415 and vesting

[CTipper]

Had an interesting experience this morning

Had someone tell me that their lawyer told them (yes, 2nd or 3rd hand information)

1. Even if the Employer has been sponsoring a 401(k) Plan for many years that it is okay for the Employer to establish a new qualifed ESOP with years of service starting from plan effective date; and

2. That when an Employer is sponsoring both an ESOP and a 401(k) Plan, that the 415 limit applies to each individual plan. In other words, it could be $45,000 in the ESOP and $45,000 in the 401(k).

Before I'd had this meeting I would have thought the answer to both was obvious --- no. But now I'm not sure about anything anymore.

Thanks

Christopher

[John Feldt ERPA CPC QPA]

I haven't looked up anything regarding #1, I assume you are talking about vesting service. I don't recall that would be a problem, unless one of the plans terminates with 5 years of the startup of the other or something like that (don't hold me to this answer, it is Friday the 13th).

For #2, the dividend payments on the stock won't count as annual additions. Also, if this is a leveraged ESOP, then a portion of the allocation is payment toward principal and some is payment of interest on the loan, so only a portion of that entire allocation counts as an annual addition.

I have not looked at the ESOP sections in the recent final 415 regs, though, so take the above response with caution.

[CTipper]

Yes, #1 is vesting service. I know from combining DB and DC plans that if they have had a DC plan for a number of years I can't have service for vesting start from the DB plan's inception date. I was presuming that would be true with an ESOP and a 401k plan. I've done a bit of looking but can't find anything saying anything either way.

For #2, I know that there are portions of the allocation that don't count towards the 415 limit, so it could SEEM like someone has a $90,000 415 limit, but that's not the same as saying the dollar limit applies individually to each plan, right?

Also, as I type this, I just realized I've always read everything regarding the divident payments, etc., not counting towards the annual limit. But, I've always interpreted that to mean the flat dollar limit. (not sure why). What if those allocations than exceed the participant's compensation? Is it still okay?

Christopher

[stephen]

#1 - Yes No (see answer 4/16/07 11:25 am below)

#2 - No - The 415 limit applies accross plans of the same employer. There is an incraesed 404 limit available as discussed below. I preseneted the information below at the 2005 ASPPA Conference. There are several items that may be of assistance to you with your questions.

Contribution Deduction Limits (IRC §404)

1. For C Corporation and S Corporation ESOPs up to 25% of eligible compensation can be contributed whether leveraged or non-leveraged.

2. For C-Corporations interest above the 25% is also deductible.

3. Elective deferrals to a 401(k) plan are no longer included as employer contributions for this limit.

4. Compensation

a. Compensation paid or accrued during the employer’s tax year for participants who benefit under the plan for the year.

b. Prior to 2002 compensation excluded pre-tax 401(k) and Section 125 contributions. For plan years beginning after December 31, 2001, compensation includes pre-tax 401(k) and Section 125 Contributions.

c. Subject to limits of IRC §404 (a)(17), which was $210,000 for 2005.

5. According to Private Letter Ruling (PLR) 200436015 leveraged C-Corporations can take an additional 25% deduction to pay principal. In the June 9, 2004 ruling the IRS evaluated a request from a company that contributed 12% to a money purchase plan, a 401(k) plan with a match up to 3½ % and the intent to establish an ESOP with a 25% of pay contribution to repay principal. The IRS concluded that “section 404(a)(9)(A) [of the code] allows a separate deduction for contributions applied by an ESOP to the repayment of principal of a loan.” While PLRs only apply to the taxpayer requesting them the definitive language in the ruling suggests a very strong likelihood that the IRS would come to the same conclusion in other cases.

a. This does not apply to S-Corporations.

b. This only applies to the maximum employer contribution (IRC § 404).

c. The individual employee limit (IRC § 415) is still 100% of pay up to $42,000 (2005).

Potentially a company could make a principal payment of 25% of eligible compensation, up to 25% of other employer contributions, plus salary deferrals, interest and deductible dividends to achieve a total deduction of more than 50% of eligible compensation.

Dividend Deduction (IRC §404(k))

1. Dividends do not count as employer contributions. Thus, they do not count against an employer’s 404 limit or against a participant’s 415 limit. Thus, the use of cash dividends can permit a corporation to accelerate loan repayment or allow a corporation with small eligible payroll in relation to its outstanding ESOP debt the ability to support its ESOP debt.

2. Dividends on unallocated shares may be allocated to participant’s accounts in proportion to participants’ compensation or as additional income of the ESOP trust.

3. C Corporation employers can deduct certain dividends paid on employer stock held by an ESOP.

4. In order to be deductible, the dividend must be paid in one of the following ways:

a. Paid directly to the participants (or beneficiaries) in the plan.

b. Paid to the ESOP trust and distributed to the participants (or beneficiaries) within 90 days after the close of the plan year in which the dividend is paid. This is known as a “pass through dividend”.

c. Used to repay an exempt loan.

(i) If the plan has more than one loan, dividends must be used to make payments on the same ESOP loan used to acquire such employer stock, unless the dividend is paid on employer stock acquired on or before August 4, 1989, in which case the dividend can be used to repay any exempt ESOP loan.

(ii) If a dividend paid on allocated stock is used to repay an ESOP loan, each participant’s account must receive an allocation of employer stock, which has a current fair market value not less than the cash dividend that the account would have otherwise received.

Example:

1,000 shares

Dividend rate of $0.50 per share

Cash dividend would be 1,000 x 0.50 = $500.00

If this dividend is used to release 12.5000 shares at $30.00 each = $375.00.

In this case the stock release from the dividend is smaller than the cash value of the dividend. Thus, the dividend must be made whole.

The share difference 4.1667 shares (500 shares / $30.00 = 16.6667 shares less 12.5000 shares = 4.1667 shares) is often made up by recharacterizing shares released on unallocated shares.

d. Dividends voluntarily reinvested in employer stock are deductible (for plans years starting after December 31, 2001).

5. Dividends (earnings distributions) paid by an S Corporation are not deductible under 404(k).

6. S Corporation ESOPs can now use dividends paid on allocated shares for debt payment; provided the rule in 4©(ii) above is followed.

7. C corporation dividends must be reasonable.

Allocation Limits (IRC §415©)

1. Plan years beginning after December 31, 2001, the limit on annual additions is the lesser of 100% of gross compensation or $40,000 (indexed).

2. Annual additions consist of contributions and forfeitures (under EGTRRA, elective deferrals to a 401(k) plan are still included as annual additions).

3. All plans of the employer must be aggregated.

4. In C Corporation ESOPs, if no more than one-third of the employer contributions applied to principal and interest payments on an exempt loan are allocated to the highly compensated employees, the 415 limit shall not apply to either forfeitures of employer securities acquired with the proceeds of the loan or employer contributions applied to interest payments on such loan.

Example:

C 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 including $8,333.33 interest

Total Annual Addition $46,000

This fails 415.

If the plan passes the 1/3 test, you do not have to include interest or forfeitures of leveraged stock.

Deferral $14,000.00

Match $6,000.00

ESOP Lev Stock Forfeiture $0.00 exclude leverage stock forfeiture

ESOP Contribution $16,666.67 excluding $8,333.33 interest

Total Annual Addition $36,666.67

This allows the participant to pass 415.

5. If the plan allows, current fair market value of stock allocated from the loan suspense account rather than actual contribution dollars used to release such stock may be used to determine the annual addition.

What if plan fails 1/3 test? Or ESOP is not leveraged? You may be able to use the current fair market value approach for 415.

Example:

C-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.

6. To reduce any excess annual additions, the plan document may allow for deferrals to be returned to the participants, 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.

7. No deduction is allowed with respect to any contribution amounts that result in excess annual additions.

[CTipper]

Stephen

Thank you for your response. It's going to take a bit of digesting.

Hope you take this the right way -- is there a site I can go to for the vesting issue, please? And, just to make sure I understood your answer -- Even if a 401k plan started 01/01/2000 they can have an ESOP effective 01/01/2007 with years of service for vesting starting at 01/01/2007 so that everybody is 0% vested. Right?

Christopher

[stephen]

Christopher,

I apologize for my earlier answer. Prior service is generally included for VESTING. The info below is from The ERISA Outline Book page 4.42 of the 2006 edition.

What service must be credited for vesting purposes?As a general rule, the plan must count all years of service for vesting purposes, even if the employee is credited with the service before satisfying the plan's eligibility requirements, or is suspended from participation in the plan because of an employment classification. Treas. Reg. §1.411(a)-5(a).

[Guest tmills]

Christopher,

I apologize for my earlier answer. Prior service is generally included for VESTING. The info below is from The ERISA Outline Book page 4.42 of the 2006 edition.

What service must be credited for vesting purposes?As a general rule, the plan must count all years of service for vesting purposes, even if the employee is credited with the service before satisfying the plan's eligibility requirements, or is suspended from participation in the plan because of an employment classification. Treas. Reg. §1.411(a)-5(a).

I don't think the above post goes far enough into the reg. The last part of (a)-(5)(a) says count all years except years of service described in paragraph (b) of this section may be disregarded. (b)(3) says that in general an employee's years of service during any period for which the employer did not maintain the plan (or a predecessor) may be disregarded.

We just had a "discussion" w/ an IRS auditor on this issue. We did not do a good job in the document defining the start date for vesting computation, so they claimed we had to go back to date of employment if the plan didn't specify otherwise. We eventually got them to come around to our position. However, they never claimed you couldn't exclude the pre-plan service, only that you had to properly state in the plan what you were doing.

[Guest Guest_named_dee_*]

I believe your friend of a friend who hear something from someone else is referring to the private letter ruling that allowed a company to deduct contributions of 25% of compensation to a leveraged ESOP and 25% of comp to another profit sharing plans in the same year. The contribution limits of 415 still apply (aka 45,000).