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Repaying ESOP Loans with Salary Reductions

David Johanson

February 1996

In October 1994, the Internal Revenue Service (IRS) issued a Technical Advice Memorandum that concluded that a participant's direction of salary reduction contributions (to a 401(k) plan) as a source of repayment for an ESOP loan that is otherwise exempt under section 4975(d)(3) of the Internal Revenue Code of 1986, as amended (the Code), would not cause the plan to violate the exclusive benefit rule under section 401(a)(2) of the Code. Section 401(a)(2) of the Code provides, in part, that plan assets must not be "used for, or diverted to, purposes other than for the exclusive benefit" of plan participants. In reaching its conclusion, the IRS relied upon the legal conclusion that elective deferrals to a 401(k) plan are treated as employer contributions.

In a January 16, 1996, letter from the Department of Labor's (DOL's) Director of Regulations and Interpretations, Mr. Robert J. Doyle, to the director of the IRS' Employee Plans Division, Ms. Evelyn Petschek, the DOL outlined the following concerns it has with the IRS' position. First, section 408(b)(3) of the Employee Retirement Income Security Act of 1974, as amended (ERISA), provides a conditional exemption from the prohibited transaction rules for a loan to an employee stock ownership plan and trust (ESOP) if, among other things, the loan is "primarily for the benefit of the participants and beneficiaries" of the ESOP. Second, under section 403(c)(1) of ERISA, the assets of a plan must never inure to the benefit of the plan sponsor (or any member of its controlled group) and must be held for the exclusive purposes of providing benefits to plan participants and beneficiaries and defraying reasonable expenses of administering the plan. Third, section 404(a)(1)(A) of ERISA provides that a fiduciary must discharge his or her duties solely in the interest of plan participants and beneficiaries and for the exclusive purposes of providing benefits to such individuals and defraying reasonable expenses of administering the plan.

In concluding that an ESOP loan could not satisfy the "primary benefit" requirement if it were structured to be repaid with participant contributions and, in turn, that this also would cause a violation of the "exclusive purpose" and "solely in the interest" requirements of sections 403 and 404 of ERISA, the DOL made the following specific comments:

The use of participant contributions to repay the [ESOP] loan . . . serves directly to relieve the employer of its obligation to contribute to the plan. In addition, such use of participant contributions causes participants to forego other investment opportunities which might prove more beneficial to the participants than the securities purchased [with the proceeds of] the loan.

The DOL's analysis is flawed in a number of respects. First, the fact that the use of participant contributions to pay down the loan incidentally benefits the employer that established the ESOP in the first place by limiting its responsibility for making contributions to the ESOP to amortize the debt incurred to fund the ESOP's purchase of stock does not violate ERISA. Every transaction involving an ESOP benefits multiple parties (i.e., the plan sponsor and selling shareholders) in addition to the ESOP. The key to an ESOP loan (and the purchase of stock) being exempt from the prohibited transaction rules is that it "primarily" benefit plan participants and beneficiaries. As long as the repayment of the ESOP loan results in the proper release and allocation of stock to participants accounts, it is possible for such repayment to "primarily" benefit plan participants and beneficiaries and incidentally benefit the plan sponsor.

Second, the DOL indicates that participants could direct the plan fiduciary to invest their contributions in other investment vehicles and thereby achieve a greater return than they might achieve by effectively using their contributions to purchase stock in the company for which they work. This is very speculative and could go either way based upon the performance of the companies that the participants direct the plan fiduciary to invest in. Studies by the National Center for Employee Ownership and others have shown that when broad-based employee ownership is combined with proper employee participation programs, employee-owned companies tend to be more productive and profitable than other companies. Increased productivity and profitability, in turn, tends to increase the value of the underlying investment. Therefore, how can the DOL support its sweeping and overly general conclusion that "other investment opportunities might prove more beneficial" to plan participants and beneficiaries? Especially when the participants are the ones who are making the decision to invest in the company for which they work.

Finally, the DOL has recently encouraged the direction of investments by plan participants and beneficiaries by the issuance of at least one Interpretive Bulletin that focuses on the importance of passing investment decisions on to such individuals. Assuming participants are given adequate disclosure regarding the decision they are making to use their contributions to pay down an ESOP loan and the financial performance of the company for which they work, it is very difficult to conclude (and inconsistent with the concept of self-directing investments) that such directions by participants will not meet the "primary benefit," "exclusive purpose" and "solely in the interest" requirements of sections 408(b)(3), 403 and 404 of ERISA.

The DOL should reconsider its position in light of these comments. Input from readers also would be very beneficial; send email to drj@esop-law.com.

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