Labor Department Says Pretax Salary Contributions to Repay ESOP Loans Inappropriate

On October 13, 1994, the IRS issued a technical advice memorandum (TAM 95030002) saying that employees could make voluntary pretax contributions to their ESOP or ESOP/401(k) plans to help pay off an ESOP loan. An employee, for instance, might defer 2% of pay to help pay off the loan, receiving an equivalent value in company shares above what would otherwise be contributed. While the IRS thought this was fine, in a January 16, 1996 letter to the IRS, the Department of Labor (DOL) disagreed. The DOL argued that "the use of participant contributions to repay the exempt [ESOP] loan...serves directly to relieve the employer of its obligation to contribute to the plan." The DOL also contended the participant would forego other investment opportunities that might be better.

ESOP consultants have argued that the DOL position precludes employees from making a purely voluntary choice. As long as there is no coercion, and the employee is provided with appropriate information concerning the risks of the decision involved, there should not be a problem. In its letter, the DOL is asking the IRS to change its position; if it does not do so, the TAM would stand and, presumably, companies could continue to allow such contributions.