RSM McGladrey ESOP Blog

How to fix an error relating to the compensation definition

So now that you realize how precise and important the definition of compensation included in your ESOP document is to the qualification of your ESOP, what do you do if you find that the compensation actually used does not match the document’s definition?

As noted in prior posts, the IRS is definitely encouraging voluntary correction. So how would you correct an error like this? It depends upon the extent and nature of the error. Maybe it is isolated to an inadvertent omission of some bonus information for one year for a small group of participants. Or maybe it involves more participants and more years.

The first instance where the error is limited may be able to be fixed without even notifying the IRS.

The Self Correction Program (SCP) allows the employer to fix the failures without involving the IRS. There are no fees or penalties, and you are not required to submit anything to the IRS. 
• Only operational errors can be fixed under SCP. These are errors that happen because of how the plan was run in operation. In other words, the document itself meets the requirements, but there was an error in operating the plan (i.e., operations inconsistent with the plan terms).
• Practices and procedures must have been established and followed, and the failure arose due to an oversight or a mistake in applying them, or due to an inadequacy in the procedures.
• If the error is "significant" the Plan Sponsor must have received a favorable IRS determination letter with respect to the plan's tax qualified status.  Significant operational errors must be fixed within two years after the end of the plan year in which the operational failure occurred.
• Insignificant operational errors can be fixed at anytime, no matter how old. Insignificant operation errors can even be fixed during an IRS examination.
• The IRS uses a list of factors to determine if an error is considered significant or insignificant (e.g., whether other errors have occurred, number of years involved, number of participants involved and percentage of plan assets involved, etc.).

If the error is a failure to include some compensation for a few participants, the fix may be to make additional contributions on behalf of theses participants based on that inappropriately excluded compensation. That fix would meet the IRS’s general principles of putting the plan into the position that it would have been had the error not occurred and keeping assets in the plan.

More on your ESOP’s definition of compensation

On Monday, I indicated that there were 3 definitions of compensation that were considered to be nondiscriminatory. Isn’t that amazing? Isn’t compensation the same for all plans and all participants? Well, welcome to the complexity of our Internal Revenue Code!

So what are the basic differences between those three definitions?

The definition of W-2 compensation is exactly what you would expect – it is the compensation that must be reported on the annual Form W-2. (Note, as mentioned previously, most plans typically adjust all three definitions to add back the pre-tax contributions to 401(k) plans, cafeteria plans, etc. )

The federal income tax withholding definition would include all types of payments upon which the employer must withhold federal income taxes. In general, these would be the same items of compensation as in the W-2 definition. One difference would be group term life insurance premiums that are taxable to the employee. These must be included on the Form W-2 but are not subject to income tax withholding.

The current income definition under Code Section 415 is again substantially similar as it includes the most obvious components of compensation such as salary, bonuses etc. One difference here would be a distribution from a nonqualified deferred compensation plan. These amounts would be included in the first two definitions but could be excluded in the current income definition.

So you can see that the definition of compensation can be pretty precise. And it is important that you follow the definition of compensation provided for in your plan document down to each nitty gritty detail.

Grrrrrrr!

I saw this late yesterday - Owning too much company stock puts workers' retirement at risk

I chose not to post it right away because I was struggling with whether to distribute it further.

However, those of us in the ESOP community need to know that there are these opinions out there so we can rally together to fight such perceptions.

We know that there is evidence that employee ownership increases employee productivity, that companies that sponsor ESOPs typically have much richer benefit programs for their employees than non ESOP companies and on and on.

And thanks to The Employee Ownership Foundation, the NCEO and others, there will be more research coming that will likely support what we already know – ESOPs are generally good for companies and employees alike.

I will say that reading this article will be good to maintain the intensity level of my work outs in the near future.

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?

IRS To Focus on Qualified Retirement Plan Failures

Here is a piece that is very much related to the discussion that I have just started - IRS To Focus on Qualified Retirement Plan Failures.

It includes the following which clearly illustrates the value of finding and correcting any operational failures on your own.

"Because the failures were uncovered during an IRS audit, in addition to making the required correction the plan sponsor was required to pay a penalty that was 8 times higher than the fee which would have applied for a voluntary compliance prior to notice of the IRS audit. The pre-negotiation penalty asserted by the IRS was about 16 times the voluntary compliance fee."

I plan to discuss some of the common operational failures in future posts.

So how do I fix a plan amendment failure?

Let’s say that you discover that your ESOP is missing one of the amendments that I mentioned in yesterday’s post. Now what? This is where that IRS voluntary correction program comes in. And the good news is that the IRS realizes that these failures do occur. In fact, the following is from their website:

“One of the most common qualification failures currently resolved under the Voluntary Correction Program (VCP) is the nonamender failure occurring in individually designed plans. The term “nonamender failure” includes a failure to adopt timely required good faith plan amendments under the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. 107-16 (EGTRRA good faith amendments), interim, and certain other plan amendments.”

The correction is pretty easy if the failure relates to an EGTRRA good faith, interim or optional amendment. The IRS has a streamlined application for these types of failures.

On the other hand, if the failure relates to the GUST restatement due back in 2002 or a failure to amend within your designated Cycle (see yesterday’s post), the process is more involved.

Still the best course of action if you find that your ESOP has not had one of the necessary amendments is to get the problem fixed by using the IRS’s voluntary correction program as soon as possible.

Required amendments to your ESOP document

I want to start our discussion of common operational errors with a common error that is not really operational in nature.  Sorry for the confusion but it seems like a logical starting place in this discussion is the ESOP plan document.

The importance of your ESOP document can not be overstated. And it is equally important that you maintain the qualified status of your ESOP by adopting all amendments required by legislative or regulatory changes on a timely basis. Failure to do so could disqualify your ESOP.

Here is a list of the amendments that have been required over the past several years:
 GUST Restatement and Good Faith EGTRRA amendment – must have been adopted by February 28, 2002
 Required Minimum Distributions amendment – must have been adopted by the last day of plan year ending on or after December 31, 2003. 
 Mandatory distributions (a.k.a. Automatic Rollover amendment) required for plans containing automatic cash-out provisions– must have been adopted by the later of the last day of first plan year ending on or after 3/28/05, December 31, 2005, or the plan sponsor’s tax filing due date (including extensions) for the first tax year that ends on or after March 28, 2005.
 Final 415 Regulation Amendment - must have been adopted by the later of the last day of the plan’s “Limitation Year” (see plan document to determine limitation year) ending on or after July 1, 2007; or the plan sponsor’s tax filing due date, including extensions, for the first tax year that begins after June 30, 2007.   For corporate employer’s with calendar tax years, due date is March 15, 2009, or if corporate tax return is extended, September 15, 2009.

Note, there are some additional amendments that would have been applicable for your 401(k) plan and any defined benefit plan.

Also, if you prepare an amendment to your ESOP that is not required but rather is a discretionary change to the design of the ESOP, please make sure that these amendments are also signed on a timely basis. If you inadvertently forget to have these amendments approved and signed but begin to operate the ESOP in accordance with such amendment, your ESOP could now be disqualified for the failure to follow the terms of the plan document.

The timing of the entire restatement of your ESOP document is now based on the last digit of your company's EIN as follows:

Extension of the EGTRRA Remedial Amendment Period and Schedule of Next Five-Year Remedial Amendment Cycle
If the EIN of the employer ends in —	The plan’s cycle is —	The last day of the initial cycle (i.e., EGTRRA remedial amendment period) is —	The next five-year remedial amendment cycle ends on —
1 or 6	Cycle A	January 31, 2007	January 31, 2012
2 or 7	Cycle B	January 31, 2008	January 31, 2013
3 or 8	Cycle C	January 31, 2009	January 31, 2014
4 or 9	Cycle D	January 31, 2010	January 31, 2015
5 or 0	Cycle E	January 31, 2011	January 31, 2016

Midwest Regional Conference, ESOP Operational Errors, Etc.

The Iowa/Nebraska, Minnesota/Dakota and Wisconsin chapters of The ESOP Association will be hosting the first ever Midwest Regional Conference on September 24 – 25, 2009 at the Ramada Mall of America in Bloomington, MN. I am sure this is going to be a great conference! There will be more information released as we get closer to those dates.

I will be speaking on the topic of ESOP operational errors and how to correct such errors.  So I thought it might be a good topic to explore here as well.

Anyone involved with a qualified plan can easily attest to the fact that errors happen. They just do, no matter how good your service providers are. No matter how experienced your staff is. Errors do happen. The bad news is that practically any error has the potential to cause a plan disqualification. Fortunately, the IRS has recognized this and established a group of formal programs under "EPCRS" for plan sponsors to voluntarily correct their plan failures and avoid disqualification.  EPCRS stands for Employee Plans Compliance Resolutions System.

EPCRS has different subprograms for different types of failures. For each of the subprograms some general correction principles apply across the board including:

• The correction should be reasonable and appropriate for the failure, but there may be more than one reasonable and appropriate correction method.
• The correction method should, to the extent possible, resemble one already provided for in the Tax Code, IRS Regulations, or other guidance of general applicability.
• The correction method should keep plan assets in the plan.
• Corrective allocations should come only from employer contributions.
• Correction must be made for all affected years, even those closed under the statute of limitations.
 
The key is that the IRS is encouraging plan sponsors to voluntarily correct any operational errors on their own. The potential bad consequences can be significantly reduced through this voluntary correction.

I plan to discuss some of the more common operational errors and how they might be corrected using EPCRS here in future posts.

Unlock the Power of Employee Ownership

I realize that many companies are reducing their discretionary spending in the current environment but here is a course that you should definitely still consider attending – Employee Ownership Management

The topic is more essential than ever today because of the current environment.
The panel is excellent!
The location is pretty exceptional!

Making Stock Distributions from your ESOP

Here is a very interesting piece on this subject - Be Careful to Preserve Beneficial Taxation of ESOP Stock Distributions

I know that more of my clients are making distributions in the form of company stock for a variety of reasons. Typically, the driving reason is related to either to repurchase obligation planning or addressing a Haves vs. Have Nots situation. However, the possible tax advantage to the employee is also important.

I was especially interested in the following from this piece:

“The ruling DOES NOT consider the situation where the ESOP itself purchases the stock from the terminated employee, instead of a purchase by the employer. There is some language in the ruling that implies a sale back to the ESOP would not be eligible for the special method of taxation without first issuing the stock certificate to the employee. Therefore, if the ESOP is purchasing the stock from a terminated employee, and the employee will not be rolling over to an IRA, best practice would be to actually issue a stock certificate to the terminated employee which will then be immediately sold back to the ESOP.”

Many companies try to avoid the administrative burden of actually issuing a stock certificate to that former participant that will immediately be sold and cancelled. However, that administrative exercise might be well worth it if it preserves the favorable tax treatment for the former employee. More importantly, if the IRS does not consider the shares to be distributed for purposes of the former employee’s taxation, then it is possible that they would have the same position relating to the employer’s funding of such distribution.

In other words, the importance of the stock distribution is often that it allows the ESOP to repurchase such shares using a securities acquisition loan. If the stock is not considered to have been distributed, then there could not be a securities acquisition loan so the funds coming from the employer would be considered to be a contribution, a dividend, or something other than proceeds from a securities acquisition loan. This would likely defeat the purpose behind the intent to make the stock distribution.

So again, perhaps the exercise of issuing a stock certificate to those former participants is worth the effort required.  I am very interested to hear from any other ESOP attorneys out there that may have an opinion on this subject.