Definitions You Need To Know
Some of the terms used in this publication are defined below. The same term used in another publication may have a slightly different meaning.
Annual additions. Annual additions are the total amounts of all of your contributions in a year, employee contributions (not including rollovers), and forfeitures allocated to a participant's account.
Annual benefits. Annual benefits are the benefits to be paid yearly in the form of a straight-life annuity (with no extra benefits) under a plan but excluding the benefit attributable to employee contributions or rollover contributions.
Business. A business is an activity in which a profit motive is present and some type of economic activity is involved. Service as a newspaper carrier under age 18 is not a business, but service as a newspaper dealer is. Service as a sharecropper under an owner-tenant arrangement is a business. Service as a public official is not.
Common-law employee. A common-law employee is any individual who, under common law, would have the status of an employee. A common-law employee can also include a leased employee.
A
common-law employee is a person who performs services for an employer who has the right to control and direct both the results of the work and the way in which it is done. For example, the employer:
- Provides the employee's tools, materials, and workplace, and
- Can fire the employee.
Common-law employees are not self-employed and cannot set up retirement plans with respect to income from their work, even if that income is self-employment income for social security tax purposes. For example, common-law employees who are ministers, members of religious orders, full-time insurance salespeople, and U.S. citizens employed in the United States by foreign governments cannot establish retirement plans with respect to their earnings from those employments, even though their earnings are treated as self-employment income.
However, a
common-law employee can be self-employed as well. For example, an attorney can be a corporate common-law employee during regular working hours and also practice law in the evening as a self-employed person. In another example, a minister employed by a congregation for a salary is a common-law employee even though the salary is treated as self-employment income for social security tax purposes. However, fees reported on Schedule C (Form 1040) for performing marriages, baptisms, and other personal services are self-employment earnings for Keogh plan purposes.
Compensation. Compensation for plan allocations is the pay a participant received from you for personal services for a year. You can generally define compensation as including:
- Wages and salaries,
- Fees for professional services, and
- Other amounts received (cash or noncash) for personal services actually rendered by an employee, including, but not limited to:
- Commissions and tips,
- Fringe benefits, and
- Bonuses.
Compensation also includes amounts deferred in the following employee benefit plans, unless you elect not to include any amount contributed under a salary reduction agreement (that is not included in the gross income of the employee).
- Qualified cash or deferred arrangement (section 401(k) plan).
- Salary reduction agreement to contribute to a tax-sheltered annuity (section 403(b) plan), a SIMPLE IRA plan, or a SARSEP.
- Section 457 nonqualified deferred compensation plan.
- Section 125 cafeteria plan.
The limit on elective deferrals is discussed later under
Salary Reduction Simplified Employee Pension (SARSEP) and
Keogh Plans.
Other options. In figuring the compensation of a participant, you can treat
any of the following amounts as the employee's compensation.
- The employee's wages as defined for income tax withholding purposes.
- The employee's wages that you report in box 1 of Form W-2.
- The employee's social security wages (including elective deferrals).
Compensation generally cannot include:
- Reimbursements or other expense allowances (unless paid under a nonaccountable plan), or
- Deferred compensation (either amounts going in or amounts coming out), other than certain elective deferrals unless you elect not to include those elective deferrals in compensation.
For a self-employed individual, compensation means the
earned income, discussed later, of that individual.
Contribution. A contribution is an amount you pay into a plan for all those (including self-employed individuals) participating in the plan. Limits apply to how much, under the contribution formula of the plan, can be contributed each year for a participant.
Deduction. A deduction is the amount of plan contributions you can subtract from gross income on your federal income tax return. Limits apply to the amount deductible.
Earned income. Earned income is
net earnings from self-employment, discussed later, from a business in which your services materially helped to produce the income.
You can have earned income from property that your personal efforts helped create, such as books or inventions on which you earn royalties. Earned income includes net earnings from selling or otherwise disposing of the property, but it does not include capital gains. It includes income from licensing the use of property other than goodwill.
If you have more than one business, but only one has a retirement plan, only the earned income from that business is considered for that plan.
Employer. An employer is generally any person for whom an individual performs or did perform any service, of whatever nature, as an employee. A sole proprietor is treated as his or her own employer for retirement plan purposes, and a partnership is the employer of each partner. A partner is not an employer for retirement plan purposes.
Highly compensated employees. Highly compensated employees are individuals who:
- Owned more than 5% of the capital or profits in your business at any time during the year or the preceding year, or
- For the preceding year, received compensation from you of more than $80,000 and, if you so elect, was in the top 20% of employees when ranked by compensation.
Leased employee. A leased employee who is not your common-law employee must generally be treated as your employee for retirement plan purposes if he or she:
- Provides services to you under an agreement between you and a leasing organization,
- Has performed services for you (or for you and related persons) substantially full time for at least 1 year, and
- Performs services under your primary direction or control.
Exception. A leased employee is not treated as your employee if the employee is covered by the leasing organization under its qualified pension plan and leased employees are not more than 20% of your nonhighly compensated work force. The leasing organization's plan must be a money purchase pension plan providing:
- Immediate participation,
- Full and immediate vesting, and
- A nonintegrated employer contribution rate of at least 10% of compensation for each participant.
However, if the leased employee is your common-law employee, that employee will be your employee for all purposes, regardless of any pension plan of the leasing organization.
Net earnings from self-employment. Compensation is your net earnings from self-employment. For SEP and Keogh plans, net earnings from self-employment is your gross income from your trade or business (provided your personal services are a material income-producing factor) minus allowable deductions for your business. Allowable deductions include contributions to SEP and Keogh plans for common-law employees and the deduction allowed for one-half of your self-employment tax.
Earnings from self-employment do not include items that are excluded from gross income (or their related deductions) other than foreign earned income and foreign housing cost amounts. For the deduction limits, earned income is net earnings for personal services actually rendered to the business. You take into account the income tax deduction for one-half of self-employment tax and the deduction for contributions to a qualified plan made on your behalf when figuring net earnings. Net earnings include a partner's distributive share of partnership income or loss (other than separately stated items, such as capital gains and losses). It does not include income passed through to shareholders of S corporations.
Guaranteed payments to limited partners qualify as net earnings from self-employment if they are paid for services to or for the partnership. Distributions of other income or loss to limited partners do not qualify.
For SIMPLE plans, compensation is your net earnings from self-employment (line 4 of Short Schedule SE (Form 1040)) before subtracting any contributions made to the SIMPLE IRA plan for yourself.
Owner-employee. An owner-employee is:
- A sole proprietor, or
- A partner who owns more than 10% of either the capital interest or the profits interest in a partnership.
Participant. A participant is an
eligible employee who is covered by your retirement plan.
Partner. A partner is an individual who shares ownership of an unincorporated trade or business with one or more persons. For retirement plans, a partner is treated as an employee of the partnership.
Self-employed individual. An individual in business for himself or herself is self-employed. Sole proprietors and partners are self-employed. Self-employment can include part-time work.
Not everyone who has net earnings from self-employment for social security tax purposes is self-employed for Keogh plan purposes. See
Common-law employee, earlier. Also see
Net earnings from self-employment.
In addition, certain fishermen may be considered self-employed for setting up a Keogh plan. See Publication 595,
Tax Highlights for Commercial Fishermen, for the special rules that apply.
Sole proprietor. A sole proprietor is an individual who owns an unincorporated business by himself or herself. For retirement plans, a sole proprietor is treated as both an employer and an employee.
VEBA Funded Cafeteria Plan Benefits
- The provision of IRC 125 benefits, such as health insurance, disability, life insurance, child care through a VEBA trust is not necessarily inconsistent with exempt status under section 501(c)(9).
- IRC 505(b)(3) provides that if a benefit is subject to nondiscrimination rules under some other section of the Internal Revenue Code, those rules must be satisfied and not the nondiscrimination requirements of IRC 505(b)(1).
- Benefits that are provided through a VEBA and a related cafeteria plan can be viewed as meeting the nondiscrimination requirements of section 501(c)(9) if the following standards are met:
- The nondiscrimination rules applicable to a specific benefit must be met so that the specific benefit is treated as nontaxable. For example, a dependent care assistance program must meet the rules in section 129(d), a self-insured medical expense reimbursement plan must meet the rules in section 105(h), and group-term life insurance must meet the rules in section 79(d).
- In addition to the nondiscrimination rules which determine whether specific benefits are nontaxable, the cafeteria plan itself must also meet the nondiscrimination requirements set forth in section 125(b).
- Because the Service will not rule on the qualification of IRC 125 plans, the following caveat should be used in these situations:
- We are not making a determination directly or indirectly, on whether the arrangement which you describe as a "cafeteria plan" meets the requirements of section 125 and other related sections of the Internal Revenue Code. Further, this determination is not to be construed by inference or otherwise as approving, for purposes of exemption under section 501(c)(9), any other arrangement which purports to be a "cafeteria plan" .
- Since cash or deferred savings arrangements can be provided through a cafeteria plan, but are not permissible benefits under IRC 501(c)(9), any exemption ruling or determination under IRC 501(c)(9) should clearly only cover permissible 501(c)(9) benefits.
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INFORMATIVE NON-PROFIT PUBLIC WEBSITES CONTAINING CURRENT USEFUL INFORMATION AND RESEARCH ABOUT 401K:
Information about 401k advisors at www.advisors401konline.com .
401K PLANS FOR SMALL BUSINESSES--WHY SMALL COMPANIES NEED 401K PLANS at www.401k-administrator.com . Small business SIMPLE IRA, Simplified Employee Pensions-SEPs, 401k and payroll deduction IRAs for small businesses at www.401k-plan.com .Small business 401k contributions, 401k SPD summary plan descriptions and section 404c rules for small businesses and small 401k plans at www.401k-regulations.com .IRA rollover information for small business 401k plans and 401k retirement savings and IRA rollover information at www.ira-easy.com .Small business 401k salary deferral employee contributions and small business 401k employee and employer 401k salary contributions at www.myvideoclip.com .Small business 401k pension plan services and automatic passive enrollment, negative elections and passive automatic enrollment for small 401k plans at www.pension-plan-services.com . Small profit sharing 401k for small companies and small company 401k defined contribution plans at www.profit-sharing.com . Small company 401k retirement plans and 401k fiduciary liability and 401k fidelity bonds for small businesses at www.retirement-plans.com . Small business 401k plan replacement and takeovers for small businesses wanting a 401k conversion from another small business 401k plan at www.what2ware.com . Comparison of small 401k plan costs and 401k fees for small business 401k plans at www.401k-fees.com .401k plan expenses and small business 401k expense comparisons and small business 401k cost comparisons at www.401kplans.net .
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Digests of Published Rulings and Procedures
- Medicare payment reimbursed.--An organization which is exempt from Federal income tax under IRC 501(c)(9) may reimburse its members for premiums paid under the medical benefits program (medicare) provided under the Social Security Amendments of 1965, Public Law 89-97, 1965-2 C.B., 601. Rev. Rul. 66-212, 1966-2 C.B. 230.
- Employment taxes; collection and payment.--An organization established by a collective bargaining agreement between an association of manufacturers and a labor union to collect Federal and State employment taxes which the manufacturers are required to deduct from the wages of their employees who are members of the union, and pay over the amounts so collected to the appropriate tax authorities, does not qualify for exemption under IRC 105(c)(4), 501(c)(5), 501(c)(6), or 501(c)(9). Rev. Rul. 66-354, 1966-2 C.B. 207.
- Workmen's compensation benefits, collection and payment. --An association formed by a corporation to provide workmen's compensation benefits that the corporation was already obligated to pay under State law does not qualify for exemption under IRC 501(c)(9). Rev. Rul. 74-18, 1974-1 C.B. 139.
- Organization with only one member.--An organization that has as its purpose the provision of life, sick and accident benefits to all employees of a specified professional corporation does not qualify for exemption under IRC 501(c)(9) when the professional corporation has only one employee. Rev. Rul. 85-199, 1985-2 C.B. 163.
- For taxable years beginning after December 31, 1987, the Tax Reform Act of 1986 provides that the determination as to whether an individual is a highly compensated individual shall be made under rules similar to those under IRC 414(q). IRC 414(q) covers a broader range of individuals than covered by the definition of highly compensated employees under prior law. Specifically covered under IRC 414(q) are employees who at any time during the year (or preceding year):
