More on your ESOP’s definition of compensation

On Monday, I indicated that there were 3 definitions of compensation that were considered to be nondiscriminatory. Isn’t that amazing? Isn’t compensation the same for all plans and all participants? Well, welcome to the complexity of our Internal Revenue Code!

So what are the basic differences between those three definitions?

The definition of W-2 compensation is exactly what you would expect – it is the compensation that must be reported on the annual Form W-2. (Note, as mentioned previously, most plans typically adjust all three definitions to add back the pre-tax contributions to 401(k) plans, cafeteria plans, etc. )

The federal income tax withholding definition would include all types of payments upon which the employer must withhold federal income taxes. In general, these would be the same items of compensation as in the W-2 definition. One difference would be group term life insurance premiums that are taxable to the employee. These must be included on the Form W-2 but are not subject to income tax withholding.

The current income definition under Code Section 415 is again substantially similar as it includes the most obvious components of compensation such as salary, bonuses etc. One difference here would be a distribution from a nonqualified deferred compensation plan. These amounts would be included in the first two definitions but could be excluded in the current income definition.

So you can see that the definition of compensation can be pretty precise. And it is important that you follow the definition of compensation provided for in your plan document down to each nitty gritty detail.