New 401(k)/401(m) Rules Simplify Integrating ESOPs and 401(k) Plans

In recent years, it has become more common for companies (particularly publicly traded companies) to integrate their 401(k) plans and ESOPs, using the ESOP to make their corporate match and, in many cases, allowing employees to invest in company stock as an option for their deferrals. Companies usually do this to take advantage of the unique tax-deductibility of dividends paid on ESOP shares. If companies are matching in and/or allowing deferrals into company stock anyway, designating the company stock portion of a 401(k) plan as an ESOP makes the plan more tax efficient. Other companies that have separate ESOPs for other purposes may choose to designate the ESOP contribution as the match to employee deferrals in the 401(k) plan.

Until recently, however, companies had to separately test the ESOP and 401(k) portions of their plans for purposes of applying the Actual Deferral Percentage test and Actual Contribution Test (tests to make sure that highly compensated employees do not contribute or receive too much in the plans relative to other employees). This was an expensive administrative hassle and could cause plan qualification problems if highly compensated employees tended to invest more in company stock than other employees. The result would be a different contribution pattern in the ESOP than the 401(k) plan that could be great enough to cause problems. Under recently proposed rules (Reg-108639-99, July 17, 2003), companies can now aggregate this testing. The rules also would allow companies to aggregate separate ESOP and 401(k) plans to meet testing rules.

The new rules still would require that the two plans be separately tested to see if they meet the required eligibility rules under Code Section 410(b). In addition, the rules would add a new specification that dividends distributed to employees or reinvested in company stock (but not those used to repay a loan) would not be included in the definition of a "Cash or Deferred Arrangement" within a qualified plan, meaning these amounts would be excluded from testing rules in combined ESOP/401(k) plans.

The proposed rules do not allow "good faith compliance" until the final rules are issued, so these new procedures cannot be used until those regulations are finalized.