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The Employee Ownership Update

Corey Rosen

June 11, 2004

(Corey Rosen)

IRS Says Leveraged ESOP Contributions Deductible in Addition to Other Contributions

For many years, there has been uncertainty about whether contributions to repay the principal on an ESOP loan are deductible in addition to contributions made to 401(k), profit sharing, and other defined contribution retirement plans. Generally, ERISA limits total contributions to defined contribution plans to 25% of eligible pay, aggregating all employer contributions to all plans. But laws governing ESOPs also seem to state that the contributions to a leveraged ESOP to repay principal do not have to be aggregated. For instance, if a company is contributing 10% of pay to a profit sharing plan and wanted to contribute 25% of pay to repay principal on an ESOP loan, would its total deductible limits be 25% or 35%? Many ESOP attorneys were reluctant to advise clients it was the higher number, believing that this would be too aggressive an interpretation. Moreover, because the laws governing annual additions to employee accounts (as opposed to maximum employer contributions) set a 25% of pay limit as well, there were few situations when the issue came up. But with changes in the tax law in 2001 increasing annual addition limits, the hypothetical possibility became very real.

Now that issue has been resolved. In a June 9 private letter ruling (not yet published), the IRS looked at a company that had a money purchase pension plan to which it contributed 12% of pay, a 401(k) with a match up to 3.5% of pay, and the intention to create a leveraged ESOP with a 25% of pay contribution to repay principal. The IRS concluded that "Section 404(a)(9)(A) [of the Code] allows a separate deduction for contributions applied by an ESOP to the repayment of principal of a loan." While private letter rulings apply only to the case at hand, the definitive language in the ruling suggests a very strong likelihood that the IRS would come to the same position in other cases.

There are two important caveats in interpreting this ruling. First, it does not apply to S ESOP corporations because the statute governing S corporation ESOPs specifically is different from C corporation ESOPs on the 25% rule. Second, this applies only to the maximum employer contribution. It remains the case that no employee can get more than $41,000 (in 2004) or 100% of pay added to his or her account each year from all employee and employer contributions to defined contribution plans (ESOP dividends are not included in this).

New Towers Perrin Study Shows Expensing Won't Affect Share Prices

In a new study, Towers Perrin analysts Michael Grund and Richard Ericson looked at 335 companies that voluntarily chose to expense options between April 2, 2001, and August 14, 2003 ( "Options Expensing Announcement Has No Impact on Share Prices," March 31, 2004). Share prices were tracked from the day of the company's earnings declarations and the 150 days before and after. The results were then compared to the S&P 500 and MidCap 400 indices. Adjusted for general market movement, the average price of the announcing companies over the period showed no significant variation from the 900 companies in the companies index. The report concluded that options expensing does not affect share prices and that incentive compensation should be driven by actual costs and benefits, not accounting norms. The study is one in a long line of studies now coming to the same conclusion. No study has concluded expensing will significantly affect share prices.

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