Treas. Reg. § 1.414(s)-1: Compensation Definitions

Treasury Regulation § 1.414(s)-1 establishes the framework for defining “compensation” within qualified retirement plans. The regulation’s primary function is to ensure a plan’s definition of compensation does not unfairly favor Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs), which is a core requirement for maintaining a plan’s tax-qualified status. The rules prevent plans from skewing benefits by, for example, including bonuses paid mostly to HCEs while excluding overtime earned mainly by NHCEs. The regulation provides several approved methods for defining compensation. This choice is integral to nondiscrimination testing for plans like 401(k)s and has direct consequences for how employee and employer contributions are calculated and allocated.

Foundational Definitions of Compensation

The regulations provide several baseline definitions of compensation that are automatically considered nondiscriminatory. The most comprehensive of these is derived from Internal Revenue Code (IRC) Section 415(c)(3). This definition includes all payments to an employee that are includible in their gross income for the year, capturing regular salary, wages, overtime, commissions, bonuses, and taxable fringe benefits.

Another common foundational definition is based on wages subject to income tax withholding under IRC Section 3401(a). This definition is slightly narrower than the Section 415(c)(3) definition because it excludes certain statutory fringe benefits that are not subject to federal income tax withholding.

A third option is to use the amount of wages reported in Box 1 of an employee’s Form W-2. This is often seen as a straightforward administrative choice because it aligns directly with year-end tax reporting. The W-2 definition is similar to the Section 3401(a) definition but can differ based on the timing of certain income recognitions.

Permissible Modifications and Safe Harbor Definitions

After selecting a foundational definition of compensation, a plan sponsor can make certain specified adjustments and still maintain a “safe harbor” status. A safe harbor definition is one that is deemed nondiscriminatory without requiring annual testing, which provides a significant administrative advantage. These modifications are permitted under Treasury Regulation § 1.414(s)-1.

One of the most frequently used modifications is the exclusion of certain elective deferrals. This means a plan can start with a broad definition like Section 415(c)(3) compensation and then subtract amounts an employee contributes on a pre-tax basis to a 401(k), 403(b), or cafeteria plan under Section 125. This approach is a safe harbor because the choice to defer is available to all eligible employees.

The regulations also permit the exclusion of specific types of compensation, provided the exclusion applies uniformly to all employees. For instance, a plan may choose to exclude all bonuses and all overtime pay from its definition of compensation. Other permissible safe harbor modifications include excluding items like moving expenses or welfare benefits. The principle is that any exclusion must be applied consistently across the entire employee population to avoid the complexities of annual nondiscrimination testing.

Nondiscrimination Testing for Alternative Definitions

When a plan’s definition of compensation does not meet a foundational or safe harbor definition, it is an “alternative” definition. This definition must be tested annually with a process, often called the compensation ratio test, to prove it does not discriminate in favor of HCEs.

The first step is to separate all eligible employees into two groups. An HCE is an employee who either owned more than 5% of the business during the current or preceding year or received compensation of more than $155,000 in the preceding year. All other eligible employees are NHCEs.

Next, the plan calculates an individual compensation ratio for every employee. This is done by dividing the employee’s compensation under the plan’s alternative definition by their total compensation under a foundational definition, like Section 415(c)(3). For example, if a plan’s definition results in $90,000 for an employee whose total compensation is $100,000, their ratio is 90%.

After calculating individual ratios, the plan determines the average ratio for the HCE group and the average for the NHCE group. To pass the test, the HCE group’s average ratio cannot exceed the NHCE group’s average by more than a de minimis amount. As this is a small margin, the two averages must be reasonably close, and failing the test requires the plan to amend its definition or take corrective action.

Plan Document and Operational Requirements

The specific definition of compensation chosen by the employer must be explicitly and clearly written into the official plan document. This document is the governing instrument for the retirement plan, and its language dictates all administrative actions. Ambiguity or omission of the compensation definition is a drafting error that can lead to compliance issues.

Beyond the written document, strict operational compliance is mandatory. The plan sponsor and its administrators must consistently and accurately apply the definition stated in the plan document for all relevant calculations. Any deviation, even if unintentional, between the plan document’s definition and the definition used in practice constitutes an operational failure.

An operational failure can have serious consequences, such as jeopardizing the plan’s tax-qualified status. This could result in retroactive taxes and penalties for the employer and immediate taxation of vested benefits for employees. Plan sponsors should conduct periodic self-audits to ensure the compensation data being used for plan administration matches the definition outlined in the plan document.