Publication 560, Retirement Plans for Small Business - Definitions (Consumer Pages)
Retirement Plans for Small Business - Definitions
Certain 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 of all 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 to which employees do not contribute and under which no rollover contributions are made.
Business. A business is an activity in which a profit motive is present and economic activity is involved. Service as a newspaper carrier under age 18 or as a public official is not a business.
Common-law employee. A common-law employee is any individual who, under common law, would have the status of an employee. A leased employee can also be a common-law employee. A common-law employee is a person who performs services for an employer who has the right to control and direct 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 for 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 set up retirement plans for their earnings from those employments, even though their earnings are treated as self-employment income.
However, an individual may be a common-law employee and a self-employed person 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), Profit or Loss From Business, for performing marriages, baptisms, and other personal services are self-employment earnings for qualified 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 all the following payments.
- Wages and salaries.
- Fees for professional services.
- Other amounts received (cash or noncash) for personal services actually rendered by an employee, including, but not limited to, the following items.
- Commissions and tips.
- Fringe benefits.
For a self-employed individual, compensation means the earned income, discussed later, of that individual.
Compensation generally includes amounts deferred at the employee's election in the following employee benefit plans.
- Section 401(k) plans.
- Section 403(b) plans.
- SIMPLE IRA plans.
- Section 457 deferred compensation plan.
- Section 125 cafeteria plan.
However, an employer can choose to exclude elective deferrals under the above plans from the definition of compensation.
- 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 you report in box 1 of Form W-2, Wage and Tax Statement.
- The employee's social security wages (including elective deferrals).
- Compensation generally cannot include either of the following items.
- Nontaxable reimbursements or other expense allowances.
- Deferred compensation (other than elective deferrals).
- SIMPLE plans. A special definition of compensation applies for SIMPLE plans. For SIMPLE plans, compensation for employees is the total wages, tips, and other compensation from the employer subject to federal income tax withholding and the amounts paid for domestic service in a private home, local college club, or local chapter of a college fraternity or sorority. Compensation also includes the employee's salary reduction contributions made under this plan and, if applicable, elective deferrals under a section 401(k) plan, a SARSEP, or a section 403(b) annuity contract and compensation deferred under a section 457 plan required to be reported by the employer on Form W-2. If you are self-employed, compensation is your net earnings from self-employment (line 4 of Short Schedule SE or line 6 of Long Schedule SE (Form 1040)) before subtracting any contributions made to the SIMPLE IRA plan for yourself.
Contribution. A contribution is an amount you pay into a plan for all those participating in the plan, including self-employed individuals. 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 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 also have earned income from property your personal efforts helped create, such as royalties from your books or inventions. 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.
Earned income includes amounts received for services by self-employed members of recognized religious sects opposed to social security benefits who are exempt from self-employment tax.
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. However, a partner is not an employer for retirement plan purposes. Instead, the partnership is treated as the employer of each partner.
Highly compensated employee. A highly compensated employee is an individual who:
- Owned more than 5% of the interest in your business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
- For the preceding year, received compensation from you of more than $115,000 (if the preceding year is 2013 or 2014, or $120,000 if the preceding year is 2015) and, if you so choose, 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 does all the following.
- 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.
- Performs services under your primary direction or control.
- Exception. A leased employee is not treated as your employee if all the following conditions are met.
- Leased employees are not more than 20% of your non-highly compensated work force.
- The employee is covered under the leasing organization's qualified pension plan.
- The leasing organization's plan is a money purchase pension plan that has all the following provisions.
- Immediate participation. (This requirement does not apply to any individual whose compensation from the leasing organization in each plan year during the 4-year period ending with the plan year is less than $1,000.)
- Full and immediate vesting.
- 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. For SEP and qualified 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 business deductions. Allowable deductions include contributions to SEP and qualified plans for common-law employees and the deduction allowed for the deductible part of your self-employment tax.
Net earnings from self-employment does not include items 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 the deductible part of self-employment tax and the deduction for contributions to the 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 are 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 are not net earnings from self-employment.
For SIMPLE plans, net earnings from self-employment is the amount on line 4 of Short Schedule SE or line 6 of Long Schedule SE (Form 1040), Self-Employment Tax, before subtracting any contributions made to the SIMPLE plan for yourself.
Qualified plan. A qualified plan is a retirement plan that offers a tax-favored way to save for retirement. You can deduct contributions made to the plan for your employees. Earnings on these contributions are generally tax free until distributed at retirement. Profit-sharing, money purchase, and defined benefit plans are qualified plans. A 401(k) plan is also a qualified plan.
Participant. A participant is an eligible employee who is covered by your retirement plan. See the discussions of the different types of plans for the definition of an employee eligible to participate in each type of 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, and whose business is not incorporated, 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 qualified plan purposes. See Common-law employee and Net earnings from self-employment , earlier.
In addition, certain fishermen may be considered self-employed for setting up a qualified plan. See Publication 595, Capital Construction Fund for Commercial Fishermen, for the special rules used to determine whether fishermen are self-employed.
Sole proprietor. A sole proprietor is an individual who owns an unincorporated business by himself or herself, including a single member limited liability company that is treated as a disregarded entity for tax purposes. For retirement plans, a sole proprietor is treated as both an employer and an employee.