Prepayment of Loan - Reg. 54.4975-7(b)(5) Limitations

[Yesrod5]

As silly as it may seem, it appears to me that a literal reading of Reg. 54.4975-7(b)(5) leads to the conclusion that - absent substantial C corp dividends or S corp distributions - an ESOP is hamstrung and cannot prepay a loan even though: (i) the loan documents expressly permit prepayment, (ii) the ESOP has plenty of cash (assume that the cash has accumulated through employer contributions that were in excess of the ESOP's payment obligation and were not designated as being made to the ESOP to enable it to meet its loan obligation), and (iii) prepayment would be in the best interests of participants and beneficiaries of the ESOP.

Reg. 54.4975-7(b)(5) reads as follows (in italics) - -

BEGIN QUOTE:

"(5) Liability and collateral of ESOP for loan.-- An exempt loan must be without recourse against the ESOP. Furthermore, the only assets of the ESOP that may be given as collateral on an exempt loan are qualifying employer securities of two classes: those acquired with the proceeds of the loan and those that were used as collateral on a prior exempt loan repaid with the proceeds of the current exempt loan. No person entitled to payment under the exempt loan shall have any right to assets of the ESOP other than:

(i) Collateral given for the loan,

(ii) Contributions (other than contributions of employer securities) that are made under the ESOP to meet its obligations under the loan, and [emphasis added]

(iii) Earnings attributable to such collateral and the investment of such contributions.

The payments made with respect to an exempt loan by the ESOP during a plan year must not exceed an amount equal to the sum of such contributions and earnings received during or prior to the year less payments in prior years. Such contributions and earnings must be accounted for separately in the books of account of the ESOP until the loan is repaid." [emphasis added]

END OF QUOTE

Beginning with the next-to-last sentence, we see that "payments made with respect to an exempt loan by the ESOP during a plan year must not exceed an amount equal to the sum of such contributions and earnings received during or prior to the year less payments in prior years." If there are no signficant dividends or S corporation distributions, doesn't the language effectively mean that payments cannot exceed "such contributions" (i.e., contributions shown in bold above; in other words, contributions "made under the ESOP to meet its obligations under the loan")? And doesn't this effectively foreclose any possibility of prepayment by the ESOP in the situation described?

Please set me straight on this.

[Marcus R Piquet]

Allow me to clarify - are you asking if prior years' contributions of cash that were NOT originally designated as debt-service contributions at the time of contribution can be used to make payments on the exempt loan?

[Yesrod5]

Marcus,

Yes; you have put it very succinctly.

[RLL]

Your interpretation of the regs is correct. It essentially means that an ESOP can prepay the loan only to the extent that the employer pays contributions that are intended to make loan payments or when certain dividends on employer stock are paid to the ESOP.

I don't think that this rule is "silly," as you have suggested. It is intended to protect the interests of ESOP participants and has generally worked out well for 35+ years.

[Yesrod5]

RLL,

Thank you for your response.

I regret using the word "silly"; but it seems to me that in the situation described (I.e., the loan documents permit prepayment, the

ESOP has the cash, and the fiduciaries have determined that prepayment would be in the best interests of participants and beneficiaries), there should be no limitation on prepayment. To the contrary, prepayment would appear to be beneficial to participants inasmuch as stock would be released from the suspense account and allocated sooner.

I would be interested in learning the policy for this limitation.

Thanks again.

[ESOP Guy]

Yesrod5:

As a practical matter does it matter much? If the plan in question has turnover you could use the cash in the plan to fund the distributions and use 100% of the allowed contribution to pay/pre-pay the loan. I suppose it could turn out the plan has so much cash at this point that it exceeds the distrbution payments and the deductable limit but that is a less common set of facts. Most ESOPs with loan tend to short on cash not over running with them.

Just trying to help think of way to reach what seems to be the objective of paying down the loan with the existing rules. This observation may have been obvious and wasn't trying to explain the obvious.

[Yesrod5]

ESOP Guy,

Thank you. In fact, the 2012 contribution just went in (and it is well in excess of the loan payments currently due). As to that portion of the excess that is not needed to fund disbutions, we have been considering setting that portion up on the books of the ESOP as prepayment of the exempt loan (rather than allocating it to the "Other Investments Account"). This would not result in prepayment in full but would still help in moving in that direction.

Regards.

[Guest MaineERISA]

My question is slightly different. Following Marcus Piquet's comment above the question is "Can prior years' contributions of cash that were originally intended to be used for debt service contributions at the time of contribution be used to make payments on the exempt loan?" If so, how are the shares released and allocated?

For example. Plan established in December 2011 with small contribution. In 2012, a significant cash contribution was made retroactive to 2011. The contributions was allocated to participants pro rata based on 2011 compensation as of December 31, 2011. Loan payment due June 2013. Can previously allocated contributions be used to pay the loan? If so, are shares released based on the priniciple and interest method (similar to the release following a cash contribution). How are shares allocated back to participant's? The plan provides for a comp-to-comp allocation for the plan year of the loan payment, but that would be unfair. Are released shares allocated back pro rata based on the amount debited from participant accounts to pay the loan?

I appreciate any comments.

[ESOP Guy]

Maine:

I have done what you are suggesting. I have woked on ESOPs where we put cash into the plan in year 1. In year 2 100% of that cash was used to make the loan payment. We allocated the shares released when we did that on the ratio of the cash in people's accounts from year 1. If there was a contribution in year 2 that also helped pay for the loan we obviously allocated those shares based on the ratio of the contributon.

I can't quote you any regs/rules on the topic. I was always working very closely with the plan's attorney and CPA. To me that is just the way to go when you are pushing the limits like that. Get everyone on the same page as they say.

Also, I have never had the time gap be as large as your example. It was always we made a contribution in 2012 for 2011 and the payment was made in 2012.

At risk of repeating myself given how expensive these errors can become if done wrong I think the client spending some money to make sure their attorney is on board is cheep insurance. It is clearly cheaper then what will have to be paid to the attorney if he has to come in after the fact and clean up the mess.

[Guest MaineERISA]

ESOP Guy - thank you. I presumed that the allocation of released shares would be different depending on the source of the debt payment. I am surprised that there is little guidance on this and that many ESOPs do directly address this issue. Thanks for your thoughts.

[GMK]

With an ESOP, your best resource may simply be the Plan Document. It will certainly detail the Plan's own rules for the allocation of released shares. It may also have the statement that prepayment of a loan is not allowed. Worth looking into.

[QDROphile]

You might ponder Treas. Reg. section 54.4975-7(b)(5), which may be reflected to some degree in plan terms.

[tghooper]

We have a similar situation. The plan had a loan in place as of 12/31/2013 and first payment due in January 2014 (per note/amortization schedule). The sponsor elected to prepay a portion of the loan payments and allocated that to participants at 12/31/2013.

My question: Is that amount deductible on the 2013 corporate tax return since it was not applied to the loan until 2014?

[ESOP Guy]

Yes it is deductible. As far as I can tell the determination if a contribution is deductible is one set of rules. And none of those rules relate to how the money is used in an ESOP-- ie to fund distributions or make a loan payment.

The rules for how the loan payment works is totally independent from the deductions rules and via versa.

[tghooper]

I forgot to mention that this is an S Corporation.

Thanks ESOP guy.