Primarily invested in stock

[Tom Poje]

Over the years an ESOP has made cash contributions to the plan to the point where cash assets are gretaer than 50% of the total balance, hence the plan is no longer invetsed primarily in stock.

what are the ramifications?

[Guest John Nelson]

Years ago (1983), the DOL issued an advisory opinion stating that an ESOP must satisfy the "primarily" requirement "over the life of the plan". So, the fact that company stock now makes up less than 50 percent of the plan's assets does not necessarily mean that the plan no longer satisfies the "primarily" requirement under ERISA and IRC.

Also, keep in mind that the plan only needs to qualify as an ESOP if the plan is leveraged. If not leveraged, then I don't see why the plan can't go merrily on its way as a stock bonus plan.

[Guest DMZ]

Hi Tom,

I agree about the "over the life of the plan" issue stated above. There may be additional ramifications other than just leveraging however. See below list of possible issues.

The result of not meeting the “primarily invested” requirement is that the plan would no longer be considered an ESOP. This means several things:

1) Already mentioned - The plan would no longer have the opportunity to leverage under the exempt loan provisions. Any prior exempt loan would be considered a prohibited transaction if the loan was extended or guaranteed by the employer sponsor.

2) There may be prohibited transactions if shareholder-employees, their families, or related corporations are selling stock to the plan.

3) More importantly, only S corporation stock held by an ESOP is exempt from tax under code §512(e). If the plan below were determined to no longer be an ESOP, Unrelated Business Taxable Income (UBIT) would be due each year on the total earnings (distributed or retained) related to the employer stock held in the plan. The UBIT is generally calculated at the corporate tax rate, with 39% being the highest incremental rate.

4) A C-corp. plan would lose their ability to deduct dividends under code §404(k), as well as the expanded limitations available for C-corp. ESOPs under 415 annual additions testing, and maximum deductible contribution limitations.

[MWeddell]

Does anyone have a citation to the authority described in John Nelson's post?

[stephen]

I do not have a citattion for what John Neslon describes but I do know that many ESOP practicioners belive that the ESOP needs to be designed to satisfy the "primarily invested in stock" over the life of the plan not necessarily on an annual basis. This is a gray area and there have been no final regulations on the matter.

I also know that some ESOPs start by accumulating cash to fund the initial stock purachase and that as long as there is a plan in place for there to be a big purchase (e.g. 30% to satisfy 1042) that the plan may continue accumulating cash for several years in this manner. Perhaps Tom's plan is saving for such a purchase?

See this thread

Perhaps Becky, Kirk, or RLL will chime in with more...

[Tom Poje]

this particualar plan was a takeover.

Based on document language, it was leveraged at one time, but that was paid off eons ago. now each year contributions are made in $.

I was begining to wonder exactly what type of plan code is used on the 5500. Is it still an 'ESOP' for all practical purposes. Or at what point in time over the years does such a plan cease to be an ESOP.

[Guest DMZ]

The cite for the 1983 DOL Opinion is below, along wtih an excerpt of the language that states the "over the life" interpretation.

DOL Opinion 83-6A

“In this regard, however, we must emphasize that the Department believes that in order to satisfy the ESOP requirements imposed by ERISA and applicable regulations, a plan must satisfy the primarily requirement of section 407(d)(6) of ERISA over the life of the plan.”

[RLL]

The statement by DMZ (on 10/18/05) that "...There may be prohibited transactions if shareholder-employees, their families, or related corporations are selling stock to the plan..." is inaccurate under these circumstances.

Merely losing status as an ESOP under IRC section 4975(e)(7) would not cause the plan to cease being a stock bonus plan, which is an "eligible individual account plan" that is permitted to acquire employer stock from parties in interest pursuant to ERISA section 408(e)....so long as the "adequate consideration" requirement of section 3(18) is satisfied.

[Kirk Maldonado]

IRC Section 4975(e)(7) defines an ESOP as follows:

The term “employee stock ownership plan” means a defined contribution plan—

(A) which is a stock bonus plan which is qualified, or a stock bonus and a money purchase plan both of which are qualified under section 401(a), and which are designed to invest primarily in qualifying employer securities; and

(B) which is otherwise defined in regulations prescribed by the Secretary.

While most people focus upon the words "invest primarily in qualifying employer securities," in this case, I think that the operative word is "designed." Specifically,

I think it is significant that the statute doesn't mandate that the plan assets actually be invested in employer securities. If Congress had intended that result, the statute would read as follows:

which are invested primarily in qualifying employer securities.

However, I will freely admit that mine is a minority viewpoint.

I look forward to reading the responses of others, particularly any that are posted by RLL. (Not that I anticipate that RLL will disagree with me; it is just that I find the posts by RLL to be some of the more insightful ones that I've read on the Message Boards.)

[BeckyMiller]

FYI - Last year we had an IRS audit on an ESOP of an S corporation where the sponsor had received a substantial cash payment as settlement on a court case. The company chose to distribute most of the cash out as a distribution to shareholders. For about 12 months, the ESOP ended up less than 50 percent invested in company stock. This was after nearly 20 years at 80 to 100 % invested in company stock. The IRS agent proposed to eliminate the plan's status as an ESOP on account of that short-term violation. We were able to overturn the agent's conclusion in part based upon the fact that the plan fiduciary had clearly documented its plan for dealing with this windfall when it arrived.

I am not saying that the agent had a leg to stand on in his argument. My point is merely to highlight the fact that because of the significant tax incentive available through ESOP owned S Corporations, the Service may be using this attack.

[ESOP Guy]

Does anyone know if there is more up to date guidence on this issue?

Since 2008 we are getting more and more ESOPs whose employer stock has slumped enough to cause it to be less then 50% of the total assets.

It would seem odd to punish an ESOP for having a good amount of cash but it seems like it is a risk.

The real issue is if like in Becky's example even short term swings are the problem. After all if you thought this was a long term problem one could either contribute stock or use the cash in the plan to pay distributions and recycle the shares. That ought to move the cash to company stock ratio back to where it needs to be after a few years.

[Guest Benefitsrock]

Also, any chance someone has a copy of DOL Advisory Opinion 83-6A? I'm out of the office and trying to track it down. Thank you!!

[Guest Benefitsrock]

Oops, I should have said, does anyone have a link to where I can find a copy of 83-6A. Thank you!!