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The ESOP Administrator's Notebook

ESOP Design Strategies, Part 2

Anthony Mathews

January 1998

(Anthony Mathews)

Leveraged ESOP Release Formula

What's Allowed

With a leveraged ESOP, you also have to consider the method for determining how much stock will be allocated each year. ESOP regulations give us two alternatives for releasing shares from the suspense account as loan payments are made. The difference between the two methods is that one includes interest in the calculation and the other does not. In general, most ESOPs use the method that includes interest (known as the "general rule") because it is available to any ESOP, and, if you have an even payment, amortizing loan, it provides an even distribution of shares over the period.

Also, a couple of interesting things have come up recently related to these limitations. The Small Business Job Protection Act of 1996 eliminated a double whammy that was a serious problem for combined ESOPs and 401(k) plans. After January 1, 1998, 401(k) deferrals and 125 salary reductions may be added back to taxable compensation when determining the maximum annual addition for an employee under Internal Revenue Code section 415. The 401(k) deferrals will still count as annual additions (as will matching or any other contributions), but the deferrals will not also lower the limit by reducing the compensation amount used to compute the maximum annual additions. Please note, however, that this applies to the section 415 limit on annual additions only. The section 404 limit on deductions for contributions is still computed with reference to taxable compensation (i.e., compensation after reduction for 401(k) or 125 plan contributions). But be sure your definitions of compensation in the documents conform to what you want to do.

Also, recently published IRS audit guidelines seem to authorize the testing of 415 limits either with reference to the company's contribution amount or by the fair market value of the shares released for allocation by virtue of that contribution. (Though there is some disagreement as to the guidelines, the IRS in several private letter rulings has allowed the alternate testing method.) Where a company's stock has fallen in value as a result of ESOP loans, this approach could give a much better outcome to participants, but the document must state accordingly (e.g., that the 415 limit will be tested with reference to the lesser of the contributions or the fair market value of released and allocated shares.)

Some Thoughts on the Matter

With regard to the selection of release method, when you have a rough idea of the terms of your loan, check to see if you will qualify for the special rule. If you can, it makes sense to do hypothetical amortization schedules and test the outcome both ways. Sometimes the results are surprising. Most important, if someone tells you that one method or the other always releases shares more or less rapidly, you are talking to someone who hasn't much experience on the subject. Which method releases shares more rapidly depends entirely on the loan terms and amortization schedule.

Actually, this is not strictly a design issue as your plan document will undoubtedly give latitude to do either. On a particular loan, however, once you have selected the release method you're generally stuck with it, so it is important to anticipate the outcome before you are committed.

Dealing With Dividends

What's Typical

More than just "typical," with all the fanfare, the deductible dividend has become almost a panacea for any transaction which doesn't work because of covered payroll considerations. Typically, today, ESOP dividends (whether on allocated or unallocated shares) are intended to be used to pay down on ESOP debt. For a variety of reasons, often, at least some portion of the dividend is passed through to participants directly. So, what's typical is that ESOP dividends are almost always applied in a way as to make them deductible for the employer, and leaving aside for the moment that the amount and timing of dividends are controlled by many non-ERISA factors as well, funding an ESOP with deductible dividends creates very tricky administration problems.

Some Thoughts on the Matter

In this area, the law is unusually specific. Section 404(k) of the Internal Revenue Code provides very specific guidance on how to handle allocations of deductible dividends, although in reality much of that very specific guidance is unworkable.

In general, dividends are only deductible if they are either paid out directly to employees or used to pay down an ESOP loan (in most cases only the ESOP loan used to purchase them.) There are many specific procedural and timing issues related to the deductibility, but our interest here is the unique allocation issues they raise.

To begin with, there is very little if any guidance on the proper basis for allocating shares which were paid for and released from suspense by dividends on shares which were not yet allocated to anyone's account. These released shares could be allocated on the basis of stock account balances, total account balances, compensation, or whatever your plan document dictates. And your plan document must specify how this is to be done. It is fairly easy to determine the effect of different allocation bases for these shares, so if your document doesn't spell it out already, it's worth spending some time testing the alternatives before you decide.

The rules related to allocating shares released with dividends on allocated shares are much more specific. This process must cause an allocation to a participant's account of value at least equal to the dollar amount of the dividend which would have been allocated to his or her account if it had not been used to pay down on the loan. This can be very difficult in a leveraged ESOP where released shares have changed in value from their purchase price. You may very well find yourself unable to use these dividends to pay down an ESOP loan if the stock has gone down in value, and in order to get the deduction, you may have now choice but to pass these through.

The decisions that are made on all these basic design issues related to dividends are significant. The best that can happen if these are left unaddressed is significant delays in administration while everybody tries to figure out what the designers had in mind.

Author biography and other columns in this series

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