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The Employee Ownership Update

Corey Rosen

February 4, 2003

(Corey Rosen)

The Impact of Bush's Retirement Plan and Tax Proposals on ESOPs and 401(k) Plans

The retirement plan proposals of President Bush would represent the most sweeping changes in retirement plans in decades. While the cornerstone of the proposal is to create two new savings plans to replace IRAs, 401(k)s, and other savings plans, the new Employer Retirement Savings Account would make major changes in the discrimination testing rules for defined contribution plans, including ESOPs. This column will focus on the proposed changes to ESOPs and 401(k) plans. It will also look at how eliminating the taxation of dividends will affect ESOPs.

Proposal Overview

The proposal would replace all existing retirement plans that can be funded at least in part by employee contributions. ESOPs would not be replaced, however, even though a small minority of these plans allow employees to be funded by employee contributions. The new Lifetime Savings Account (LSA) would allow individuals to contribute up to $7,500 per year on an after-tax basis. Money would earn income tax free while in the plan and would not be taxed when withdrawn. Money could be withdrawn at any time for any reason. Parents could contribute $7,500 for each child as well. IRAs would be replaced by the Retirement Savings Account (RSA), which would allow individuals to contribute up to another $7,500 per year. Like Roth IRAs, neither plan earnings nor withdrawals would not be taxed. Withdrawals, however, would be tax-free only after age 58. Only money individuals earn could be put into the account, but spouses could make contribution for their non-working spouses. People with traditional IRAs could, but would not be required to, convert them into RSAs, but the conversion would be taxable.

On the employer side, 401(k) plans, along with thrift, 403(b), 457 plans, SARSEPs, and SIMPLE IRAs would be replaced by the Employer Retirement Savings Accounts (ERSA). The contribution limits for the plans would be the same as for existing 401(k) plans. Any employer will be able to set up an ERSA. Aside from consolidating existing defined contribution plans, the proposal's major change would be in discrimination testing. Existing multi-pronged alternative tests would be replaced with just one, taken from existing law: the percentage of an employer's non-highly compensated employees covered under a plan would have to be at least 70% of the percentage of the employer's highly compensated employees covered under the plan. In addiiton:
  1. Permitted disparity and cross-testing would be prohibited for defined contribution plans (something rarely used by ESOP companies).
  2. The top heavy rules would be repealed for defined contribution plans.
  3. There would be a uniform definition of compensation for all purposes for defined contribution plans - the amount reported on form W-2 for wage withholding, plus the amount of ERSA deferrals.
  4. A simplified definition of highly compensated employee would be adopted under which all individuals with compensation for the prior year above the Social Security wage base for that year would be considered to be highly compensated employees.

The existing ratio and safe harbor tests for 401(k) and similar plans would be replaced with a simpler test for ERISA plans. According to Treasury Department information, the plan would be meet the rules if:
the average contribution percentage for non-highly compensated employees is no greater than 6% and the average contribution percentage for highly compensated employees does not exceed 200% of the average contribution percentage for non-highly compensated employees. If the average contribution percentage for non-highly compensated employees is greater than 6%, then the average contribution percentage for highly compensated employees may be any amount. Regardless of this test, there would be a safe harbor if:

1. The employer makes a non-elective contribution on behalf of each participant in the plan equal to 3% of the employee's compensation,
2. The employer makes a matching contribution equal to 50% of each employee's deferrals (up to 6% of compensation), or
3. The employer makes a matching contribution that does not increase based on the level of an employee's deferrals and the match is equal to the amount that would be made under a 50% match (up to 6% of compensation), such as a match of 100% of each employee's deferrals (up to 3% of compensation).

Effect on ESOPs

The proposal would have little impact on ESOPs. The vast majority of ESOPs already well exceed the strictest discrimination tests, generally including at least all full-time employees with more than 1,000 of service. Moreover, existing anti-discrimination rules present an obstacle for ESOP formation. A small number of ESOPs run afoul of existing top-heavy rules, so these plans would be able to maintain normal vesting schedules (the main impact of top-heavy rules is to require faster vesting). ESOPs that are combined with 401(k) plans would now find it somewhat easier to meet anti-discrimination tests. More important, it is not likely that the new rules would cause companies to abandon ESOPs for an ERSA. Companies set up ESOPs because they want to share ownership with employees broadly. An ERSA plan could be used for that purpose, but subject to much stricter rules about diversification that could well become stricter is current reform proposals favored by the President and most of Congress become law. Moreover, ESOPs have special tax advantages that other plans do not. In short, there would be little direct impact on ESOPs of the new proposals.

Dividend Proposals and ESOPs

The president has also proposed to eliminate taxes on dividends paid to shareholders. This could effect ESOPs directly and indirectly. The direct effect would be on dividends paid to ESOP participants. According to Michael Keeling of the ESOP Association, it appears dividends used to repay a loan or paid into the plan but not distributed would be taxable to the employee when withdrawn from the ESOP or from distributions rolled into an IRA and later withdrawn. That's because the proposal appears to require that dividends be taxed at least once; if the company deducts them, then the employee will have to pay tax on them. Similarly, dividends passed through to employees would be taxable if the company deducted them, but not taxable if the company did not. Keeling cautions, however, that there is no legislative language in this yet, so this remains an interpretation.

The indirect affect could be more significant. The proposal would allow companies to increase shareholder basis for dividends that are retained as earnings rather than paid out (much as in a S corporation). So owners of closely held companies would have less incentive to defer taxation by selling to an ESOP because their taxable gains would be lower. This effect would not become significant for many years, however.

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