Compensation: The Missing Link – Part 2

Posted by Chris Ciminera

Compensation Planning - The Missing LinkMy previous blog, Compensation: The Missing Link – Part 1, stressed the importance of ascertaining a solid link between the definition of compensation in the plan document and the one used operationally. An understanding of the components that make up eligible compensation and utilizing those components in practice, as defined in the plan document, is crucial to calculating the correct deferrals, match and profit sharing contributions. Understanding the definition of compensation also includes other important factors including the timing and nature of payments within different service periods.

Difficulties can occur based on the timing of payments. For example, does compensation earned by December 31st for a calendar year employer, but paid in the months following the year count as eligible compensation? In general, Treasury Regulation Section 1.415(c)-2(e) states that compensation:

“…must be paid or made available to an employee (or, if earlier, includible in the gross income of the employee) within the limitation year.” 

Also, compensation:

“…must be paid or treated as paid to the employee prior to the employee’s severance from employment…”

Generally, this means that the payments included in a person’s W-2 are the payments considered in a calendar plan year. Payroll tax reports are the relevant measurements. We recommend to our audit clients and their third-party administrators to create a spreadsheet that reconciles gross wages per the W-3 (or K-1’s, if applicable) to the definition of eligible wages per the plan documents. Plan sponsors who have different definitions of compensation for different plan features should complete a separate spreadsheet for each plan feature.

Additional issues can be created with compensation paid after an employee’s termination from employment. Compensation that is earned during the period that is paid after termination is included in compensation if:

  • the payments are made by the later of 2 ½ months after termination or
  • the end of the limitation year including the date of termination

Further, post-termination plan compensation may include amounts that are payable after severance but that would have been paid or usable had the participant continued in employment, such as accumulated unused sick, vacation or other leave.

Generally, amounts paid after severance of employment or solely because of severance are excluded from compensation.

It is important for plan sponsors to work closely with their third-party administrators to ensure that there are no missing links between the definition of compensation in the plan document and the one they use operationally.