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New Changes in Retirement Plan Law

Part 1: ESOP Provisions

Anthony Mathews

June 2001

Wow, what a weekend we had at the end of May. In one fell swoop, Congress approved pension provisions in the Economic Growth and Tax Relief Reconciliation Act of 2001 that more greatly expand the possibilities of employee retirement planning than any in the last 20 years or so. Now that the President has signed the bill (not surprising since it's his bill), it is clearly time to start thinking about what they might mean to us in administering our plans when these provisions all become effective (ranging from now to as far in the future as 2004). To begin with, let's look at the changes of specific interest to ESOP companies (my first and, truth be told, only real interest).

With respect to C corporation ESOPs, the provisions of Section 404 have been modified to allow for the direct implementation of a form of what we used to call a "dividend switch-back." There are other, less gentle, names for this, but we don't need to go into that here. A dividend switch-back refers to giving ESOP participants the right to direct that any dividend that is otherwise payable to them be transferred instead to a 401(k) portion of the ESOP or a 401 (k) plan sponsored by the company. Under the original rules, this very sensible plan would always result in either the dividend not being deductible to the company (because it wasn't passed through to the participant) or the company having to administratively create a simultaneous salary deferral to the (k) feature equal to the dividend they were passing through, so that the dividend would be deductible and the participant would be in essentially the same place as he or she would have been if the dividend had been rolled over.

Well, some of that worry has been removed. Under the revised Section 404, a C corporation ESOP company may pay a dividend and offer the participant the right to have the dividend reinvested in qualifying employer securities in a 401(k) portion of the ESOP, and the dividend will still be deductible to the company. The principal value of this change (other than somewhat decreased complexity) would be that whereas the dividend itself is clearly earnings of the trust (and therefore, not limited by contribution or deduction limits), the "equivalent salary deferral" has always been subject to limits at several levels. Hence, certain switch-backs can now be accomplished that will no longer interfere with the company's (or the participant's) other contribution plans. This provision is effective for plan years beginning in 2002.

As a practical matter, because this provision is only applicable to "switchbacks" invested in company ctock, this item will probably only be of interest to public companies (who can now essentially implement a dividend reinvestment program for their ESOPs without giving up the deduction for the dividend). Because of securities issues, most closely held company ESOPs will not be able to benefit from this one.

In any case, the real value of this particular benefit is somewhat muted by several other improvements in the new law that would have greatly decreased this interference in any case. But a gift's a gift, and we're happy to get them.

The most significant specific ESOP change comes to our S corporation brethren in what was referred to (through all of last year) as the Breaux-Ramstad anti-abuse measures. It is felt that these provisions remove the government's most significant concerns about the operation of ESOP-owned S corporations and, therefore, protect those provisions into the future. As you may recall, the Treasury was very concerned about potential abuses of the ESOP S corporation becoming a tax shelter for a few highly paid individuals through mechanisms I won't go into here. This provision is intended to guarantee that ESOP S-corporations will benefit a broad cross section of employees.

How does this work?

In general, you want to avoid incurring a nonallocation year. A nonallocation year exists in a plan year in which "disqualified persons" own, or are deemed to own, 50% or more of the of the S corporation, including all stock as well as synthetic equity, at any time during the plan year.

Let's start with the penalties when you incur a nonallocation year:

In any nonallocation year, an excise tax will be charged to the plan sponsor equal to 50% of the value of ESOP allocations to disqualified persons plus the value of any synthetic equity held by disqualified persons. In addition, the disqualified persons will be deemed to have taxable income equal to the allocations.
In the first nonallocation year, the excise tax on ESOP allocations will apply to any stock that has been allocated up to that date to any disqualified person (as if it was all allocated in that year) as well as any synthetic equity held by any disqualified person.

Like presidential liaisons, it's all in how you define things. Key definitions in this case include:

A "disqualified person" is (1) an individual who holds 10% or more of the "deemed owned shares" of the company, or (2) an individual and his/her family who hold 20% or more of the "deemed owned shares" of the corporation.
"Deemed owned shares" include stock allocated in the individual's accounts in the ESOP, plus the individual's relative portion of the unallocated shares held by the ESOP (assuming they had been allocated in the same manner as the most recent contribution was allocated), plus any "synthetic equity" held by the individual, but only if the "synthetic equity" held causes the person to be disqualified. That is, you can't just issue stock options to every employee and get around the problem.
"Synthetic equity" is a broad concept and includes any stock options, warrants, restricted stock, or any other instrument that gives a person the right to obtain stock in the future, and also includes any stock appreciation rights or phantom stock whose value is based upon the S corporation's stock, and it appears that we are required to count each of these units as if they were actual shares of stock (again, only if by counting them we either create more disqualified persons or cause a non-allocation year…these can only work against you, never for you).
A person's "family" includes (1) a person's spouse, (2) ancestors or lineal descendants of the individual or spouse, (3) a brother or sister of an individual or spouse and any lineal descendant of the brother or sister, and (4) the spouse of any person in item 2 or 3. This definition is much broader than the general rules of Section 318 of the Internal Revenue Code.

The provisions are effective for existing ESOPs for plan years beginning after December 31, 2004, and for new plans established, or S corporation status elections made, after March 14, 2001 these provisions apply immediately.

The law also includes a provision allowing the IRS to declare a non-allocation year in any case in which it determines that a corporate structure is devised solely for the purpose of avoiding these penalties.

It looks like most (although not all) legitimate applications of the ESOP S-corporation structure (at least ones we could all probably agree are legitimate) will be able to fly with these rules.

Let's don't forget, though, that if there is a problem with these tests, there are a couple of things you can do about it. The simplest solution, of course, would be to forego the S corporation election. None of these provisions relate to C corporations, so the whole issue would be moot. Once the S corporation election is revoked, the problem goes away. Other possible solutions include (and who ever thought they'd hear me say this) rebalancing the shares in the trust. If you've gotten afoul of these tests because your mature ESOP has a high concentration of stock ownership among a few long-term employees with everyone else holding relatively more in cash, you can always rebalance the shares so that everyone has the same mix of stock and cash, and perhaps resolve the issue. You could presumably also use a special diversification election to get to the same place. Of course, any change like that would require and amendment to the plan before it could be implemented. I'm sure we'll see many more good solutions developed for these problems as time goes by.

Next month: General pension provisions

Biography and list of other "Administrator's Notebook" installments

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