A review of IRS definitions that affect qualified plans
Accurately defining compensation is one of the more complex areas in qualified plans. The term “compensation” is used in various ways, and the choices made by an employer will directly affect the administration, and ultimately the costs, of maintaining a qualified plan.
For starters, the annual compensation limitation under Internal Revenue Code (IRC) Section 401(a)(17) applies to almost all qualified plans. In 2013, the annual compensation limit is $255,000. Let’s take a closer look at additional definitions of compensation types.
Many statutory rules involving the definition of compensation require the use of IRC Sec. 415(c)(3) participant compensation. Compensation includes all amounts paid during a defined 12-month limitation year.
A plan sponsor can choose from these safe-harbor definitions for participant compensation:
• A simplified definition that includes only wages, fees for professional services and other amounts received for personal services to the extent these amounts are includable in gross income,
• W-2 compensation, or
• Compensation for income tax withholding.
Under all three definitions, the IRC adds back in pretax salary deferrals to 401(k), 403(b), 457, and cafeteria plans, as well as qualified transportation fringe benefits.
Qualified retirement plans use the participant compensation definition for a number of qualified plan rules, including:
• Limits on contributions and benefits under IRC Sec. 415 (the 100% limit),
• The highly compensated employee rule (in general, more than 5% owners and employees with compensation in the prior plan year exceeding $115,000 in 2013),
• Limits on 401(k) plan catch-up contributions, and
• Top-heavy rules (key employees and required top-heavy contributions).
Compensation generally excludes amounts earned after termination, such as severance pay. However, payment to the terminated employee within a limited time after the termination date for work already performed and for accrued sick or vacation time counts as compensation.
Nondiscrimination rule compensation
The nondiscrimination rules define compensation in IRC Sec. 414(s). Under this section, the employer can choose a safe harbor definition or an alternative. The safe harbors include any of the Sec. 415 definitions, and plans can alter the safe harbor definitions to exclude salary deferrals.
An employer can elect an alternative definition that doesn’t satisfy a safe harbor if it’s reasonable and doesn’t discriminate in favor of highly compensated employees. To satisfy this requirement, the plan must demonstrate that the average percentage of total compensation for an employer’s highly compensated employees doesn’t exceed by more than a de minimis amount the average percentage of total compensation for nonhighly compensated employees.
For example, if an employer uses regular pay as the definition of compensation, and only nonhighly compensated employees receive additional compensation (overtime), the definition would be considered discriminatory. On the other hand, if only highly compensated salespeople were receiving additional pay (commission), the definition might not be discriminatory.
Other 401(k) plan compensation issues
Several additional compensation issues arise for 401(k) plans. As previously mentioned, the plan must use a definition that complies with Sec. 414(s) for testing whether salary deferrals and matching contributions satisfy the actual deferral percentage and actual contribution percentage (ADP/ACP) tests for nondiscrimination. However, the plan can disregard compensation earned before an individual becomes eligible to participate in the plan. This is a good election to make because it generally increases the deferral percentage for nonhighly compensated employees.
Also, 401(k) plans can make only salary deferrals from Sec. 415(c)(3) participant compensation. This means, for example, that an individual can’t 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 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 because this test requires a more inclusive definition of compensation.
Type of entity
The type of entity affects the definition of compensation, as well. For example, the definition of compensation in an S corporation is different from that of a partnership. Only wages reported on a W-2 are includable as compensation for an S corporation owner; the pass-through income reported on the owner’s Schedule K-1 isn’t includable as compensation. For partners in a partnership, as well as sole proprietors, compensation generally is defined as earned income derived from the business each year.
It’s important to understand the statutory definition of compensation as well as to identify the entity type in which the business operates. Once this is completed, it’s easier to determine which type of qualified plan will work best in achieving the employer’s retirement benefit objectives.