An often overlooked aspect of qualified plan administration is “compensation.” At last count, it was conceivable that a qualified plan sponsor might need to deal with as many as eight different definitions of compensation in order to keep a plan qualified.
Compensation can be a problem because:
1- most plan documents have not been updated for the most recent IRS regulations,
2- most plan documents do not have one centralized set of definitions,
3- not all definitions of compensation need to appear in the plan document and
4- corporate activities not directly related to the plan, such as adopting a cafeteria plan, can affect compensation for the retirement plans.
Most anti-discrimination tests cannot be properly performed unless the administrator has accurate compensation data. Therefore, it is important for both plan design and administration purposes that the sponsor pay careful attention to compensation.
In general, definitions can be divided into two categories, those governed by Sec. 414(s) and those not governed by Sec. 414(s). If a definition is governed by Sec. 414(s), the sponsor must either choose a safe harbor definition under the regulations or establish that its definition is nondiscriminatory. (A complete listing of all of the optional safe harbor definitions is beyond the scope of this item and can be found in TD 8361.) A plan administrator may need to deal with the following definitions.
* The basic definition for allocating contributions and forfeitures or calculating accrued benefits: In theory, this definition is not governed by Sec. 414(s). However, the actual allocations or accruals must comply with Sec. 401(a)(4), and the Sec. 401(a)(4) testing definition is governed by Sec. 414(s).
* The Sec. 401(a)(4) definition: Plans must comply with the antidiscrimination requirements of Sec. 401(a)(4). There is apparently no requirement that the definition of compensation used for Sec. 401(a)(4) testing appear in the plan document. Furthermore, the sponsor may use different definitions each year or different definitions for different plans, provided that the plans are tested separately.
* The Sec. 415 definition, which governs limits on allocations or benefit accruals. Note that for plan years beginning after 1991, accrued compensation is not counted for Sec. 415 purposes.
* The Sec. 404 definition, which governs limits on tax deductions. Because amounts contributed to fund benefits on annual additions in excess of the Sec. 415 limit are not deductible (Sec. 404(j)(1)), this definition is the same as the Sec. 415 definition. However, accrued compensation may be counted for Sec. 404 purposes.
* The definitions for Sec. 401(k), employee after-tax or matching contributions: The plan document must specify what compensation is used for determining how much a participant may contribute or how his matching contribution will be calculated. In theory, different definitions could be used for different types of contributions.
* The definitions for actual deferral percentage (ADP) and actual contribution percentage (ACP) tests (under Sec. 401(k) and (m)): There is no requirement that the definition(s) used for calculating ADP and ACP percentages be included in the plan document. The plan administrator may test under every permissible definition until it finds the most favorable result, and may use different definitions each year.
The IRS’s flexibility creates a plan design question. Should the definition for calculating ADP and ACP percentages be included in the plan document? If not, the plan administrator has considerably more flexibility to do the testing. On the other hand, will the administrator know how to do the testing without being able to use the document? In addition, is the cost of running the ADP and ACP tests with multiple definitions of compensation likely to outweigh the benefits?
Mercifully, the Service does not require a sponsor to run the tests under every permissible definiton of compensation. Therefore, the sponsor has the option to run the tests once and take whatever corrective action is needed based on the first test results.
* The Sec. 414(q)(2) definition for determining who is highly compensated: This definition is used for determining who is a “highly compensated employee,” who is a “key employee” (under the “top-heavy” rules of Sec. 416(i)) and who is a “top-paid employee” (under the separate line of business (SLOB) rules of Regs. Sec. 1.414(r)-11(a)(3)).
* The Keogh definition: Only net earnings from self-employment (as defined in Sec. 1402(a)) are compensation for sole proprietors or partners. There are additional modifications in Sec. 401(c)(2). Compensation for purposes of Sec. 404 is not the same as compensation for purposes of the self-employment tax or the income tax. Considering that the Medicare wage base is no longer the same as the old age, survivors’ and disability insurance (OASDI) wage basis, the calculation of Keogh compensation, especially for partners in integrated plans, can be very complicated.
In addition to deciding which items of compensation should be included for a specific purpose, the sponsor must decide over what period compensation will be measured. Regs. Sec. 1.414(s)-1(g)(2) defines the term “determination period,” but this definition is generally not very useful. In general, the determination period will be the plan year, but there can be exceptions. For example, if the plan provides for a mid-plan year entry date(s), should allocations to a participant’s account be based on full year compensation or only on compensation for the participation period? Regs. Secs. 1.401(k)-1(g)(2) and 1.401(m)-1(f)(2) now permit ADP and ACP testing based on using compensation only for the participation period.
A related issue is the “lookback period” for determining who is highly compensated. Sponsors that have less than 100 higly compensated employees and that operate on calendar years should consider making the election available under Temp. Regs. Sec. 1.414(q)-!T, Q&A-14(b), which would have the effect of eliminating the lookback period.
Impact of cafeteria plans
Example: Employee E participates in a Sec. 125 plan and a Sec. 401(k) plan. E has a base salary of $50,000, earns a $10,000 bonus, elects to contribute $8,000 in Sec. 401(k) elective contributions, elects to have $4,000 in salary deferral contributions under the Sec. 125 plan, and elects to receive medical insurance under the cafeteria plan rather than an extra $100 per month that his employer was offering to participants who drop medical coverage (presumably because they are covered under spouses’ plans).
For purposes of Secs. 404 and 415, E’s compensation is $48,000 ($50,000 + $10,000 – $8,000 – $4,000). Salary deferrals under Secs. 125 and 401(k) are not included in Sec. 415 compensation. His Sec. 415 limit is $12,000 (0.25 X $48,000). Therefore, if his matching contributions plus any other employer defined contribution plan contributions plus forfeitures exceed $4,000 his allocations would violate Sec. 415.
For purposes of determining whether he is highly compensated, his compensation is $61,200; under Sec. 414(q)(7), all salary deferral contributions are added back. In addition, the extra $1,200 ($100 per month) that he could have received, but elected not to, is included. Depending on the facts and circumstances, E may be a highly compensated employee.
The extra $1,200 would also be added back to compensation for purposes of calculating a top-heavy minimum allocation (assuming that E is not a “key employee”). It is not necessary to add back the $1,200 for purposes of calculating his ADP and ACP percentages.
It is possible (depending on how the plan is written and administered) that (1) an employee’s ability to make Sec. 401(k) contributions will be based only on his base salary, (2) his ADP percentage will be based on his salary plus bonus, (3) his status as a highly compensated employee will be determined by a third figure and (4) an entirely different definiton will be used for purposes of determining whether the plan complies with Sec. 401(a)(4).
In conclusion, a plan sponsor, especially a Sec. 401(k) plan sponsor, now has to deal with numerous definitions of compensation; failure to differentiate among the definitions can lead to regulatory compliance problems.