RLL

kenw --- You asked "what constitutes a group of employees" ? I can't define it, but I know it when I see it. You described a group of employees which is servicing a separately identifiable book of business in two branch offices in different locations from the rest of the company. It seems to me that this would likely be a "group of employees" that could be defined in a plan document as being ineligible to participate in an ESOP. I think that such an exclusion (from ESOP participation) could have been effected through a valid amendment to the ESOP adopted either before the transaction or before such employees became eligible to receive ESOP allocations.

Hi kenw --- The Internal Revenue Code and ERISA, the federal laws which prescribe the rules for ESOPs and other retirement plans, allow an ESOP to exclude specified groups of employees, so long as certain minimum participation/coverage requirements are met and the terms of the written plan documents provide for such exclusion. See IRC section 410(B) and the IRS regulations thereunder. If the ESOP plan documents (adopted by the employer) do provide for the exclusion of a group of employees, the ESOP trustees must administer the ESOP in accordance with such exclusion. See ERISA section 404(a)(1)(D). I suggest that you take a look at the ESOP plan documents (and the summary plan description for the ESOP).

Hi CitationSquirrel --- Under the ESOP regulations, the plan may be amended to become a "non-ESOP," subject to maintaining certain non-terminable rights with respect to the shares of employer stock (if still in the 401(k) plan). These rights are outlined in the regulations and include the put option requirement if the shares are not readily tradable. In addition, the right to diversify and the applicable voting pass-through rights should continue to apply to the stock. The non-ESOP 401(k) plan will not continue to allow for certain ESOP tax benefits, such as the deductibility of dividends undert IRC section 404(k).

Hi Kirk --- It appears that the "over-diversification" here resulted from a mistake in determining the amounts available for diversification, rather than from a plan provision that permitted diversification in excess of the amount required under IRC section 401(a)(28)(B). Accordingly, under these circumstances there would have been no right to elect a distribution in employer stock. In addition, if diversification is effected through investments under the ESOP, there is no present right to any distribution. Also note that IRC section 401(a)(28)(B) provides for a diversification right of "at least 25%" (50% in the 6th year) of the employer stock allocated to the participant. Accordingly, allowing a diversification election in excess of 25% still results in the amounts being diversified "under" section 401(a)(28)(B), so the "excess" amount is not subject to the right to demand stock under section 409(h)(1)(A)...even if the exceptions of section 409(h)(2)(B) do not apply. Now get back to work!

mbozek --- I certainly won't deny the benefits of investment diversification. But it's not fair for you to say that "The participants are probably better off with more diversification since this is a privately held company" in a particular situation that you know nothing about. It's been my experience with closely-held ESOP companies (over the past 29 years) that the ESOP participants have usually been much "better off" with investments in employer stock than they would have been with diversified investments under a non-ESOP retirement plan. Maybe I've been fortunate to work with the "cream of the crop," but I also know many other professionals whose experience with ESOP companies has been similar to mine.

If diversification was effected through benefit distributions from the ESOP, it may be difficult to correct....particularly if the distributions occurred in a prior year. But it may possible to give the affected participants the option to repay the "excess" distributions back to the ESOP. If diversification was effected through investment choices within the ESOP or by transfer of assets to another plan, it should be relatively easy to give the affected participants an option to "un-diversify" the "excess" portion and reinvest it in employer stock under the ESOP.

Hi mbozek --- You say that "The participants are probably better off with more diversification since this is a privately held company." Doesn't that depend on the business/financial prospects of the company involved? What if the company also provides some other generous retirement plan for its employees? Unless you know something about the particular company, there is no valid basis for your comment....other than, perhaps, an anti-ESOP bias. It is not uncommon for some private equity investments to result in average annual returns in the range of 15%-30% per year. Such returns are very uncommon for diversified portfolios over a period of years.

BJW --- As noted in my previous post, if the noteholders were parties in interest at the time of the ESOP loans, they continue to be treated as such for purposes of the special "default rule" of the ESOP loan regulations. For purposes of the default rule, shares of employer stock pledged as collateral for the ESOP loan are treated as having the value determined as of the time of the default. The pledged shares are worth what they're worth. Obviously, a decline in value can result in the collateral becoming worth less than the amount of the unpaid debt. The selling shareholders should have considered this possibility at the time they agreed to take promissory notes from the ESOP....particularly in light of the fact that a transaction whereby an ESOP borrows funds to acquire outstanding shares from existing shareholders almost always results in an immediate decline in value of the shares (unless, in certain cases, when the shares are purchased by the ESOP for a price less than fair market value). Are the ESOP loans guaranteed by the company? If so, is that guarantee supported by a security interest in any assets of the company? The primary security for most ESOP loans is the guarantee of the company (and the underlying assets of the company), not the shares pledged as collateral by the ESOP.

Hi BJW --- With respect to an ESOP transaction, the status as a "disqualified person" or a "party in interest" is determined at the time of the transaction. In connection with an ESOP loan, if the lender is a party in interest EITHER at the time of the loan (being incurred by the ESOP) OR at the time a promissory note is in default, the special "default rule" in the ESOP regulations (which limits the ability of the lender to satisfy the loan against assets, including collateral, of the ESOP) would apply to that lender.

BJW --- This is not something that should involve "difficult research." It's a matter of interpreting various parties' rights and obligations under the applicable documents, and then likely negotiations among the parties (noteholders, Company and ESOP fiduciary) to arrive at a satisfactory resolution.

jcr --- Of course a distribution may be subject to the 10% additional [not excise] tax on early distributions under IRC section 72(t), even if the distribution is made to satisfy a diversification election under section 401(a)(28)(B). But the tax may be avoided through a rollover to an IRA (or other eligible retirement plan) at the election of the participant.

BJW --- You are dealing with a complex situation. The rights and obligations of the various parties will be governed by the specific terms of the ESOP plan documents and the ESOP stock purchase documents and promissory notes, as well as the rules under ERISA. No one can provide appropriate guidance here without a careful review of the documents, as well as a complete understanding of all the surrounding circumstances. Each of the parties should obtain the advice of separate counsel experienced in ESOP matters in order to determine their best courses of action. In this regard, the ESOP should also be represented by an independent fiduciary. Good luck.

jcr --- If you're concerned about the ESOP being invested "primarily" in employer stock by reason of more liberal requirements for diversification, perhaps the ESOP should effect diversification elections through distributions or by transfer of assets to another plan. This would avoid having the diversified assets being held under the ESOP. mbozek --- President Bush's proposal for "diversification" elections out of employer stock would apply to an ESOP only to the extent of employer stock which is attributable to 401(k) and 401(m) contributions. Some of the more extreme bills introduced in Congress would require earlier diversification in ESOPs than under current IRC section 401(a)(28)(B), but I think it's a bit too early to predict that the law "will probably be changed to allow diversification at a far earlier age."

If the ESOP company is closely-held, ESOP participants are NOT entitled to the information that the company provides to shareholders. ERISA only requires that ESOP participants be given the same information that is provided to participants of any retirement plan. This does NOT include information regarding the company's financial condition or business activities. ESOP participants are not direct shareholders of the company and are not entitled by law to be treated as shareholders or given the information provided to shareholders. They are indirect shareholders through their status as participants in an employee benefit plan which owns company stock. Most ESOP companies, however, have chosen to provide ESOP participants with some information regarding business activities and financial condition even though the law does not so require.

Hi IRC401 and Kirk --- It appears that the President's proposal would adversely affect those companies (particularly closely-held companies) that provide a matching contribution to an ESOP that is either combined with or separate from the 401(k) plan. This is a common arrangement in ESOP companies. A closely-held ESOP company would find it very difficult to live with a rule allowing all participants with three years of service to be able to sell company stock (provided as a match) at any time. The ESOP community does not welcome this change as it will adversely affect many ESOP companies. Hopefully, if this becomes law, it will include appropriate and fair transitional rules and effective date provisions. Kirk is correct about the corrective amendment to IRC section 2057. It was not adverse ESOP legislation...but rather was a correction to close a clearly unintended loophole in an ESOP tax incentive (which was also closed by the IRS on an interpretive basis). That corrective legislation was strongly supported by the ESOP community....just as the addition of the S corporation loophole-closing ESOP provision in last year's tax bill was strongly supported by the ESOP community. Closing such unintended loopholes in ESOP legislation is not adverse to ESOPs, but rather promotes the proper uses of ESOPs. This becomes necessary when unscrupulous, so-called "professionals" and other promoters devise abusive schemes to take improper (and unintended) advantage of tax incentives provided by Congress for legitimate social/business purposes.

DLH --- The IRC says "age 55 and ten years of participation" to be eligible for diversification. What does the plan document say? If there's no plan provision relating to the predecessor plan, the participant has no right to an earlier diversification election. [i'm assuming that the ESOP (in its present form) has an IRS determination letter that covers the diversification provision].

Hi DLH --- Section 401(a)(28)(B)(iii) of the Internal Revenue Code requires that an ESOP provide the diversification election for participants who have attained age 55 and completed 10 years of participation in the ESOP.....without regard to the participant's years of service. [For this purpose, "participation" may include participation under a "predecessor plan"....although this an unclear area]. There is nothing in current law that would require the ESOP to offer diversification to a participant with 20 years of service but less than 10 years of participation...but it is possible for an ESOP to be amended to allow for diversification to participants who meet specified requirements that are less stringent than section 401(a)(28)(B)(iii). Remember, however, that a closely-held ESOP company is generally required to provide cash to fund the ESOP diversification election. If the company is not "in the best of financial shape," it would likely not want this additional cash burden.

Hi Robert Reynolds --- I recommend that you check with The ESOP Association (at www.esopassociation.org) and the National Center for Employee Ownership (at www.nceo.org).

Hi JONB --- There are voting rights to be "passed through" to ESOP participants only when a matter is presented for a vote by shareholders of the company. Most matters voted on at a board of directors meeting are not subject to shareholder approval. When a "pass-through" of voting rights is required under IRC section 409(e), it applies to all shares allocated to participants' accounts...whether vested or non-vested.

Hi bfsw --- I'm sure that you can find an appraiser who will do that.

Hi John Nelson --- Presumably, you're referring to IRC section 409(e)(3), which is applicable to closely-held companies. "Substantially all" could mean 80%, 85% or 90%....no regs under section 409(e)(3) yet [but, of course, it's only been about 16 years since that language was put into 409(e)(3)....can we expect IRS to do regs so quickly?]. But sale of a division constituting 25% of assets may very well require voting pass-through if it constitutes a separate trade or business of the corporation (again, no regs)....but ONLY IF applicable corporate law (or the corporate charter or bylaws) requires a shareholder vote to approve such a sale.

AMK --- I see no 414(l) issues. To obtain the maximum possible 404(k) deduction, the company stock portion of the 401(k) can remain part of the ESOP. The "spin-off" of the 401(k) plan should be limited to the non-company stock assets.

Hi AMK --- The restructuring that you describe is certainly permissible under current law, and the proposed KSOP arrangement is not uncommon. Under the 401(k) regulations, ADP testing (if required) must be done separately for the ESOP and non-ESOP portions of the KSOP. An issue to address is whether 401(k) elective deferrals invested in company stock will be in the ESOP portion or the non-ESOP portion. Is the dividend deduction under IRC section 404(k) a factor? Another consideration at this time should be the extent to which ERISA and the IRC might be amended this year to place restrictions on 401(k) arrangements (including matching contributions) which provide for investments in company stock.....in light of the concerns raised by Enron.

The deduction under 404(k) is attributable to X Holdings, the parent corporation and payor of the dividends.

rocnrols2 - The deduction under IRC section 404(k) is allowed on the X Holdings consolidated income tax return.