Blue Ridge ESOP Associates Industry News

How to be Creative with Compensation Used to Allocate Contributions

Posted by Anthony Brunsvold

Aug 4, 2015 3:17:16 PM

If you are wondering if your plan can be creative with compensation used to allocate employer contributions, then you need to be aware of the ramifications of such changes.

There are many different ways to define compensation in a qualified plan, such as an ESOP or a 401(k). In fact, the sponsor can use various compensation definitions for different purposes in the administration of the plan. Most plans use a Safe Harbor definition, which is defined in the Internal Revenue Code as nondiscriminatory. By being nondiscriminatory, the plan does not have to perform any tests to prove the compensation they are using favors the highly compensated employees (HCEs) over the non-highly compensated employees (NHCEs). An example of a Safe Harbor definition of compensation is gross compensation.

However, some plan sponsors get creative and design their plan to use a non-Safe Harbor definition of compensation when allocating Employer Contributions. For example, they might not want to use bonuses, over time, or night differential pay when Employer Discretionary Contributions are allocated. The plan would need to perform a test to determine this definition doesn’t discriminate in favor of the HCEs. That test is known as the 414(s) – Compensation Ratio Test.

The 414(s) test is a rather simple test. The test determines the average ratio of plan compensation to total compensation for all eligible employees. The HCEs average ratio can not be greater than the NCHEs average ratio by more then a de minimis amount. Unfortunately, the IRS has never defined a de minimis amount. The IRS has used 3% as a safeguard, but each plan is viewed on a facts and circumstances basis. A simple example can make this test understandable.

Assume company XYZ has 8 employees, 3 HCEs and 5 NHCEs. Their ESOP uses gross compensation, less bonuses and over time pay, to allocate the annual Employer Discretionary Contribution. Assume the 8 employees’ compensation is as follows:

Name

(A)

Gross Compensation

(B)

Bonus/Over time Pay

(C)`

Allocation Compensation

Ratio

C/A= Ratio

HCEs

 

 

 

 

Nancy

$200,000

$50,000

$150,000

75.00%

Bob

$160,000

$35,000

$125,000

78.13%

James

$140,000

$         0

$140,000

100.00%

Average Ratio

 

 

 

84.38%

NCEs

 

 

 

 

Sally

$70,000

$20,000

$50,000

71.43%

Richard

$65,000

$15,000

$50,000

76.92%

John

$40,000

$ 5,000

$35,000

87.50%

Betty

$35,000

$       0

$35,000

100.00%

William

$25,000

$ 4,000

$21,000

84.00%

Average Ratio

 

 

 

83.97%

Since the NHCE’s ratio of 83.87% is within 3 percentage points of the HCE ratio, this plan would pass the 414(s) test.

Most employers believe allocating their contributions using one of the Safe Harbor Definitions of compensation meets their needs. There are planning opportunities for those sponsors who want to use different definitions of compensation for contribution allocations. If you desire to change to a non-Safe Harbor definition of compensation, Blue Ridge ESOP Associates can assist you by preparing projected 414(s) tests to determine if your plan would pass.

Topics: ESOP & 401(k) Plans, ESOP Administration

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