Qualified Retirement Plan Definition of Compensation: More Complicated Than You Would Think

What Is Plan Compensation? (Part 1 of 3)

(click here to see Part 2)

One of the most fundamental definitions for a qualified retirement plan is eligible compensation for plan purposes. The definition of compensation, as detailed in the plan’s adoption agreement, determines many things, including highly compensated employees, key employees, contribution allocations and non-discrimination testing. Employees may think that Box 1 of the Form W-2 or the gross wages line item on their pay stub defines their compensation. However, these amounts are not necessarily defined as compensation by the plan’s adoption agreement. The IRS has three safe harbor compensation definitions, in addition to IRC 415(c)-2(b) compensation (statutory compensation), as they relate to a qualified retirement plan that will satisfy both IRC 415(c) and IRC 414(s). The three compensation definitions following the statutory definition of compensation are safe harbor definitions of compensation that are adjustments to the statutory definition.

There are also safe harbor adjustments to IRC 414(s) that can be made. Each of these safe harbor definitions will be defined and compared in the following article in this series. In addition to defining and comparing each of the safe harbor definitions of compensation, the final article in the series will be a brief discussion concerning IRS corrections that commonly occur when a plan sponsor uses a definition of compensation that is contrary to that which is defined in the plan’s adoption agreement.

IRC 415(c) Definitions of Compensation

IRC 415(c) Compensation – Statutory Definition

The statutory definition of compensation includes most forms of income that an employee will receive.

As expected, this definition includes: base salary, overtime, bonus, commissions, tips, vacation pay, regular compensation paid after severance of employment within the prescribed time frame and pre-tax employee deferrals. This definition also includes taxable fringe benefits, including but not limited to: “cash, cash equivalents, gift certificates, or other intangible property such as vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds and other securities,” (Publication 15-B (2017), Employer’s Tax Guide to Fringe Benefits). Furthermore, it includes allowances from a nonaccountable plan such as auto allowance; however, it does not include reimbursements for auto expenses. The statutory definition includes qualified moving expense reimbursements, taxable medical and disability benefits, income from excess group term life insurance, and income from stock options granted. While income from a Section 83(c) election for restricted property is included in this definition of compensation, income realized when the restricted property becomes freely transferable or no longer is subject to substantial risk of forfeiture is not included. Other forms of income that are not included in the statutory definition are distributions from nonqualified plans and non-statutory stock option income includable in the year of excise.

IRC 415 Compensation – Simplified Definition

The simplified definition of compensation is the same as the statutory definition above, except it excludes nonqualified moving expense reimbursements, taxable medical and disability benefits, income from a Section 83(c) election for restricted property and income from stock options granted.

IRC 3401(a) Wages

Section 3401(a) wages are defined as all wages and benefits subject to federal income tax withholding. Three items that are included in 3401(a) wages and not included in the statutory definition of compensation are: distributions from nonqualified plans, non-statutory stock option income includable in the year of excise and income realized when Section 83(c) property becomes freely transferable or no longer is subject to substantial risk of forfeiture. A taxable benefit that is not included is excess group term life insurance. Tips under $20 per month are also not included in this definition of compensation.

W-2 Compensation

W-2 compensation is almost identical to 3401(a) wages. The main difference is that W-2 wages include income from excess group term life insurance. This is defined as the taxable portion of the premiums for group term life insurance greater than $50,000.

Income Excluded from All Four Definitions

The following forms of income are excluded from the statutory definition of compensation and all three safe harbor definitions:

  • Severance pay
  • Worker’s compensation
  • Nontaxable fringe benefits
  • HSA employer contributions
  • Nonqualified plan contributions excludable from gross compensation in the year of contribution
  • Expense reimbursements under an accountable plan as defined by the IRS
  • Nonqualified moving expenses reimbursed or paid by an employer that are not deductible by the employee
  • Income from the sale or exchange of stock acquired under a qualified stock option.

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