BeckyMiller

In case this comes up again. The following comes from a speech that I just presented on this topic. 3. What about an S corporation shareholder? a. S Corporation shareholders are common-law employees. In spite of their treatment as self-employed for certain fringe benefits (IRC Section 1372), S corporation shareholders get W-2 income and should be subject to the same standards as other common law employees. b. Further, S distributions are not earned income for plan purposes. This is in spite of the series of cases discussed below where the IRS succeeded in recharacterizing such distributions as compensation. For a comprehensive discussion of this matter see, Paul B. Ding, Jane C. Ding v. Comm. (CA-9), U.S. Court of Appeals, 9th Circuit, 98-70848, 12/30/99, 200 F3d 587. Affirming the Tax Court, 74 TCM 708, TC Memo. 1997-435. c. There has been a lot of recent controversy on inadequate compensation, as opposed to excess compensation for S shareholders. i. In a case involving a veterinarian (Veterinary Surgical Consultants, P.C.), and one involving an accountant (Joseph M. Grey Public Accountant, P.C.), the Tax Court found that payments classified by the corporations as dividends were, in fact, compensation for services and held that the taxpayers were liable for the employment taxes. ii. In another case, involving a CPA (Wiley L. Barron CPA, Ltd.), the Tax Court reached the same conclusion. Characterizations of distributions to owners of S corporation stock as dividends, where less than reasonable compensation has been paid to owners and where the amount of the reported dividend exceeds a reasonable return on the owners’ invested capital, will probably not withstand scrutiny by the Internal Revenue Service or the courts. Design impact: Where plan sponsors wish to be aggressive in this regard, care must be taken to define compensation properly within the plan document. Language that specifies that compensation for allocation purposes be based upon the W-2 filed for the year, without regard to any subsequent adjustments may be appropriate. d. This is not a new position. In Rev. Rul. 74-44 the "dividends" paid to two shareholders were held to be in lieu of reasonable compensation for their services. 4.In some cases, the Social Security Administration has had success in recharacterizing S Corporation distributions as wages for purposes of determining excess earnings for recipients of Social Security benefits. See Owens [Charles B. Owens, Jr., 790 F. Supp. 195 (W.D. Ark. 1991) and Esser [Fred R. Esser, 750 F. Supp. 421 (Ariz. 1990)]. 5.The IRS's recharacterization argument was reaffirmed in Fred R. Esser, P.C. 750 F Supp 421 (DC, Ariz., 1990). 6.The IRS prevailed on the recharacterization argument in Spicer Accounting, Inc. 918 F2d 90 (CA-9, 1990). 7.See also In Joseph Radke, 712 F. Supp. 143 (E.D. Wis. 1989), aff'd per curiam, 895 F.2nd 1196 (7th Cir. 1990). 8.In Paula Construction Company [58 TC 1055, 1058 (1972), aff'd by unpub. op. 474 F 2d 1345 (5th Cir. 1973)], the Tax Court stated the standard as follows: "It is now settled law that only if payment is made with the intent to compensate is it deductible as compensation. Whether such intent has been demonstrated is a factual question to be decided on the basis of the particular facts and circumstances of the case."

The DOL posted today their Q&A on this topic. See http://www.dol.gov/ebsa/faqs/faq_compliance_5500.html

See IRC Section 404(a)(9). If the special limits of IRC Section 415©(6) are satisfied then the deduction limit does not include any contribution made to pay interest on the ESOP loan. The 25 percent of pay limit can include any employer contributions - 401(k) match, principal payment, cash payments to fund distributions, etc.

Your client is permitted to correct under the DOL's VFC program. There is no limit to the number of such requests that may be submitted. However, if they requested relief from the excise tax on the first submission, they are not allowed to request such relief again with the subsequent submission. The class exemption that provides relief from the prohibited transaction penalties for late salary deferrals is limited to a single such request on the same facts in any three years.

I must agree with Kirk. I know that at times like these, adding another layer of administrative costs seems harsh. But this is a very touchy situation and the ESOP fiduciaries need experienced, professional guidance.

I wanted to advise you that we have two ESOP clients going through DOL examinations right now where specific attention is being paid to the maintenance of the ESOP's share records. My advice to your client is to straighten out their records. They need to decide whether it is more cost effective to issue the ESOP a bunch of individual certificates that can be sold back as treasury stock or to reissue certificates whenever there is a transaction.

Establishing a leveraged ESOP in a contruction company generates a number of critical issues, not just this important issue that you have raised. The ongoing availability of other financing when a company implements a leveraged ESOP and buys out existing shareholders has to be addressed at the front end. Frequently you see a new lender come in that takes the entire book of business - the ESOP loan and the commercial loans. You are correct that they will look somewhere for guarantees and the folks offering those guarantees will expect to get something in return. The issue that I am most familiar with is the financial reportiing problem. Most construction companies are subject to bonding and the bonding companies require GAAP financial statements and a significant positive net worth. The ESOP accounting rules tend to plunk a huge negative number into the equity section and totally mess up net worth....bonding capacity....staying in business. The ESOP Association www.esopassociation.org has several construction company members. I suggest that your client look at that membership listing to see if they know any of these companies and chat with them about ways to make the ESOP work.

Boy - my immediate response is what did the designer have in mind when the plan was established that all employee contributions were invested solely in employer stock..... But, to answer your question, the required diversification rules do not trump the 401(k) rules. A plan can be designed to meet both rules by diversifying within the trust, rather than making distributions. This response assumes that the plan is not one of those combined arrangements where the 401(k) is arguable separate from the ESOP. If it is a single ESOP with multiple features, the entire balance is eligible for diversification. You need to then go through the hoops - what does the plan say, when did the shares enter the trust, etc. I would rush immediately to competent ERISA counsel and get some help for this situation.

As long as the ESOP holds non-traded stock, that stock needs to be revalued not less frequently than yearly.

Allen and Barbara are not married? Claire is Barbara's daughter only, not Allen's, right? Then, Claire could participate in the shares associated with Allen's 2005 sale. Obviously, this assumes that nothing else gets in the way - she is eligible, hasn't accumulated 25 % ownership due to allocations of the prior sale, etc. See IRC Section 409(n) - definitions of a 25% shareholder and of family.

Try GCM 34173. It is still the IRS's position. But I have not seen any enforcement activity on this matter. Sorry - typo in the original post. The big issue associated with classifying partners as W-2 employees is whether this can somehow change their status to be eligible for other tax-advantaged benefits - participation in 125 plan, exclusion of health coverage from income, etc.

Hey - non-qualified plans that use a Rabbi trust to "fund" the benefits are generally reported gross on the plan sponsor's financial statements. The assets are reported on the asset side as investments. The obligation for the deferred compensation is reported as a liability on the liability side. Thus, you wouldn't reduce the liability for the expected return on the rabbi trust assets.

You need to look at the ERISA regulations 2510.3 - where it defines a pension plan. 403(b) plans that are not subject to ERISA are basically arrangements that are selected and controlled by the participant, not the employer. The employer's role is limited to facilitating the withholding from payroll and making the deposits. It is a pretty subjective standard. The obvious difference relates to the ERISA reporting and disclosure rules. The subtle difference includes things like what court do you go to in the event of a problem, what are the bankruptcy protections, etc.

We have found Relius unhelpful for leveraged ESOPs. We end up having to customize way too many allocations. Cost basis tracking doesn't work readily when you are releasing shares from multiple loans with different original costs, etc. On the other hand, for non-leveraged ESOPs, particularly KSOPs, it is quite delightful.

Assuming that the VEBA is for an arrangement subject to ERISA, here is what I know on this subject. 1. Promissory note would be a no. No deduction is available - there is an old retirement plan case on this, not sure the full cite, but it was Don E. Williams Co. ERISA would generally treat this as a prohibited transaction - extension of credit. 2. Employer securities. Tax deduction privilege would be the same as for a retirement plan, covered by a couple of very old Revenue Rulings 62-217 and 73-583. ERISA rules would go to the general rule on employer securities - 10% of plan assets because a VEBA would not be an eligible individual account plan. If the client worries about SFAS 106 - note that employer securities don't count as plan assets for funding purposes unless they are freely marketable. NOW - this is off the top of my head, so you need to verify the cites. But, I am pretty confident in the fundamentals.

As a partner in the kind of mid-sized firms that Kirk likes, I have to admit to a fondness for doing benefit plan audits. When approached as a technical specialty, rather than a fungible commodity, they can be every bit as challenging as a corporate audit and offer all sorts of fun client service opportunities. Having said that, I have to admit, however, that there may be a reason for using the same audit firm that does the sponsor's work for the benefit plan audits. This is the participant testing. An auditor, whether doing a full scope or a limited scope audit, is required to test participant data - compensation, dates, eligibility, etc. See Chapter 10 of the AICPA Employee Plans Audit Guide. The firm that does the sponsor's work can do this testing, internal control documentation, etc. at the same time it is testing the payroll system as part of the general sponsor audit. When you hire a different audit firm, this work needs to be duplicated by them. Thus, when the sponsor only has one or two plans, there may not be much cost savings. Where the sponsor offers half a dozen or more benefit plans, you may go back to realizing a savings.

Having said all of this, don't forget the small plan audit rule. Even if you have fewer than 100 participants at all times, if the plan is subject to ERISA and has more than 5 percent of its assets in forms that can't be readily verified and protected and fails the expanded bonding requirement, they still need an audit. See the DOL web page for a discussion of what small plans will trigger an audit. http://www.dol.gov/ebsa/faqs/faq_auditwaiver.html

Each plan has its own limit under Section 415, unless the employers have to be aggregated under Section 414. There are many ways of required aggregation, but a self-employed person who also has a job with a "totally unrelated" company, would not have to worry about sharing a single 415 limit. Now - there may be weird exception to that general rule if the employer is tax-exempt and sponsors a 403(b) plan.

There is a recent bankruptcy case that gives a good discussion of these rules. See Internal Revenue Service v. Snyder, 9th Cir., No. 02-15618, 9/15/03. You can find it at http://www.cfsresearch.com/cr/CCO/02-15618.htm. It is a pretty long and complicated discussion that goes through a lot of the controversy regarding bankruptcy protections. But, it also gives you the cites to the basic authority for the IRS to file a claim against 401(a) plan assets. I also think that if you look to the regulations, there is specific authority for this in the regs. I would check that through any of your basic pension services - CCH, BNA, etc.

If it doesn't drive your system batty, this is effectively a negative cash account. If the shares that were in the former participant accounts have been allocated to the active participants, this negative cash account would be allocated to those participants in the same manner. Hope that helps.

Oh oh! I figured I better respond to this one because I know I have made this remark - regarding this definition of family. Cousins of the tested person are not covered. The reason I mention cousins is because frequently the decision maker is the child of the tested person. His or her cousins (the lineal descendants of the siblings of the tested person) are included.

Document, document, document. The first place to go with these questions is the plan document. Most private company ESOPs provide for the allocation of all trust activity as of a single, year-end date. (This is not always true, so you need to look at the document.) This is because of the valuation requirement. Few private companies are willing to deal with the complexities of valuing the shares more frequently than annually. Trust activity occurs through the year - contributions are made, distributions paid, debt service made, dividends received, other investment activity received, etc. Typically, all of this is summarized at year-end and allocated according to plan terms. In this world where the most common plan seems to be a daily valued 401(k) plan, I realize this seems archaic. But, it is typical of ESOPs and, when properly done, satisfies the IRC and ERISA standards.

The filing instructions to Form 1099-R are actually quite helpful on this point. The forms are generally completed as if the Plan Administrator had no idea what the participant actually did once the distribution was made. So, if shares are distributed in an event that is eligible for rollover, but was not a direct rollover, the Form 1099-R should show gross distribution(current value), taxable amount, NUA and the appropriate code in Box 7. If cash is distributed, there is no need to report the NUA. If you look at the instructions, you will note that there is not a code for an eligible rollover distribution. If it is an early distribution, Code 1 is generally used and the recipient is provided with guidance on how to report an indirect rollover on his or her return. Code 2 is used if there is a known exception to the premature distribution penalty. If it is not an "early distribution", then Code 6 would apply as a Normal Distribution. On this point, the instructions describing NUA are not particularly helpful. They talk about taxation, but do not describe the right to rollover and avoid tax. That is why each participant eligible for a distribution is to receive the standard tax notice.

I suggest you consider joining the ESOP Association of America. They have a committee on ESOP administration. That committee prepares a nice manual on operating an ESOP. In general, a careful reading of the Form 5500 instructions will give you the information you want. If that is too awful to dive into, Panel Publishers puts out a nice publication on the Form 5500 series which includes examples. Likewise, New England Life has published a book in the past, but I don't know if that would have much ESOP info. Another way to get some help is to register for freeerisa.com and look at the Form 5500 filings for other ESOP companies. If you join the ESOP Association or similar organization (NCEO, ESCA, FED), each has a member listing so you can identify similar entities. I have to caution you on this approach as I see a lot of Form 5500 filings that are not completed properly.

Yes - for the first year where the purchase of stock has not yet happened, the ESOP looks like a profit sharing plan. Now, I am assuming the purchase of stock has not yet happened. If there is a leveraged purchase of shares, but not payments have been made on the loan, you will need to show an asset for the shares at current value and a liability for the related debt.