Choosing a Retirement Plan’s Definition of Compensation
By Kristoffer Aas, QKA, EdM
Electing a plan’s definition of compensation may be one of the most important elections in any plan document. The elections made will significantly affect the plan’s design and its operations. Some aspects of the plan require the most inclusive definition of compensation (Internal Revenue Code Section (IRC Sec.) 415 compensation), while others permit more flexibility if the definition is considered nondiscriminatory (IRC Sec. 414(s) compensation). And a few require even less (e.g., a “reasonable” definition of compensation). Through this election employers have the power to influence how much their employees can save for retirement.
NOTE: While beyond the scope of this article, business owners commonly use a different definition of compensation than their common-law employees (e.g., earned income for business owners but W-2 wages for common-law employees). This, in addition to how the employer is taxed, may determine if the compensation is eligible in the retirement plan.
What is IRC Sec. 415 compensation?
IRC Sec. 415 compensation consists of three safe harbor definitions of compensation: 415 safe harbor compensation, W-2 wages, and IRC Sec. 3401(a) wages. All three are deemed to pass IRC Sec. 414(s) testing for nondiscriminatory definitions of compensation and are required for some important functions.
The determination of highly compensated employees (HCEs) and key employees
The employer’s maximum deductible contribution
The IRC Sec. 415 annual additions limit
Top-heavy testing
All three definitions generally include (unless specifically excluded) remuneration from wages, salaries, overtime, bonuses, and commissions. These definitions do not include workers’ compensation because it is generally not included in gross income.
IRC Sec. 415 Safe Harbor Compensation (also known as, “current includible compensation”)
In addition to the previously mentioned items, this definition also includes fees for professional services, taxable fringe benefits (e.g., use of a company car), reimbursements or other expense allowances under a nonaccountable plan (i.e., a plan that provides employees with an allowance for travel or business expenses), and other amounts paid to the participant (cash and noncash), as long as the amounts are includible in gross income. Some types of income are also specifically included.
Medical/disability benefits (if includable in gross income)
Moving expenses (if not reasonably assumed that the expenses paid or reimbursed by the employer are deductible by the employee)
Nonqualified stock options (if includable in gross income in the year granted)
IRC Sec. 83 property (received for services rendered, if elected by the employee)
Compensation attributable to nonqualified plans
Elective deferrals (not taxed, but treated as compensation)
Difficulty of care payments excluded from gross income (for plan years beginning on or after January 1, 2016)
NOTE: A simplified version of 415 safe harbor compensation (also known as the simplified compensation rule) excludes the types of compensation in the bullets above, and instead typically only includes wages, salary, overtime, bonuses and commissions. This is a common election that the employer must formally elect in the plan document.
Compensation that is specifically excluded from 415 safe harbor compensation is not permitted to be included in either this definition of compensation or its simplified version.
Employer contributions to a deferred compensation plan (as long as the amounts are not included in gross income in the taxable year contributed)
Distributions from a deferred compensation plan (even if included in gross income when distributed, unless an exemption applies)
Amounts realized from the exercise of nonqualified stock options or when restricted stock or property is no longer subject to a substantial risk of forfeiture
Amounts realized from the sale, exchange, or disposition of qualified stock options
Other amounts receiving special tax benefits, such as group term life insurance premiums (but only to the extent not includible in gross income) and employer contributions to a 403(b) plan (whether or not excludable from gross income)
W-2 Wages
These are wages paid by the employer as reported on IRS Form W-2 under Wages, Tips and Other Compensation. However, unlike 415 safe harbor compensation, W-2 wages do not include elective deferrals—such as 401(k) deferrals or IRC Sec. 125 deferrals. Similar to 415 safe harbor compensation, there are specific types of income that are included in W-2 wages.
Noncash payments such as the taxable portion of using a company car (the cash value of payments made in a form other than cash).
Foreign earned income (while not included for income tax purposes, included for IRC Sec. 415 purposes).
Distributions from an unfunded nonqualified plan (treated as wages when paid).
Amounts paid for group term life insurance (also known as PS 58 costs).
NOTE: Taxable fringe benefits are generally included in gross income unless specifically excluded by law. See IRS Publication 15-B for more information.
The following amounts are specifically excluded from W-2 wages.
Reimbursements paid under an accountable plan (i.e., a plan that reimburses employees for business-related expenses)
Qualified moving expenses (unless an exception applies)
Nontaxable fringe benefits (e.g., de minimis benefits such as a service or item of small value or on-site gym or other athletic facilities)
NOTE: Whether disability/sick pay (excluding workers’ compensation) is included depends on who is paying it. Employers should discuss this topic with a competent tax professional.
IRC Sec. 3401(a) Wages (also known as, “wages for income tax withholding”)
This definition is almost identical to the W-2 wages definition except it does not include amounts paid for group term life insurance.
Are there any alternatives to the safe harbor definitions of compensation?
IRC Sec. 414(s) defines what constitutes a nondiscriminatory definition of compensation. Each of the 415 definitions of compensation (IRC Sec. 415 safe harbor compensation, W-2 wages, and IRC Sec. 3401(a) wages) are considered safe harbor because they are deemed to pass IRC Sec. 414(s) testing. The IRC Sec. 414(s) definition of compensation is required for ADP/ACP testing, general nondiscrimination testing, and safe harbor contributions. It has three alternative safe harbor definitions that all begin with IRC Sec. 415 compensation and can exclude specific types of income (which cannot be adjusted further without failing IRC Sec. 414(s) testing).
Exclusion of fringe benefits (cash and noncash) and other special compensation items
Treatment of elective deferrals in the opposite manner as under the 415 safe harbor definition
Exclusions applied ONLY to some or all the employer’s HCEs
NOTE: The second alternative 414(s) safe harbor definition is uncommon because excluding elective deferrals requires a more complex calculation to determine deferral amounts. If elected, it is strongly recommended that the employer contact a competent tax professional to assist with these calculations.
Are there any nonsafe harbor definitions of compensation?
Yes, there are also nonsafe harbor definitions of compensation that can be modified in any other way than the above versions. These definitions are only treated as meeting IRC Sec. 414(s) compensation requirements (and therefore, are nondiscriminatory) if they are reasonable, satisfy an annual compensation ratio test, and do not favor HCEs.
A reasonable definition of compensation can exclude types of compensation that are not provided to an employee on a consistent basis. The regulations specify that a definition that excludes overtime, bonuses, premiums for shift differentials, call-in premiums, or commissions is automatically considered a “reasonable definition.” Additionally, limiting compensation to a specific dollar amount—such as using the IRC Sec. 401(a)(17) annual compensation cap (the maximum compensation considered for any plan participant when calculating contributions or completing certain annual compliance testing) is also considered reasonable.
IRC Sec. 414(s) compensation does have two unacceptable exclusions.
The employee’s compensation cannot be defined as a percentage of another definition within the plan document. For example, IRC Sec. 414(s) compensation may not be defined as 75 percent of the employee's IRC Sec. 415 compensation.
The employee’s compensation for the limitation year cannot be reduced to a one-month period. For example, IRC Sec. 414(s) compensation cannot be defined as the participant’s compensation earned in the month of July of the limitation year.
NOTE: Ultimately, the employer and its counsel should determine the types of compensation included in the plan’s definition of compensation.
The compensation ratio test looks at the percentage of each participant’s total IRC Sec. 415 compensation that is included in an alternative definition of compensation. The test is satisfied if the HCE compensation percentage does not exceed a de minimis amount greater than the nonHCE compensation percentage (which is determined on a facts-and-circumstances basis). While the IRS has not provided more guidance, the industry practice is generally three percent. More information about the test can be found here.
Are there other important aspects of compensation to consider?
Measuring Periods
The employer must elect whether compensation is measured using the plan year or the calendar year that ends with or within the plan year. An employer with a noncalendar plan year end may want to consider measuring compensation over the calendar year since that is what is already required for tax reporting purposes.
The employer must also decide, for the plan year that an employee enters the plan, whether compensation will be measured over the full year or just the portion of it from the date that the employee enters the plan.
Post-Severance Compensation vs. Severance Pay
Generally, severance pay (also known as, parachute payments) is never included as eligible compensation. However, post-severance compensation is eligible compensation if 1) the amounts paid to the participant are amounts that would have been paid for services rendered had the participant continued employment, and 2) the payments satisfy the 2½-month rule. See our Link article, Post-Severance Compensation vs. Severance, pay for more information on this topic.
