Differential Pay as Plan Compensation
Rev. 09/03/09; E-mail Alert 2009-14

A differential wage payment is defined as any payment which:
“…(A) is made by an employer to an individual with respect to any period during which the individual is performing service in the uniformed services (as defined in USERRA) while on active duty for a period of more than 30 days, and
(B) represents all or a portion of the wages the individual would have received from the employer if the individual were performing service for the employer.’’

Essentially, the employer pays the difference between the amount of the military pay and what the employee was making on the job. For example, if an individual was being paid $50,000 before being called into active military service and the employer decided to pay the individual the difference between the $50,000 and the amount the individual is receiving from the military, the amount the employer pays is called differential pay. Employers are not required to offer differential pay; it is a voluntary payment.

Prior to the HEART Act being introduced, the IRS viewed differential pay not as wages but as supplemental income.  This type of income was reported on a Form 1099-MISC, and employers had the option of treating these amounts as being eligible retirement plan compensation.    Effective with 2009, differential pay will be subject to withholding (under Code Section 3401) and reported as W-2 income.

Section 105 of the HEART Act created IRC Code Section 3401(h) requiring all differential pay that is paid after December 31, 2008 to be treated as W-2 wages, subject to Federal income tax withholding purposes.  New Code Section 414(u)(12) provides for qualified plan contributions to be made on differential pay, and that these amounts are to be treated as if the individual were an employee of the employer making the payment.  As a result, an employee can make elective deferrals on differential pay and employers will need to offer matching contributions and/or non-elective contributions (if applicable).  The HEART Act ensures that a retirement plan will not be in violation of discrimination rules by providing additional benefits to these members of the military, however, an employer must ensure that differential wage payments are made on a nondiscriminatory basis.  Plans that are members of a controlled group should also confirm that all members of the group are following the same methodology regarding differential wage payments.

Of note is that the IRS is offering a tax incentive to small employers based on differential pay from June 17, 2008 to December 31, 2009.  Employers with less than 50 employees are eligible for a tax credit of 20% of the eligible differential wage payments for each qualified employee up to $4,000.

To reiterate the key point, any differential wage payment shall be treated as a payment of wages by the employer to the employee for remunerations paid after December 31, 2008.

Below for reference is Section 105 of the HEART Act on the Treatment of Differential Pay as Wages

Bill Grossman, ERPA, QPA

HEART ACT SEC. 105. TREATMENT OF DIFFERENTIAL MILITARY PAY AS WAGES.

(a) INCOME TAX WITHHOLDING ON DIFFERENTIAL WAGE PAYMENTS.—

(1) IN GENERAL.—Section 3401 (relating to definitions) is amended by adding at the end the following new subsection:

‘‘(h) DIFFERENTIAL WAGE PAYMENTS TO ACTIVE DUTY MEMBERS OF THE UNIFORMED SERVICES.—
‘‘(1) IN GENERAL.—For purposes of subsection (a), any differential wage payment shall be treated as a payment of wages by the employer to the employee.

‘‘(2) DIFFERENTIAL WAGE PAYMENT.—For purposes of paragraph (1), the term ‘differential wage payment’ means any payment which—
‘‘(A) is made by an employer to an individual with respect to any period during which the individual is performing service in the uniformed services (as defined in chapter 43 of title 38, United States Code) while on active duty for a period of more than 30 days, and
‘‘(B) represents all or a portion of the wages the individual would have received from the employer if the individual were performing service for the employer.’’

(2) EFFECTIVE DATE.—The amendment made by this subsection shall apply to remuneration paid after December 31, 2008.

(b) TREATMENT OF DIFFERENTIAL WAGE PAYMENTS FOR RETIREMENT PLAN PURPOSES.—
(1) PENSION PLANS.—

(A) IN GENERAL.—Section 414(u) (relating to special rules relating to veterans’ reemployment rights under USERRA), as amended by section 103(b), is amended by adding at the end the following new paragraph:

‘‘(12) TREATMENT OF DIFFERENTIAL WAGE PAYMENTS.—
‘‘(A) IN GENERAL.—Except as provided in this paragraph, for purposes of applying this title to a retirement plan to which this subsection applies—
‘‘(i) an individual receiving a differential wage payment shall be treated as an employee of the employer making the payment,
‘‘(ii) the differential wage payment shall be treated as compensation, and
‘‘(iii) the plan shall not be treated as failing to meet the requirements of any provision described in paragraph (1)(C) by reason of any contribution or benefit which is based on the differential wage payment.
‘‘(B) SPECIAL RULE FOR DISTRIBUTIONS.—
‘‘(i) IN GENERAL.—Notwithstanding subparagraph (A)(i), for purposes of section 401(k)(2)(B)(i)(I), 403(b)(7)(A)(ii), 403(b)(11)(A), or 457(d)(1)(A)(ii), an individual shall be treated as having been severed from employment during any period the individual is performing service in the uniformed services described in section 3401(h)(2)(A).
‘‘(ii) LIMITATION.—If an individual elects to receive a distribution by reason of clause (i), the plan shall provide that the individual may not make an elective deferral or employee contribution during the 6-month
period beginning on the date of the distribution.
‘‘(C) NONDISCRIMINATION REQUIREMENT.—Subparagraph (A)(iii) shall apply  only if all employees of an employer (as determined under subsections (b), (c), (m), and (o)) performing service in the uniformed services described in section 3401(h)(2)(A) are entitled to receive differential wage payments on reasonably equivalent terms and, if eligible to participate in a retirement plan maintained by the employer, to make contributions based on the payments on reasonably equivalent terms. For purposes of applying this subparagraph, the provisions of paragraphs (3), (4), and (5) of section 410(b) shall apply.
‘‘(D) DIFFERENTIAL WAGE PAYMENT.—For purposes of this paragraph, the term ‘differential wage payment’ has the meaning given such term by section 3401(h)(2).’’.

(B) CONFORMING AMENDMENT.—The heading for section 414(u) is amended by inserting ‘‘AND TO DIFFERENTIAL WAGE PAYMENTS TO MEMBERS ON ACTIVE DUTY’’ after ‘‘USERRA’’.

(2) DIFFERENTIAL WAGE PAYMENTS TREATED AS COMPENSATION FOR INDIVIDUAL RETIREMENT PLANS.—Section 219(f)(1) (defining compensation) is amended by adding at the end the following new sentence: ‘‘The term compensation includes any differential wage payment (as defined in section 3401(h)(2)).’’.

(3) EFFECTIVE DATE.—The amendments made by this subsection shall apply to years beginning after December 31, 2008.

(c) PROVISIONS RELATING TO PLAN AMENDMENTS.—
(1) IN GENERAL.—If this subsection applies to any plan or annuity contract amendment, such plan or contract shall be treated as being operated in accordance with the terms of the plan or contract  during the period described in paragraph (2)(B)(i).
(2) AMENDMENTS TO WHICH SECTION APPLIES.—

(A) IN GENERAL.—This subsection shall apply to any amendment to any plan or annuity  contract which is made—
(i) pursuant to any amendment made by subsection (b)(1), and
(ii) on or before the last day of the first plan year beginning on or after January 1, 2010. In the case of a governmental plan (as defined in section 414(d) of the Internal Revenue Code of 1986), this subparagraph shall be applied by substituting ‘‘2012’’ for ‘‘2010’’ in clause (ii).
(B) CONDITIONS.—This subsection shall not apply to any plan or annuity contract amendment unless—
(i) during the period beginning on the date the amendment described in subparagraph (A)(i) takes effect and ending on the date described in subparagraph (A)(ii) (or, if earlier, the date the plan or contract amendment is adopted), the plan or contract is operated as if such plan or contract amendment were in effect, and
(ii) such plan or contract amendment applies retroactively for such period.

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