Disabled Participant and 401(k) Safe Harbor Contribution

[John Feldt ERPA CPC QPA]

Company X has an employee who became disabled and has been so now for more than 6 months (most of 2005). Company X pays for a disability policy with an insurance company to cover its employees. The insurance company had Company X act as the payor and they told Company X to also pay and withhold FICA for the first 6 months and to report the payment on the Form W-2 (box 1).

After 6 months, the insurance company explained that the FICA tax no longer needs to be paid, but that Company X must still report the amount paid on the W-2 (box 1).

Company X has a nonstandardized prototype Safe Harbor 401(k) plan that defines compensation as W-2 wages for allocation purposes. As you know, the 3% nonelective Safe Harbor contribution has no allocation conditions.

Company X has reviewed the rules for reporting the sick pay on the W-2. Company X explained to us that unless they have an agreement in place with the insurance company to act as their agent, the insurance company must provide Company X with a notice of sick pay payments (meaning the insurance company will not act as the payor for tax reporting purposes).

Company X will see if it is possible to make the insurance company the payor. However, for 2005, Company X believes that they still in an employer-employee relationship with the disabled participant (this individual is still covered as an employee in their medical insurance plan). Company X believes that they must continue to include these payments on the employee's W-2, including the payments made after six months disability.

Company X has asked us if the Safe Harbor contribution should be allocated to the participant for 2005 based on all of their W-2 pay, or just the portion before they were paid before they became disabled, or just the portion before the 6 months expired.

Is there a way to exclude this participant from getting allocation based on these disability payments that are being paid by the insurance company?