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Deductibility of Contributions: A Practical Application

David Johanson

May 1996

Many closely held companies have established ESOPs for the purpose of making a market for all or a portion of the equity owned by one or more selling shareholders. This is typically accomplished by the company borrowing funds from an outside lender, loaning the proceeds to the ESOP, and the ESOP purchasing all or a portion of the selling shareholders' equity interests.

Provided that not more than one-third of the employer contributions made to the ESOP to repay the ESOP loan are allocated to "highly compensated employees" (HCEs) (within the meaning of section 414(q) of the Internal Revenue Code of 1986, as amended (the "Code"), and that the total annual additions otherwise comply with the Code section 415 limits on an individual basis (e.g., the lesser of $30,000 or 25% of an individual's compensation), a company may contribute up to 25% of eligible payroll to the leveraged ESOP under section 404(a)(9)(A) of the Code to pay loan principal on the ESOP loan and such contributions will be deductible to the company and generally allocable to the accounts of the ESOP participants. Subject to the above caveats regarding HCEs and Code section 415, the interest payments on such ESOP loan will generally be deductible under section 404(a)(9)(B) of the Code.

In addition to the leveraged ESOP, the company may maintain a separate profit sharing plan or a stock bonus plan as a part of the ESOP. The company also may be fortunate enough to have sufficient net income to be able to contribute amounts in excess of those needed to repay the ESOP loan to the profit sharing plan or to the stock bonus plan portion of the ESOP. The Internal Revenue Service (IRS) has recently clarified in Private Letter Ruling (PLR) 9548036 how the company might go about doing so without violating the deduction limits under Code section 404 or the allocation limits under Code section 415.

The typical transaction described above also will involve the deferral of capital gains by the selling shareholder(s) under section 1042 of the Code. Under section 409(n) of the Code, no portion of the assets of the ESOP attributable to (or allocable in lieu of) company stock acquired by the ESOP in a sale to which Code section 1042 applies may accrue (or be allocated directly or indirectly under any plan of the employer meeting the requirements of Code section 401(a)) during a nonallocation period to certain individuals (e.g., the selling shareholder, certain related individuals or more than 25% owners). Although PLR 9548036 did not specifically address this issue, it may provide a means by which a company could make the necessary contributions to the ESOP to repay the ESOP loan and make additional contributions to a separate profit sharing plan or the stock bonus portion of the ESOP that are allocated based upon the pro rata compensation of all participants in the profit sharing plan or the stock bonus portion of the ESOP, including those who are subject to the nonallocation requirements of Code section 409(n).

Analysis of the Relevant Law

Under the general rule set forth in Code section 404(a)(3)(i), the deductible contributions to a stock bonus or profit sharing plan are limited to 15% of eligible payroll. Section 404(a)(3)(iv) of the Code further provides that "if contributions are made to two or more stock bonus or profit sharing trusts, such trusts shall be considered a single trust for the purposes of applying the limitations of this subparagraph." As described above, section 404(a)(9)(A) of the Code establishes special deduction rules applicable to contributions to a leveraged ESOP that are used to repay the outstanding principal and interest on the ESOP loan.

PLR 9548036 resolves the question on the application of the leveraged ESOP 25% limit under Code section 404(a)(9)(A) and the 15% limit applicable to other profit sharing and stock bonus plans under Code section 404(a)(3). The IRS concluded that the limits are applied separately and the annual contributions to a profit sharing plan or stock bonus plan are not aggregated with the annual contributions to a leveraged ESOP for the purposes of determining the 15% and 25% deduction limits.

The deductible limits on an employer's contributions to all qualified retirement plans is subject, however, to an overall ceiling under Code section 404(j). Section 404(j) of the Code provides that an employer's contributions to a qualified retirement plan must be reduced by any annual additions in excess of the limitations under Code section 415 for a given year. For the purpose of determining the employer's overall deductible limit under Code section 404(j), the contributions to all plans must be aggregated.

Practical Example

Assume that an employer's required contributions to a leveraged ESOP that was created in a tax-deferred transaction to which Code section 1042 applies amounted to 15% of eligible payroll. Assume further that the employer either maintained a separate profit sharing plan or a stock bonus plan as a part of the leveraged ESOP, either of which provide for discretionary contributions of up to 15% of eligible payroll, and that the employer proposed to make an additional contribution to the profit sharing plan or the stock bonus plan in an amount not to exceed 10% of eligible payroll. The employer's recordkeeper has conducted preliminary testing under Code section 415 and determined that the proposed allocations of the contributions will not exceed such limits. Based on the IRS' ruling in PLR 9548036, the IRS would probably conclude that the contribution to the leveraged ESOP is not required to be aggregated with the contribution to the profit sharing plan or the stock bonus portion of the ESOP and, as a result, they are both deductible under Code section 404(a). It also is possible that the IRS would conclude that the profit sharing plan or stock bonus plan contributions could be allocated to the account of the son or daughter of the selling shareholder without violating Code section 409(n). The other positive aspect of PLR 9548036 as applied to these facts is that the employer does not have to implement a money purchase pension plan with a fixed contribution in order to make tax-deductible contributions of up to 25% of eligible payroll to the two retirement plans.

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