An employee stock ownership plan (ESOP) is a qualified retirement plan — that is, a retirement plan that’s recognized by the Internal Revenue Service (IRS), established by an employer and designed to provide retirement income to designated employees and their beneficiaries.
The contributions to a qualified retirement plan are tax deductible to the business, and the benefit is tax-deferred to participants. But in order for the employer to qualify for those tax benefits, the employer has to demonstrate the ESOP’s compliance with certain Internal Revenue Code (IRC) requirements. IRC Section 410(b) requires ESOPs and other qualified deferred compensation plans to benefit a broad range of employees.
This, in a nutshell, is what ESOP coverage testing and nondiscrimination testing are all about.
ESOP Participation, Coverage, and Nondiscrimination Requirements
ESOPs are individually designed stock bonus plans qualified under IRC Section 401(a), and are subject to distribution provisions of 401(a)(14), but must also comply with the distribution and payment requirements of Section 409(o). Among the IRS’s many requirements for an ESOP to be qualified are these coverage and nondiscrimination requirements:
- Coverage requirements of IRC 410(b)
- Nondiscrimination requirements of IRC 401(a)(4)
Minimum coverage testing compares the proportion of non-highly compensated employees (NHCEs) covered by the plan against the proportion of highly compensated employees (HCEs) who are covered by the plan. This is to ensure that the ESOP doesn’t provide disproportionate benefits to high-level executives and other highly compensated employees (HCEs).
ALSO READ: Your Ultimate Guide to ESOP Eligibility: Who's In & Who's Out?
Your Compensation Definition is Essential to Your ESOP Documents and Plan Compliance
Because ESOPs are individually designed, it is vitally important for ESOP qualification that compensation is clearly defined in plan documents. Compensation is defined and used for allocating qualified plan contributions, determining deduction limits, and nondiscrimination testing.
Depending on the individual plan design, there may be differing definitions of compensation for each plan component/money source — for example, ESOP, safe harbor match, discretionary profit sharing, salary deferrals, etc.
According to Section 401(a)(4) of the Internal Revenue Code, “Identifying a plan’s highly compensated employees (HCEs) is critical to the operation of a qualified retirement plan. The definition of an HCE is set forth in IRC Section 414(q).”
Safe harbor refers to employer contributions that are added in order to help the plan meet compliance testing requirements.
Compensation needs to be defined in order to determine:
- Who is an HCE
- Who are key employees and what are top-heavy minimum contributions to non-key employees (under IRC Section 416)
- What are the company’s IRC Section 404 deduction limits
- What are each participant’s IRC Section 415(c) annual additions combined plan limits
How Can Compensation Be Defined?
Title 26 of the Code of Federal Regulations, Section 1.415(c)-2 provides four viable definitions for determining compensation for the compliance testing purposes of IRC Section 415:
- The statutory definition of “participant’s compensation” found in §415(c)(3)
- Simplified compensation (safe harbor)
- Section 3401(a) wages (safe harbor)
- W-2 compensation (safe harbor)
ESOP plan documents must clearly define which compensation definition is used.
In addition, IRC Section 414(s) requires compensation to be defined for the purposes of nondiscrimination testing. This is to ensure that the plan uses a uniform definition of compliance among participants, and does not provide contributions that discriminate in favor of HCEs.
IRC Section 414(s) compensation is used by the IRS for the following purposes:
- Section 401(a)(4) discrimination testing of the definition ESOP compensation for ESOP allocation purposes (if the definition is not a safe harbor—see below)
- IRC Section 401(a)(4) discrimination testing of ESOP contributions (if the allocation definition is not a safe harbor)
- IRC Section 410(b) coverage testing
- IRC Section 401(k) Actual Deferral Percentage testing of elective deferrals
- IRC Section 401(m) Average Contribution Percentage testing of matching and after-tax contributions
- Other advanced compliance tests as required
An ESOP’s definition of compensation will satisfy Section 414(s) safe harbor requirements if it is one of the four Section 415(c)(3) definitions listed above, or an alternative safe harbor definition as provided in Section 414(s).
ALSO READ: How Are ESOP Shares Allocated to Employees?
A 414(s) alternative safe harbor compensation definition starts with a 415 definition of compensation and adjusts it using one or more of any of the three following modifications:
- Excluding all cash and/or non-cash fringe benefits, reimbursements, or other expense allowances, moving expenses, deferred compensation, and welfare benefits
- 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)
- Excluding any portion of the compensation to some or all of the highly compensated employees
Why Your Definition of Compensation Matters
Your plan’s definition of compensation is what the IRS’s team of ESOP specialists uses to review the plan and ensure the ESOP meets qualified plan requirements.
An ESOP that discovers it has failed to comply with IRC requirements needs to address and correct plan failures in order to preserve its qualified status and prevent tax consequences for both the business and the plan participants.
Regulatory compliance is fundamental to preserving the tax qualified status of your ESOP, and following an annual timeline can help prevent missed filings and deadlines. Download our free Month-by-Month ESOP Administration Timeline Planning Workbook today, and start building out your calendar, assigning responsibilities, and breathing a little easier. Click the link below to claim your copy now.
