Practitioners use Defined Benefit Plan compensation for many elements of administration.
This article explains, at a high level, how your Defined Benefit Plan actuary and third party administrator will define and use compensation for your Defined Benefit Plan.
The owner’s Defined Benefit Plan compensation depends on the entity type. The table below shows what counts as Plan compensation.
|Entity Type||Plan Compensation|
|C Corporation||W-2 income|
|S Corporation||W-2 income|
|Sole Proprietorship||Schedule C income|
|Partnership||Schedule K-1 income|
|Limited Liability Company||Use entity tax election|
Employee’s compensation is much more simple. It always is based on W-2 income.
Practitioners use plan compensation for several elements in the Defined Benefit Plan. Here is a list of some examples. Additional detail is provided later in the article.
In summary, Defined Benefit Plan compensation is integral for determining the Plan benefit, any limitations, and ensuring benefit levels comply with IRS guidelines.
Defined Benefit Plans often provide a benefit based on the level of compensation.
A common formula for business owners is 10% of compensation times years of service. For example, assume the owner’s average Plan compensation is $200,000 and he or she has 5 years of service. In this case, the benefit would be $100,000 paid per year starting at retirement (10% x $200,000 x 5 years).
Generally, in a small business Plan, employees may receive a single sum distribution in lieu of annual payments from the Plan.
Because Defined Benefit Plans provide significant tax advantages, the IRS limits how much can be paid out per person from the Plan.
In general, the Plan may pay a person a lump sum distribution of $3.4 million at age 62. However, this limit also is a function of the employee’s Plan compensation.
The details of the payout limit are complicated and described in another article. However, at a high-level, a 62-year-old would need a 3-year consecutive average of at least $265,000 to be able to receive the full payout of $3.4 million. Defined Benefit Plan rules reduce Plan payouts prior to age 62 from $3.4 million. The reduction reflects a longer period of tax deferral. Moreover, employees who receive payouts before age 62 likely will not need a $265,000 average compensation to receive the full payout limit for their age.
For businesses to receive the tax advantages of a Defined Benefit Plan, they also must comply with additional requirements. For example, Defined Benefit Plan rules are designed to protect rank-and-file employees. More specifically, there are a number of requirements ensuring the disparity between highly compensated and non-highly compensated employees is “fair”.
One rule requires employers to provide meaningful Defined Benefits to at least 40% of employees meeting the required conditions. However, minimum participation need not be more than 50 employees. This rule is called minimum participation. Congress and the IRS did not define “meaningful” in the applicable statute or regulations. However, the IRS uses its own standard for audit purposes. This standard is a function of compensation.
Additionally, Plans must provide benefits to non-highly compensated employees that are “fair” relative to the benefits provided to highly compensated employees. These rules are extremely complex and nuanced. However, in general, “fairness” is based on employee benefits relative to their compensation. Put another way, “fairness” generally is determined by looking at benefits as a percentage of compensation.
Lastly, other benefit minimums for so-called “top heavy” Plans and the “gateway test” permitting the testing of Combo Plans as Defined Benefits are based on compensation.
If you are self-employed (not incorporated or taxed as a Corporation), owners must reduce their Plan compensation for one-half of self-employment tax. Self-employment taxes essentially are “payroll taxes” for the self-employed.
This levels the playing field between the self-employed and those taxed as a Corporation. That’s because Corporations pay one-half of payroll taxes, which reduces their profit and potentially their ability to pay a higher W-2 wage to the owner.
One drawback of being self-employed is that you cannot create a net business loss as a result of a Defined Benefit Plan deduction.
For example, assume your net income prior to the Defined Benefit Plan deduction is $100,000. In this case, you could not deduct $150,000 in a Defined Benefit Plan. Doing so would create a $50,000 loss and you could not deduct the full contribution (even if you had other income to offset).
Moreover, Plan compensation for the self-employed may be a “circular” calculation. That’s because Plan compensation is based on “profits”, and “profits” are a function of the Plan deduction (which may be based on Plan compensation). This makes the calculations more difficult. On the other hand, for Corporations, owner compensation is W-2 wages rather than “profits”, and although there may be a link between W-2 wages and “profits”, it typically is indirect.
In some cases, the definition of compensation may vary depending on the purpose. For example, the Plan document may exclude certain compensation items for determining the Plan benefit. While, on the other hand, pension rules require that employers include nearly all compensation elements for calculating most benefit “minimums”. This adds complexity to the Plan administration.
In summary, compensation is integral to Defined Benefit Plan administration. As described, practitioners use compensation for a number of purposes from defining the Plan benefit, applying IRS limitations, and ensuring compliance for Plan testing.
What’s more, the elements used in the definition of compensation may vary by purpose. As a result, it is important that Plan sponsors provide (and third party administrators describe) the compensation needed to administer the Defined Benefit Plan.