In February, I posted a blog about T.C., my new kitten. It may be just me, but since then every time Bear, our Wheaten Terrier, looks at me, I feel guilty. It is as if the dog is saying, “I have been your loyal companion for 10 years and you write about the cat?”
Today, I am going to rectify this situation in the hopes of keeping some pet harmony in my house. But, what would Bear want to know about Employee Stock Ownership Plans (ESOPs)? I can only imagine that she would want to know how benefits were going to accrue—given that she has been around almost ten times as long as T.C.
Most ESOPs accrue benefits on a pay-to-pay basis. Therefore, someone that makes $70,000 would accrue double the ESOP benefit (subject to statutory or plan limits) as someone who made $35,000. This straightforward approach offers benefits to the company:
- It is easy to explain to employees
- It rewards employees with a bigger benefit as their compensation increases (which is usually tied to increases in responsibility or performance)
- It is considered a safe harbor approach and does not need to have an I.R.C. 401(a)(4) test completed annually
If the company established a new ESOP and both employees had the same compensation, they would have the same benefit allocation regardless of length of service (please note that the employees would have to meet eligibility and entry criteria and prior service could be credited for vesting purposes). But, what if the company wanted to do more for the longer-term employees?
The plan can use other allocation formulas as long as they can pass their general nondiscrimination test (I.R.C. 401(a)(4)). Therefore, they can base allocations on several factors including:
- Employee classification
- Tenure and compensation
- Compensation excluding certain elements (such as bonus and overtime)
The company needs to balance the costs of using an allocation formula that does not meet the safe harbor definition with their goals and objectives. These costs include the nondiscrimination testing, employee education and communication. In addition, prior to putting the formula in place they may want to model out the nondiscrimination testing to determine if they are likely to pass once the plan is effective.
I should have anticipated the guilty looks from the dog when I first featured the cat. Likewise, employers should anticipate questions regarding allocation formulas and they should be able to explain their decisions— and what it means to their employees.
In addition to blogging here, I also tweet regularly about topics of interest to ESOPs. Click to follow me on Twitter – @jlripperger.
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