ESOP Operational Issues
Allocation Methods for ESOP Activity
February 15, 2010My topic for this column is how the various items of contribution, income, and so on are allocated among participants' accounts within an ESOP. This is a basic but important topic as the allocation methodologies affect the ultimate benefits provided to ESOP participants.
As a qualified retirement plan, an ESOP is subject to the IRS's nondiscrimination requirements applicable to such plans. However, there are some differences between other types of qualified plans and ESOPs, and I will touch on those as well.
Contributions and ForfeituresThe most common method of allocating these items among the accounts of ESOP participants is pro rata based upon compensation. If the contribution is a matching contribution, then its allocation will be according to the plan's specified matching formula.
It may be possible to use another allocation formula, such as a combination of compensation and years of service. However, this would require that a nondiscrimination test be performed each year, and if the allocation does not satisfy the nondiscrimination requirements, then adjustments would need to be made. Most often, those adjustments will limit the allocations to the highly compensated employees.
Other types of qualified plans are allowed to use an allocation formula that incorporates, to some degree, the Social Security contributions made by the employer. This is known as integration with Social Security or permitted disparity. An ESOP is not allowed to use that allocation methodology.
Also, other qualified plans can perform any needed nondiscrimination testing that may apply to an alternative allocation formula on a "benefits" basis. This is known as cross-testing. An ESOP is not permitted to use cross-testing.
Dividends and S Corporation DistributionsAny dividends or S corporation distributions on shares that are allocated in the participants' accounts will be allocated back to participant accounts based on those share balances.
The allocation of the dividends or S corporation distributions on any shares that are in the unallocated suspense account can vary depending upon the ESOP. The ESOP document should specify how such amounts should be allocated. In many cases, those amounts are allocated in the same manner as an employer contribution (i.e., pro rata based on compensation.) Some ESOP documents provide that the allocation of these amounts will be made in a manner similar to the allocated dividends or S corporation distributions (i.e., pro rata based on share account balances). Note there is a potential nondiscrimination issue here. The reason for that is while "earnings on balances in employees' accounts" will generally be allocated based on such account balances and not be subject to nondiscrimination testing, it is possible that the IRS would not consider the dividends or S corporation distributions on unallocated shares to be "earnings on balances in employees' accounts."
Shares Released Based on Debt Payments MadeThe method used to allocate the released shares back among the participants' accounts depends upon the source of the debt payments. So if an employer contribution was used to make the debt payment that year, then the allocation of the shares released will follow the same methodology used to allocate that contribution. If allocated dividends or S corporation distributions are used to make debt payments, then the shares released will be allocated back pro rata based on the share balances. The value test that I summarized in my last column could affect how the released shares are allocated among participants' accounts if allocated dividends or S corporation distributions are used for debt payments.
The debt payments may be funded by more than one source, and if so, the allocation of the released shares will then be based on a combination of methodologies to match the source of the debt payments.
Earnings on the ESOP's Other Investment AccountThese amounts are generally allocated to participants' account pro rata based on the account balances at the beginning of the year after adjusting for payouts to former participants.
SummaryThe allocation method chosen for these items will affect the benefits provided to participants over the long term, as will the method used to fund the ESOP's debt payments. For example, if more of the ESOP's debt payments are made with dividends or S distributions, then over time, the allocation of shares will tend to be skewed toward the longer term ESOP participants with larger share balances. So consideration should be given to both the short-term and long-term implications when deciding on which allocations methods will be incorporated into your ESOP document.
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