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The Owner’s Compensation: How Much Is Enough?

What is reasonable owner’s compensation? The IRS says it’s what an owner/employee should be paid. This concept can be somewhat elusive since there is no hard set of rules. It’s based on the facts and circumstances of each individual case. However it is an important question, especially for S Corp owners, as this is an area of audit concern for the IRS. Since most people want to pay as little in taxes as possible, the owner’s motivation may not drive him to the right decision in determining his own compensation.

For more information, read the article What Is Compensation?

If you are looking for an affordable way to pay compensation to your employees, take a moment and check out our web based online payroll.

Minnesota Terminates Income Tax Reciprocity With Wisconsin

Minnesota has terminated the tax reciprocity agreement between their state and the state of Wisconsin. This was due to Wisconsin taking approximately 17 months to submit payments to Minnesota. The state needs to receive the payments in a more timely manner to help balance their budget. The two states tried to reach an agreement on a new payment schedule but was unsuccessful. On January 1, 2010, Minnesota officially terminated the agreement.

The Minnesota website provides very helpful instructions for both individuals and employers.These instructions will help you determine what withholding certificate your employee needs to complete, what taxes need to be withheld, and how the income taxes should be filed.

NOTE:  If you are a Minnesota employer and you will no longer have any Wisconsin tax liability, you will need to inactivate your Wisconsin withholding account.

This agreement was originally put into place back in 1968.  I’m sure there are a lot of employers who need to make necessary changes to their employee’s withholding states.  This can be a painful process, but the sooner you update your files, the better.  The longer you wait, the more corrections you may need to make since it was effective the beginning of this year.

If you have any questions, you can contact:

Minnesota Individual Income Tax

Call:  (651)296-3781 or 1-800-652-9094

TTY:   711 for Minnesota Relay


Minnesota Withholding Tax

Call:  (651) 282-9999 or 1-800-657-3594

TTY:  711 for Minnesota Relay


Wisconsin Individual Income Tax

Call: (608) 266-2776


Wisconsin Withholding Tax

Call: (608) 266-2772


401(k) Discrimination Tests — Did Your Plan Pass? Part 2

In my last article, I discussed some of the 401(k) types , and the discrimination tests run on traditional 401(k) plans to ensure highly paid employees aren’t getting more of a tax break than then non-highly paid group.  The IRS requires that 401(k) plans be tested every year.

Here is a brief, over-simplified explanation of some of the other 401(k) discrimination tests:

Minimum Coverage Test — The test requires that the percentage of Non-Highly Paid employees who benefit from the plan is equal to 70% or more of the percentage of Highly Paid who benefit under the plan.  In other words, the IRS does not want a disproportionate number of Highly Paid employees to be eligible for benefits under the plan.

Catch-Up Contributions — Any participant 50 years or older can make additional contributions to their 401(k) account.  The maximum additional amount for 2010 is $5500.  The plan is tested to make sure that no one exceeded the catch-up contribution limit.

Maximum Annual Additions — The IRS sets a limit on the total amount of money that can be contributed from employees and the employer for the year.  The maximum amount for 2010 is $49,000 or 100% of compensation, whichever is less.  The plan is tested to make sure that no one exceeded this limit.

Top Heavy Test — A top heavy plan happens when the balances favor Key Employees too heavily.  The IRS defines Key Employees as either of the following:

  • Owners of the company (at least 5%)
  • Officers of the company with compensation of at least $160,000

The plan is tested annually to make sure that the account balances of the Key Employees are not more than 60% of the total plan balance.  If this is the case, the company has to pay all Non-Key Employees a minimum contribution to their accounts, which is generally 3% of their compensation.

Safe Harbor and SIMPLE Plans — No Testing Hassles

Safe Harbor Plans

Before each plan year begins, a company can decide to give a “Safe Harbor” contribution to eligible employees for the next year.  A Safe Harbor plan automatically passes the discrimination tests.  The company contributes a certain minimum amount to the employees’ accounts.  The employer has two options for giving safe harbor contributions:

  1.  The employer can choose to make a contribution only to those employees who are deferring their own money. The employer contributes 4% of the employees’ compensation.
  2. The employer can also choose to make a contribution to all eligible employees, regardless of whether the employees defer their own pay.  In this case, the employer contributes 3% of the employees’ compensation.

The IRS has specific requirements about notices that need to be given to the employees if the employer chooses to give a safe harbor contribution.

The main advantage of a Safe Harbor plan is that the ADP, ACP, and Top Heavy tests are automatically satisfied.  There isn’t the risk of Highly Paid employees receiving a taxable refund from the plan.  One possible negative consideration of a Safe Harbor plan is that it can be more expensive for the company, as the company is obligated to give a contribution for that year.  The Safe Harbor contributions become vested immediately, meaning the employee can take the employer contribution with them without having to satisfy a length of service if they leave employment with your company.

SIMPLE 401(k) Plan

A SIMPLE (Savings Incentive Plan for Employers) 401(k) plan is similar to a Safe Harbor plan, in that the employer is required to make a contribution that is immediately vested, and is not subject to the annual discrimination tests.  However, this plan is only available for employers with 100 or fewer employees who made at least $5000 in the previous year, and this plan cannot be combined with any other employer savings plans.  A SIMPLE plan also has lower annual deferral and catch-up contribution limits, so not as much money can be contributed in a SIMPLE plan compared with a traditional or Safe Harbor plan.

401(k) Discrimination Tests — Did Your Plan Pass? Part 1

If your 401(k) plan runs on a calendar year, now is the time of year you will receive the results from your discrimination testing from the 2009 plan year. Plans must be tested by March 15th.

Plan testing is required each year in order to make sure your 401(k) plan is in compliance with IRS regulations and to maintain its qualified, tax advantaged status. The IRS allows employees to get a tax benefit by not having to pay taxes on contributions or the earnings from contributions until they withdraw the money. However, in order to get this tax break, the IRS wants to make sure that highly paid employees are not getting a better tax break than everyone else. In other words, Uncle Sam puts a limit on how much tax can be deferred until later.

The tests themselves are rather complex (the IRS wouldn’t have it any other way!) and there are many different tests depending on your plan. If you have a Safe Harbor or SIMPLE 401(k) plan, your plan automatically meets some of these tests, which I’ll cover in a future article.

Two of the tests we plan sponsors tend to pay the most attention to are the ADP and ACP tests.

Actual Deferral Percentage (ADP) Test- compares the amount contributed by employees between two eligible groups: Highly Paid and Non-Highly Paid. The IRS defines Highly Paid employee as someone who is either a 5% owner of the company, or made at least $110K in 2009 (limit subject to change). The Highly Paid group’s average contribution cannot be substantially more than the Non-Highly Paid group average.

Actual Contribution Percentage (ACP) Test – same principle as above, but it compares the average percent contributed by the employer for each eligible person between the Highly Paid and Non-Highly Paid employees.

What happens if the ADP or ACP test fails?

If it is determined that your Highly Paid employees have contributed significantly more than the Non-Highly Paid group, money from the plan will need to be refunded to certain employees. The method to correct the test failure is also too complex for this article, but in short, those who contributed the most money to the plan are first in line to receive a refund. The kicker is that the employee must then claim the refunded money as taxable income the following year.

If you are concerned about failing the tests, you as a plan sponsor have some options to ensure these two tests pass. You can limit the percentage that your Highly Paid group contributes, or you can give a Safe Harbor contribution.

Performance Evaluations Made Easy

When performance evaluation time comes around, no one is happy. Employees are burdened with filling out detailed and tedious essay questions about the execution of their duties and goals.  Managers are then taxed with having to read these (often) long-winded summaries. It’s time consuming, exhausting, and usually puts everyone involved on edge.

I have been conducting performance evaluations at my company for 20 years. During that time, I’ve created (and recreated) an “easy to use” Performance Evaluation System, for both my employees and the managers reviewing them.

[RELATED ARTICLE: Do Salary Increases Cause an Entitlement Mindset?]

Based on a point system, my employees are able to grade themselves on their job performance. Instead of filling out long essay questions, the employee can rate how they think they did in a specific area (like time management, quantity of work done, reliability, etc.). I also give them the option to expand on their self-issued grades with a “Comments” area at the end of each section.

Below each question is an area where the manager can offer their grade (after the evaluations have been submitted), which you can review with each employee when you meet with them.

One part of the evaluation does ask the employee to answer 11 quick questions, and the employee can be as brief or as detailed as they’d like in their responses.

This particular evaluation system has saved my company a lot of time and energy.  It helps me understand my employees’ perspective of their jobs, and it reduces everyone’s stress.

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