Definitions of ESOP Compensation

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Tue, Feb 04, 2014
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One of the most important items for the annual ESOP administration process is preparing the compensation and census information. Unless this is the first year of your ESOP, you will most likely have an established file format to follow when organizing the information.  The most important items to gather are the various components of compensation. 

Definition of Compensation

ESOP plan documents, like other qualified retirement plan documents, define compensation in the plan document for purposes of allocating ESOP contributions, determining deduction limits, and nondiscrimination testing.  Depending on your plan design, there may be differing definitions for each money source (e.g. ESOP, safe harbor match, discretionary profit sharing, salary deferrals, etc.).

Reconcile to Source Documents

To ensure that the administration is done completely and accurately the compensation information for all employees should be gathered.  You should be able to reconcile the total wages to the IRS Form W-3 and IRS Forms 941. You should be able to reconcile all other totals to source documents as well.

If your plan only considers compensation while a participant and you have quarterly or semi-annual participation dates, it would be helpful to split the wages by the applicable period (if the information is easily attainable). 

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IRC Section 415 Compensation

Qualified plans need to define compensation for IRC Section 415 compliance testing.  This definition is also used in identifying highly compensated employees (HCEs), key employees, calculating minimum benefits to non-key employees under top heavy plans, and determining deduction limits for Defined Contribution plans.  Treasury Regulation §1.415(c)-2 provides for four viable definitions to determine IRC Section 415 Compensation:

  • §415(c)(3) Compensation (the statutory definition)

  • Simplified compensation (safe harbor)

  • Section 3401(a) wages (safe harbor)

  • W-2 Compensation (safe harbor)

The plan must clearly state which definition is being used.

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IRC Section 414(s) Compensation

IRC Section 414(s) Compensation is the definition of compensation used for nondiscrimination testing to make sure the plan does not provide contributions discriminate in favor of Highly Compensated Employees (HCEs).  IRC Section 414(s) Compensation is used in IRC Section 401(a)(4) discrimination testing and IRC Section 410(b) coverage testing.

Compensation will satisfy the IRC Section 414(s) safe harbor definition if it is one of the four IRC Section 415(c)(3) definitions discussed above or an alternative safe harbor definition of Section 414(s).  An alternative safe harbor definition of 414(s) compensation starts with an IRC Section 415 Compensation definition and adjusts it by one or more of any of the three following modifications:

  1. Excluding all cash and/or non-cash fringe benefits, reimbursements or other expense allowances, moving expenses, deferred compensation, and welfare benefits

  2. Excluding all elective deferrals under a 401(k) arrangement or a 403(b) plan, contributions to a cafeteria plan under IRC 125, a nonqualified salary deferral under IRC 457, or any qualified transportation fringes under IRC 132(f)(4)

  3. Exclude any portion of the compensation to some or all of the highly compensated employees (HCEs)

Compensation for ESOP Allocation Purposes

A plan is not required to use a 414(s) safe harbor definition of compensation to allocate ESOP contributions. However, if a plan is not using an IRC Section 414(s) Compensation safe harbor definition, it will be subject to additional discrimination testing.

Annual Compensation Limit

In addition, compensation definitions are subject to the IRC Section 401(a)(17) annual compensation limit ( $260,000 in 2014).

Compensation Errors

The IRS has identified multiple Compensation Errors related to compensation:

Errors related to compensation can occur when:

  • the third party administrator or payroll processor does not know the plan’s definition of compensation;

  • the plan’s definition of compensation is amended, but the third party administrator or payroll processor is not notified;

  • payroll systems are not updated to reflect the revised definition; or

  • payroll systems are not updated when the types of compensation paid change.

Correcting Compensation Errors

Contribution errors caused by incorrect compensation figures can be corrected using the Employee Plans Compliance Resolution System (EPCRS).  EPCRS allows a plan sponsor to take corrective action to avoid the tax consequences of plan disqualification.  The IRS released Revenue Procedure 2013-12 on December 31, 2012, which modifies and supersedes Revenue Procedure 2008-50. 

Self-Correction

The error can be self-corrected, without IRS approval, if the mistake is insignificant or, if significant, if the plan sponsor corrects the mistake within two years. A plan sponsor can use self-correction only if the plan has practices and procedures in place designed to promote overall tax law compliance. 

Voluntary Correction Program

Plan sponsors can correct errors with IRS approval by using the Voluntary Correction Program.

Your submission to the VCP should:

  • describe the plan failure and proposed correction method,

  • show calculations for your proposed corrective contributions, and

  • state your proposal for fixing the administrative practices that allowed the failure to happen.

Appendix D of Rev. Proc. 2008-50 may be used for your VCP submission.

Whether compensation should have been included or excluded, you will have to take corrective action to ultimately put the participants in the position they would have been, including corrective earnings, had the failure not occurred.  You may need to distribute excess amounts from the plan or make corrective contributions as needed.

Preventing Compensation Errors from Occurring Again

You will also need to make sure that the mistake doesn’t happen again:

  • Perform an annual review of your plan’s operations to ensure that contributions are made based on the correct definition of compensation.

  • When you amend or restate your plan, check its compensation definitions against the old plan document, noting any differences.

  • If you start to pay a new type of compensation, such as bonuses or overtime, check your plan language to confirm its proper treatment, and then tell your payroll processor or third party administrator about it.

  • If possible, simplify your plan’s definition of compensation and use the same definition for multiple purposes.
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Topics: Compliance, Employee Stock Ownership Plan (ESOP)

Aaron Juckett, CPA, CPC, QPA, QKA
Written by Aaron Juckett, CPA, CPC, QPA, QKA

Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

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