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ESOP Operational Issues

Safe Harbor 401(k) Contributions Made to an ESOP

Nancy Dittmer

June 3, 2009

(Nancy Dittmer)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.

Now that I have provided a general overview, it is time to get to some of the complexities.

The first issue I want to explore is how the safe harbor contribution is measured when the contribution is made to a leveraged ESOP and applied to debt payments. For example, assume that the applicable safe harbor contribution is the 3% contribution and further assume that 3% of safe harbor eligible compensation is $200,000. Such $200,000 is applied to principal and interest payments due on the ESOP's loan. These payments release shares with a fair market value of $175,000. So is the safe harbor satisfied since the cash contribution was at the $200,000 level? Or would the cash contributed need to be increased to release shares with a value of $200,000?

This is a gray area. That means that there is not any conclusive, formal authority to which we can turn to answer a given question. It also means that there may be disagreement between practitioners and the IRS and even among practitioners on what is the correct answer. So this is definitely an issue that you should discuss with your own ESOP advisors. I can tell you that I have seen plans designed so that the answer to the first question above is "yes" and I have also seen plans designed so that the answer to the second question is "yes."

Another issue to consider when the safe harbor contribution is made to an ESOP is the distribution restrictions applicable to such contributions. The safe harbor contributions may not be distributed prior to age 59-1/2. However, an ESOP is subject to the diversification requirements that provide that an employee who attained age 55 and completed 10 years of participation in the ESOP must be able to diversify a certain percentage of his or her company stock account in the ESOP. Many ESOPs are designed to provide an in-service distribution to a participant who elects diversification. So you can see the potential conflict here - the ESOP diversification requirements may trigger an in-service distribution prior to the participant's attainment of age 59 1/2 but the safe harbor requirements prohibit such an in-service distribution.

In that situation, the diversification requirement should be met by taking the distribution from a non safe harbor contribution source. If that is not possible, then the form of diversification should be changed so that it is not an in-service distribution but a transfer to the 401(k) plan that offers sufficient investment options. The transferred funds will continue to be subject to the distribution restriction in the 401(k) plan and must be accounted for accordingly.

Finally, in these tough economic times, some companies that have been making the safe harbor contributions now need to suspend such contributions to conserve cash flow.

In general, a safe harbor plan must maintain its status as a safe harbor plan for a full 12 month plan year. There has always been an exception that allows for the suspension of the safe harbor matching contribution during a given plan year. There are several requirements applicable to this exception such as providing the employees with advance notice of this suspension, giving them a reasonable opportunity to change their deferral elections, etc.

There had not been an exception that would have allowed an employer to suspend the 3% non elective safe harbor contribution during a plan year until earlier this year. The IRS issued proposed regulations in May, 2009 to grant relief to companies with this form of safe harbor contribution. The requirements to be able to suspend the 3% non elective contribution are similar to those applicable to the suspension of the matching contribution with one notable difference. The plan sponsor must incur a "substantial business hardship" in order to be able to suspend the 3% non elective safe harbor contribution. Some factors that will apparently be considered in determining this substantial business hardship include (a) whether the employer is operating at an economic loss, (b) whether there is substantial unemployment or underemployment in the trade or business and in the industry concerned, (c) whether the sales and profits of the industry concerned are depressed or declining, and (d) whether it is reasonable to expect that the plan will be continued only if the safe harbor contributions are suspended or reduced.

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