One of the more
complicated and confusing parts of qualified plan design and
administration is determining the proper definition of compensation.
It’s complicated for a number of reasons. First, the term is used in
many contexts. For example, it is used to determine:
- The maximum contribution for each participant;
- The employer’s maximum deductible contribution;
- The participant’s contribution or benefit accrual;
- Whether the plan satisfies the nondiscrimination requirements;
- The types of compensation that can be deferred in a 401(k)
plan;
- Who is a highly compensated employee; and
- The amount of top heavy contributions required.
Second, there are several statutory definitions that have to be
used for different purposes and each of these definitions lets the
sponsor choose from several alternatives.
Third, in the important area of determining benefit accruals, the
sponsor is not limited to a specific statutory definition, but the
choice will have an impact on administration and, more importantly,
on the overall cost of providing benefits.
To help the sponsor get a better understanding of this topic, we
will first explore the statutory definitions of compensation and
then review the key areas in which the definition of compensation
comes into play.
Statutory Definitions
Code Section 415(c)(3)
Many statutory rules involving the definition of compensation
require the use of Code Section 415(c)(3) compensation. The sponsor
can choose from one of three safe-harbor definitions:
- A simplified definition that only includes wages, fees for
professional services and other amounts received for personal
services to the extent that the amounts are includible in gross
income;
- W-2 compensation (Code Sec 6041, 6051 and 6052 compensation);
and
- Compensation for income tax withholding (Code Sec 3401(a)
compensation).
Also note that under all three definitions, pretax salary
deferrals to 401(k) plans, 403(b) plans, 457 plans, cafeteria plans
under Code Section 125 and qualified transportation fringes under
Code Section 132(f)(4) are added back to the definition.
Compensation includes all compensation paid during a defined twelve
month limitation year.
The 415(c)(3) definition is required for a number of qualified
plan rules including:
- The limit on contributions and benefits under Code Section 415
(the 100% limit);
- The highly compensated employee rule (determining who earns
$100,000 or more);
- The limit on catch-up contributions to a 401(k) plan; and
- The top heavy rules (determining who is a key employee and
required top heavy contributions). Note that since the whole year
of compensation must be counted, top heavy contributions must
consider the whole year even if the employee was only a
participant for part of the year.
Another issue is that compensation generally excludes amounts
earned after termination, such as severance pay. However, payment
for work that had already been performed and payment for accrued
sick or vacation time that is made to the terminated employee within
a limited time after termination can be counted as compensation.
Code Section 414(s)
Code Section 414(s) provides a definition of compensation that is
required under the nondiscrimination rules. Under this Section, the
employer can choose a safe-harbor definition or an alternative. The
safe harbors include any of the Section 415 definitions. Also, any
of the Section 415 safe-harbor definitions can be altered to exclude
salary deferrals.
An employer can elect an alternative definition that does not
satisfy one of the safe harbors as long as it is reasonable and does
not discriminate in favor of the highly compensated employees (in
general, more than 5% owners and employees with compensation in the
prior plan year exceeding a specified level ($100,000 in 2006)).
Regulations require that, to satisfy this requirement, the plan
must demonstrate that the average percentage of total compensation
included under the alternative definition of compensation for an
employer’s highly compensated employees does not exceed by more than
a de minimis amount the average percentage of total compensation for
the non-highly compensated employee group.
For example, if the employer uses regular pay as the definition
of compensation and only non-highly compensated employees receive
additional compensation (overtime), then the definition would be
considered discriminatory. On the other hand, if only highly
compensated salesmen were receiving additional pay (commission),
then the definition would most likely not be discriminatory.
Code Section 404
Under the maximum deductible contribution limits, compensation is
essentially the same as Code Section 415 compensation, although it
is based on the taxable year for which the deduction is being taken,
rather than the limitation year (which is typically the plan or
calendar year).
Maximum Compensation Limit
It is important to remember that, for virtually all qualified
plan purposes, compensation has an upper limit under Code Section
401(a)(17). For 2007, the maximum compensation amount is $225,000.
Contribution and Benefit Structures
From a plan design perspective, the most important definition of
compensation is the one used to determine plan benefits or
contributions. How compensation is defined directly affects plan
costs and participants’ benefits.
The definition chosen has to satisfy the nondiscrimination
requirements. For this purpose, the simplest option is to choose one
of the safe-harbor alternatives under Code Section 414(s). However,
to limit costs and keep them more predictable, some employers will
want to choose a definition that only includes base or regular pay
and excludes extras such as overtime and bonuses. This is acceptable
as long as the plan can satisfy the nondiscrimination requirement
that was described above.
401(k) Plans
There are several additional issues that come up for 401(k)
plans. For testing whether salary deferrals and matching
contributions satisfy the nondiscrimination rules (ADP and ACP
tests), the plan has to use a definition that complies with Code
Section 414(s). However, the plan can disregard compensation earned
before an individual becomes eligible to participate in the plan.
This is generally a good election to make since it generally
increases the deferral percentage for non-highly compensated
employees.
Also, salary deferrals in a 401(k) plan can only be made from
Code Section 415(c)(3) compensation. This means, for example, that
an individual cannot make a salary deferral on severance pay but
could defer a portion of a payment for accrued sick time paid after
termination of employment.
In some cases it may be useful to limit the type of compensation
that a participant can defer. For example, eliminating irregular pay
such as bonus and commission income can simplify administration.
However, this could make it more difficult to satisfy the ADP
nondiscrimination test since this test requires a more inclusive
definition of compensation (Code Section 415(s)).
Other Planning Considerations
Here are a number of additional issues that bear mentioning:
Controlled Groups
An extra layer of "compensation confusion" may occur if you are
in a brother/sister or parent subsidiary group. In this case you’ll
need to coordinate the different definitions of compensation as they
apply across businesses. Also, if an employee is employed by two or
more entities that are aggregated under Code Section 414(b), (c),
(m), or (o), compensation includes compensation from all members of
the group, including those employers that do not offer the qualified
plan.
Measuring Period
Another consideration is the measuring period that is used to
identify compensation. Whether you use plan year, limitation year or
another alternative, you’ll need to make sure that you are comparing
apples with apples.
Self-Employed Persons
For a self-employed person (which includes sole-proprietors and
partners in a partnership), compensation is generally earned income,
determined at the end of the year, reduced by employer contributions
to retirement plans made on behalf of the self-employed individual
(other than 401(k) deferrals).
Employee contributions can only be made with respect to earned
income derived from the business that sponsors the plan. Even though
compensation is not determined until the end of the year,
regulations provide that a 401(k) plan is permitted to accept
deferrals made during the year by partners from guaranteed payments
or other cash advances made during the year, so long as these
payments do not exceed a reasonable estimate of the partner’s earned
income during the year.
S Corporations
In S corporations, only income that is distributed to the owner
as wages can be used for retirement plan purposes (pass through
income reported on Schedule K-1 cannot be included).
Choosing Compensation Definitions
When making decisions about the appropriate definition of
compensation, the sponsor and third-party administrator ("TPA")
should consider the following factors:
- Choosing compensation definitions should begin by reviewing
the types of compensation paid by the employer and the records
available for tracking compensation;
- A definition of compensation needs to be understandable and
manageable for everyone involved in the administration of the
plan, including the sponsor, payroll provider and TPA;
- To simplify administration in a small plan, it may be
appropriate to choose a uniform definition of compensation; and
- For larger employers, it may be more cost effective to use a
number of compensation definitions. To streamline administration,
compensation should be reported to the TPA in its component parts
(base compensation, overtime, bonuses, salary deferrals, etc.).
Conclusion
Gaining more appreciation for the complexity of the term
compensation should help employers be more sensitive to the TPA’s
request for compensation data. Similarly, the more the TPA
understands about the employer, the more carefully definitions can
be chosen that gel with the employer’s payroll system and benefit
objectives.
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