Understanding SERPs Defined Benefit Plans and Defined Contribution

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Understanding SERPs, Defined Benefit Plans, and Defined Contribution Plans and how Ohio Municipal Income

Understanding SERPs, Defined Benefit Plans, and Defined Contribution Plans and how Ohio Municipal Income Tax Law Applies to Same Presented By: Jennifer Bibart Dunsizer David A. Froling 614 -464 -5631 | [email protected] com 614 -464 -3022 | [email protected] com Vorys, Sater, Seymour and Pease LLP © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 1

Overview • Summary of different types of deferred compensation arrangements. • Summary of Medicare

Overview • Summary of different types of deferred compensation arrangements. • Summary of Medicare (FICA) taxation timing. • Summary of the Federal Moving Statute (limiting when state and local jurisdictions can tax deferred compensation paid to nonresidents). • Overview of Am. Sub. H. B. 5, Mac. Donald, and proposed legislation following Mac. Donald. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 2

Summary of Different Types of Deferred Compensation • Different names: ― Deferred Compensation Plan;

Summary of Different Types of Deferred Compensation • Different names: ― Deferred Compensation Plan; ― Supplemental Executive Retirement Plan (SERP); Ø Mirror Plans or Excess Benefit Plans provide the benefits that would have been provided under a qualified plan but for IRS limits; other SERPs provide additional benefits; ― Top Hat Plan: an “unfunded” plan to provide deferred compensation to a select group of management or highly compensated employees; © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 3

Summary of Different Types of Deferred Compensation • Different names: ― 457(f) Plan: deferred

Summary of Different Types of Deferred Compensation • Different names: ― 457(f) Plan: deferred compensation for employees of a governmental (state or political subdivision or their agencies or instrumentalities) or tax exempt employer; ― Severance: amount payable after termination from employment: Ø May require “retirement” after meeting age and service criteria; Ø Without cause; Ø Condition payment on execution of release. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 4

Summary of Different Types of Deferred Compensation • Internal Revenue Code Section 409 A

Summary of Different Types of Deferred Compensation • Internal Revenue Code Section 409 A broadly defines “deferred compensation” as any amount that is earned based on performance of current services that is payable in a future tax year. • Employee Retirement Income Security Act (ERISA) Section 3(2) generally defines a pension plan as “any plan, fund or program … which is established or maintained by an employer … [that ] provides retirement income to employees, or results in a deferral of income by employees for periods extending to the termination of covered employment or beyond. ” © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 5

Summary of Different Types of Deferred Compensation • Frequently divided based on status under

Summary of Different Types of Deferred Compensation • Frequently divided based on status under the Internal Revenue Code: ― Qualified retirement plans: 401(a) (qualified plan) 401(k) 457(b) 403(b) 408 (SEP IRAs) 403(a) ― Non-qualified plan – anything that isn’t qualified. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 6

Summary of Different Types of Deferred Compensation • Generally divided based on type of

Summary of Different Types of Deferred Compensation • Generally divided based on type of promise: ― Defined contribution (account based) [401(k) plans]: benefit is whatever the contributions plus deemed investments grows (or shrinks) to at the time of payment; ― Defined benefit (non-account based): employer contractually obligated to provide the benefit calculated under a formula: Ø Flat dollar amount or fixed percentage of pay; Ø Dollar amount (or percentage of pay) times years of service; Ø May be offset by benefits accrued under another plan; or ― Hybrid (account based defined benefit plan) [cash balance plans]: contributions plus guaranteed rate of return. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 7

Summary of Different Types of Deferred Compensation • Also divided based on source of

Summary of Different Types of Deferred Compensation • Also divided based on source of contributions: ― Employee deferrals/contributions; ― Employer provided contributions/benefits: Ø Match; Ø Profit sharing; Ø Percentage of compensation; Ø Floor offset (target % of pay offset by benefit in another plan). © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 8

Summary of Different Types of Deferred Compensation • Equity compensation: ― Stock options: right

Summary of Different Types of Deferred Compensation • Equity compensation: ― Stock options: right to buy shares in the future at a stated price per share (only have value if the stock price goes up). Exercise price must be at or above FMV on the date of grant. Generally not deferred compensation for 409 A: Ø Nonqualified Stock Option (NQSO, nonstatutory stock option): at the time of exercise, the “spread” between the exercise price and the fair market value of the stock on that date is taxable for federal income and FICA tax purposes; © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 9

Summary of Different Types of Deferred Compensation Ø Incentive Stock Option (ISO, statutory stock

Summary of Different Types of Deferred Compensation Ø Incentive Stock Option (ISO, statutory stock option): at the time of exercise, if continuously employed and hold the shares post-exercise for a minimum holding period, the spread is not taxable for either federal income or FICA tax purposes; ― If any of the requirements aren’t met on the date of exercise, the spread is taxable for both federal income and FICA tax purposes; ― If the requirements are met on the date of exercise, but the shares are sold before the holding period has been satisfied, the spread is taxable for federal income tax BUT NOT FICA tax purposes. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 10

Summary of Different Types of Deferred Compensation • Equity compensation: ― Restricted Stock: issuance

Summary of Different Types of Deferred Compensation • Equity compensation: ― Restricted Stock: issuance of shares subject to a risk of forfeiture; either taxable at issuance or when the risk of forfeiture lapses (depending on whether the employee makes a Section 83(b) election). Not deferred compensation for 409 A. ― Restricted Stock Unit (RSU): promise to issue shares in the future; taxable for federal income tax and FICA purposes when shares are issued. May be deferred compensation for 409 A (depending on the vesting and issuing criteria). © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 11

Taxation under I. R. C. Section 3121 (When is deferred comp in W-2, Box

Taxation under I. R. C. Section 3121 (When is deferred comp in W-2, Box 5? ) • Generally taxed at the time of payment (Treasury Regulation Section 31. 3121(v)(2)-1(a). • Special timing rule allows taxation of vested contributions (or an estimate of the earned and vested accrued benefit) at the later of accrual and vesting. ― If taxed at this point, subsequent appreciation is not taxable. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 12

Federal “Moving Statute” • 4 USC Section 114 limits the ability of the work

Federal “Moving Statute” • 4 USC Section 114 limits the ability of the work jurisdiction to tax deferred compensation payable to a former resident if: ― Payable by a qualified retirement plan; ― Payable under another type of plan if part of a series of substantially equal payments payable at least annually over: Ø Ø the life or life expectancy of the recipient/beneficiary; or at least 10 years; or ― Payable after termination of employment under a plan, program, or arrangement that only provides benefits in excess of the limitations imposed on qualified retirement plans by certain Internal Revenue Code sections. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 13

Examples • Deferral only plan not structured as a mirror plan – Employees defer

Examples • Deferral only plan not structured as a mirror plan – Employees defer base salary into a plan, credited with interest and account paid in a lump sum after the employee has a separation from service. ― Generally going to be taxable by the work and residence locations. • Deferral only plan not structured as a mirror plan – Employees defer base salary into a plan, credited with interest and account paid in 10 annual installments after the employee has a separation from service. ― Generally going to be taxable only by the residence location. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 14

Examples • Deferral only mirror plan – Employees defer base salary into a plan,

Examples • Deferral only mirror plan – Employees defer base salary into a plan, credited with interest and account paid in a lump sum after the employee has a separation from service. ― Generally going to be taxable by the work and residence locations. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 15

Questions? © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 16

Questions? © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 16

Ohio Revised Code Chapter 718 Prior to Am. Sub. H. B. 5 a. Chapter

Ohio Revised Code Chapter 718 Prior to Am. Sub. H. B. 5 a. Chapter 718 did not require cities to exempt pension income from city tax. b. Chapter 718 did not define the term “pension. ” c. Most cities exempted pension income from tax through their own ordinances. d. Most cities did not define “pension” by way of ordinance. e. This was the law for taxable years beginning prior to January 1, 2016. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 17

Ohio Revised Code Chapter 718 After Am. Sub. H. B. 5 a. Chapter 718

Ohio Revised Code Chapter 718 After Am. Sub. H. B. 5 a. Chapter 718 requires cities to exempt pension income from tax. b. Chapter 718 does not define the term “pension. ” c. Cities updated their ordinances to mirror Chapter 718. d. Cities took the additional step of defining “pension” by way of ordinance. i. Income reported on a 1099 -R is a pension. ii. Income reported on a W-2 is not a pension. e. This was the law for taxable years beginning on or after January 1, 2016. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 18

Mac. Donald v. City of Cleveland, 151 Ohio St. 3 d 114 (Sept. 26,

Mac. Donald v. City of Cleveland, 151 Ohio St. 3 d 114 (Sept. 26, 2017). a. b. c. d. d. e. f. g. h. i. j. k. This case involved taxable years that pre-dated Am. Sub. H. B. 5. Mac. Donald had a SERP while employed by National City Corporation. The SERP was a nonqualified deferred compensation plan. The SERP was a defined benefit plan. National City funded the SERP; Mac. Donald did not. Mac. Donald was entitled to receive his SERP benefits upon retirement. Mac. Donald retired in 2006. Mac. Donald chose to receive his SERP as an annuity over the course of his and his wife’s lives. Mac. Donald was required to pay Federal Medicare tax based on the present value of his annuity as determined on Mac. Donald’s retirement date. The present value on his retirement date was roughly $9. 1 M. National City reported the present value of Mac. Donald’s SERP in box 5 of Mac. Donald’s 2006 W-2. The City sought to tax the present value of Mac. Donald’s SERP. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 19

Mac. Donald (cont’d): Cleveland Law a. Cleveland exempted pension income from tax by way

Mac. Donald (cont’d): Cleveland Law a. Cleveland exempted pension income from tax by way of ordinance. b. Cleveland defined the term “pension” by way of regulation. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 20

Mac. Donald (cont’d): The City’s Arguments a. Cleveland made four arguments. i. Mac. Donald’s

Mac. Donald (cont’d): The City’s Arguments a. Cleveland made four arguments. i. Mac. Donald’s SERP was compensation for services rendered. ii. Mac. Donald’s SERP was not a “pension” as the City defined that term by way of regulation. iii. Mac. Donald’s SERP was taxable as a nonqualified deferred compensation plan under Cleveland ordinances. iv. Mac. Donald’s SERP was taxable as a matter of state law. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 21

Mac. Donald (cont’d): Procedural History a. The Cleveland Income Tax Board of Review ruled

Mac. Donald (cont’d): Procedural History a. The Cleveland Income Tax Board of Review ruled in favor of the City. b. The Ohio Board of Tax Appeals ruled in favor of Mac. Donald. c. The Ohio Supreme Court ruled in favor of Mac. Donald. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 22

Mac. Donald (cont’d) a. The Court defined the term “pension” as: i. “a fixed

Mac. Donald (cont’d) a. The Court defined the term “pension” as: i. “a fixed sum paid regularly to a person (or to the person’s beneficiaries), esp. by an employer as a retirement benefit. ” ii. “a fixed sum paid regularly to a person ***: one paid under given conditions to a person following his retirement from service (as due to age or disability) or to the surviving dependents of a person entitled to such a pension. ” b. “Under either definition, the SERP plainly is a pension. ” c. “An ordinary speaker of the English language would have little difficulty concluding*** [that Mac. Donald received a pension]. ” © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 23

Mac. Donald (cont’d): Not Compensation for Services Rendered a. Cleveland’s ordinance exempting pension income

Mac. Donald (cont’d): Not Compensation for Services Rendered a. Cleveland’s ordinance exempting pension income from tax read as follows: “The tax…shall not be levied on the following: …pensions, disability benefits, annuities, or gratuities not in the nature of compensation for services rendered from whatever sourced derived. ” b. The Court said the ordinance has “broad reach, evidencing an intent to reach a multitude of retirement payments. ” c. The exclusion is phrased to encompass all those amounts that are themselves “not in the nature of compensation for services rendered” but instead substitute for such compensation upon retirement. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 24

Mac. Donald (cont’d): Not Compensation for Services Rendered d. The city’s argument stretched the

Mac. Donald (cont’d): Not Compensation for Services Rendered d. The city’s argument stretched the meaning of “compensation for services” too far. e. Virtually any pension comes about as a result of someone having performed services for an employer. f. If the ordinance is to have any application at all then the phrase “in the nature of compensation for services” must have a more limited scope than the city would give it. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 25

Mac. Donald (cont’d): Cleveland’s Regulation • Pensions means distributions from retirement plans as reported

Mac. Donald (cont’d): Cleveland’s Regulation • Pensions means distributions from retirement plans as reported on Federal Form 1099 R in the year paid, and which are designed to provide primarily for the retirement income of employees. • Contributions to pension plans, retirement plans, and deferred compensation plans are taxable in the year the income is earned and deferred. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 26

Mac. Donald (cont’d): Court’s Response • The problem with the City’s argument in support

Mac. Donald (cont’d): Court’s Response • The problem with the City’s argument in support of its regulation is that it requires the Court to hold that the tax administrator has the power to adopt rules that supercede an ordinance passed by city council. • The tax administrator does not have the power to change the terms of ordinances. • The regulation creates a substantive change as to what is taxable. • An administrative rule that conflicts with an ordinance is invalid. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 27

Mac. Donald (cont’d): Cleveland’s Third Argument a. Cleveland argued city ordinances allowed Cleveland to

Mac. Donald (cont’d): Cleveland’s Third Argument a. Cleveland argued city ordinances allowed Cleveland to tax qualifying wages which correspondingly included compensation attributable to a nonqualified deferred compensation plan. b. The Court acknowledged that the two Cleveland income tax ordinances are at odds, with nonqualified retirement benefits potentially falling under the pension exclusion and potentially falling under the inclusion of nonqualified deferred compensation plans described in Internal Revenue Code Section 3121(v)(2)(C). c. The Court drew a distinction between deferred compensation plans attributable to employee deferrals (which they found to be taxable) and deferred compensation plans attributable to employer contributions (which would fall within the pension exclusion) © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 28

Mac. Donald (cont’d): Cleveland’s Fourth Argument a. Cleveland argued state law requires Cleveland to

Mac. Donald (cont’d): Cleveland’s Fourth Argument a. Cleveland argued state law requires Cleveland to impose tax on qualifying wages so Cleveland is required to impose tax on SERP income. b. Cleveland misread state law and the Court’s holding in Gesler v. City of Worthington, 138, Ohio St. 3 d 76 (2013). c. State law allows, but does not require, cities to exempt income attributable to a nonqualified deferred compensation plan. d. Cleveland exempted pension income by ordinance. e. The General Assembly can restrict a city’s power to tax. The General Assembly cannot command a city to impose tax on specific income when the city has chosen not to tax that income. See, Gesler. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 29

Mac. Donald (cont’d) c. The Court’s definition applies to all “open” taxable years that

Mac. Donald (cont’d) c. The Court’s definition applies to all “open” taxable years that pre-date Am. Sub. H. B. 5. d. The Court’s definition should apply to all “open” taxable years following Am. Sub. H. B. 5 unless and until the Ohio General Assembly statutorily defines the term pension. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 30

Proposed Legislation following Mac. Donald • 718. 01 (XX) “Pension” means a retirement benefit

Proposed Legislation following Mac. Donald • 718. 01 (XX) “Pension” means a retirement benefit plan, regardless of whether the plan satisfies the qualifications described under section 401(a) of the Internal Revenue Code, including amounts that are taxable under the “Federal Insurance Contributions Act. ” Chapter 21 of the Internal Revenue Code, excluding employee contributions and elective deferrals, and regardless of whether such amounts are paid in the same taxable year in which the amounts are included in the employee’s wages, as defined by section 3121(a) of the Internal Revenue Code. © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 31

Proposed Legislation following Mac. Donald • 718. 01 (YY) “Retirement benefit plan” means an

Proposed Legislation following Mac. Donald • 718. 01 (YY) “Retirement benefit plan” means an arrangement whereby an entity provides benefits to individuals either on or after their termination of service because of retirement or disability. “Retirement benefit plan” does not include wage continuation payments, severance payments, or payments made for accrued personal or vacation time. ” © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 32

Proposed Legislation following Mac. Donald (noncodified lanaguage) • “Section _____. The amendment by this

Proposed Legislation following Mac. Donald (noncodified lanaguage) • “Section _____. The amendment by this act of section 718. 01 of the Revised Code is intended to clarify and reflect the General Assembly’s understanding of, and intent with regard to, that section as it was enacted by Sub. H. B. 5 of the 130 th General Assembly. The amendment applies to municipal taxable years beginning on or after January 1, 2016. An employer, agent of an employer, taxpayer, or other payer that paid or remitted municipal income or withholding tax on a pension for any municipal taxable year beginning on or after January 1, 2016, may request a refund of the payment or remission pursuant to section 718. 19 of the Revised Code. The tax administrator of a municipal corporation that receives such a request for refund shall determine the amount of refund due based on the definition of “pension” prescribed by section 718. 01 of the Revised Code, as amended by this act. ” © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 33

Questions? © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 34

Questions? © Copyright 2018, Vorys, Sater, Seymour and Pease LLP. All Rights Reserved. 34