Plan Design Risk: S-Corporations with Low Owner’s Wages

Low owner’s wages can elevate compliance risk for S-Corporations.

Generally, S-Corporation owners only have a portion of their income reported as W-2 wages eligible for 401(k) contributions, and the remaining portion of their wages reported on a K-1. Owners who then elect to defer a high portion of their W-2 compensation to their 401(k) can have a very high Actual Deferral Percentage, putting the plan at risk of exceeding the ADP testing limit.

Example: Alexis is an S-Corp owner who reports $70,000 of income on a K-1 and receives $30,000 in wages. If Alexis defers $9,000 (only half the annual limit and less than 10% of her total income), she will have an actual deferral percentage of 30%. It is unlikely that non-owners will have a similar deferral percentage and very possible that the plan is outside ADP limits and would require corrections at year-end.

Owners who wish to contribute larger amounts to the 401(k) plan should consider safe harbor plan design or increasing their W-2 wages and be aware that their wage deferral percentage is what is used for testing purposes. 

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