The #1 entity structure for a cash balance plan is the S-Corp. In fact, around 75% of our clients use an S-Corp or C-Corp structure. This post will examine W2 compensation and give you some insight into how to report your compensation to us at year-end.
Note – if your business is structured as a sole proprietor or partnership, you should not run a payroll for yourself. You can see our article here about calculating your net profit.
Table of contents
How do I report W2 wages at year-end?
Form W2 reports the total wage (or earned income) your company paid to you during the year. It also summarizes the payroll taxes, and federal and state tax withholdings.
What W2 number is needed for your administrator? Many people believe that their earned income for purposes of these plans is reported in box 1. Even though this can be correct, it is often not the case.
You should report to us the number in box 5. The reason is because social security tax is capped each year and income in excess of social security is still considered compensation (up to the annual limit). In addition, box 1 is reduced by any 401(k) deferral. This is an employee designated salary deferral and is not an actual reduction of the earned income paid to the employee.
Please see the W2 graphic below:
Payroll Questions
In this section will address some of the payroll FAQs that we receive.
Do I have to run payroll?
Cash balance plans are for company employees. As such, if your entity structure is a corporation (either S or C), you must have a W2 to contribute to a plan. If your corporation does not issue a W2, then your company technically has no employees. These are company-sponsored retirement plans, so no employees mean no contributions.
The critical point is that the IRS must receive payroll withholdings for Social Security and Medicare. If this has not be done, you might have an independent contractor arrangement.
When do I have to report my wages and payroll?
You should technically run a payroll as you provide services to your business. This is just like any other employee. However, we know CPAs and payroll companies that run payroll quarterly or annually.
Whatever timeframe you use, it does not make any difference to us. We need a W2 at the end of the year to support the payroll made.
What happens if I failed to do payroll?
The first thing I would do is contact your CPA. This may have just been an oversight on their part (or yours).
If you truly determine that a payroll did not occur, you still have some time as long as you catch it before the end of the year. Check with your CPA and contact payroll providers to see if they still have time to process. If not, consider the following:
- File your payroll late. You will likely get penalties and interest charges, but they can often be abated. You may also find that the penalties are minor compared to the tax savings you will receive under the plan.
- You can set up the plan for the subsequent year. This might be the best option if it is deemed too challenging to get done.
The point is that there is always time to run a payroll. But if you are very late, penalties and interest can often be more than 50% of the payroll tax.
What about my spouse?
Retirement plans are only for people with earned income that is subject to Social Security and Medicare tax. So if your spouse works in the business, you’ll need to generate a W-2 if you want them to get a contribution. In addition, your plan could have entry date restrictions. But we can often amend plans to make this work.
Remember that your spouse has to work in the business, and the salary you pay must be reasonable. So make sure you discuss the compensation with your CPA or tax professional. But if your goal is to get more money into the plan to reduce your tax liability, contributing for your spouse can make a lot of sense.
What is reasonable compensation?
Reasonable compensation is an IRS concept that does not technically have anything to do with your cash balance plan compliance. Because S-Corp profits are not subject to employment taxes, many business owners think they can generate a very low wage to save on Social Security and Medicare.
But the IRS rules require that S-Corp shareholders receive reasonable compensation for their work. For example, if they stopped working for a year, what would they need to pay someone to come in to do the job that they do? It is a very subjective issue.
However, I just noted that most S-Corp owners want to make their compensation as low as possible. However, because cash balance plan contributions are driven based mainly on age and compensation, you generally want a higher wage if you’re looking to make a higher contribution.
So even though the concept of reasonable compensation does not tie directly to cash balance plan compliance, you should consider funding levels when discussing a reasonable wage with your CPA.
Summary
As you can see, there are many payroll issues that tie either directly or indirectly to your cash balance plan. Reporting the correct compensation or salary is critical to generating an accurate funding range. If you have any questions, please reach out to us to discuss.
