Frequently Asked Questions

Employee Ownership FAQs

Common questions about employee stock ownership plans (ESOPs), employee ownership trusts (EOTs), and other forms of employee ownership, from the basics to technical topics.

This FAQ is written primarily for business owners, managers, and advisors involved in setting up or running an employee ownership plan. If you're an employee at an ESOP company looking to understand your own benefits and rights, see our articles on Working at an ESOP Company and The Rights of ESOP Participants.

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What happens if an ESOP, 401(k) plan, or other qualified plan is found to be violating legal requirements, such as not covering enough participants, failing to distribute benefits according to the requirements of the Internal Revenue Code, allocating stock

What happens depends on the nature of the violation. Because of the potentially serious consequences of these violations, it is important to consult with an attorney with experience in the specific kind of plan involved. If the plan has been operating in violation of the law, and the IRS or the Department of Labor audits the plan and finds this out, taxes that should have been paid by the company, the participants, and, if applicable, lenders to the ESOP and/or sellers to the ESOP, would have to be repaid, with interest and, possibly, 50% excise tax penalties.

Disqualification applies only to some kinds of violations, such as allocations in excess of the limits in Section 415 on maximum contributions, a failure to meet the minimum participant coverage rules (not covering a percentage of non-highly compensated employees which is at least 70% of the percentage of highly compensated employees who are covered), not passing through required voting rights (a failure which would cause the ESOP tax benefits to be lost, but which would not disqualify the plan), etc. It would not usually apply to other problems, such as failing to send people an annual account statement or failure to file an annual return. Because there is no simple dividing line, it is important to be very clear with your legal counsel about what kind of problem will result in what kind of remedy. Also note that Sections 1042 (the "ESOP Rollover" rules allowing tax deferral from certain sales to ESOPs) has specific penalties for violating their terms.

If a plan is disqualified, the company may have to pay taxes, if any, that should have been paid as a result of the error, plus, where someone received an improper allocation because of a Section 1042 restriction, a 50% excise tax. Participants who receive a prohibited allocation have to pay tax on whatever part of the allocation caused it to be prohibited. To remedy the plan shortcoming, the company could either enter a voluntary compliance program or a closing agreement program (see other questions in this section).

Link to this FAQ Topic: Governance, Fiduciaries & Compliance