The definition of compensation is foundational to every plan’s design because it provides a basis for the calculation of employee deferrals and employer contributions. It also becomes relevant for purposes of annual nondiscrimination and compliance testing.
Federal Treasury Regulations under Internal Revenue Code ("Code") section 415(c)(3) require employers to elect a "reasonable" definition of compensation. Certain definitions of compensation are deemed to be reasonable per se under the regulations. These safe harbor definitions are:
General/Traditional Code section 415 – All compensation received from the employer that is includible in gross income.
W-2 wages – All income reported in Box 1 of the employee’s Form W-2, plus
Code section 3401(a) – All wages taken into account for federal tax withholding purposes, plus the required additions to W-2 wages listed above.
The plan document must state the plan’s definition of compensation without ambiguity.
Required exclusions from a plan’s definition of compensation include:
The only permissible exclusions outside of the list above are forms of irregular or additional compensation, such as bonuses, overtime, call-ins, shift differential and the like. Any other general exclusion from the plan’s definition of compensation could result in an "unreasonable" definition of compensation requiring painful correction.
In the event that a plan’s definition of compensation excludes more than what is required or permissible, the plan should undergo compliance testing under Code section 414(s). Section 414(s) testing is often burdensome, so exclusions outside the regulatory boundaries should be considered carefully. If 414(s) testing is necessary, compensation ratios of nonhighly compensated employees are compared to those of highly compensated employees. A passing score is earned only if the nonhighly compensated employee compensation ratio is at least as high as the highly compensated employee compensation ratio. A failing score generally requires amendment to the definition of compensation until a passing score is attained. Then, elective deferrals and employer contributions must be recalculated based on the new, reasonable definition of compensation and reallocated to participants accordingly.
Post-severance compensation is not severance or parachute compensation. By definition, post-severance compensation is compensation paid to the employee by the later of 2.5 months after severance from employment or what usually amounts to the end of the plan year. Employers must elect whether to include or exclude post-severance compensation from the definition of plan compensation. In any event, salary continuation arrangements and any other post-severance agreements must be consistent with the plan’s provision in this regard. An employer may not include post-severance compensation for one employee and exclude it for another.
If an incorrect amount of compensation is used to determine deferrals and contributions, those deferrals and contributions will be incorrect, resulting in an operational failure under the Employee Plans Compliance Resolution System ("EPCRS") maintained by the Internal Revenue Service and published most recently under Revenue Procedure 2013-12. EPCRS prescribes a path to correction that will depend on the specific facts and circumstances of the situation. In general, though, employers must put participants in the place they would have otherwise been in had the error not occurred. Most frequently, this means distributing excess deferrals or contributions, plus earnings, or making corrective contributions, plus earnings. Corrective contributions often consist of 50% missed pretax elective deferrals and 100% of missed employer contributions, plus earnings in both cases. Errors should always be corrected as swiftly as possible once detected.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.