) and 457 regulations to mandate that post-severance payments may only be deferred to the extent they are deemed compensation under Section 415.

Coordination with Section 401(a)(17)
The final regulations provide that a plan cannot take into consideration compensation in excess of the maximum compensation limit ($225,000 in 2007). This has created a problem impacting elective deferral elections based on a percentage of compensation for participants who exceed the limit mid year. The final regulations do not require a plan to determine a participant's compensation on the basis of the earliest payments of compensation during a year. Thus, a participant could still defer out of their bonus as opposed to earlier payments of compensation or continue to make deferrals throughout the plan year.