Do you know your ESOP’s definition of compensation?

If you are like many ESOP sponsors, you get a request at the end of each year from your third party administrator (TPA) that asks for an employee census file that shows the compensation paid to each employee during such year. So you download a file from your payroll system and sent it off to the TPA. But did the compensation information that you just sent match the definition of compensation in your ESOP document?  For example, what if the definition in your ESOP document excludes bonuses? Did you remember to back those out of the file that you sent to the TPA?

If the information submitted to the TPA does not match the definition in your ESOP document, you have just committed one of the most common operational errors of retirement plan sponsors. Well, how hard can that be? Compensation is compensation right?

The good news is that a plan sponsor is afforded some flexibility in choosing a definition of compensation for purposes of the ESOP. But that can also be the bad news because once a definition is chosen, then that is the definition that must be used every year or you will be violating the terms of your plan document.

To start with, the following three definitions of compensation are deemed to be nondiscriminatory:
1. W-2 definition
2. federal income tax withholding definition, and
3. the current income definition under Code §415.

I will provide more information on the above definitions later.

Another definition can be used if can pass a special nondiscrimination test. So for example, your ESOP’s definition could possibly exclude bonuses as long as this special nondiscrimination test is satisfied.

Also, it is fairly common to for a plan document to specify that only compensation paid after a new participant actually enters the plan will be considered.  So you need to know your ESOP’s eligibility provisions and entry dates to be able to accurately determine the compensation to be used for ESOP allocations.

Just imagine that you have new staff in your HR department and they get the request from the ESOP TPA for an employee census file. Will they know to read the ESOP document to determine exactly what information to send to the TPA?