Congress Passes Retirement Reform as Part of Tax Bill; ESOPs and 401(k) Plans Affected

The tax cut legislation passed by Congress and about to be signed into law (H.R. 1836) has incorporated a revised version of the Comprehensive Retirement Income Security Act (S. 742, H.R. 10) as part of its income tax reduction legislation. The tax bill incorporates just about all of the House and Senate provisions, generally phasing in the rules according to the faster schedules proposed by the House. [Note on June 7: The President signed the bill today, and it became Public Law No. 107-16.]

The legislation is the most significant change in retirement plan law in many years. The major provisions affecting employee ownership are outlined here. For a more detailed explanation, search at thomas.loc.gov under bill no. H.R. 1836.

S Corporation ESOPs

On the ESOP front, the bill provides severe tax disincentives to use an ESOP in an S corporation so as to benefit just a few employees in the plan. The proposal includes a two-step process to determine if the S corporation ESOP will not be subject to punitive tax treatment.

1. First, define "disqualified persons": Under the law, a "disqualified person" is an individual who owns 10% or more of the allocated and unallocated shares in the ESOP or who, together with family members (spouses or other family members, including lineal ancestors or descendants, siblings and their children, or the spouses of any of these other family members) owns 20% or more. Synthetic equity, broadly defined to include stock options, stock appreciation rights, and other equity equivalents, is also counted as ownership for this determination if it means that an individual would become a 10% or 20% owner under this definition.
2. Second, determine if disqualified individuals own at least 50% of all shares in the company: In making this determination, ownership is defined to include:
   1. shares held directly
   2. shares owned through synthetic equity
   3. allocated or unallocated shares owned through the ESOP

If disqualified individuals own 50% or more of the stock of the company, then these individuals may not receive an allocation from the ESOP during that year. If such an allocation does occur, it is taxed to the recipient as a distribution and a 50% corporate excise tax would apply to the fair market value of the stock allocated. If synthetic equity is owned, a 50% excise tax would also apply to its value as well. In the first year in which this rule applies, there is a 50% tax on the fair market value of allocated shares of disqualified individuals even if no allocations are made to those individuals that year (in other words, the tax applies simply if disqualified individuals own more than 50% of the company in the first year).

Effective Date for S Corporation ESOP Changes: For plans in existence before March 14, 2001, the rules become effective for plan years beginning after December 31, 2004. For plans established after March 14, 2001, or for preexisting C corporation ESOPs that switched to S status after this date, the effective date is for plan years ending after March 14, 2001.

Authorization to Disallow Existing Abuses: In addition, the conference report directed the IRS to develop regulations to define existing plans as subject to this legislation, regardless of when they were established, if their purpose is "in substance, an avoidance or evasion of the prohibited allocation rule."

The new legislation will not prevent every sham ESOP transaction from occurring, and a few legitimate ones will be inadvertently caught in its definitions; however, it should go a long way toward preventing the kinds of abuses that have occurred.

ESOP Dividend Reinvestment

Effective for taxable years after December 31, 2001, companies can deduct dividends on ESOP-held shares that employees voluntarily reinvest back into the ESOP to buy more company stock. The conference agreement instructs the Secretary of the Treasury to disallow any deduction if its purpose is "in substance, the avoidance or evasion of taxation." However, the language specifically defines dividends paid on common stock in public companies as reasonable, as well as dividends paid in closely held companies that are comparable to dividends paid on company stock in comparable public companies (companies of similar size, line of business, dividend history, etc.).

Changes to Defined Contribution Plan Limits

In addition, changes to contribution limits and other rules governing defined contribution plans would make it easier to combine an ESOP with a 401(k) plan. All provisions are effective for plan years after December 31, 2001, unless otherwise noted. The major provisions that affect employee ownership are listed below:

• The dollar limit on annual additions that can be made to an employee account would be raised from $35,000 to $40,000 per year and thereafter indexed for inflation in $1,000 increments. As under current law, this limit covers the combination of employer contributions and employee deferrals.
• The current limit on salary defined as eligible pay for making contribution to employee accounts would be raised from its current $170,000 to $200,000, then indexed for inflation in $5,000 increments.
• The maximum amount an individual can defer to a 401(k) plan is increased to $11,000 in 2002 then increased in $1,000 increments until 2006, when it will be indexed for inflation, rounding up to the closest $500 increment annually. Individuals 50 and over could add another $5,000 annually to this amount, a maximum that would be reached in $1,000 increments.
• Elective deferrals no longer reduce the employer's tax-deductible limit on what can be contributed to a defined contribution plan, or combination of plans. Under current law, if an employee defers pay into a 401(k) plan, that percentage is added to what the company can itself contributes pre-tax to all defined contribution plans. This combined amount then cannot exceed either 15% of total eligible pay or 25% (the higher limit currently applies to leveraged ESOPs or combined defined contribution and money purchase plans). So if employees defer 5% of pay, in a typical non-leveraged plan, only 10% could be contributed pre-tax by the company. The new law will mean this 5% no longer is counted.
• The current limit on annual additions to employee accounts in defined contribution plans of 25% of pay per year is increased to 100% per year. Because of other limits (the maximum dollar annual addition limit, the maximum dollar deferral limit, and the maximum deductible employer contribution limit of 25% of pay), the effect of this will primarily be to allow lower and mid-level employees to put more into a 401(k) plan.
• The current limit of 15% of eligible pay that can be contributed to plan participants in non-leveraged ESOPs and other defined contribution plans will be increased to 25% of pay. Amounts deferred by employees into 401(k) plans no longer reduce the definition of eligible pay (under current law, if a $30,000/year employee defers $2,000 per year, eligible pay is defined as $28,000; now it will be $30,000). However, money purchase plans are now considered as profit-sharing or stock bonus plans for purposes of this limit, meaning that you can no longer contribute up to an additional 10% of pay (over the now 25% of pay limit) by adding a money purchase plan.
• Elective deferrals can be treated as after-tax contributions. Effective for tax years after December 31, 2005, employees can put after-tax dollars into a 401(k) plan, subject to existing maximum contribution limits on all elective deferrals, that could be withdrawn at retirement on a non-taxable basis (like a Roth IRA, in other words).

Small Employer Benefits

Two provisions were added to encourage small employers to set up plans:

• For the first five years, user fees for filing letter of determination requests are no longer required for employers with fewer than 100 employees and whose plan cover at least one non-highly compensated employee.
• A 50% tax credit is provided for the first $1,000 of costs in the first three years for establishing, administering, and communicating a retirement plan for employers employing 100 employees or less with compensation over $5,000. Costs currently deductible would be eligible for the credit; credited amounts would not also generate a tax deduction.

Rollover Rules

The new law allows employees to roll over distributions from any qualified retirement plan, including an IRA, into any other qualified plan. Rollovers into an IRA will be made automatically for involuntary distributions over $1,000 unless the employee affirmatively chooses not to have a rollover occur.

Top-Heavy Rules

The definition of employees in the "top-heavy" group is simplified in both versions of the bill. Top-heavy plan ESOPs and other defined contribution plans are those allocating more than 60% of the benefits to a defined group of highly paid "key" employees. Plans that are top-heavy are required to provide faster vesting. Prior definitions of key employees were complex; the new law defines a key employee as (1) an officer with compensation over $130,000 (adjusted for inflation in $5,000 increments), (2) a 5% owner, or (3) a 1% owner with compensation over $150,000. Current law defining a key employee as a top-10 owner is repealed.

Faster Vesting of Employer Matches

Employer matches to employee deferrals in a 401(k) plan (including those done through an ESOP) will have to vest faster than under current law. Cliff vesting must be completed after three years of service and graduated vesting must start at 20% after not more than two years and be completed at not less than 20% per year till the sixth year is completed.

What It All Means for ESOPs

The new tax law is very favorable to ESOPs. First, its reform of S corporation ESOP law, which was promoted by ESOP advocates, will help protect legitimate S corporation ESOPs from being attacked as tax evasion. The dividend reinvestment provision for ESOPs will primarily be of interest to public companies because the reinvestment would be subject to securities law requirements. Exemptions from registration requirements for employee offers are available for closely held companies, however, although anti-fraud disclosure requirements will still need to be met for companies that want to allow employee dividend reinvestments.

The new contribution limits will make it much easier to combine ESOPs with 401(k) plans, allowing many companies now unable to allow employee deferrals into 401(k) plans because of annual addition limits to make these deferrals available. Higher company contribution limits will also make life easier for non-leveraged ESOPs and S corporation ESOPs. Companies no longer will have to use a money purchase plan feature to get to a 25%-of-pay company contribution limit.

Small companies will find ESOP costs reduced by the tax credit for plan design. New key employee rules also make plan design a little easier, although the faster vesting rules for matching contributions could mean some ESOP companies have to choose between having one set of rules of matching contributions and one set for other contributions, or simply making all their vesting rules faster.