ESOP Repurchase - Contribution and Dividend Limitations

[A Shot in the Dark]

Quick Facts: Employer is an "S" Corp. 100% employee owned via an ESOP. Distributions to terminated Participants are made as soon as administravely feasible following the separation of service using the prior plan year end valuation/appraisal. During the plan year the employer makes a cash deposit to the ESOP. The cash is used to to facilitate the distribution to the terminated participant(s).

A few of the higher balanced participants separated service during the last plan year. Employer deposits $1,500,000.00 and issues distributions equaling that amount.

Plan year end processing is taking place. Employer Contribution 404 Deductible limit and 404 declared dividend equates to $1,000,000.00.

For easy math say, share price is $10.00 per share.

So we issued and paid $1,500,000.00 in distributions, but we can allocate only $1,000,000.00.

This leaves 50,000 shares unallocated at the end of the plan year.

Any thoughts.

[RLL]

My first thought is that someone screwed up here.

The entire $1,500,000 (and the remaining 50,000 shares) must be allocated not later than the end of the plan year in which the "deposits" were made. If a dividend (an S corp distribution) was not (or cannot be) declared in an amount sufficient to cover the additional $500,000, the excess amount would be a non-deductible contribution to the ESOP (which must be allocated, subject to section 415 limits), subject to the tax on non-deductible contributions.

It may be possible to do some sort of "recharacterization" or refund of the employer "deposits" here, depending on the timing involved and the provisions of the plan documents. I strongly recommend that the employer engage competent, experienced ESOP counsel to explore what alternatives may be available.

[Guest Doug Johnston]

Why not treat the $500k excess as a loan or a purchase of the shares? As I see it, there are basically four ways for a company to get cash in an ESOP - contributions, dividends, loans, and purchases of stock. I have worked with ESOPs where the employer advanced funds during the year in order to fund distributions and then the administrative committee sent a letter to the trustee at year-end telling the trustee to consider $x to be contribution, $y to be a loan (with necessary documents enclosed), and $z to be a purchase (with instructions for the surrender and replacement of the stock certificate(s)).

[RLL]

Doug ---

Are you suggesting that the "necessary documents" be "backdated" ? That's certainly not an appropriate (or legitimate) way to address this problem.

It's critical to look at the documentation (including both employer and trustee accounting entries, as well as plan documents and board minutes) in place at the time the employer deposited the funds into the ESOP. What was the trustee told at the time of the deposit(s)?

An administrative committee (presumably, an ESOP fiduciary) can't unilaterally decide at year-end (or later) how to characterize amounts previously paid into the ESOP by the employer.

I think that there is no easy "fix" here. The employer should get counsel involved at once.