What are the three Safe Harbor Definitions of compensation?
Rev. 01/01/01

The regulations provide three Safe Harbor definitions of compensation. 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 Code §415(c) compensation include wages and fees included in gross income, earned income of the self-employed, taxable health reimbursements, the cost of group-term life insurance coverage in excess of $50,000, reimbursed moving and auto expenses, taxable nonqualified stock options and restricted property. Because it is so broad, it is the definition of choice for unincorporated businesses.

Code §3401(a) compensation is compensation that is subject to federal income tax withholding. 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, bonuses and commissions, and includes stock options taxable at time of grant, but excludes all taxable reimbursements and the taxable cost of group-term life coverage.

Code §6041 and §6051 compensation is better known as W-2 compensation. It is what is reported in Box 1 of Form W-2. It consists of Code §3401(a) compensation plus all taxable reimbursements and the taxable cost of group-term life coverage. Many employers use this definition because it is the information most easily provided by their payroll service providers.

Nonstandardized prototype and individually designed plans may use alternative definitions that may exclude various items of employee compensation such as bonuses, commissions and overtime. While this provides flexibility, the downside is the plan must demonstrate that its definition is nondiscriminatory. This must be shown when the plan is submitted for a determination letter and documented annually thereafter. Because of the potential for failure, "total" compensation definitions are easier to work with.