404(k) - How to satisfy fmv of allocated dividends?

[Guest crosseyetester]

An ESOP has adopted 404(k) provisions. In my role as a recordkeeper for this plan, I'd like to make sure I understand what is being done correctly.

For the 2006 plan year, they paid in cash the full amount of the loan payment. They also paid in cash a dividend, which is to be put into a suspense account and then applied to the 2007 loan payment. This dividend can be broken up into what would have been the allocated and unallocated parts.

The documentation says, "Any cash dividends attributable to company stock allocated to participant accounts shall be utilized to pay plan obligations under a loan only if the accounts to which such dividends would have been allocated receive a respective allocation of company stock for the plan year for which the dividends would have been allocated, with a fair market value not less that the current value of the dividends."

Previously, the unallocated portion of the dividend would have been applied to the loan and release of stock shares. Currently, with the annual loan payment being made in full in cash (no unallocated dividends being used), there is larger than normal shares being allocated to those eligible to share in the contribution. I can then compare this allocation amount, maybe the fair market value of the amount attributable to what would have been the unallocated dividends(?), to the value of what would have been the allocated dividends. However, a terminated participant would not be eligible to share in the contribution, and would therefore not have any allocation that would compare to what would have been the allocated dividends, not satisfying the documentation. Any thoughts on how to approach this?

Second question...meanwhile, a year later, gains attributed to the cash deposit of the suspended dividends... can they also be used to pay down the loan? (similarly if there is a loss would the paydown just be less?)

Thank you

[Guest tmills]

I question how 2006 dividends on allocated shares can be put in a suspense account and not truly allocated to participants. I think they have some problems with that strategy. Look at the language you quoted, ". . .only if the accounts to which such dividends would have been allocated receive a respective allocation of company stock for the plan year for which the dividends would have been allocated. . ." They aren't receiving an allocation of stock for the plan year in which the dividend would have been allocated, therefore how can the allocated share dividend be used to make a loan payment?

You don't say what happened to the 2006 unallocated dividend. You mention "there is larger than normal shares being allocated to those eligible". Is that b/c the unallocated dividends were used to make additional principal payments and therefore release more shares? It doesn't sound like it but I don't see how else you would get more shares than normal. In any event, dividends on unallocated shares are not subject to the fmv test, only dividends on allocated shares.

The test looks at the dividends the participants would have received on their allocated shares and compares that to the fmv of the shares they receive as a result of being forced to give up the dividend. They have to receive at least as much in share value as they gave up in dividend value. What isn't clear in the code is how to fix it if the test is failed. Presumably you would take shares that were released by methods other than the dividend payment and allocate them to the participants who didn't get their dividend until the test is passed. But that is getting ahead of what you asked.

The second question illustrates why you wouldn't/shouldn't put amounts in suspense. Ignoring that for the moment, I think a loss would present a significant problem, however I would think the money would be in a MMF and therefore that should not be an issue. My opinion on the gain is it should also be used to pay down the loan. I'm guessing the document doesn't help on the issue.

[Guest crosseyetester]

Thank you for your time and for your reply. I just talked to the attorney who drafted the document and he says he pulled it from the regs. He's more interested in the 'preferential income tax treatment' provided by section 404(k) and does not really know how to put into practice, he's relying us for that.

Until 2005, the standard procedure, which I believe is pretty basic, was that there is a dividend made, the unallocated portion is used towards the loan payment, and then the rest of the loan payment is made by the company. This resulted in a release of shares. The allocated portion of the dividends was allocated to accounts appropriately based on stock balances.

2006 seems to be a transition year. Now, the full amount of the dividends, allocated and unallocated, is to be put into a suspense account, to be used towards loan payment starting in 2007. What I was trying to say by participants receiving more shares than normal is that, since under this new procedure, there is no unallocated dividend used towards the loan, the company is making up that difference in their loan payment, and making the full amount of the loan payment, in addition to the full amount of the dividends. There are no stock shares being released in 2006 which can be attributable to dividends.

Therefore, a terminated participant who is not eligible for the contribution but has a share balance receives no allocation, and fails the test of receiving the fmv of what would have been received.

So instead of allocating all released shares based on eligible compensation, are you saying that I back out a fair market value of the share release that equals the value of the allocated dividends, and allocate those similarly to how we would have allocated cash dividends? Is that allowable, since the shares are released based on loan payment that's not attributable to dividends at all?

[RLL]

If cash dividends are received by the ESOP during 2006, they must be allocated to participants' accounts by year-end 2006. This applies to the dividends on both allocated and unallocated shares. Crediting any of the cash dividends to a suspense account without any corresponding allocations to participants' accounts is a violation that can result in loss of qualified status under IRC sections 401(a) and 4975(e)(7).

If the lawyer who drafted the plan says that "he pulled it from the regs" and cannot provide advice as to what his document means and how it should be applied, you should recommend that the client retain a lawyer who understands ESOPs and knows what he/she is talking about (and understands the documents that he/she drafts for a client). The lawyer's response demonstrates incompetence. It is not the responsibility of the recordkeeper to interpret vague language in the plan document.

[QDROphile]

Good on you, RLL.

[Guest tmills]

If cash dividends are received by the ESOP during 2006, they must be allocated to participants' accounts by year-end 2006. This applies to the dividends on both allocated and unallocated shares. Crediting any of the cash dividends to a suspense account without any corresponding allocations to participants' accounts is a violation that can result in loss of qualified status under IRC sections 401(a) and 4975(e)(7).

If the lawyer who drafted the plan says that "he pulled it from the regs" and cannot provide advice as to what his document means and how it should be applied, you should recommend that the client retain a lawyer who understands ESOPs and knows what he/she is talking about (and understands the documents that he/she drafts for a client). The lawyer's response demonstrates incompetence. It is not the responsibility of the recordkeeper to interpret vague language in the plan document.

I agree. Couldn't have said it better myself.