Because a significant part of our practice involves the representation of cities, counties, districts, commissions, school districts, and joint powers authorities throughout California, we've been able to identify some common practices that – though well-intended – can cause significant compliance and tax problems for governmental employers and their employees.
One: Offering Cafeteria Benefits Without A Plan
A significant number of agencies attempt to accommodate their employees by allowing them to have a choice between certain benefits that are employer-provided, such as medical coverage and paid time off (PTO) and cash. Whenever, an employee is given a choice between receiving a benefit that is not currently taxable (e.g., health plan coverage) and cash, the "opportunity" to elect cash can give rise to taxable income (even if the cash is not elected), unless the choice is made pursuant to a properly documented cafeteria plan or similar rules governing the deferral of income. The outcome – tax problems for the employee and the employer.
Two: Allowing "Opt-Outs" Of Employee Elections To Make Mandatory Contributions
Some agencies require their employees to make employee contributions in order to receive an employer-funded retirement benefit. Furthermore, many agencies have adopted resolutions whereby the employing agency has agreed to "pick up" the mandatory contributions and deduct such amounts from the employees' pay, thereby converting what were after-tax employee contributions into pre-tax contributions. Unfortunately, we have seen a number of instances where agencies have allowed their employees to temporarily or permanently "opt out" of their employee contribution commitment after it has commenced. Such an opt-out is not permitted and should not be allowed.
Three: Permitting Employees To "Retire" And Then Return To Work
Most tax-qualified pension plans maintained by local agencies, including CalPERS, require that an employee "retire" from employment in order to begin receiving regular pension payments. A substantial and recurring problem is that many agencies seem to be allowing their employees to retire with the understanding that the employee will be re-hired on a limited basis shortly afterwards. This practice can create real problems because the terms of the plan are likely violated whenever an employee obtains retirement benefits based on retirement – but in fact has not really retired!
Four: Converting Non-reportable Wages Into Reportable Wages
All retirement plans contain a definition of "compensation" or "reportable wages" that is used for calculating a participant's benefits. Too often we see practices that have evolved in agencies that have the effect of improperly converting what should be non-reportable wages (e.g., SDI benefits) into reportable wages. Such practices need to be reviewed and corrected because the use of improper compensation can jeopardize the tax-qualified status of an entire plan – even CalPERS. These types of conversions also can create significant income tax and payroll tax problems.
Five: Classifying Employees As Independent Contractors
Despite the warnings contained in the California Superior Court case, Metropolitan Water District v. S.C. (Cargill) (2004), some agencies are still treating significant numbers of their workers as independent contractors who are not entitled to coverage under their retirement plans. Because one of the consequences of improperly classifying such workers can be full retroactive coverage in the agency's retirement plan, it is critically important to get this right. If it is the agency's intention not to provide benefits to certain groups of employees, it may make more sense to exclude them under the terms of the applicable plans than to attempt to classify them as independent contractors who are not covered by the plan because they are not employees.
Six: Not Satisfying Fiduciary Requirements In Connection With Participant-Directed Section 457(b) Plans
Many, if not most, local agencies have established section 457(b) plans (also known as "eligible deferred compensation plans") that enable their employees to defer a portion of their compensation on a pre-tax basis. Most of these plans are "participant-directed" – that is, they allow the participants to manage the investments within their accounts. Unfortunately, many agency-sponsors of such plans do not understand that the California Government Code requires them to comply with ERISA-like fiduciary rules regarding such arrangements; otherwise the agency can be held liable for investment losses resulting from the participants' direction of their own accounts!
What To Do
If your local agency (or one you work with) is engaging in any of these practices – or anything similar – you should contact your benefits counsel or adviser. In many cases, these types of problems are much easier dealt with if they are found early and corrected early.