ESOP Operational Issues
How Many "Buckets" of Shares Does Your ESOP Have?
July 15, 2009As I mentioned when discussing safe harbor contributions made to an ESOP, those safe harbor contributions will likely need to be accounted for separately from other contribution sources. In fact, there are many circumstances that necessitate that the company stock (and the related other investment or cash account) should be maintained in its own separate "bucket." The following is not intended to be an all-inclusive list but does include many of the more significant reasons for separate tracking:
- 1042 Shares: Shares acquired in a tax deferred sale to an ESOP are subject to certain restrictions against allocating such shares to the selling shareholder, certain family members and other more than 25% shareholders. Thus, the 1042 shares should be tracked separately from any non-1042 shares. And if there are multiple 1042 transactions, there may be a need for a separate bucket for each transaction.
- Dividends: Dividends and S corporation distributions may generally only be applied to the repayment of the loan which was incurred to acquire those shares. (Note, there is a special exception for dividends on shares acquired on or before August 4, 1989.) As a result, shares acquired in different leveraged transactions should be maintained in separate buckets.
- Cost Basis: Shares acquired in different transactions will have a different cost basis. The most efficient method of tracking cost basis will likely be to maintain the shares acquired in different transactions in separate buckets.
- Forfeitures: In certain circumstances, the forfeitures attributable to leveraged shares do not have to be included as annual additions for purposes of the Code Section 415 testing. In order to be able to exclude these forfeitures, the leveraged shares likely will need to be tracked separately from any purchased shares.
- Diversifications: Shares that were acquired after December 31, 1986 are subject to the age 55 and 10 years of service diversification provisions of the Internal Revenue Code. Shares acquired prior to that date are not necessarily subject to these requirements (but could be if your ESOP document so provides.)
- Shares that were acquired after December 31, 1986 are subject to the special distribution rules applicable to ESOPs. These rules govern the timing and form of distributions. Shares acquired before December 31, 1986 do not have to be subject to these rules unless the plan document so provides.
- The ESOP document may delay distributions of share balances until the loan used to purchase such shares is completely repaid. In that situation, such shares should be tracked separately from other shares that may need to be distributed earlier.
- Any shares attributable to either safe harbor or money purchase pension contributions are subject to restrictions prohibiting in-service distributions and accordingly should be tracked separately from shares not subject to these restrictions.
- Plan Mergers: If another plan's balances were merged into your ESOP at some point, those balances may have different benefits, rights or features (such as the right to certain forms of payment, timing of distributions, in-service withdrawal options, etc.) attached to such balances that may need to be preserved.
- 409(p) Profit Sharing Transfers: If an ESOP maintained by an S corporation is on the verge of failing the Code Section 409(p) testing, shares can be transferred into a profit sharing component of the ESOP to avoid such failure. The S corporation income attributable to such shares will be subject to unrelated business income tax.
From my perspective, all of these issues are just part of why working with ESOPs is so fun!