Compensation: The Missing Link – Part 1

Posted by Chris Ciminera

Disclaimer: All blog posts are valid as of the date published.

Compensation PlanningCompensation, you might think, should be easy to quantify. However, in a retirement plan, determining compensation can actually be quite complex. Not only can plan sponsors easily make mistakes in the calculation, but highly trained and experienced third-party administrators and auditors can get tripped up trying to decipher what the calculation should be to arrive at accurate plan compensation.

What, then, is eligible compensation?  The answer is: “IT DEPENDS!”

The plan document defines compensation for each plan feature. As such, each plan document can have a different definition for eligible compensation used to determine elective deferrals, matching, and/or profit sharing contributions.

Many plans use the statutory definition of compensation in Treasury Regulation Section 1.415(c)-2 for all plan features. The general statutory definition in the Treasury Regulation Section specifically includes the following:

“…commissions paid to salespersons, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, bonuses, fringe benefits, and reimbursements or other expense allocations under a nonaccountable plan…”

Listed later in the Treasury Regulation Section are items not to be included in compensation:

  • profit sharing contributions,
  • amounts realized from the exercise of a nonstatutory option,
  • amounts realized from the sale, exchange, or other disposition of stock acquired under a statutory stock option,
  • other amounts that receive special tax benefits such as premiums for group-term life insurance (only to the extent that the premiums are not includible in the gross income of the employee and are not salary reduction amounts described in Section 125), and any other similar items.

To achieve their specific goals, plan sponsors have the ability to exclude specific items in the definition of compensation such as fringe benefits, compensation exceeding a certain dollar amount, bonuses, commissions, overtime, etc., by making the relevant choices in the adoption agreement or through an individually designed plan document. Operationally, plan sponsors sometimes exclude items from plan compensation that the adoption agreement does not show as exclusions. In these cases, there is a missing link between the plan provisions and the plan operations. It is important for plan administrators and sponsors to compare the definition of compensation in the plan document to what is being used operationally. One of the top ten findings in IRS audits of qualified plans is that the plan administrator is using the wrong definition of compensation. Needless to say, it is also one of the most common findings during our audits of retirement plan financial statements.

An understanding of the components that make up eligible compensation and utilizing those components as defined in the plan document is crucial to calculating the correct employee and employer contributions. Our recommendation is for sponsors to create a spreadsheet that starts with gross compensation, a reconciliation to the wages on the W-3 plus K-1s as applicable, and an additional column for each separate exclusion, so that control totals can be compared with control totals on the original payroll documents. These reconciliations of control totals with original source documents will also ensure that the census data submitted to the third-party administrator is complete and accurate. Plan sponsors must continually reconcile the payroll data to the census data to the plan document to ensure there are no missing links between their plan documents and their plan operations.