One of the most complicated and sometimes confusing aspects of ESOP administration is determining the compensation required for various plan purposes. Compensation impacts many different areas of administration including: (1) allocations to participants, (2) determination of highly compensated employees (HCEs) and key employees, (3) nondiscrimination testing, (4) maximum annual additions to participants, the employers maximum deductible contribution, and (5) top heavy minimum benefit calculations
While the plan sponsor has some discretion in how compensation is defined in the plan for allocations to participants, for all other purposes compensation must conform to the Internal Revenue Codes (IRC) prescribed definition. Further complicating matters are the several alternative definitions allowed in each area. It is important to be familiar with the compensation rules, all compensation definitions in your ESOP document, and the various categories of your company’s compensation so that your ESOP allocations and compliance tests are completed using the correct compensation.
Section 415 Compensation
IRC Section 415 limits the amount of annual additions (contributions and forfeitures) which are allocated to a participants account. These limits are calculated using one of four possible definitions of compensation:
- the current includible compensation definition — wages, salaries, fees for professional services and other amounts received for personal services to the extent that the amounts are includible in gross income,
- compensation for federal income tax withholding,
- W-2 compensation, and
- a simplified version of the current includible compensation definition.
The plan document must specify which of these four definitions apply, usually in the section of the document which addresses the annual addition limits. All four definitions include elective deferrals. The list of compensation items in each definition of compensation is fairly lengthy and the differences between the definitions can seem complicated. However, if your company pays only wages, salaries, bonuses, overtime, and commissions, there are no differences between the four definitions. In addition to applying the 415 limits, one of these four definitions must be used in identifying HCEs, identifying key employees, and calculating the required minimum contribution if your plan is top-heavy. Section 415 compensation may also be used for all other aspects of plan administration.
Section 414(s) Compensation
ESOPs, like other qualified plans, must be designed so that the contributions and benefits provided in the plan do not discriminate in favor of HCEs. Certain nondiscrimination testing is required and IRC Section 414(s) defines the compensation to be used in the testing. Any of the four Section 415 definitions of compensation can be used alone or in conjunction with any or all of the following three modifications:
- Exclusion of fringe benefits and other specified compensation items (all applicable items must be excluded),
- exclusion of all elective deferrals, or
- exclusion of any compensation item as long as the exclusion applies to only some or all of the HCEs.
If compensation is modified in any other way, the compensation ratio test must pass in order for the compensation to be considered nondiscriminatory. The first part of this test requires that the compensation be considered reasonable. The second part of the test divides the plans definition of compensation by total compensation and averages these percentages for HCEs and non-HCEs. The average of the HCEs can only exceed the average of the non-HCEs by a minimal amount.
To illustrate, lets assume the ESOP allocates contributions based on compensation which is defined as total pay minus bonuses. This definition is not one of the Section 415 or 414(s) definitions of compensation, so the compensation ratio test must be performed. The reasonableness test passes as bonuses are considered a reasonable exclusion. Participants compensation net of bonuses must be divided by total compensation to calculate a percentage. These percentages are averaged for HCEs and non-HCEs and compared. If bonuses tend to favor the HCEs, the test results would be favorable as less pay is being used in allocations to HCEs.
In contrast, a definition which excludes overtime may have more difficulty passing the test as non-HCEs would be the likely recipients of overtime pay.
While some ESOPs may have more creative allocation methods, most ESOPs are designed to allocate employer contributions solely based on compensation. Compensation to be included for allocation purposes must be defined in the plan document. If this definition is any of the Section 415 or 414(s) definitions (including a modified definition which passes the compensation ratio test), the allocation method is considered nondiscriminatory.
The plan may be written to allocate employer contributions using a compensation definition which does not meet one of these prescribed definitions. While this is allowable, the plan sponsor should be advised that additional complicated nondiscrimination testing must be completed and passed.
Compensation for Calculating Deduction Limits
The maximum that an employer can contribute to the plan is determined using 415 compensation, regardless of how the plan defines compensation for allocating the contribution. The compensation considered in the deduction limit calculation is based on the employers taxable year and the compensation considered in the 415 limit calculation is based on the limitation year, which is usually defined as the plan year. If these years are different, the plan sponsor will end up using at least two sets of compensation in their calculations (three sets if the allocation compensation definition is different than the 415 definition).
Maximum Compensation Limit
Qualified plans can only consider compensation up to a certain amount (indexed for cost of living adjustments) in allocations and compliance testing. For 2013, this compensation limit is $255,000..
If your ESOP contains multiple definitions of compensation or uses a definition which requires additional testing, determining the proper compensation for all aspects of your ESOP administration and compliance testing can be a complex undertaking. Further complications can arise in plan years where special compensation items occur which are beyond the scope of this article such as post-severance compensation, military employees, or leaves of absences to name a few. Plan sponsors should review the compensation being considered in the ESOP to ensure compliance with both the compensation rules and the plan document.
The authors consulted with Committee Chair, Pete Shuler, Crowe Horwath LLP, Columbus, OH on this article.
This article originally ran in the October 2013 ESOP Report newsletter, the newsletter of The ESOP Association. Reprinted with permission from The ESOP Association. © The ESOP Association All Rights Reserved 2013
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