Loan Payments Exceed Deductibility Limit

[Guest SRH]

I have taken over the administration of a leveraged ESOP for a S-Corp. The ESOP was set up to pay out a partner with a 5-year loan which ended in 2012. The problem is that the loan payments from the very first year were more than the deductibility limit. The previous administrator 'solved' this problem by allocating released shares up to the deductibility limit and then allocating the remainder of the shares as dividends. The number of shares used as dividends were greater in most plan years than the number of shares allocated. I've done research, but cannot figure out if this is an allowable solution. Any ideas?

[Marcus R Piquet]

The company can certainly supplement the annual contributions with dividends. Those dividends, in turn, can be used by the ESOP to make payments on the exempt loan with the significant caveat that the "FMV rule" of IRC §4975(f)(7) is met. If there are problems with this "FMV rule" (based upon the value of stock allocated pursuant to dividends on allocated shares), then there are techniques might be used to modify the allocation of the shares so released. This is a pretty technical and nuanced area. To be frank, if this is not a subject that you are comfortable with you might want to consider taking a pass on the TPA work.

[ESOP Guy]

Marcu is correct S corp distributions (as S corps don't really have dividends) are not subject to 415 or 404 limits. In fact I have seen plans that from day one it was projected they would need dividends in order to pay the loan off.

The orginal question is unclear on this point so a word of warning.

I would advice against just putting a bunch of money into an ESOP and then after the fact deciding which is a contribution and which is a dividend. To me the sponsor should declare what it is as the money goes into the plan. I have been to ESOP conferences where the IRS has struck me as hostile to the way ESOP use dividend to put so much money into plans. To decide what the money is after you start testing invites a challenge is was all contribuoins. This obviously takes some planning to estimate how much contribution can go in and how much dividend is needed but declaring up front seems safer to me.

Also, at risk of pionting out the obvious contributions and dividend are allocated on a different basis and that creates its own issues in an ESOP.

[Marcus R Piquet]

I agree, it's always better to decide upon the character of the funds at the time of the transfer. Usually you can estimate this in advance. Sometimes not.

ESOP Guy - I can't help myself so please forgive me. S Corporations do pay dividends. State corporate law makes no distinction between C corps and S corps - they all pay dividends. The Internal Revenue Code calls dividends paid by S Corporations "distributions of earnings," true, but even the concept of S Corporations is a tax code concept and has nothing to do with corporate law. You'll find that the financial statements of most S Corps company call them dividends, not distributions. Again, sorry, just a pet peave of mine.

[ESOP Guy]

I agree, it's always better to decide upon the character of the funds at the time of the transfer. Usually you can estimate this in advance. Sometimes not.

ESOP Guy - I can't help myself so please forgive me. S Corporations do pay dividends. State corporate law makes no distinction between C corps and S corps - they all pay dividends. The Internal Revenue Code calls dividends paid by S Corporations "distributions of earnings," true, but even the concept of S Corporations is a tax code concept and has nothing to do with corporate law. You'll find that the financial statements of most S Corps company call them dividends, not distributions. Again, sorry, just a pet peave of mine.

I can live with being told I am wrong.

[Marcus R Piquet]

The other reason I prefer the term "dividends" in the context of ESOPs (whether it's a C Corp or an S Corp) is because some of my clients confuse S-corp distributions with distributions of benefits to the terminated participants. Seems easier to just call them dividends (which they are) and avoid the confusion. Sorry to get off-topic.

[Guest SRH]

Thank you for your answers. I'm not sure if I should start a new topic, but another issue I have is that the administrator calculated the number of shares released using the IRS formula for a leveraged ESOP. They would then divide the total number of contributions by the total number of released shares for a 'release price' and would allocate the shares based on this price. The released shares would then be valued using the current appraisal in the reports and participant statements. This release prices is always the same every year and is almost double the current appraised value of the shares.

I am not familiar with this method. I've always allocated shares and then valued them. Any comments?

[ESOP Guy]

If I understand the question correctly what is happening is as follows:

1) the participant's accounts are being credited with cash from a contribution per the terms of the document

2) The cash is being taken from their accounts and shares are being put into their accounts-- it is being done via a purchase transaction it sounds like-- to effect for the loan payment that happened in the plan

3) the shares are then being valued at the correct price

If that is what is happening that is fine. The net effect is the shares are being released and allocated on the same ratio as the contribution.

My guess they are doing it that way to get the 415 test done correctly by allocating the loan payments as contributions on their system. If the document does not allow you to use the FMV of the shares release you woud in fact have to at least know how much contribution is going into everyone's accounts for the 415 test.

This all assume my points above accurately describe what you were seeing. If I don't understand the facts correctly obviously my answer could be wrong.