Written by Kristina Kananen
The foundation of nearly every contribution, allocation or accrued benefit in a qualified retirement plan is based on a participant’s compensation. Compensation is remuneration for an employee’s services to the employer. The simplicity of the arrangement can be deceptive. In fact, the IRS has found that the most common error found in plan examinations is using the wrong amount of compensation to determine contributions or benefits in the plan.
So, what can make compensation so difficult to get right? Unfortunately, advisors, plan sponsors and, of course, the IRS can make compensation difficult for any plan administrator. The difficulty arises when different definitions of compensation are used for different purposes in the plan.
Each plan must define the compensation to be used in the plan for several purposes. Compensation is used to determine:
- A participant’s allocation in a defined contribution plan or benefit accrual in a defined benefit plan
- The limit on allocations or benefits
- Minimum top heavy benefits
- Non-discrimination testing
- Deduction Limits under IRC Section 404
Compensation is wages or earnings for services rendered by the employee to the Plan Sponsor and include:
- Fees for Professional Services
- Fringe Benefits
A plan’s definition of compensation must recognize each type of remuneration, and which are to be included in or excluded from a participant’s plan compensation. There are three definitions of compensation to choose from for the plan. There is a statutory IRC Sec. 415 definition and two safe harbor definitions: IRC Sec. 3401(a) and W-2 under IRC Sections 6041 and 6051
IRC Sec. 415(c) or Treasury Regulation 1.415-2(d)(2)(i) includes all the following in the definition of compensation:
- All Wages;
- All Salaries;
- Other amounts received which are includable in the employee’s gross income such as overtime;
- Commissions, fees for professional services, tips, bonuses, fringe benefits and reimbursements or other expense allowances under a non-accountable plan; and
- Foreign earned income
Certain amounts are excluded from this definition such as contributions to a plan of deferred compensation whether funded or unfunded, distributions from a deferred compensation plan and stock options.
The W-2 definition includes all compensation that is required to be reported in Box 1, ‘Wages, tips, other compensation’ of the Form W-2. In addition to wages, cash value of payments not paid in cash are included. Amounts excluded are expense reimbursements under an accountable plan (Treas. Reg 1.62-2), tips of less than $20 per month and non-cash tips, and moving expenses paid by the employer to a third party or furnished in kind by the employer. Self-employed individuals are not permitted to use this definition, but instead will use earned income.
The Section 3401(a) definition includes wages and/or bonuses and taxable fringe benefits. For the purposes of our discussion, the term ‘wages’ includes overtime pay and commissions. Taxable fringe benefits are non-cash benefits and can include personal use of company car, current cost of life insurance protection for group term insurance, moving expenses paid by employer, gift cards and the value of stock options. Payments under an unfunded nonqualified deferred compensation plan are included.
Elective deferrals to a 401(k) or 403(b) plan or to a Welfare plan are added back into all three definitions of compensation for plan purposes. For example, an employee has gross income of $50,000 and defers $5,000. Even though the $5,000 deferral is not included in W-2 wages, the employee’s full $50,000 is used for plan purposes. Likewise differential pay to certain military personnel is included in all three definitions.
Another complication in the definition of compensation is post-severance from employment compensation. Certain amounts paid by the later of 2 ½ months after severance or the last day of the limitation year in which the severance occurred and which would have been included in Section 415 compensation if paid prior to severance. These amounts include:
- Regular compensation paid after severance often referred to as ‘trailing compensation’ must be included in Section 415 compensation;
- Unused leave cashouts for accrued bona fide sick, vacation or other leave can be excluded from Section 415 compensation; and
- Nonqualified deferred compensation payments that are paid under the terms of the nonqualified plan and NOT because of severance of employment and can also be excluded from Section 415 compensation
Severance pay and parachute payments are excluded even if paid within the 2 ½ months or by the end of the limitation year.
Back pay awards by an administrative agency, court or by agreement by an employer are includable for the limitation year to which the back pay relates even though they may be paid after severance of employment.
It is possible to exclude certain types of compensation from consideration under the plan. However, the exclusion must not discriminate in favor of the highly compensated employees. The test for this is found under IRC Section 414(s) where the percentage of the amount excluded over total compensation is calculated for each employee. If it is found that the non-highly compensated employees have a higher percentage of compensation excluded than the highly compensated employees, the definition fails. For example, excluding overtime pay would likely result in a failed Section 414(s) test. Even though a plan may exclude some compensation in the plan, government regulations may add it back for certain purposes. For example:
- Determining whether Section 415 maximum limits have been exceeded must be calculated on the basis of the 415 definition of compensation. Compensation for the full year is included, even though the employee was not a participant for the full year.
- Allocating non-elective employer contributions in a defined contribution plan or determining accrued benefits in a defined benefit plan can be based on any definition of compensation, but it can cause issues with nondiscrimination testing and safe harbor non-elective contributions to a 401(k) plan if the definition does not satisfy Section 414(s). The plan may choose to recognize compensation while a participant, instead of for the whole year.
- When calculating a plan-imposed limit on 401(k) deferrals as a percent of compensation, such as 15% of compensation, any definition of compensation is allowable. However if the definition does not satisfy Section 414(s) the compensation used to apply the plan-imposed limit can not be used to determine deferral rates for ADP testing. Compensation can be limited to the period when the employee was a participant OR when the participant was actually making elective deferrals to the 401(k) plan.
- A plan sponsor could limit the compensation an employee can defer from under a 401(k) arrangement (such as regular pay only), but again if the definition does not pass section 414(s), the definition of compensation can not be used to determine deferral rates for ADP testing.
- A plan sponsor may decide to limit the compensation used to determine matching contributions. Such compensation would not be required to satisfy Section 414(s) UNLESS the matching contribution is intended to satisfy the ADP Safe Harbor OR the ACP Safe Harbor. Also, if the definition does not satisfy Section 414(s), that definition cannot be used in the regular ACP test. Limiting the compensation for the match to the period the employee was an active participant OR was actually making elective deferrals to the plan.
- Identification of highly compensated employees for purposes of coverage testing and nondiscrimination test must be based on 415 compensation. The determination is made on the basis of the lookback year or the 12 month period preceding the current plan year.
- Compensation for ADP/ACP testing must satisfy Section 414(s). Compensation may be limited to the portion of the measuring period that the employee was eligible to participate for 401(k) or 401(m) purposes. It can not be limited to the period that the employee is making elective deferrals only.
- IRC Section 401(a)(4) testing can be based on any definition of compensation with the exception of the 5% safe harbor gateway test which must be based on 415 compensation regardless of the plan definition of compensation. If the allocation formula is based on safe harbor testing rules such as permitted disparity formulas, the compensation definition must satisfy Section 414(s). If the plan is relying on the general test to show non-discrimination, the compensation is NOT required to satisfy Section 414(s), however under the rate group test the compensation must satisfy Section 414(s). Compensation can be defined as compensation while an eligible participant, even for the gateway.
- Identifying key employees under Section 416 must use 415 compensation. Full year compensation must be used.
- Computing a participant’s top heavy minimum contribution must be based on 415 compensation. Full year compensation must be used.
- The employer’s deduction limit for contributions to a qualified plan under IRC Section 404(a)(3), IRC Section 404(a)(7) or IRC Section 404(a)(9) must be based on 415 compensation.
While it may be reasonable to exclude some types of compensation from the definition in the plan, such as non-cash fringe benefits, the exclusions can increase the cost of administering the plan each year as well as increasing the complexity of assuring plan compliance.