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.
[top of
page]
| 
Home 
