When someone says “Happy New Year” or “have a good year,” most of us do not stop to think what that means. We automatically think 365 days, or the year 2017. But what does “year” mean in the ESOP world? As with most things involving an ESOP, one word can have many diverse meanings. Here is a summary of the most common uses of the word “year” when dealing with ESOP plan administration:
• Plan Year: This is defined in the ESOP plan document as the twelve-month period beginning with the first day of the plan year and ending with the last day of the plan year. The last day of the plan year is typically the day the stock in the ESOP is valued by an independent appraiser and the plan administration is done as of this date. The plan sponsor chooses the plan year that is best suited for the company needs.
• Short Plan Year: Any plan year that is not twelve months is considered a short plan year. There are many reasons why a short plan year might be necessary. For example, if the plan sponsor is changing from a C Corporation to S Corporation, the change may require a non calendar plan year to change to a calendar year. This would be accomplished by having a short plan year.
• Required Minimum Distribution Year: This year is based on the calendar year regardless of the plan year because it always correlates with the participant’s tax year, which is the calendar year.
• Limitation Year: This is defined in the plan document and is the year the annual addition testing for IRC Section 415 is done. The limitation year is typically the plan year which makes testing simpler. It is preferable to have all qualified plans maintained by the same plan sponsor to use the same limitation year.
• Look back Year: When determining if someone is a highly compensated employee based upon the compensation test, one must refer to the compensation in the previous plan year, also called the look back year.
• Tax Year: The company tax year can either be measured on a calendar year or a fiscal year basis. Eligible compensation to calculate the employer contribution deductibility testing under IRC Section 404 is determined based on the tax year, even if this period is different than the plan year.
• Year of Service for Eligibility to enter ESOP: This is defined in the plan document and can have a variety of requirements depending on how the ESOP document is written. This “year” is typically found in the definition section of the document as the Eligibility Computation Period. The most common Eligibility Computation Period is the twelve-consecutive month period beginning on the first day that an employee is entitled to be credited with an hour of service, and subsequent 12-month periods beginning on the first day of the plan year occurring during an employee’s initial eligibility computation period. Please note that initially this “year” is not a calendar year or a plan year, but the twelve months from the date of hire to the one year anniversary of the date of hire. If the eligibility requirements are not satisfied during this “year”, then most documents switch the next Eligibility Computation Period to the plan year. Again, this provision could differ based upon specific plan provisions.
• Year of Service for Contribution Eligibility: This definition relates to participants that have already entered the ESOP by satisfying eligibility requirements. The next step is to determine if the participant meets the requirements to receive a portion of the employer contribution for the plan year. Typically the document will state that the participant shall share in company contributions for any plan year during which he or she is employed on the last day of the plan year. Most documents will also have an hour requirement. This is another definition that can vary widely based on how the document is written, but usually this “year” refers to the plan year.
• Year of Service for Vesting: Typically the plan document will define this “year” as a plan year during which an employee completes 1,000 or more hours of service. Plans may require less than 1,000 hours; however, a plan cannot require more than 1,000 hours. The document can further define years of service for vesting to include years prior to the plan effective date, only years after the effective date, or perhaps only include a certain number of prior years of service. Some plans may also exclude years prior to the date the participant attains age 18. In addition, some plans may not measure hours, but instead measure months of service with the company. This method of not counting hours is called the Elapsed Time Method pursuant to Treasury Regulations Section 1.410(a)-7. This is another area where one needs to examine the plan document to see how specific plan provisions are defined.
• Break in Service: Break in service is used when considering forfeiture timing, rehire issues, and on occasion, distribution timing. Most documents define a break in service as the failure of a participant to complete more than 500 hours of service during a plan year. Again, this can vary from plan to plan. For example, plans using the Elapsed Time Method define a break in service as the continuous severance of a participant’s employment for at least 12 consecutive months from the date of termination.
• Year of Participation for Diversification: Diversification commences in an ESOP when a participant reaches age 55 and has ten years of plan participation, unless the document allows for earlier diversification. Years of participation are measured as years after the date of entry into the ESOP. However, these years could be determined as all plan years after the date of entry regardless of employment status, only plan years while actively employed, or only plan years where the participant was eligible for contribution or a vesting year of service. This is another section of the plan document to read carefully.
As you examine your ESOP plan document, focus on the different definitions of “year” that apply to your plan, you may have questions. Please contact SES ESOP Strategies for clarification and discussion. We love to help you understand how your ESOP works. We look forward to collaborating with you!