ESOP Loan Prepayment

[Guest blaum8]

I have a situation where the plan sponsor of a leveraged ESOP made a substantial prepayment on its ESOP loan via a "dividend." Now it has missed over a year's worth of required installments under the ESOP loan agreement. Sponsor says that it has "prepaid" the installments.

The note itself permits loan prepayments but does not contain any langauge supporting the plan sponsor's position (i.e., prepayment relieves obligation for future regular installments until one would become due under the normal amortization schedule).

These facts raise several issues:

1) Presumably the missed installments cause the note to be in default notwithstanding the prepayment. What actions must the plan's fiduciaries take?

2) How are shares allocated with respect to the prepayment. The amount of the prepayment exceeded the deduction limits, so the deduction is limited. I assume that shares can be released up to the 415 limits, but no more. Thus, should a pre-payment "suspense" account be created for the shares that have been paid for but cannot be released due to section 415?

3) What other issues are lurking out there?

[Kirk Maldonado]

The first thing that the plan should do is to hire competent ESOP counsel.

[RLL]

blaum8 ---

Does the promissory note specify how prepayments are to be applied (to the next installment of principal or to the last installment) ? Is the plan sponsor obligated under the terms of the loan documents or the ESOP plan documents to make contributions needed to make loan payments? Is the plan sponsor the lender or is it a third party?

The shares released (from the suspense account) by reason of the prepayment MUST be allocated to participants' accounts in the manner provided in the ESOP plan documents for the allocation of shares released by reason of a dividend on employer stock. Note that only dividends on shares acquired with the proceeds of that loan may be used for loan payments; and, if the plan sponsor is an S corporation, dividends on any allocated shares may not be used for loan payments.

If the payment to the ESOP by the employer was truly a dividend (and not a disguised contribution), the allocation of the shares released by reason of the loan prepayment does not result in annual additions under IRC section 415©. If the employer is not an S corporation, the dividend may be deductible under IRC section 404(k).

You've got a situation here with many potential problems. Kirk's recommendation should be followed.