ESOP Compensation for ESOP Allocations

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Tue, Mar 31, 2015
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ESOP-Compensation-forESOP-AllocationsAs mentioned in our prior article on ESOP Compensation for Compliance and Nondiscrimination Testing, one of the most important items that a plan sponsor will need to gather for ESOP administration purposes is plan compensation.  The legal compensation requirements are defined by the Internal Revenue Code and your specific plan requirements are defined in your plan document. 

Compensation is defined for allocating ESOP and other qualified retirement plan contributions, determining deduction limits, and nondiscrimination testing.  Depending on your plan design, there may be differing definitions for each plan component/money source (e.g. ESOP, safe harbor match, discretionary profit sharing, salary deferrals, etc.).

Determine Your Plan’s IRC Section 414(s) Compensation Definition

A plan is not required to use an IRC Section 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 can still be used if:

  1. It is Reasonable
  2. It does not favor Highly Compensated Employees (HCEs)
  3. It passes the Compensation Ratio Test, also known as Demo 9.  The test must show that the average percentage of total compensation for the HCEs does not exceed the average percentage of total compensation for the NHCEs by more than a de minimis amount based on the facts and circumstances of the individual case
Severance payments are included or excluded in the definition based on your plan definition.  They are generally included if you are using one of the four IRC Section 415 definitions and excluded if using an IRC Section 414(s) definition that excludes welfare benefits.

Annual Compensation Limit

In addition, compensation definitions are subject to the IRC Section 401(a)(17) annual compensation limit ($265,000 in 2015).

Reconcile to Source Documents

Once you have identified the appropriate definitions, it is important to gather the compensation information for all employees.  This will help ensure that the administration is done completely and accurately.  You should be able to reconcile the total wages to the IRS Form W-3IRS Forms 941, and other source documents as appropriate.

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). 

Compensation Errors

The IRS has identified multiple Compensation Errors:

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).  The IRS released EPCRS Revenue Procedure 2015-27, generally effective January 1, 2015, which modified EPCRS Revenue Procedure 2013-12, which was generally effective April 1, 2013, which superseded EPCRS Revenue Procedure 2008-50.  EPCRS allows a plan sponsor to take corrective action to avoid the tax consequences of plan disqualification by offering three programs for self-correction:

  1. Self-Correction Program (SCP)
  2. Voluntary Correction Program (VCP)
  3. Audit Closing Agreement Program (Audit CAP)

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, ESOP Administration

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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