Definition of Compensation: A Common Risk for Not-for-Profit Employee Benefit Plan Sponsors

For many plan sponsors, the definition of compensation seems straightforward. If everyone is paid a salary, determining compensation can be simple. However, in practice, compensation is one of the most critical and complex elements of plan administration. It is the foundation for participant deferrals, employer matching contributions, nonelective and profit-sharing contributions, forfeiture allocations and a number of nondiscrimination tests. Errors, even small ones, in how compensation is defined or in how the definition is applied can have considerable consequences.

Why Compensation Drives Everything in the Plan

Compensation is not a single number that flows through the plan unchanged. A plan may apply one definition to elective deferrals, another to employer matching contributions, and yet another to nonelective or profit-sharing allocations. On top of these are the statutory definitions used for testing and qualification purposes, including the annual compensation limit under Section 401(a)(17), the annual additions limit under Section 415, the identification of highly compensated employees, and the ADP and ACP tests where applicable.

Because so many calculations depend on it, a single misclassified pay code rarely stays contained. A bonus code that is excluded in the plan document but included in payroll will overstate deferrals and the match, potentially distort the ADP and ACP results and push at least some participants toward the wrong annual additions figure. The error is usually discovered years after it started, and by then it spans multiple plan years and multiple participants.

Compensation Complexities in Not-for-Profit Organizations

Not-for-profit organizations tend to carry unusually complex pay structures. An organization can pay hourly wages, salaries, overtime, night and weekend differentials, stipends, bonuses, taxable fringe benefits, tuition overload pay, housing or cell phone allowances, and post-employment payments. Each of these has its own payroll code and each code must be mapped to the plan’s definition of compensation.

At Withum, our Employee Benefit Plan Services Team comes across many of these complexities during our audits of not-for-profit plans. For example, we often see bonuses and overtime included for employee deferrals but excluded for the employer matching contribution, and we just as regularly see both types of compensation excluded from all compensation.

We also see the definition of compensation vary by employee type. Another example we have seen states that compensation starts with taxable wages on IRS Form W-2, but for elective deferrals, compensation will exclude cellular phone stipends. For purposes of nonelective contributions, compensation will exclude for union faculty members, transportation reimbursement and for all employees other than union faculty members, will exclude cellular phone stipends, academic earnings, overtime, stipends and bonuses. It is not difficult to see why a pay code can get lost in translation.

Several other conditions common in the sector make plan administration harder to maintain. Budget pressure and grant restrictions can change how a position is funded from one year to the next. Shared service or outsourced payroll arrangements can be another challenge. Also, turnover in finance and human resources means the institutional knowledge of why a code was set up in a particular way often walks out the door.

One Plan, Multiple Definitions

The plan document, together with the adoption agreement, controls which types of compensation are included and which are excluded. Keep in mind that these are the governing documents of the plan and not the Summary Plan Description (SPD). While the SPD is a summary of these documents, not all necessary details may be included, which is why it is especially important to always go back to the source of truth. The plan document and adoption agreement control how the plan operates. The Adoption Agreement will typically state what the starting point of compensation is. You may then need to go to the definition section of the Basic Plan Document to further understand the definition. What you find there is typically one of the safe harbor definitions under Section 415(c)(3):

The three commonly used starting points are:

Each of these is only a starting point. The adoption agreement can then add elective deferrals back in and frequently notes what is to be excluded such as overtime, bonuses, commissions, fringe benefits, reimbursements or amounts paid before a participant becomes eligible. This is often where most operational failures begin because these are the provisions payroll is least likely to know about.

Best Practices to Reduce Errors

After you have a thorough understanding of the definition of compensation, it is good practice to regularly spot-check a sample of participants who have different pay types: an hourly employee with overtime, a salaried employee with a bonus, an employee receiving a stipend or allowance, and a terminated employee with a final check.

It is also important to do a review after any plan amendment, payroll system conversion, merger, or acquisition. An amendment can change the definition of compensation while payroll continues doing what it has always done, and that gap is the single most common cause of a multi-year compensation failure.

What It Costs When It Goes Wrong

Consider a plan that defines compensation for employer-matching purposes as W-2 wages, excluding bonuses, while the payroll system calculates the match based on total gross wages. Every employee who received a bonus was matched on an amount that the plan document does not recognize. The plan has made excess allocations that must be identified participant by participant, adjusted for earnings, and removed or reallocated in accordance with the plan’s correction provisions and the plan document’s forfeiture rules.

The opposite error is much more extensive and expensive. If the definition includes bonuses and payroll excludes them, participants were under-matched and were also not given the opportunity to defer on the compensation. Correction generally requires the employer to fund the missed match, plus a corrective contribution for the missed deferral opportunity, plus earnings on both, for every affected participant and every affected year. This can be a very costly correction.

Compensation errors are correctable. The Employee Plans Compliance Resolution System sets out the framework, and SECURE Act 2.0 significantly expanded the ability of plan sponsors to self-correct eligible inadvertent failures without filing with the IRS, provided the plan has established practices and procedures and the failure is corrected within a reasonable period after it is identified. Correction is generally designed to put affected participants in the position they would have been in had the error not occurred, which means corrective contributions adjusted for earnings.

How Withum Can Help

A clear, correctly applied definition of compensation is one of the most effective ways to prevent operational errors in an employee benefit plan. For not-for-profit organizations, where payroll spans multiple employee groups and pay types, aligning the plan document, the payroll codes, and the contribution calculations strengthens compliance and removes surprises from the audit. Withum’s Employee Benefit Plan Services team works with not-for-profit sponsors on exactly this kind of matter. Reach out to your Withum advisor or contact us directly to discuss your plan.