Leveraged S-corp ESOP and 415

[Brenda Wren]

In a leveraged S-corp ESOP, 51% of the company is sold to the ESOP at the beginning of the year. At the end of the year the first payment of $300,000 is paid and shares are released and allocated to the plan participants. The principal portion of the payment is $250,000 and the interest is $50,000.

1. For 415 purposes, is the contribution $300,000 or $250,000 or the current value of the released shares (which, by the way is slightly higher than the encumbered price)?

2. Is the $50,000 of interest a factor in the participant allocation at all? I don't see how it could be. I believe the interest should be shown as a plan expense on Schedule I, but the allocation is simply the share allocation as determined by the release calculation (either the principal method or the principal & interest method as dictated by plan document).

[stephen]

1. For an s-corp ESOP either count the full $300,000 as an annual addtion (as 415©(6) exception to exclude interest does not apply to S-corp.) or if the plan allows you can use the current fair market vale.

2. Otherwise the interest piece of the allocation does not affect the participant allocation other than in the share release.

[Brenda Wren]

Thanks, Stephen. Unfortunately, I'm still confused. I use Relius software. Although there is no money in the cash account of the ESOP and no cash contributions were made, I did what you said and allocated the full $300,000 to cash just so that I could determine if anyone was hitting their 415 limit. There was one. His allocation of the $300,000 (including the interest on the loan) was cut back from $38,000 to $28,000 due to participation in the other 401(k) plan. However, not taking into account the $10,000 cutback, the value of the shares he is receiving is only $23,000. So from his perspective, he deferred $13,000 into the k-plan and is receiving employer stock valued at $23,000 for a total benefit of $36,000 for the year.....far from $41,000. It would appear that I am going to have to show the full contribution of $300,000, expense the interest, then "purchase" the shares so that I can run an accurate 415 test and also explain to the plan participant why his contribution was cut back. So what I'm saying is that if the interest on the loan is part of the 415 limit, it would appear that I HAVE to have it reflected in the allocation.

In a C-corp scenario I have always considered the interest on the loan as a normal business expense and have not reflected it on the valuation at all. I realize that for 404 purposes the interest is excluded in a C-corp scenario and included in an S-corp scenario. I guess what I'm not understanding is the extension of these rules to 415.

Comments? Help?

[stephen]

I am not sure what you have to do in Relius to get the testing to work correctly but it seems that you do need to include the interest. I have included an example of how using the current fair market value approrach can help you pass 415.

If the plan document allows you may be able to use the current fair market value approach for 415.

Example:

Corporation with 401(k) plan providing match equal to 100% up to 6% of the deferral and ESOP contribution of 25% of eligible compensation.

Participant age 45 earning $100,000 in 2005

Deferral $14,000

Match $6,000

ESOP Lev Stock Forfeiture $1,000

ESOP Contribution $25,000 release 200 shares at $100.00/sh.

Total Annual Addition $46,000

This fails 415.

If the plan document allows you may use the fair market value approach.

Deferral $14,000

Match $6,000

ESOP Lev Stock Forfeiture $1,000

ESOP Contribution $20,000 ( = 200 x $100)

Total Annual Addition $41,000

This allows the participant to pass 415.

You may want to Double check your plan document to see if returning deferrals is an option- As it is permissible to reduce any excess annual additions, by allowing deferrals to be returned to the participants. Other options: reduce the participant’s share of the ESOP contribution and reallocate to other participants, or allocate the excess amount to a suspense account to be allocated in the next plan year.

[Brenda Wren]

Stephen, in your first example you said the contribution of $25,000 released 200 shares at $100 per share. Is the remaining $5,000 of the contribution interest on the exempt loan? Or is it the difference in the current market price vs the inventory price, i.e. encumbered price?

[stephen]

The $25,000 in the first example represents the principal and interest.

[Brenda Wren]

So, it's strictly a document issue. The interest portion of the contribution is considered part of the 415 annual addition in a leveraged S-corp ESOP unless the document allows the use of current market value. Is that correct?

[stephen]

Yes.