Compensation is generally determined on a 12-month basis. Certain situations complicate the selection of the appropriate time period for determining annual compensation:
Both the employer/sponsor of a retirement plan and the Plan itself have a designated Fiscal Year. For the Plan, this fiscal year is called the Plan Year. If the sponsor's Fiscal Year and the Plan Year are not the same, certain complications arise in determining employees' annual compensation. For most small employers, their Fiscal Year and Plan Year are both on a calendar year basis. When this is not the case, however, decisions must be made about how compensation will be determined.
If either the employer or the Plan has a short year, decisions must be made regarding the determination of annual compensation related to that short year.
Non-Calendar Fiscal Years
If the Corporate Fiscal Year is not the calendar year, compensation can be reported on either a Fiscal Year or a calendar year basis. For a Defined Benefit plan, it is usually easiest to measure compensation based on the calendar year ending within the Fiscal Year. This would apply whether the Plan Year is the calendar year or is the same as the Fiscal Year. Whatever method of reporting compensation is used, it should be used consistently and must be specified in the Plan Document.
Example: Nonconcur Rents, Inc. has a Fiscal Year running from December 1 to November 30, and sponsors a Defined Benefit plan with the Plan Year running from February 1 to January 31. For the 2004-2005 Plan Year (February 1, 2004 to January 31, 2005), W-2 earnings are reported for the 2004 calendar year. The "current compensation" for the President is her compensation as reported on her 2004 W-2 statements, and her history of prior earnings can be provided by reporting her W-2 earnings for 2003, 2002, 2001, etc.
Short Fiscal Year
Changing Fiscal Years
When a corporation changes Fiscal Years and/or when the Plan Year is changed, a short Fiscal Year or short Play Year is created. It must then be decided whether to maintain the prior compensation reporting period (this may be preferrable if the prior reporting period was the calendar year), or to change to the a new reporting period. If the reporting period changes, the transition must be handled by overlapping periods, proration of a short year to an annual amount, or some other special method of averaging pays.
Year of Incorporation
The year of incorporation may also be a short year. In this situation, for Defined Benefit plans, compensation for the short year can be prorated to arrive at an annualized level of compensation for funding valuation purposes.
Example: Suppose Shorty Yarrow incorporates Shorts, Inc. on December 2, 2004 with an initial Short Fiscal Year ending December 31, 2004. If he receives W-2 compensation for the short 30-day Fiscal Year of $4,931.51, this can be prorated to $60,000 annualized salary ($4,931.51 x 365 / 30 = $60,000). This annualized $60,000 level of salary can be used to determine the corporate contribution to the plan.