Comparison of Safe Harbor Nondiscriminatory Definitions of Compensation

As is true with all information requested by BPC, it is critical for the compensation information submitted to be accurate. Various aspects of compliance testing for qualified retirement plans are based on compensation. If inaccurate data is reported, deduction limits, 401(k) deferral limits, contribution allocations and annual addition limits are some of the calculations that can be incorrect as a result.

The Treasury regulations under Code §415 prescribe three alternative definitions of compensation. The general 415 definition of compensation (for purposes of Code §415(c)(3)) includes elective deferrals to a 401(k) plan, a SARSEP, a 403(b) plan or a SIMPLE IRA plan, and pre-tax contributions to a cafeteria plan, a 457 plan or a qualified transportation fringe benefit plan. The two "alternative" 415 compensation definitions are "net" of these pre-tax amounts. Therefore, for 415 purposes, if the plan uses one of the alternative definitions, it must be increased for elective deferrals.

For nondiscrimination purposes, the Code §414(s) regulations consider the three 415 definitions as safe harbor testing definitions of compensation. However, an employer may modify any of the three alternative definitions by "including" or "excluding" elective deferrals (except 457 plan contributions) and remain within the nondiscrimination safe harbor.

The following items are includible in all 3 definitions: wages, salaries, fees for professional services, and "other amounts received" (cash or noncash) for personal services rendered in the course of employment to the extent includible in income, including commissions on sales, commissions on insurance premiums, bonuses, fringe benefits and reimbursements (or expense allowances) under a non-accountable plan.

The first step in determining the appropriate compensation figures to report on the census is to review the plan document for the definition of compensation used for the plan. Most clients use one of our prototype documents. If this is the case, there will be an 'adoption agreement' section in the document binder for your plan. Compensation information is located in Section 9 (1.11(B)) of the adoption agreement. The first item in this section indicates which basic definition of compensation is being used - 415 compensation, Code §3401(a) federal income tax wages increased by Elective Contributions, or W-2 wages increased by Elective Contributions. For clients using a prototype sponsored by BPC, Elective Contributions are always "included" unless the Employer elects otherwise. Following is a chart outlining which components of compensation are included or excluded under each definition:

Item 415 Compensation
(Current Income Definition)
Federal Income
Tax Wage Withholding
Form W-2
(Box 1)
1. Salary reduction amounts
(Code §125, 401(k), etc.)
Include.* Exclude. Exclude.
2. Employee's receipts pursuant to an unfunded nonqualified plan. Exclude.+ Include. Include.
3. Tips. Include. Include, but exclude noncash tips and cash tips less than $20/month. Include, but exclude noncash tips and cash tips less than $20/month.
4. Fringe benefits. Include all amounts includible in income. Include all except items specifically excluded under §3401(a): benefits/ payments excludible from income under §§74(c), 117, 132, 127, 129. Include all amounts includible in income.
5. Amounts paid under accident and health plans (which are includible in income). Exclude.+ Exclude medical reimbursement under a self-insured medical plan within §105(h)(6). Include.
7. Cost of group term life insurance in excess of $50,000. Include. Exclude. Include.Box 12(a)
8. Amounts realized from exercise of non-qualified stock option or when restricted stock or property becomes fully transferable or no longer subject to substantial risk of forfeiture. Exclude. Include. Include.
9. Amounts realized from sale or exchange of stock acquired under a qualified stock option. Exclude. Exclude. Exclude.
10. Value of a non-qualified stock option included in income in the year in which granted. Exclude.+ Include. Include.
11. Amount includible in income upon making §83(b) election. Exclude.+ Include. Include.

* Treas. Reg. §1.415-2(d)(10), which specifies the "current income" definition, reflects the pre-SBJPA "net" definition of 415 compensation. The Revenue Service has issued comprehensive proposed regulations that take into account SBJPA and other law changes. See Prop. Treas. Reg. §1.415(c)-2. The inclusion of salary reduction amounts in this Comparison reflects the statutory 415 compensation definition.

+ The "current income" safe harbor definition, as prescribed by Treas. Reg. §1.415-2(d)(10), actually is a modification of the general 415 compensation definition prescribed by Treas. Reg. §1.415-2(d)(1) and is less inclusive. A plan may modify the "current income" safe harbor definition to include items 2, 5, 6, 10 and 11 described below. See Treas. Reg. §1.415-2(d)(2)(iii), (iv), (v) and (vi) and Treas. Reg. §1.415-2(d)(3)(i). The chart shows treatment under the alternative definitions of specified items assuming the plan does not modify the definition.

Please be aware Section 11 (1.11(G)) of the document also indicates any modifications your plan may have to the basic definitions of compensation. For example, it is possible this section of the document indicates bonuses are excluded from your definition of compensation. In this case the compensation reported on the census should reflect not only one of the three basic definitions, but should be reduced by the amount of bonuses.

Finally, Section 10 (1.11(H)(I)) of the document also indicates what compensation should be used for participants during their initial year of participation in the Plan. The prototype documents allow plan sponsors to choose if they want to consider compensation for the entire plan year (regardless when the employee entered the Plan), or only for the period of time in which the employee was eligible. Once we have reviewed the eligibility status of everyone in the Plan and determined the dates of entry for new participants, we will request additional information on any participant we need partial year compensation for.

It is important to note these definitions of compensation apply to most employees. However the income reported for sole proprietors or partners is somewhat different. The compensation reported for the owners of a sole proprietorship should be earned income reported on Schedule C of their individual tax return. Partners should report earned income from Schedule K-1.

If you have any questions regarding the appropriate compensation you should be using, please feel free to contact the BPC administrator for your plan. We would be happy to review any issues with you to ensure the appropriate information is used in the preparation of your annual compliance report.

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