Issue Snapshot – Design-based Safe Harbor Plan Compensation

 

This snapshot discusses the requirement that plans submitting an application for a determination letter that claim reliance on a design-based safe harbor must contain a definition of compensation that is nondiscriminatory without the need for annual testing.

IRC Section and Treas. Regulation

  • IRC Section 401(a)(4)
  • IRC Section 401(a)(5)(B)
  • IRC Section 414(s)
  • IRC Section 415(c)
  • Reg. Section 1.401(a)(4)-2(b)
  • Reg. Section 1.401(a)(4)-3(b)
  • Reg. Section 1.401(a)(4)-12
  • Reg. Section 1.414(s)-1
  • Reg. Section 1.415(c)-2

Resources

Background

A design-based safe harbor plan that bases allocations on compensation must use a definition of compensation that is nondiscriminatory under Reg. Section 1.414(s)-1. See IRC Section 401(a)(5)(B); Reg. Sections 1.401(a)(4)-2(b) and 1.401(a)(4)-12. (The requirement to use a nondiscriminatory definition of compensation also applies, for example, to testing an IRC Section 401(k) or 401(m) plan’s actual deferral percentage (ADP) and actual contribution percentage (ACP), or for IRC Section 401(k) plans relying on the ADP or ACP safe harbors. See the above-referenced Issue Snapshot on Compensation Definition in Safe Harbor 401(k) Plans.)

Reg. Section 1.414(s)-1 includes several definitions that are automatically nondiscriminatory under IRC Section 414(s). These definitions of compensation do not require annual testing to demonstrate nondiscrimination.

Alternatively, a plan may use another definition of IRC Section 414(s) compensation, provided that the alternative definition is reasonable, not designed to favor highly compensated employees, and defined in such a way that that the average percentage of total compensation included for highly compensated employees as a group does not exceed the average percentage for non-highly compensated employees by more than a de minimis amount. An alternative definition of IRC Section 414(s) compensation must be tested annually to ensure that it is nondiscriminatory. In addition, under certain circumstances a plan may use rate of compensation, imputed compensation, or prior-employer compensation under a definition of compensation that satisfies IRC Section 414(s). See Reg. Section 1.414(s)-1.

Definitions that automatically meet IRC Section 414(s)

The following definitions of compensation automatically satisfy IRC Section 414(s) without the need for annual nondiscrimination testing:

1.   Any definition of compensation that meets IRC Section 415(c)(3) automatically satisfies IRC Section 414(s). See Reg. Section 1.414(s)-1(c)(2).
   Four variations of IRC Section 415 compensation are available:
  • Statutory IRC Section 415 compensation - generally includes all compensation currently includible in taxable income such as salary, bonuses, commissions, and taxable fringe benefits or reimbursements, and excludes items not currently included in taxable income such as nontaxable fringe benefits, worker’s compensation and nontaxable group term life insurance. Included elements of compensation are listed in Reg. Section 1.415(c)-2(b) and excluded elements are listed in Reg. Section 1.415(c)-2(c).
  • Simplified IRC Section 415 compensation - nearly identical to statutory IRC Section 415 compensation, but it excludes certain types of compensation that are typically reserved for highly compensated employees, such as taxable moving expense reimbursements, income from an IRC Section 83(b) election (for stock grants), and nonqualified deferred compensation. Types of compensation included and excluded from the simplified definition are listed in Reg. Section 415(c)-2(d)(2).
  • IRC Section 3401(a) wages - includes all  wages within the meaning of IRC Section 3401(a) (for purposes of income tax withholding at the source), plus amounts that would be included in wages but for an election under IRC Section 125(a), 132(f)(4), 402(e)(3), 402(h)(1)(B), 402(k), or 457(b). Any rules that limit the remuneration included in wages based on the nature or location of the employment or the services performed are disregarded for this purpose. Reg. Section 1.415(c)-2(d)(3).
  • Information required to be reported under IRC Sections 6041, 6051 and 6052 - includes amounts that are IRC Section 3401(a) wages, plus all other payments of compensation to an employee by his employer (in the course of the employer's trade or business) for which the employer is required to furnish the employee a written statement under IRC Sections 6041(d), 6051(a)(3), and 6052. This safe harbor definition of compensation may be modified to exclude amounts paid or reimbursed by the employer for moving expenses incurred by an employee, but only to the extent that, at the time of the payment, it is reasonable to believe that these amounts are deductible by the employee under IRC Section 217. Reg. Section 1.415(c)-2(d)(4).

All the IRC Section 415 compensation definitions include elective deferrals or contributions to a 401(k), 403(b), 457, SIMPLE IRA or SARSEP plan, IRC Section 125 cafeteria plan, or IRC Section 132(f)(4) transportation fringe benefit plan. IRC Section 415(c)(3)(D).

2.   Any of the IRC Section 415 definitions modified by any one or more of these safe harbor modifications will also automatically satisfy IRC Section 414(s). The safe harbor modifications are:

  • Excluding ALL of the following:
    • taxable fringe benefits such as use of a car or educational assistance
    • reimbursements or expense allowances such as for travel or childcare
    • moving expenses
    • deferred compensation
    • welfare benefits such as legal services, scholarships, unemployment, etc. Reg. Section 1.414(s)-1(c)(3).
  • Excluding any amount which is contributed by the employer pursuant to a salary reduction agreement and which is not includible in the gross income of an employee under IRC Section 125, 132(f)(4), 402(e)(3), 402(h), or 403(b). IRC Section 414(s)(2).
  • Adding IRC Section 414(h)(2) governmental plan pickup contributions to the list of elective deferrals and contributions included by default in IRC Section 415 compensation (deferrals under IRC Sections 125, 402(e)(3), 402(h), 403(b), or 457(b)). Reg. Section 1.414(s)-1(c)(4).
  • Excluding a portion of compensation received only by some or all highly compensated employees, such as commissions exclusive to those employees. Reg. Section 1.414(s)-1(c)(5).

Definitions that do not automatically meet IRC Section 414(s)

A plan’s definition of compensation for IRC Section 414(s) can exclude one or more items, such as bonuses, overtime, commissions, etc. Such a definition does not automatically satisfy IRC Section 414(s). However, the definition may be considered nondiscriminatory if it:

  • is reasonable,
  • is not designed to favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs), and
  • passes the “compensation ratio test” in Reg. Section 1.414(s)-1(d)(3). 

Under the compensation ratio test, if the plan’s definition of compensation does not meet IRC Section 415(c)(3) or any of the safe harbor modifications provided in the regulations under IRC Section 414(s), then the average percentage of IRC Section 415 compensation included for highly compensated employees as a group must not exceed the average percentage for non-highly compensated employees by more than a de minimis amount. If it does not, then the plan’s compensation definition meets IRC Section 414(s).  If it does, then the definition is not an alternative definition of compensation that satisfies IRC Section 414(s). This test must be met annually for any definition that does not meet IRC Section 414(s) automatically. Reg. Section 1.414(s)-1(d)(3)(i).

Design-based safe harbor plans

A plan with a design-based safe harbor satisfies the nondiscrimination in amount requirement of IRC Section 401(a)(4) without the need to test the actual allocations or benefits under the plan. The design-based safe harbors are defined in Reg. Sections 1.401(a)(4)-2(b)[1] (for defined contribution plans) and 1.401(a)(4)-3(b) for defined benefit plans. One example is a profit-sharing plan under which employer contributions are allocated pro rata by participant compensation. Another example is a contribution formula that allocates the same dollar amount to each participant.

If a plan relies on a design-based safe harbor and bases allocations on compensation, it must use a definition of compensation that is nondiscriminatory under Reg. Section 1.414(s)-1. A definition of compensation can either satisfy this IRC Section 414(s) requirement automatically or by satisfying the requirements for an alternative definition of compensation (including passing the compensation ratio test on an annual basis).

Determination letter applications claiming design-based safe harbor status

Generally, a plan submitted for a determination letter will not be reviewed for, and a determination letter may not be relied on with respect to, whether a plan satisfies the nondiscrimination requirements of IRC Section 401(a)(4). See Section 9.03 of Rev. Proc. 2020-4. However, if the applicant elects, a plan will be reviewed for, and a determination letter may be relied on, with respect to whether the terms of the plan satisfy one of the design-based safe harbors in Reg. Sections 1.401(a)(4)-2(b) (for a defined contribution plan) and 1.401(a)(4)-3(b) (for a defined benefit plan).

Before May 1, 2012, a plan applying for a determination letter could request a ruling that the plan’s definition of compensation was nondiscriminatory by submitting an attachment, Demonstration 9, to the determination letter application. See Rev. Proc. 93-39, 1993-2 C.B. 513. Thus, under prior procedures, a determination letter could be issued for a plan with a design-based safe harbor provision, regardless of whether the definition of compensation required annual testing. However, this and all other elective demonstration features of the determination letter program were eliminated in mid-2012. See Announcement 2011-82, 2011-52 I.R.B. 1052.

Section 9.03 of Rev. Proc. 2020-4 (or its annual successor) clarifies current procedures and requires a plan requesting a letter expressing an opinion on a design-based safe harbor formula to have a definition of compensation that satisfies Reg. Section 1.414(s)-1(c). In other words, the definition of compensation must comply with Reg. Section 1.414(s)-1 automatically, without need for annual testing.

If an applicant elects to have a plan reviewed to determine if it meets a design-based safe harbor, the IRS will review the compensation definition to determine if it automatically meets IRC Section 414(s). If it does not, a determination letter will not be issued, unless the applicant either (a) amends the plan’s definition to conform, or (b) the application is amended to remove the election to request review of the formula.

Note that to submit a determination letter request on behalf of an individually-designed plan, the plan must meet the criteria set forth at Section 4 of Rev. Proc. 2016-37, as amplified and modified by Rev. Proc. 2019-20.

Examples

Example (1) W-2 Compensation

Plan X is submitted for a determination letter. The applicant makes an election, on line 13 of Form 5300, Application for Determination for Employee Benefit Plan, for a determination regarding a design-based safe harbor. Plan X’s definition of compensation is titled “W-2 Compensation” and defines compensation for benefit purposes as compensation that is reported on a participant’s Form W-2, Wage and Tax Statement. This definition is one of the definitions that meets IRC Section 415(c)(3). See Reg. Section 1.415(c)-2(d)(4). Because the definition meets IRC Section 415(c)(3), it also automatically satisfies IRC Section 414(s), and a determination letter can be issued.

Example (2) Compensation less Deferrals

Plan Y is submitted for a determination letter. The applicant makes an election, on line 13 of Form 5300, for a determination regarding a design-based safe harbor. Plan Y’s definition of compensation is titled “Compensation” and defines compensation for benefits purposes as compensation that is reported on a participant’s Form W-2, but without regard to amounts electively deferred into the plan’s IRC Section 401(k) arrangement. Although IRC Section 415(c)(3)(D) requires elective deferrals to be included in IRC Section 415 compensation, IRC Section 414(s)(2) explicitly permits them to be excluded from IRC Section 414(s) compensation. The definition thus automatically satisfies IRC Section 414(s) without testing, and a determination letter can be issued.

Example (3) Compensation less Deferrals and Commissions

Plan Z is submitted for a determination letter. The applicant makes the Form 5300, line 13 election for a design-based safe harbor determination. Plan Z’s definition of compensation is titled “Compensation” and defines compensation for benefits purposes as compensation reported on a participant’s Form W-2, but without regard to amounts electively deferred into the plan’s IRC Section 401(k) arrangement, and “Commissions” paid by the employer to employees. Although the exclusion of deferrals is a safe harbor modification to IRC Section 414(s) as described above in Example 2, the exclusion of commissions is not. The exclusion of this compensation element requires the plan’s compensation definition to be tested annually for nondiscrimination as required by Reg. Section 1.414(s)-1(d)(3). Thus, unless the applicant either withdraws the request for a determination on the design-based safe harbor feature or amends the plan’s definition of compensation to one which automatically meets IRC Section 414(s), a determination letter will not be issued.

Reviewer Tips

Review the plan document to determine if the plan’s compensation definition automatically satisfies IRC Section 414(s), by meeting one of the safe harbors at Reg. Section 1.414(s)-1(c)(2) through (5).

  • If it does not, on a determination case where the applicant has elected to have the plan reviewed as a design-based safe harbor, secure either an amendment to the plan, or a revised Form 5300 changing this election request to the negative.
  • If it does not, on an examination where nondiscrimination in the amount of employer-provided benefit is being evaluated, secure and review a compensation inclusion test.
    • If the compensation inclusion test is not passed, an employer cannot claim reliance on a design-based safe harbor, and plan benefits would have to pass the general test for nondiscrimination.

[1] Applicable regulations also provide ‘non design-based safe harbors,’ a discussion of which is beyond the scope of this Snapshot.