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ESOP Operational Issues

Safe Harbor 401(k) Contributions Made to an ESOP

Nancy Dittmer

June 3, 2009

(Nancy Dittmer)First, let me open by saying how excited I am to be writing this column for the NCEO. I have been assisting companies with the design and administration of their ESOPs for many years. I welcome the opportunity to be able to communicate with more ESOP companies and ask that you contact me if you wish to share any comments on any of the topics that I address in this column. The learning process is a two way street—I learn from my clients just as they learn from me.

My first topic is the use of safe harbor 401(k) contributions in an ESOP. I plan to start with a general overview and then move on to more detailed issues in a subsequent column.

The concept of the safe harbor 401(k) plan design is to avoid the need to perform the special nondiscrimination testing applicable to 401(k) plans. Such tests are known as the average deferral percentage (ADP) test and the average contribution percentage (ACP) test. These tests are designed to limit the 401(k) deferral contributions made by, and the matching contributions made on behalf of, the highly compensated employees.

If your plan qualifies as a safe harbor plan, then this testing is no longer needed. More importantly your highly compensated employees can contribute up to the maximum allowable dollar amount to the 401(k) plan and not worry about receiving a refund after the end of the year because these tests have been failed. (Note, there may be other tests that still trigger a refund.)

To qualify as a safe harbor plan, the employer commits to provide either (1) a matching contribution on a dollar-for-dollar basis up to 3% of compensation; plus 50% of the next 2% of compensation that is deferred by the employee, or (2) a profit sharing contribution of 3% of pay or more for all participants, whether they make 401(k) contributions or not.

If your employer contributions already total 3-4% of compensation and the 401(k) plan has problems passing the ADP and/or ACP tests, safe harbor is definitely something worthwhile to look at and consider.

If you already are making a safe harbor contribution into your 401(k) plan, you may not have thought about making such contribution to the ESOP instead. This could be a solution for a company with cash flow concerns and/or a desire to reduce its overall retirement plan contribution.

There are some other requirements applicable to the safe harbor arrangement that would need to be considered:
  1. All safe harbor contributions must be immediately 100% vested.
  2. The safe harbor contributions may not be distributed prior to age 59-1/2 or on account of financial hardship.
  3. Employees who are not employed on the last day of the plan year or who did not complete a minimum number of hours during the year (i.e. 1,000 hours) cannot be excluded from receiving a safe harbor contribution.
  4. If there are employees who are eligible for the 401(k) plan and not the ESOP because of differences in eligibility and entry dates, they will receive the safe harbor contribution and will now have an ESOP benefit.
  5. Eligible employees must be provided written notice of rights and obligations under the safe harbor 401(k) plan at least 30 days (and not more than 90 days) before the beginning of each plan year.

Because of the first two items, the safe harbor contributions made to the ESOP will need to be tracked separately from other contributions to the ESOP but that should not be an obstacle.

The safe harbor contributions generally can be used within the ESOP in the same manner as any other contribution. In other words, the safe harbor can be used to make payments on the ESOP's securities acquisition loan, it can provide the cash for payments to former participants, it can be used to purchase shares, etc.

So one contribution can serve two purposes:
  1. Meet the safe harbor contribution requirement so that highly compensated employees can contribute to the 401(k) plan without the restrictions of the ADP and ACP tests.
  2. Provide cash in the ESOP for a variety of possible needs.

Author biography and other columns in this series

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