All employers are required to elect a “reasonable” definition of compensation for their employees under Federal Treasury Regulations under Internal Revenue Code (IRC) section 415(c)(3). Not only that, but employers must strictly enforce this definition and make sure all employees are in compliance. This is considered by many plan sponsors as a complex and somewhat confusing part of plan administration—if you are a plan sponsor, you’ll want to make sure you are well-read on the requirements.

Purpose of the Plan’s definition of compensation

The Plan’s definition of compensation serves to:

• Determine how much each participant can contribute (max)
• Determine each participant’s benefit accrual through the years
• Decide the employer’s maximum deductible contribution
• Facilitate annual non-discrimination and compliance testing
• Determine what types of compensation can be deferred in the Plan
• Provide details on all highly compensated employees (for 2016, those earning more than $120,000)

Important steps in developing the compensation agreement

Putting together your Plan compensation definition begins by:

• Reviewing the types of compensation paid by the employer and records available for tracking compensation;
• Employing an understandable and manageable definition for everyone involved in plan administration. This includes the third-party administrator, payroll provider and plan sponsor.
• Assessing what, if anything, would be more simple and cost-effective to implement depending on the size of your Plan. For example, larger companies might use several compensation definitions to be more cost-conscious.

Make sure the compensation agreement is reasonable

IRC Section 415(c)

There are three ‘safe harbor’ compensation definitions in the Code. The plan sponsor can choose one of the three, all considered reasonable agreements:

1. “Simplified compensation”- An abridged definition that includes only wages, fees for professional services and other amounts received for personal services (to the extent that the amounts are able to be included in gross income)
2. W-2 Wages- All income reported in Box 1(wages, tips and other compensation)
3. IRC 3401(a)- Compensation for income tax withholding

Under all definitions listed above, the IRC adds pretax salary deferrals back in to compensation for purposes of 401(k), 403(b), and 457 plans.

IRC Code 414(s)

IRC Code 414(s) provides a definition of compensation that is required under the nondiscrimination rules mentioned above. 414(s) has the same safe harbor definitions as 415(c).

What is considered discriminatory?

If you use regular pay as the definition of compensation, but only grant overtime pay to highly compensated employees, your Plan is discriminatory.

Compensation also has an upper limit under IRC Section 401(a)(17). For 2016, the maximum compensation amount is $265,000.

Can an employer elect a different definition?

Yes, you can elect an alternative definition that does not satisfy one of the safe harbors, as long as it is reasonable, meaning that it does not favor highly compensated employees (typically no more than 5% of employees can have compensation in excess of $120,000).

The term “compensation” holds much more significance than one might think. Your Plan’s compensation definition should be carefully thought-out and encompass the best interests of all your employees.

For assistance and further guidance on your compensation arrangement, contact one of our Employee Benefit Plan Specialists today.