ESOP Administration: 414(s) Compensation

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ESOPs, like other qualified retirement plans, define compensation in the plan document for purposes of allocating contributions, determining deduction limits, and nondiscrimination testing.  Depending on your plan design, you may have multiple definitions of compensation for different plan purposes.

414(s) Compensation

IRC 414(s) is a definition of compensation utilized in nondiscrimination testing.  A qualified plan must provide contributions or benefits that do not discriminate in favor of Highly Compensated Employees (HCEs).  Section 414(s) compensation is used in Section 401(a)(4) testing for discrimination purposes and Section 410(b) testing for coverage purposes.

A plan is not required to use a 414(s) safe harbor definition of compensation to allocate contributions. However, if a plan uses a 414(s) safe harbor definition, many discrimination testing issues are eliminated or simplified.

Compensation will satisfy the 414(s) safe harbor definition if it is:

• one of the four IRC 415(c)(3) definitions

• an alternative safe harbor definition of Section 414(s)

An alternative safe harbor definition of 414(s) compensation starts with an IRC 415 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)

Summary

You must follow the plan document’s compensation definition(s) in the operation of the plan for allocating contributions, determining HCE and Key employees, performing compliance testing, and computing deduction limits.  Perform annual reviews of compensation definitions and ensure that the person in charge of determining compensation is properly trained to understand the plan document.