| Are you familiar with the differences between withholding compensation, W-2 compensation, and 415 compensation? |
Background
Compensation is used for multiple purposes under qualified retirement plans. First, it determines the amount of contributions that the employee and employer can make to the plan and how those contributions are allocated. Secondly, it is a key factor in the performance of the annual qualification and nondiscrimination tests imposed under the Internal Revenue Code.
Although a qualified plan may adopt any reasonable definition of compensation for purposes of making elective deferrals or allocating contributions, Tax Code §414(s) requirements dictate that the definition be nondiscriminatory. Three separate “safe harbor” definitions of total compensation that are deemed nondiscriminatory can be found in Tax Code Section 414(s).
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Code §415(c)(3) provides a “soup-to-nuts” definition of compensation. It is total compensation, plus certain items of income that are not included on Form W-2. Examples of 415(c) compensation include wages and fees included in gross income, earned income of the self-employed, taxable health reimbursements and the cost of group-term life insurance coverage in excess of $50,000, reimbursed moving and auto expenses, and taxable nonqualified stock options and restricted property. It is the required definition for owners of unincorporated businesses such as partnerships and sole proprietors. Employees of these entities may have an alternative definition applied. It is the required definition for determining annual additions; however, the following two definitions are available for this purpose because they are safe-harbor definitions under Code §414(s). Note: Since 1998 this definition includes pre-tax deferrals to 401(k), 403(b) and Section 125 plans. Those amounts can be disregarded and the definition would still satisfy the Code §414(s) requirements |
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Tax Code §3401(a) compensation is based on amounts subject to federal income tax withholding at the source. This is a “purist” definition because it is based on what the employee sees on each pay stub. It starts with an individual's wages plus bonuses and includes stock options taxable at date of grant and taxable restricted property, but excludes all taxable reimbursements and the cost of group-term life coverage. Our document defaults to this definition, if one of the others is not selected. This definition excludes all pre-tax deferrals to 401(k), 403(b) and Section 125 plans. This definition may be grossed up to include those amounts. |
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Tax Code §6041 and §6051 compensation is better known as W-2 compensation. It is what is reported annually in Box 1 of Form W-2. It consists of Code §3401(a) compensation plus taxable reimbursements and the cost of group-term life coverage. Many employers prefer this definition because it is the information most easily provided by their payroll service providers. Similar to the §3401(a) definition, this definition excludes all pre-tax deferrals to 401(k), 403(b) and Section 125 plans. This definition may also be grossed up to include those amounts. |
Plan Document Usage
Nonstandardized Prototype, Volume Submitter and Individually Designed Plans may use alternative definitions that may exclude various items of employee compensation such as bonuses, commission and overtime. While this provides flexibility, the downside is that the plan must demonstrate on an annual basis that its definition is nondiscriminatory. This must be demonstrated when the plan is submitted for a determination letter and a ruling is requested on the plan's definition of Compensation and documented annually thereafter. Because of the potential for failure, we generally recommend using “total” compensation. A plan that disregards a category of compensation that applies only to the highly compensated remains within the safe harbor.
Compensation for Contributions and Allocations
For purposes of determining contributions and allocations, a plan other than a standardized prototype may include or exclude elective deferrals under a 401(k) or 403(b) retirement plan or a Code §125 cafeteria plan. However, excluding those amounts penalizes participants in these arrangements. In addition, nonstandard prototypes, Volume Submitter and individually designed plans may exclude such items as commissions, overtime, and bonuses or exclude amounts over a stated dollar limit from the definition of compensation for deferral and allocation purposes. Further, a plan may limit compensation to that earned while an employee is a participant. In our document, this is accomplished by choosing “plan year” while a participant compensation rather than calendar year or fiscal year compensation in the Adoption Agreement. This is our document default position if no election is made. The other acceptable compensation time periods, calendar year and employer's fiscal year, include the individual's compensation earned during those time periods regardless of participation status. In addition, our plan document permits an additional choice, “plan year” compensation, that includes compensation earned during the entire plan year rather than limited to the time while the individual was participating.
Compensation for Testing
Code §415 compensation ordinarily is used when testing for compliance with the top-heavy and the annual addition limitation requirements. The regulations under Code §414(s) permit the substitution of Code §3401 or W-2 Compensation for both purposes. Beginning with the 1998 plan year, elective deferrals to Tax Code Sections 401(k), 403(b) and §125 plans have been included in compensation for purposes of determining the annual addition limit.
The employer has the option of including or excluding elective deferrals when performing the Average Deferral Percentage (ADP) and Average Contribution Percentage (ACP) tests. In our document, this choice is documented by a selection on the plan's adoption agreement. Generally, testing on a net basis is more favorable if you have highly compensated employees earning over the Code §401(a)(17) dollar limit ($205,000 in 2004 and $210,000 in 2005).
Including Compensation for Deductions Under Code §404
Determining what compensation must be included in calculating the deductible contribution limit under Code §404 for defined contribution plans can be complicated. The limit for a profit-sharing or money purchase pension plan is 25% of eligible compensation, as noted above. Often, questions arise over the treatment of compensation of terminated participants or employees who receive allocations in order for the plan to pass coverage requirements or nondiscrimination testing. Is the employer entitled to include the compensation of such individuals when determining its maximum deductible amount? The answer is yes. Where an individual receives a plan allocation for any purpose including satisfying coverage or correcting a failed ADP or ACP test, the entire compensation of these individuals is included in determining compensation paid by the employer. Similar treatment is also extended to 401(k) plans providing employer matching and discretionary contributions. So long as a participant is eligible to make elective deferrals to the plan, his or her compensation is included in determining the maximum deductible contribution. Whether the employee is eligible to receive a match or profit-sharing contribution is irrelevant for this purpose. |
