ADP/ACP Testing

[Guest T-BONE]

An existing 401(k) plan has two types of contributions, deferrals and matching contributions. The plan has a number of participant directed investment options, including company stock of a large publicly traded corporation.

The goal is to obtain dividend deductions paid on qualified employer securities.

Assuming there are no plan design changes (i.e., investment in company stock is at the election of the participant for both deferrals and matching contributions, and participant can exchange freely between investment options):

(1) how would you perform ADP/ACP testing? (2) Would you have two ADP tests and two ACP tests? (3) Would the deduction of dividends be accomplished through a KSOP or a stock bonus plan design? (4) How do you apply the "primarily invested in employer securities" rule, assuming it's relevant??

Any help would be greatly appreciated. Thank you!!

[david rigby]

I must be an idiot today, because I don't understand your question.

What does dividend payment have to do with ADP/ACP testing? Aren't the dividends a portion of the investment return on assets? Don't ADP and ACP tests concern themselves with actual contributions?

[RLL]

T-BONE ---

Deduction of dividends on company stock under IRC section 404(k) is available only to statutory ESOPs, not to non-ESOP stock bonus plans.

As you have indicated, the "invest primarily in employer stock" requirement applies to an ESOP; and compliance therewith is required to assure deductibilty of dividends under section 404(k).

Accordingly, unless the overall 401(k) arrangement can satisfy the ESOP "primary investment" rule, it might be necessary to limit the "ESOP designation" to the company stock fund. This would result in having separate ESOP and non-ESOP portions of the 401(k) plan....thus requiring separate ADP/ACP testing of those ESOP and non-ESOP portions.

pax ---

The special ESOP rules under the IRC and ERISA are often a bit confusing for those benefits professionals who don't specialize in ESOPs.

T-BONE's question relates to the deductibilty of dividends under IRC section 404(k)......which requires compliance with ESOP requirements.....and the possibility of separate ADP/ACP testing for an ESOP. There is no ADP/ACP testing of dividends....just the rule that you must have a statutory ESOP in order to deduct dividends on company stock.

[Guest T-BONE]

RLL

I think I'm finally beginning to understand. Thank you for your guidance.

Would you agree that generally this employer has the following two options in order to take advantage dividend deductions:

(1) Treat the entire 401(k) plan as an ESOP so long as all investments in the plan, when aggregated, satisfy the "primarily invested" requirement (which I imagine would be difficult in this case). I assume that regardless of whether participants invest some of their deferrals and match in company stock, the employer would run just one ADP test and one ACP test.

OR

(2) Treat all investments in company stock as the ESOP portion of the plan, and all other investments as the non-ESOP portion. This would require running a separate ADP test for deferrals invested in employer securities, and a separate ACP test for match invested in employer securities.

I don't know if these additional facts make any difference, but the employer will always use cash to purchase investments (including company stock) selected by participants. Also, the investments are 100% participant directed . . . the employer does not require that any percentage of contributions (either pre-tax or match) be used to purchase company stock.

Again, your insight is GREATLY appreciated. Thank you.

[RLL]

T-BONE ---

The employer also has the option of using the "safe harbors" to avoid the requirements for ADP/ACP testing.

Also, note that if the entire 401(k) arrangement is designated as an ESOP, certain of the special ESOP requirements will apply to the entire plan...such as the requirement that all benefits be "distributable" in company stock. This may result in a need for some minor drafting and administrative "tweaks." I assume that the 401(k) plan already provides for a "pass-through" of voting rights on company stock.

Also note that the dividend deduction under IRC section 404(k) is not automatic. It requires the actual "pass-through" of cash dividends on company stock or a participant election for reinvestment of such dividends into company stock.

[Guest PAL100759]

We've looked at several plan designs that would get around the testing issue. All had advantages and disadvantages. I think the one that had the most possibility involved using two stock funds.

You designate the stock fund as an ESOP. Then, set-up a second stock fund that all current year contributions go into. The dividend pass-through would apply only to dividends paid to the ESOP stock fund. The non-ESOP stock would be moved into to the ESOP at the end of each plan year.

Advantage: single ADP/ACP test. Disadvantage: must track current year contributions and explain why the pass-through is not available on all dividends. The duplicate funds could be fairly invisible to the participant depending on your existing plan design and the capabilities of your recordkeeper.

Lots of luck!

PAL