Deferring Vacation Pay Into a 401(k) Plan


Employee benefits-related topics are fairly regular features in the Wall Street Journal, but it isn't often that one is so hot that it makes the Today show. In December, 1996, those and various other news outlets latched onto a year-old IRS Technical Advice Memorandum and billed the arrangement as a way to contribute unused vacation pay into a 401(k) plan and make an end run around the $9500 current annual limit on pre-tax 401(k) deferrals.

On closer scrutiny the TAM looks more like a quarterback sack than an end run. To be in the same ballpark with the company that got the favorable TAM, a company's vacation policy must be of the use-it-or-lose-it variety.

Next, the employer will have to incur the expense and effort of subjecting the vacation pay contributions to required complex and stringent compliance tests. This article asserts that in most cases, it is likely those tests will not be met and can only be met by the requiring the employer to contribute still more money out of its till to the 401(k) plan.

The TAM

Company A had a use-it-or-lose-it vacation policy. In other words, if employees did not take all of the vacation they accrued for the year, that vacation would be forfeited. Company A also had a qualified plan that included a cash-or-deferred arrangement ("CODA"). For an 11-year period, ending in 1991, the plan permitted employees who did not take vacation they accrued and would otherwise forfeit it to elect to have all or a portion of the pay for this vacation (except for the first two weeks' worth) contributed to the 401(k) plan.

Company A asked whether the pay contributed to the 401(k) plan was subject to FICA tax under section 3121 of the Internal Revenue Code (the "Code"). In TAM 9635002, the IRS concluded that the contributions were not subject to FICA tax.

To reach that conclusion, the IRS had to conclude that the contribution was not made under a CODA, because Code section 3121(v)(1)(A) provides that contributions to a 401(k) plan made under a CODA do constitute FICA wages.

IRS Conclusion and Basis

The IRS' conclusion was completely dependent upon the fact that Company A's vacation policy was a use-it-or-lose-it policy. Employees could only contribute pay for vacation they had forfeited, and if they did not defer the pay, they would not have been entitled to take the vacation or to receive compensatory pay.

Under Code section 401(k)(2)(A), a CODA involves a choice between the contribution and cash. Since the employees in this case had no option to receive anything if they did not elect the contribution, the IRS concluded that the contribution was not made under a CODA. Instead, the IRS concluded that the contribution was an employer nonelective contribution, which is not subject to FICA tax.

The TAM and the 402(g) Limit

The TAM says nothing about the limit on elective deferrals under Code section 402(g), which is $9500 for 1996. However, since Code section 402(g), by its terms, applies to contributions made to a 401(k) plan under a CODA, it is reasonable to conclude that the IRS, if asked, would have been compelled to agree that the 402(g) limit would not have applied to the vacation pay contributed to the plan by Company A.

The news reports take this reasonable conclusion too far, however, because they do not examine the underpinnings of the TAM and the consequences of the IRS conclusion that the vacation pay contributions are employer nonelective contributions.

Vacation Pay Must Be Forfeitable

As noted above, the linchpin reason why the IRS concluded that contributions of vacation pay to the 401(k) plan were not elective deferrals made under a CODA was that the vacation pay would have been forfeited otherwise. For another company even to consider this strategy, then, its vacation policy must provide for the forfeiture of pay for unused vacation.

If the company's policy permits employees to defer unused vacation they have accrued, or to receive compensatory pay or other benefits for the accrued vacation, then the analysis of the TAM is completely inapplicable. In that type of arrangement, the contribution of accrued vacation pay to the 401(k) plan would involve a choice between the deferral and cash or another taxable benefit (i.e., the future vacation or compensatory pay). Therefore, the contribution would be made under a CODA and would be subject to FICA tax and the section 402(g) dollar limit on elective deferrals.

Changing the Company's Vacation Policy

Changing the company's vacation policy to a use-it-or-lose-it policy to take advantage of the retirement planning opportunity would likely be an employee relations disaster and, in the collective-bargaining context, probably a pipe dream. What is more, instituting vacation forfeitures would be impossible in some states, such as California, that outlaw forfeiture of accrued vacation.

Some companies use vacation accrual caps, rather than forfeitures. The accrual cap is particularly common in states that outlaw forfeitures. Under the accrual cap approach, once an employee reaches an employer-defined accrual limit (150% or 200% of the annual accrual, for example), further accrual stops until he or she takes some of the already-accrued vacation.

For example, assume an employee accrues three weeks of vacation per year (ratably per month) and has an accrual cap of six weeks. If the employee does not take vacation for two years, s/he will have accrued six weeks of vacation, the cap amount, and will lose out on each month's new accrual until s/he takes some of the already-accrued vacation. Let's say he or she waits for five months after hitting the six weeks maximum of accrued vacation before taking two weeks of vacation.

In that case, the five months of vacation that would normally have accrued will not accrue. Accruals will only recommence for months after the date when he or she takes the two weeks of vacation and, by doing so, frees up room for accrual under the cap.

Might an employee be able to defer pay for vacation that cannot accrue because of a company's accrual cap and get the same tax treatment as the contribution in the TAM? It seems highly unlikely because, simply by taking some vacation, the employee would make room to accrue the vacation, which would then become nonforfeitable. Those facts would likely compel the IRS to conclude that the contribution was being made under a CODA.

If the employer actually does have forfeitable vacation, the next hurdle to adopting the TAM strategy is satisfying nondiscrimination compliance requirements.

The Amount of the Vacation Pay Contributions Must Satisfy Code Section 401(a)(4)

The TAM noted that the vacation pay contribution constituted a "nonelective employer contribution." Under Code section 401(a)(4), contributions provided under a qualified plan must not discriminate in favor of highly compensated employees ("HCEs").

Treasury Regulation section 1.401(a)(4)-2 describes the tests for demonstrating nondiscrimination in the amount of contributions under a defined contribution plan. There are safe-harbor provisions in this regulation that obviate the running of tests, but none of the safe harbors would apply to the payment of forfeited vacation into a plan.

The safe harbors not only require a uniform formula that allocates the same percentage of compensation, dollars or dollar amount per unit of service or age-and-service unit for each employee; they also require that nearly all plan participants actually receive the allocation.

If no safe harbor is available, contributions must satisfy the general test set forth in Treasury Regulation section 1.401(a)(4)-2(c). To satisfy the general test, each "rate group" must satisfy the minimum coverage requirements of Code section 410(b). A "rate group" must be made up for each HCE, which rate group also comprises each other participant who has an allocation rate that is at least equal to the HCE's allocation rate. Each participant's "allocation rate" is his or her allocation of contributions for the year, expressed either as a percentage of compensation or a dollar amount.

The General Test of Code section 401(a)(4)

Once each participant's allocation rate is determined, the rate groups are formed and each rate group is subjected to minimum coverage testing. Using the relatively simple ratio percentage test of compliance with Code section 410(b), the nonhighly compensated employee ("NCE") benefitting percentage for each rate group would have to be at least 70% of the HCE benefiting percentage.

The NCE benefiting percentage for a rate group would be the ratio of NCEs in the rate group to all NCEs in the employer's controlled group of companies (other than the "statutory exclusions"; i.e., those who are under 21, have less than a year of service, are nonresident aliens with no U.S.-source income or who are collectively-bargained employees).

The HCE benefiting percentage would be determined in the same way, with respect to HCEs in the rate group and the controlled group.

If HCEs are significantly more likely than NCEs not to use up all of their vacation (which is a safe assumption for most companies), then a plan is not at all likely to have all of its rate groups meet the ratio percentage test of Code section 410(b). Even if the employer were to limit the amount of vacation pay that could be contributed to the plan, so that HCEs were not able to contribute amounts in excess of amounts contributed by NCEs, it is still unlikely that the test could be met, for the reason that the test that applies to each rate group is the minimum coverage test---fundamentally a head-counting type of test. As long as a greater percentage of HCEs than NCEs tend not to use their vacation, this head-counting test will not be met.

The Average Benefit Test Alternative

If rate groups cannot meet the ratio percentage test of Code section 410(b), an alternative is to meet the average benefit test of Code section 410(b)(2). This test has two components: a nondiscriminatory classification test and an average benefit percentage test. The nondiscriminatory classification test applies to each rate group in the same fashion as the ratio percentage test would apply, but the passing ratio percentage is lower than 70%. (Reg. ' 1.410(b)-4.)

The passing ratio percentage varies, depending upon what percentage of the employer's controlled-group workforce consists of NCEs, but it will range from a high of 45% (if 60% or less of the workforce is NCEs) to a low of just over 20% (if 99% of the workforce is NCEs).

The lower passing percentage for the nondiscriminatory classification test makes it easier to satisfy than the ratio percentage test, but it is still fundamentally a head-counting test and could still be failed if vacation contributions are concentrated among the HCE group.

Each rate group is deemed to satisfy the second component of the average benefit test, the average benefit percentage test, if the plan as a whole satisfies this test. (See Treasury Regulation section 1.401(a)(4)-2(c)(iii)) It is beyond the scope of this article to describe the average benefit percentage test in detail.

Simply put, the average benefit percentage test requires the employer to express all employer-provided contributions and benefits as a percentage of each employee's compensation, and then to determine an average benefits percentage for the HCE group and then for the NCE group.

The average benefit percentage of the NCE group must be at least 70% of the average benefit percentage of the HCE group for the test to be satisfied. The test can be applied to a single plan or to aggregated plans.

Advantage of Average Benefit Percentage Test

The advantage of the average benefit percentage test over the rate group testing component of the section 401(a)(4) general test is that the former test lacks the head-counting element of the latter. That would tend to make it more likely that compliance testing might be satisfied by limiting the amount of vacation that HCEs could contribute to the plan, so long as the somewhat less stringent head-counting requirement of the nondiscriminatory classification test hurdle is passed.

As one final compliance-testing hurdle, the option to contribute unused vacation is a right that must also be available to a group of employees that satisfies the ratio percentage test of Code section 410(b). (See Treasury Regulation section 1.410(a)(4)-4)

It is not entirely clear how to define the group of employees to whom this option is available, but the most likely reading of the regulation is that the group is those employees who end the year with forfeitable vacation.

If so, this is another head-counting type of test that is likely to be failed so long as the HCE group is more likely than the NCE group not to use all of its vacation. The consequence of failing this availability test is that Code section 401(a)(4) is not satisfied.

Conclusion

By this time, it should be clear that the consequence of having vacation pay contributions characterized as nonelective employer contributions is having to satisfy an extremely complex and stringent nondiscrimination testing regime. Employers who must turn to third parties to perform the section 401(a)(4) general test will find that this is an expensive proposition.

Worst of all, if section 401(a)(4) testing is failed, refunds and/or forfeitures will not cure the failure the way they do under ADP/ACP testing. Instead, failure of the section 401(a)(4) nondiscrimination tests can be cured only by having the employer make additional, fully vested, contributions in an amount sufficient to pass the tests.

An employer that decides to adopt vacation pay contributions will already have decided to incur the cost of making the contributions, instead of enjoying the benefit to the company of the forfeitures. It seems unlikely that many employers will also be willing to bear the additional expense of compliance testing, the inability to predict from year to year whether compliance testing can be satisfied and, if it is not, the further expense of making additional contributions to cure the test failure.

Perhaps the only situation in which the vacation pay contribution option works is for the employer willing to restrict the option to the NCE group. This design seems unlikely since, in the author's experience, it is the more highly-paid members of the workforce who have been pressuring their employers to adopt the option.

But the compensation threshold for determining HCE status is being raised to $80,000 for 1997, and there may be some relatively small employers who will then be left with few or even no HCEs and will, therefore, be candidates for an NCE-only vacation pay contribution option if they happen to have NCEs interested in it.