Compensation is an important component in the equation that develops the contributions to both Defined Contribution Plans and Defined Benefit Plans, and the interplay between compensation and contributions can play an important role as the entrepreneur seeks to manage cash flow for the firm. Managing compensation for qualified plan benefit purposes can be a valuable tool in both weak and strong economies.
Digging up past W-2s for the owner of a corporation, or gathering figures from past Form 1040s for a Sole Proprietor, may at times take a bit of effort, the nuisance of the task can be w ell worth it in view of the maximum allowable contribution it may produce for the entrepreneur in their defined benefit plan.
Maintaining accurate records is always a must in order to sustain these contributions under potential IRS Plan Audits. Having c opies of relevant W-2s and 1040 Forms accessible for quick retrieval when needed to support contributions to a retirement plan is one more reason for entrepreneurs to keep them among their valuable papers . In addition, for Sole-Proprietors, copies of page 1 of 1040 Forms should be on file with the actuary so that he/she can support the contributions to these plans based on the numbers taken from these forms.
How Compensation is used in Plans
The definition and determination of compensation is important in Qualified Plans because most retirement plan benefits are directly related to a participant's compensation. This is true for both Defined Benefit Plans and Defined Contribution Plans.
Defined Contribution Plans
In Defined Contribution plans (such as Profit Sharing and 401(k) plans), the contribution to a person's account for the year is defined as a percentage of their compensation for the year.
Example: The PS Company has a Profit Sharing plan that allocates 20% of each participant's pay to their account. Two sample employees:
Position and Name
2005 Pay
% Allocation
2005 Contribution
Vice President Perry
$120,000
20%
$24,000
Technician Sullivan
$20,000
20%
$4,000
Defined Benefit Plans
In traditional Defined Benefit plans, the future retirement benefit is a percentage of their average compensation multiplied by years of service.
Example 1: The DB Company has a Defined Benefit plan that provides a monthly income at age 65 equal to 3% of a participant's high 3-consecutive year average pay multiplied by years of service. The following sample employee has an accrued benefit based on 3 years of service:
Position, Name and
Service (at End of Year)
Pay History
High 3-Year
Average Pay
Accrued Benefit based on
Service to End of Year
Receptionist Derry
3 Years of Service
2003: $22,000
2004: $24,000
2005: $26,000
$24,000 annual
average = $2,000
monthly average
3% x $2,000 x 3 years
= $180 per month
starting at age 65
Example 2: Taking the same DB Company and Defined Benefit plan as described above, but this time we are looking at the owner of the plan, whose pay may fluctuate from year to year. Since the plan formula uses the high 3-consecutive year average pay, it may not be the last 3-year average that determines the participant's benefit, but instead an earlier 3-year average:
Position, Name and
Service (at End of Year)
Pay History
High 3-Year
Average Pay
Accrued Benefit based on
Service to End of Year
President Berry
17 Years of Service
(prior years not shown)
2001: $120,000 2002: $110,000
2003: $115,000
2004: $135,000
2005: $105,000
$120,000 annual
average
(for 2002-2004)
= $10,000
monthly average
3% x $10,000 x 17 years
= $5,100 per month
starting at age 65
Comparison
These examples also illustrate some essential differences between DCPs and DBPs.As a general rule, an entrepreneur must participate in a DCP for 25 years to achieve a good retirement income, while the same retirement income can be achieved in a DBP in 10 or fewer years. See article on Accumulation For Retirement Income.
For both types of plans, accurate compensation records are critical in order to:
calculate the benefit to be received by the participant
determine the sponsor's contribution to the plan
Compensation for an Entrepreneur
How an entrepreneur's compensation is determined depends on the legal organizational structure of the business. The basic principle is clear:
Corporation
If the business is a Corporation (C-Corp) or a Subchapter S Corporation (S-Corp), the owner's compensation is reported on W-2 statements. Providing a complete pay-history is a simple matter of providing a list of W-2 earnings for past years.
S-Corp
Pass-through income or dividends in an S-Corp is not earned income, and cannot be used by a qualified plan in its benefit or contribution formula. Only W-2 earnings are considered as compensation from an S-Corp. Frequently, in order to increase or maximize benefits and contributions under a retirement plan, it is desirable to increase the salary paid to the S-Corp shareholder(s). If the owner of an S-Corp has always had $0 W-2 compensation, they cannot benefit from a qualified pension plan.
Sole Proprietors
For Sole Proprietors, the owner's compensation is more complex, determined by a formula using three interrelated amounts from his/her personal tax return:
Net Schedule C earnings - gross business income, less expenses - called "Net profit" at the bottom of Schedule C and "Business Income" on Form 1040; MINUS
1/2 of the Self-Employment Tax; MINUS
Retirement Contributions Deducted - that portion of plan contributions made on behalf of the owner. This includes the total of contributions to the current plan, any other qualified retirement plan, and any SEPs.
Compensation History
For past years, this is a simple arithmetic calculation with all 3 items taken straight off of page 1 of the owner's Form 1040 return.
Example:The following excerpts show the relevant lines for the 2004 Form 1040:
The specific line numbers may change from year-to-year, but the basic placement of these lines on the Form 1040 and the labeling of these lines remains pretty constant.
Current Year Compensation
For the current year, since the Contribution to be made for the owner is dependent in whole (for DCPs) or in part (for DBPs) on their Considered Compensation, which in turn is caclculated using the Contribution amount , we have a bit of a circular formula that must be solved by computer using successive iterations. The picture is even more complex if there are other employees to be considered because the contribution cost for these other employees is one of the business expenses that are deducted on Schedule C.
Additional Considerations
As mentioned above, the contribution cost associated with other employees is deducted as a business expense on Schedule C at (about) line 19 - Pension and profit-sharing plans. This expense is quite similar to the deduction on (about) line 26 - Wages paid to the other employees. See highlighted sample of 2003 Schedule C.
Note that line 31 - Net profit comes after the deduction of all expenses (see sample of Schedule C), and that this is the number that
is carried forward to Form 1040 as Business income
is the "Net Schedule C earnings" that form the first component of Considered Compensation defined above
is carried to Schedule SE to determine the Self-Employment Tax
Because the contribution cost for the owner's benefit is deducted on Form 1040 after the Self-Employment Tax has already been calculated, Self-Employment Tax is in fact paid on the owner's contribution. This is a disadvantage for the Sole-Proprietor who sponsors a retirement plan as compared to an incorporated sponsor since under corporate sponsorship the contribution would be paid and deducted by the corporation and would not be subject to FICA tax. To the extent that the Sole-Proprietor's contribution cost falls below the current Taxable Wage Base ($90,000 for 2005 - see reference table) the tax rate on the contribution is 15.3%; to the extent that the contribution is taxed above the Taxable Wage Base level, the SE tax rate on the contribution drops to 2.9%.
If Form 1040 summarizes earnings from more than one Schedule C business (such as for both husband and wife), it will be necessary to get the individual components for calculating Considered Compensation from the actual Schedule C's, Shcedule SE's, and other supporting documents for Form 1040.
We strongly recommend providing the actuary with a copy of page 1 of your finalized Form 1040 for each tax year in order to maintain accurate records of your compensation history.
Compensation from Multiple Businesses
Many entrepreneurs operate more than one business. These may form a Controlled Group (controlling ownership is held by 5 or fewer people) or an Affiliated Service Group (having some common ownership and operated in conjunction with each other to provide related services). In either case, both (or all) businesses are treated as a single employer for many purposes. Generally, both (or all) businesses will sponsor the same plan, and compensation will be combined. The compensation from the different entities is simply added together, including situations where one business is incorporated while a related business is a sole-proprietorship.
Example: Fred Garza is a real estate agent operating as a sole-proprietor and is also 100% owner of a real estate management service, Apartment Managers, Inc. He sponsors a Defined Benefit plan for both businesses. His compensation for 2002 to 2005 is developed as follows:
Year
Apartment
Managers,
Inc.
Sole-Proprietorship
Total
Compen-
sation
W-2
Compen-
sation
Net
Schedule C
Earnings
1/2 SE
Tax
Plan
Contribution
Considered
Compen-
sation
2002
88,000
100,150
1,341
12,000
86,809
174,809
2003
93,000
98,756
1,322
12,500
84,934
177,934
2004
94,500
88,654
1,187
13,000
74,467
168,967
2005
62,250
121,740
3,351
30,000
88,389
150,639
The Plan Contributions from 2002 to 2004 were to a Sep. For 2005 the contribution was made to a Defined Benefit Plan.
Contributions were also made and deducted from Apartment Managers, Inc., but these are not shown on this chart since they do not affect the calculation of compensation.
Note that the average pay from 2002 to 2004 is higher than from 2003 to 2005, and it is the former average that is used to establish his projected Defined Benefit retirement benefit. See additional discussion in the article on 3-Year Average Pay.
The same principle of counting compensation from different businesses within a Controlled Group also applies to former businesses that were owned by the entrepreneur. Suppose that a physician previously practiced as a sole-proprietor for 10 years and has recently decided to incorporate. In the process of incorporating, he also decides to establish a Defined Benefit plan. The Considered Compensation (calculated as described above) from the 10 years of practice as a sole-proprietor can be used to immediately establish a high 3-year average pay on which the benefit under the new Defined Benefit plan, which is sponsored by the new corporation, is based.
If the businesses do not form a Controlled Group (or Affiliated Service Group), compensation is to be counted separately. Each business can establish its own retirement plan, and contributions for each business are determined separately based on the compensation received from that business. The limitations on benefits and contributions imposed on plans are imposed separately on each Controlled Group, so the entrepreneur may be able to benefit by "double-dipping"--getting the maximum benefit under two separate plans.
Similarly, if an entrepreneur is also an employee of another business (his or her "day job"), he or she can establish a retirement plan for the side-business that they control. There is no interaction of limits between plans sponsored by these different Controlled Groups. In other words, no limitations are imposed on an employer by the fact that one of their employees (or even the only employee!) happens to be a participant in the plan of an unrelated employer.
Example: Addie Moore works for a corporate giant for her "day job", but also runs several convenience stores as a "moonlighting" endeavor. Her stores are incorporated as an S-Corp named A+, Inc. Until recently she was only taking a salary of $20,000 from A+, but she has now assumed new responsibilities since her business manager quit on her. She now decides to increase her salary to $60,000 for 2004 and to establish a Defined Benefit plan for the employees of A+, Inc. She is to be included in the Defined Benefit plan. Her past years of service (up to 5 years) can be counted towards plan benefits, and her new salary of $60,000 is projected to future years as the compensation level on which her future benefits are projected. She can continue to participate in her 401(k) and a Defined Benefit plan at her "day job". There is no interaction between the limits on benefits and contributions imposed on the plan she sponsors and the plans of which she is a participant at her "day job".
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