CHAPTER 17

Fringe Benefits

INTRODUCTION

The employment relationship not only provides compensation to employees by way of salary, but it may include many additional or fringe benefits as well. In this chapter, we will discuss some of the more common fringe benefits that may be available today. Because technology and the law continue to expand, opportunities frequently change and possible benefits regularly evolve. The items discussed in this chapter are merely a starting point, and employers as well as employees should determine what additional fringe benefits are available on a regular basis. Once a new opportunity is identified, then the parties should determine whether it can be added to the employment relationship, and, if so, how that modification can be worked out.

RETIREMENT PLANS

One of the most important fringe benefits for employees is a retirement plan. These plans provide employees with ongoing support after they retire. A retirement plan is a written savings program. If the plan meets specific rules and regulations, then it is called a qualified plan. This means contributions are tax-deductible to some extent for the person or the business making the investments. Income taxes on the investment earnings are delayed until benefits are paid to participants. A qualified plan is one of the last remaining legal tax shelters available to highly compensated individuals. It may be used to set aside funds for retirement and to attract and retain key employees. If properly structured and invested on a prudent basis with a diversified portfolio of investments, the plan should provide financial security for the individual’s retirement.

Since 1982, federal tax laws have allowed unincorporated businesses the same status as corporations with regard to qualified retirement plans. Further, this same legislation eliminated the need for a corporate trustee (who was approved by the Internal Revenue Service), thus allowing the self-employed person to be the trustee of their own plan.

IN PLAIN ENGLISH

When choosing a plan, employers should consider the needs of both the company and the employees.

There are essentially two types of qualified plans—defined benefit and defined contribution.

Defined Benefit Plans

Contributions to a defined benefit plan are determined by a relatively complex formula and are then monitored by an enrolled actuary. The promised benefit is not to exceed the lesser of 100 percent of the employee’s annual average income for the three highest-salaried consecutive years or a specified amount that is adjusted annually and dependent on changes in the Consumer Price Index. For the current permissible amount, see the IRS website at www.irs.gov. Excess earnings (investment income greater than the assumptions made by the actuary) are used to reduce the cost of contributions to the plan by the employer.

Advantages

Normally, defined benefit plans are appropriate where the business owner is mature, with less than ten to fifteen working years until retirement. Defined benefit plans are appropriate—and potentially beneficial—for businesses that have enjoyed considerable financial success with limited fluctuations in cash flow. The defined benefit plan can be designed to drain excess funds and allocate them to retirement on behalf of the senior preferred participant (the principal owner). In many instances, this same advantage can be attained through the use of an age-weighted defined contribution plan, such as a profit-sharing or target-benefit plan.

Defined Contribution Plans

In a defined contribution plan, the contribution on behalf of the participant is defined and is usually either a discretionary amount or a percentage of their annual compensation (ignoring compensation in excess of $220,000). The benefit that will be available to the participant at retirement is not defined. Investment earnings increase the retirement benefit for the plan participants, and the longer the period over which investments are accumulated and interest is earned, the greater the amount of benefits that will be available to the participants at retirement.

IN PLAIN ENGLISH

A major difference between a defined contribution plan and a defined benefit plan is who bears the risk of poor investment performance. The employer bears the risk in defined benefit plans, whereas participants bear this risk in defined contribution plans.

Profit-sharing plans, money-purchase plans, and salary savings or reduction plans, such as 401(k)s and SIMPLE plans, are all defined contribution plans, as are Simplified Employee Pension Plans (SEPs) and Employee Stock Ownership Plans (ESOPs).

Profit-Sharing Plans

If the income from a business varies significantly from year to year, a profit-sharing plan may be the most appropriate type of plan to offer employees. Contributions may be determined at or after the end of the tax year. Contributions to the plan can be determined by a vote of a business’s management (i.e., managing partners or the board of directors) or by a formula previously designated in the plan’s documents. It is no longer required that business entities, such as corporations or certain types of LLCs, actually have a profit in order to make a contribution. The maximum deductible contribution to a profit-sharing plan is now 25 percent of an employee’s annual compensation, with each participant’s total annual addition limited to $44,000 per year.

Salary Savings/Reduction Plans

These plans, which include 401(k)s, are a variant of profit-sharing plans. Under this type of plan, the employee elects to have a percentage of their gross salary diverted into a qualified plan. Employees can have a choice of saving on a tax-deferred basis or by making after-tax Roth contributions that may eventually qualify for tax-free withdrawal. Depending on the plan, the employer may elect to match all or a portion of the contributions made by the employee. Usually, the amount of the matching contribution has a self-imposed percentage limit.

The main feature of salary savings/reduction plans is that a portion of the cost shifts from the employer to the employee. The business, therefore, makes less of a cash contribution.

A major drawback is the limitation of contributions by highly compensated employees. The maximum contributions allowable continuously change and can be found on the IRS website at www.irs.gov. In addition, owners and highly compensated employees may not be allowed to save the maximum amount if the savings rate of the other employees is too low. They are generally allowed to save about 2 percent of compensation more than the average of the non-highly compensated employees. To avoid being limited by this restriction, you may consider a safe harbor 401(k) plan that requires advance notice to participants and a nonforfeitable employer contribution.

A new approach to dealing with low savings rates of rank-and-file employees is called “automatic enrollment.” Instead of being asked how much they want to save, they are informed that they will be saving at a plan-prescribed rate unless they elect otherwise. A year later, the plan’s “automatic escalation” feature kicks in to raise their savings rate unless they act. Studies have proven that this “inertia” approach increases the overall savings rate substantially.

Simplified Employee Pension Plans

These plans are often viewed incorrectly as an alternative to the more highly structured qualified plans. The maximum contribution that the employer may contribute per participant to a SEP continues to change and can be found on the IRS website at www.irs.gov. Contributions are based on an equal percentage of annual salary for all employees twenty-one years or older who have performed service for the employer during at least three out of five years and have received a salary specified by the tax laws. You should also consult the IRS website for the current salary range. Although its low maintenance cost is an initial attraction, its simplicity results in a significant inflexibility that many employers are not willing to accept. For example, those whose employment has been terminated must share in any contribution and all contributions are 100 percent vested and nonforfeitable. (Vesting is more thoroughly explained below.)

Simple IRAs

SAR/SEPs (Salary Reduction Simplified Employee Pension Plans) could no longer be created after December 31, 1996. Existing SAR/SEPs were grandfathered in and are allowed to exist until the employer terminates them. A new salary reduction plan called the SIMPLE IRA was introduced to replace the SAR/SEP. This plan is available to employers with up to one hundred employees. Employees are eligible if they earned at least $5,000 during any of the previous two years and are expected to earn at least $5,000 during the current year. These requirements can be reduced or eliminated if the employer waives them. The maximum employee contribution for 2006 is $10,000 for participants under the age of fifty and $12,500 for participants aged fifty or older. The employer is required to match up to 3 percent of the employee compensation. Vesting for the employer contributions is 100 percent and immediate.

Money-Purchase Plans

This type of defined contribution plan has a fixed funding requirement, such as 10 percent of compensation of all eligible participants. It also requires that participants be offered a qualified joint and survivor annuity as a form of benefit distribution. It has the same tax deduction and annual addition limits that apply to profit-sharing plans. Most new plan sponsors choose the profit-sharing plan instead. Many money-purchase plans have been converted to profit-sharing plans.

Employee Stock Ownership Plans

In an ESOP plan, the majority of the assets are shares of stock in the corporate plan sponsor. Generally, ESOPs are not useful for owners of small businesses.

Hybrid Plans

The target-benefit plan is receiving renewed interest as a result of changes in income tax law. This hybrid plan combines the contribution and benefit levels of a defined contribution plan with the recognition for mature employees found in defined benefit plans. Another hybrid, the age-weighted profit-sharing plan (AWPSP), is also available. As with the target-benefit plan, the contributions are weighted or skewed toward senior employees.

Designing and Documenting a Plan

The creation of a qualified plan requires the creation and adoption of a written plan document and trust agreement before the end of the first plan year. A summary plan description must also be drafted to inform participants about the plan. Documentation is available in two forms—prototype documents and individually drafted documents. Each form has its own advantages and limitations. It is, therefore, essential to work with an experienced professional when selecting and establishing a plan.

Employer-Sponsored Plans

Many qualified plans of small businesses are top heavy. This is a special status that results from key employees having more than 60 percent of the plan’s benefits. As a result, minimum contribution rules and faster vesting rules apply. The minimum contribution is the lesser of 3 percent of compensation or the highest rate allocated to a key employee. The vesting schedule options are a three-year cliff of a graded schedule of 20 percent per year from the second to the sixth year of employment.

Plans may be combined or stacked in order to more specifically meet the needs of the business. However, this creates a need for separate sets of rules and limitations. Stacking also increases the amount of administrative paperwork and forms, thus driving up the cost of operating and maintaining the plan. Fortunately, the need to stack plans was significantly reduced in 2002 when the deduction limit of profit-sharing plans was raised from 15 percent to 25 percent.

The design features outlined below can be used to limit or reduce the cost of rank-and-file employees in the employer-sponsored plan.

Vesting

A key element of any qualified plan is rewarding long-term service by employees. One method used to limit benefits for employees who have been employed for a relatively short period of time is by a vesting schedule that forfeits all or some of the participant’s employer-provided benefits. Vesting means having rights in, which is to say that the employee has the right to all or part of their benefits in the retirement plan.

Currently, there are two primary vesting schedule formulas.

1. Five-year cliff vesting. This schedule does not allow vesting for employees with less than five years of service. Upon completion of five years of service, the employee is 100 percent vested in all employer-provided benefits. When the plan is top-heavy, the longest permitted cliff vesting schedule is three years.

2. Three-to-seven-year graded vesting. This vesting schedule provides for 20 percent vesting after three years of employment and an additional 20 percent for each subsequent year. After completing seven years of employment, the employee is eligible to receive 100 percent of the employer-provided benefits upon termination of employment. When the plan is top-heavy, the graded schedule must start with the second year of employment rather than the third year.

Minimum Hours

The plan sponsor may limit the participation of employees by permanently excluding those who work fewer than one thousand hours per year and then by limiting each year’s contributions to those who have worked at least five hundred hours during the year. This feature is very important for businesses that use temporary employees.

Minimum Age

The plan sponsor may also limit participation of employees through the use of a minimum-age requirement. Current law allows an employer to postpone participation by employees under twenty-one years of age. At the time the employee reaches age twenty-one, they enter the plan and all of their years of employment are counted in the vesting formula.

Unions

Employees that are a part of a collective bargaining unit may be specifically excluded from participation in a qualified plan established by an employer for its nonunion employees, provided that retirement benefits were the subject of good-faith bargaining. (A more extensive discussion of unions is found in Chapter 4 and of collective bargaining agreements in Chapter 5.)

Integration with Social Security

This feature allows the plan sponsor to recognize contributions made on behalf of the employee to Social Security. An integrated plan (also referred to as allowing permitted disparity) has an extra contribution for those whose compensation is greater than the Social Security wage base.

Investments in a Qualified Plan

The primary governing law regarding investments made by a qualified plan comes from the Employee Retirement Income Security Act (ERISA). Under its Prudent Expert Investment Principle, investments should be made with primary consideration given to what an expert, rather than an amateur investor, would do.

There is a plethora of investment opportunities, including stocks, bonds, money market accounts, real estate, and partnership interests. Therefore, it is essential that you confer with a registered investment advisor or certified financial planner to structure your plan investments based on the plan’s goals, the economy, and other relevant factors.

HEALTH-CARE PLANS AND THE AFFORDABLE CARE ACT

Another extraordinarily important fringe benefit for employees is a medical plan. These plans can provide employees with the ability to obtain medical assistance for themselves or their families. Employees should determine which plan best serves their needs and those of their families. There are a host of different types of employment medical plans, as described below.

Health Maintenance Organizations (HMOs)

HMOs have a network of doctors, hospitals, and other health-care providers, who have agreed to accept payment at lower than market level to keep costs down for its members. Examples of HMOs are Cigna, Humana, and Kaiser Permanente.

Preferred Provider Organization (PPO)

A PPO is a medical care organization in which medical professionals and facilities provide services to insured individual at a lower cost. These professionals are known as preferred providers. This allows members of PPOs more flexibility in choosing their medical professionals. Examples of PPOs are Blue Cross Blue Shield, Aetna, and United Healthcare.

Health Savings Accounts (HSA)

These plans are used in conjunction with insurance policies that have high deductibles. These accounts have a tax advantage because they are not subject to federal income tax at the time of contribution. If the funds are not spent during the annual term, then those funds can be rolled over into the following year and used in that year. These funds can be used to pay for qualified medical expenses such as dental, vision, and chiropractic care. HSAs allow for insurance premiums to be lower by raising the deductible but still allow employees to seek care without overly worrying about the associated costs. These plans follow the employee; that is when an employee changes jobs, the plan permits the employee to take those benefits to the new job.

Health-care Reimbursement Arrangements (HRA)

An HRA is a benefit in which the employer can reimburse an employee’s out-of-pocket medical expenses up to a specified amount. These arrangements cannot be transferred after the employment relationship has ended. Starting in 2020, employers may offer an HRA in lieu of an insurance policy so that employees may purchase, with pretax dollars, their own individual health insurance. Employers that continue to offer traditional group health insurance can offer excepted benefit HRAs to reimburse employees up to $1,800 per year.

Consolidated Omnibus Budget Reconciliation Act (COBRA)

COBRA is a law that requires employer with more than twenty employees to provide employees with the opportunity to continue medical benefits after the employment terminates for a limited period. The employee must pay for these benefits, though it is common for employees to negotiate payment by the employer as part of a severance package.

Because the items discussed in this chapter vary from state to state and from employer to employer, it is essential for both employers and employees to work with experienced insurance agents so that the best arrangement can be adopted. Whether you are an employee or an employer, it is important for you to have the best benefits package available for your needs.

TIME OFF

Another benefit that is typically available is time off. This would include both paid and unpaid time off. The time off could be for specified holidays, sick days, special celebrations such as birthdays, vacation, family leave, and any other specified occasions for employees to have time off. The employee handbook discussed in Chapter 6 and the employment contract discussed in Chapter 3 should identify this benefit, spell out in detail the amount of time off available, whether it is paid, and when employees are entitled to enjoy this benefit.

Some of these items—for example, sick leave—are regulated by both state and federal law. The Family Medical Leave Act (FMLA) deals with serious medical issues and, as of the date of this writing, nine states and the District of Columbia provide for paid sick leave. Those states are Arizona, California, Connecticut, Maryland, Massachusetts, New Jersey, Oregon, Rhode Island, Vermont, and Washington. Because laws frequently change, it is important for you to determine what the rules are in your state.

Another important category is maternity and paternity leave, which may be available for new mothers and new fathers. In some situations, it also available for individuals who adopt children. FMLA provides for twelve weeks of leave, though it is unpaid. Some businesses may provide more by either paying for some or all of the time and some go so far as too extend the period. The employment handbook discussed in Chapter 6 and the employment contract discussed in Chapter 3 should address this benefit.

As of the date of this writing, five states and the District of Columbia require paid maternity and paternity leave. These states are California, New Jersey, New York, Rhode Island, and Washington. The US Congress has been considering legislation on this subject for some time. Because this is a very dynamic area, you should consult with an experienced attorney in order to determine whether your benefits comply with the law and are up to date.