An ESOP must include a definite formula for allocating employer contributions and forfeitures annually to the individual accounts of plan participants.
Usually, employer contributions to an ESOP are allocated among the participants’ accounts in the plan based on their compensation from the company during the plan year. However, the allocation can also be based on a combination of compensation and years of service with the company. The latter option is more complicated to administer because of IRS rules designed to prohibit discrimination in favor of the highly compensated.
There is a ceiling on the amount of annual compensation that can be recognized for determining participant allocations in ESOPs and other tax-qualified retirement plans. The ceiling is set at $220,000 for plan years beginning in 2006, with future adjustments based on cost of living increases.
For calendar 2006, an employee who is compensated at an annual rate of $350,000 will receive the same allocation within the ESOP as an employee who earns $220,000.
The Code also imposes limits on the maximum annual additions to a participants ESOP account. Annual additions consist of the participants allocated share of the company’s contribution and any forfeitures. For 2006, the maximum annual addition is the lesser of $44,000 or 100% of a participants compensation from the employer. For leveraged ESOPs which satisfy a special nondiscrimination test, interest paid on the ESOP loan and forfeitures do not count as an annual addition. A leveraged ESOP may also use the fair market value of the company stock released from the expense account (See Section 19) to determine the maximum annual additions to participants accounts.
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