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Convert 401 to ESOP to get 404(k) deduction


Guest Rudy

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We have a plan whose employer wants to convert their 401k to an ESOP in order to take advantage of the Code 404(k) deduction. Obviously, one of the investment options in the 401k is employer stock.

My concern lies with the fact that the employer wishes to allow participants to continue to direct their investments (deferral and match - the plan has no profit sharing component). Basically, they want to continue to operate as a 401k, but on an ESOP document.

I have never heard of an ESOP where a participant could opt out of company stock via an investment election. This employer's accounting firm is really pushing this issue, stating they have done this same thing with other clients.

Am I missing something, or can participants (under 55) in an ESOP opt out of investing in the company stock and the plan is still an ESOP? Any suggestions, cites etc. would be greatly appreciated.

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Hi Rudy ---

It's permitted so long as the ESOP as a whole, or the entire portion of the plan that's designated as an ESOP, complies with all the requirements applicable to an ESOP under IRC sections 4975(e)(7) and/or 409(a).

Just because you haven't heard of this doesn't mean it's not OK. This type of arrangement, often referred to as a "KSOP," has been used increasingly by many companies since the late-1980's.

To keep informed on current ESOP developments and practices, you ought to join The ESOP Association (www.esopassociation.org) and/or the National Center for Employee Ownership (www.nceo.org).

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Stange as it seems, that is the scam that the IRS has appeared to bless as an ESOP under numerous private letter rulings.

A regular contributor to this board will probably disagree, but if I were participating in the scam, I would want my own ruling, just in case the IRS wakes up some day.

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There are many IRS private letter rulings that consider just the employer stock fund portion of the plan to be an ESOP. Certainly getting your own ruling is the safest route, but there's enough rulings out there to constitute a clear trend.

Remember that ESOP and non-ESOP portions of the plan must be tested separately for various discrimination tests, which complicates things a bit.

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Mweddell,

I assume you mean that under a typical KSOP, setting up a component ESOP means that you need separate testing for coverage, ADP/ACP testing and other 401(a)(4) (i.e., profit Sharing) testing. I was wondering if you could elaborate a bit on the need to do separate testing under 401(a)(4). For example:

1) What are the mechanics of running such tests?

2) If the plan currently passes nondiscrimination on a combined basis, why would separate testing be affected on a separate basis?

Thanks.

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401(a)(4) testing is required if (1) there are employer nonmatching contributions made to the plan, and (2) the contributions are not allocated in proportion to 414(s) compensation.

The ESOP portion must be treated separately from the non-ESOP portion of this test. The ESOP portion must be tested on a contributions basis without imputing permitted disparity.

Explaining in greater detail how to perform the 401(a)(4) testing is probably more than I can do on a bulletin board post. One classifies the employees of the employer as highly compensated employees and nonhighly compensated employees, sorts the contribution percentages for participants, runs ratio percentages for each participant and those with higher contribution percentages although one may group together certain employees, and compares the results to the midpoint between the plan's safe and unsafe harbor percentages. Yes, I know that was probably jibberish -- you'd really have to read the 401(a)(4) regulations or a book to figure it all out. Perhaps others can suggest an appropriate book to read.

It strikes me as very common for the plan to pass 401(a)(4) on a combined basis but to fail when separating it between the ESOP and non-ESOP portions of the plan because the highly compensated employees might be clustered in the ESOP portion of the plan (or theoretically in the non-ESOP portionof the plan) to a greater extent than the nonhighly compensated employees.

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If you really believe the scam, as long as all contributions are in cash (non-ESOP portion of the plan), you don't have any contributions to the ESOP. The ESOP feature depends on the investment in employer securities, which occurs independently of the contributions. So what is to test?

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QDROphile,

Can you expand on why you think this arrangement constitutes a scam?

While I am aware that PLRs do not give the whole story and very often can be misrepresented by slick salesmen, and that I have not ready any of the PLRs that MWeddell alluded to, I must ask if you have read any of them, and if so, why do you think that they do not give any guidance in this matter?

Is it that the PLRs are not consistent or on-point with the arrangements that you have seen designed or installed?

George D. Burns

Cost Reduction Strategies

Burns and Associates, Inc

www.costreductionstrategies.com(under construction)

www.employeebenefitsstrategies.com(under construction)

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If possible, I would like to move away from the policy discussion and get back to thoughts on the difference of opinion between Mweddell and QDROphile regarding whether ND testing would be impacted in converting a 401(k) plan to a KSOP.

It appears that QDROphile has a good argument in saying that as long as contributions go in to the plan as cash, testing on the plan will not change if it is designed as a KSOP.

MWeddell, you seem to be saying that a profit sharing contribution would need to be tested separately. Does this mean the plan would need to run a 414(s) test on the ESOP portion of the plan and a separate test on the rest of the plan?

In addition, you bypassed my point about coverage and ADP/ACP testing. Would those tests need to be done on a disaggregate basis?

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Regarding the "scam" issue:

Think about it this way-

The plan has been around for a while. The HCE's have lots of company stock in their accounts (perhaps a disproportionate amount from the NHCE's). Now you can allocate a dividend to the plan based on the stock holdings and get a deduction for it.

Thus it may be possible to make a huge contribution to the HCE's and not be discriminatory.

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stephen ---

A dividend paid by the employer on company stock owned by an ESOP is not an employer contribution. A dividend is paid equally on all shares of stock (of that class), whether owned by the ESOP or by non-ESOP shareholders. As to the ESOP, the dividend is a return on its investment in company stock....just like interest or dividends on other investments. Dividends are paid as an investment return to all shareholders, while ESOP contributions are paid as deferred compensation to employees. Dividends are properly paid (and allocated under the ESOP) with respect to shares of company stock, not based on participants' compensation.

The fact that the highly-compensated employees have larger account balances is usually a result of larger prior allocations of contributions (and forfeitures) over longer periods of time. This is not unlike what happens in most other defined contribution plans...ESOP or non-ESOP.

If the HCEs have disproportionately higher balances of company stock as a result of their 401(k) investment elections, it's because they were willing to take the investment risk of non-diversification....and that risk may have paid off. As you know, however, there have been many recent cases of 401(k) participants having elected large investments in company stock which have suffered significant decreases in value over the past two years.

And remember that the employer does not get a deduction under IRC section 404(k) merely by paying a dividend on company stock held by the ESOP. The dividend must be used by the ESOP for payments on ESOP debt or must be "passed through" in cash to participants or (under new law) must be either "passed through" or reinvested in company stock at the election of participants. And, if the employer is an S corporation, dividends are not tax-deductible.

If the amount of dividends paid (to an ESOP) on company stock is "huge" and truly unreasonable, it is also possible (under certain circumstances) that dividends could be recharacterized as employer contributions.....thereby raising some potentially "sticky" issues under IRC sections 401(a)(4), 404(k) and 415©.

Paying dividends on company stock is very different from paying employer contributions to an ESOP. If you're going to call something a "scam," you ought to have better reasons than this one.

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Yes, all discrimination tests including coverage and ADP/ACP testing must be performed separately for the ESOP and the non-ESOP portion of the plan. I suppose 414(s) testing officially is separated too for ESOP and non-ESOP, but 414(s) testing doesn't involve any plan-specific data, just a comparison of plan compensation to total compensation, so it seems to me that there'd be only one 414(s) test as a practical matter.

How to determine which contributions are ESOP versus non-ESOP contributions is unclear -- does one do so when they are contributed or based on where the money is on the last day of the plan year? If one is using the first alternative -- contributions are considered made to the ESOP portion of the plan based on where they are initially invested -- contributions directed to the employer stock fund (assuming that's what the plan document designates as an ESOP) should be considered as ESOP contributions in my opinion regardless of whether they are made in cash or stock. There's not much guidance on that point, but it strikes me as unreasonable to call all cash contributions non-ESOP regardless of where they are invested, a position that might be implied by one of QDROphile's posts.

I could be wrong, but I read QDROphile's comments about it being a "scam" as saying that he disagrees with the policy behind the IRS rules, not that he disagrees with my understanding of the current IRS position.

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I did not mean to imply that the 404(k) didvidend is a scam I thought that may have been what QDROphile was implying or afraid of doing without having a Determination Letter.

I understand dividends are earnings not employer contributions and did not mean to cause any misunderstanding regarding this issue either.

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Mweddell, thanks for your response.

I agree that there is no clarity regarding how to determine which contributions are ESOP versus non-ESOP contributions for purposes of ND testing. However, I think I agree with QDROphile's post that all cash contributions should be treated as non-ESOP.

The interesting point is that none of the 30 or so PLRs that deal with the "switch back" programs addresses this point. I would be surprised if any of the companies that implemented the switch back idea actually tests separately.

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carsca ---

Why should all cash contributions be treated as "non-ESOP" for testing purposes? What if cash contributions are immediately used to buy company stock (per participant elections or otherwise) or to repay an ESOP loan? If cash contributions are initially directed for investment in the company stock fund of the KSOP (and many will stay invested in company stock), how can such contributions be "non-ESOP" for testing purposes?

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RLL ---

Cash contributions should be treated as "non-ESOP" for testing purposes because the contributions are being made to the non-ESOP portion of the Plan.

I understand the questions you are asking make it difficult to accept this approach but I think accepting the alternative is just as difficult. For example, if you take the other approach, who is covered for 410(B) purposes in the ESOP portion of the Plan? Only participants who elected to invested in employer stock?

I don't have a definitive answer, but this has to be a significant issue companies need to consider before amending to become a KSOP.

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I can't resist. The reason for calling the arrangement a scam is that there is no "plan" that is an ESOP (what does the "P" stand for?). It is just an individual investment choice that gets twisted into a tax deduction for dividends. So it is no wonder we are confused when we try to apply rules about how to run or test a plan! There is no such thing as a contribution "to" the "ESOP" when the defining characteristic of the ESOP is a participant's decision (made or changed at any time) about how to invest the participant's account. The ESOP is just another name for the investment fund (among all the other funds) that holds employer securities.

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carsca ---

Cash contributions aren't made to the "non-ESOP" portion of a KSOP if they are made for the purpose of repaying an ESOP loan or if made on behalf of a participant who has directed the initial investment of that contribution into company stock under the ESOP portion.

QDROphile ---

The ESOP regulations adopted by the IRS in 1977 clearly state that an ESOP may constitute a portion of a plan, the balance of which may be a non-ESOP. The purpose of these provisions, as well as the section 404(k) tax incentive, was to encourage companies to broaden stock ownership among employees. In section 803(h) of the Tax Reform Act of 1976, Congress specifically directed the IRS to promulgate regulations which would expand, and not impede, the creation and operation of ESOPs. The creative use of KSOPs, as endorsed by the IRS, is merely a reflection of continuing Congressional intent regarding employee ownership over the past 28 years.

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RLL,

My question only concerns a non-leveraged ESOP.

With respect to your second question, what if the plan provided that contributions are first made into a default money market fund and then a participant had the right to designate the investment?

Also, you haven't provided me with an alternative for demonstrating HOW the tests could be run in a KSOP scenario.

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carsca ---

The temporary holding of contributions in a money market fund pending investment in company stock does not change the fact that participants have directed the investment initially into company stock.....usually it's done prior to the time that the contributions are made. I think that those would constitute contributions to the ESOP portion of the KSOP.

I think that the testing should be done on the separate ESOP & non-ESOP portions of the KSOP based upon the extent to which participants have directed the initial investment of each contribution.

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First, thanks to RLL, QDROphile, MWeddell for really getting involved on this issue.

Now, back to the bashing.....

RLL, how would you run the 410(B) test?

Would you include in the ESOP as participating only those who actually elect to invest in employer stock?

Would you include in both portions of the plan as participating those participants who invest in both employer stock and other investments?

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carsca ---

Doesn't section 410(B) apply to a 401(k) plan by including all eligible employees as "benefiting under the plan," whether or not they elect to defer, per Reg. Sec. 1.410(B)-3(a)(2)(i) ?

If so, each employee who is eligible to defer contributions into the ESOP portion (that is, one who is eligible to elect to invest in company stock, whether or not she/he actually so elects) is treated as "benefiting" under the ESOP.....so 410(B) compliance would not be a problem merely because "separate testing" is required.

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I agree with RLL. If one uses the rule that contributions are classified as ESOP or non-ESOP when they are contributed rather than where they are at the end of the plan year, then it seems to me that all contributions to the ESOP portion of the plan regardless of whether they are made in cash or stock should be called ESOP contributions. Carsca, I'd be very cautious about proceeding with your suggested interpretation -- get a legal counsel's opinion and IRS determination letter at least.

Responding to Carsca's latest post, if all money goes into money market and then a participant has to affirmatively elect to transfer the money into the employer stock fund, that sounds like a signficantly different set of facts. Sure, you may have no "ESOP contributions" but you'll also have a lot less money going into the employer stock fund.

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And you will have a neat counting task if you characterize contributions to the ESOP according to the participant's investment elections at the time of contribution. The participant starts with electing all contributions to be invested in employer securities. Next month, 50% employer securities. The next month 0% employer securities. You have to keep track, add them at the end of the year based on the contribution date (regardless how the accounts have changed because of portfolio transfers), and test separately. Each employee will be disproprtionate to the others with respect to each amount and class of contribution (elective, matching, discretionary).

Doesn't that seem a bit absurd? Can you reconcile that with principles behind the coverage and discrimination rules? The idea is that employers should not discriminate in amount of benefits. The tests won't test the economic benefit of what the employer provides (in cash!). It will test how employees happen to allocate investment choices.

When phenomena start looking so strange and divorced from principle, one wonders if something is wrong.

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