Leveraged ESOP

[Tom Poje]

company puts in 25% of pay.

shares to be released is principal/(principal + future principal)

I am using original share price for allocation purposes because it is smaller. This would result in 26% contribution being allocated to participants. Ah, a clear violation of 415 limit.

Which of the following is permissable:

1. Release the shares anyway, but don't allocate them. Hold in 'suspense', but not same 'suspense' as unreleased shares.This would seem to me to imply a penalty for overcontribution.

2. Only release enough shares to cover the 415 limit, and consider the remaining contribution as loan payment for next year.

Plan is 6/30 Year end, and last loan payment was made 6/22, so it is within a week of year end.

[QDROphile]

You may use either the contribution amount allocated in the same proportion as the released stock) or the value of the stock allocated for section 415 calcualtions. I got two determination letters that allow the plan to use the lesser of the contribution amount or the value allocated. The ruling that OKs the use of the value of the allocated stock does not say that the plan gets to switch back and forth as it may desire, so a plan provision and a detrmination letter would be prudent. See PLR 9625045.

[Guest Beavis]

Maybe you tried this already, but...

If you're a C-corp and you pass the 1/3 test, you don't have to include interest paid on an exempt loan (or forfeitures) as an annual addition.

[Tom Poje]

here is the deal. numbers,numbers,numbers.

(rounded for convienience)

contribution was 84,000.

(25% of pay = 65,500)

interest = 18,500

so principal was 65,500.

loan balance was 234,000.

so, less principal, now = 168500

using principal only method to release shares I have:

numerator = 65,500

denominator = 65,500 + 168,500, which results in 28% of shares to be released.

there are 198,770 shares, so this means 55,638 shares get released.

original share price (since smaller) was 1.25, so 55,638 shares * 1.25 = 69,548.

But this is greater than the 25% of pay which is only 65,500!

So now I have an extra 4000 or so above the 415 limit that I can't allocate.

no hces (owners)receive, since they put the shares in (leveraged esop) and take the deduction, so 1/3 rule doesn't come into play.

so, now what? count the 'extra' contribution as loan payoff for next year, and release fewer shares?

[BeckyMiller]

Numbers, numbers, numbers. In my experience, when you are on the principal only method and you have applied it properly and consistently throughout the loan term, you will always release the number of shares whose original cost was equal to the principal reduction for the year. So I am confused why it is not working out that way for you.

[Tom Poje]

let's say I have a 1 person ESOP.

I make $10,000. so 25% is 2,500.

Lets say this releases (through the formula in the document) 1000 shares.

I now have to allocate the 1000 shares.

I am the only one in the plan, so I receive 1000 shares. I can do so at either: original share price or current share price. If my original share price is 3.00 then I have received 1000 shares valued at $3000 which is over my 415 limit. That is the way leveraged ESOPs work.

Then you turn around and say the stock is now worth 5.00, and you get a fantastic gain.

Or, look at from another point of view. I allocate the 2500 to the cash account.

Fine and dandy, thats 25% of pay. I now go and buy shares at $3. I get 833.33 shares. But I released 1000 from suspense, so I have 166.67 shares that are unallocated.

They are not in 'suspense' because they have been released through the plan formula. I have no choice.

It's bizarre, evn though my cash contribution was 25% of pay, the shares released constitute a contribution > 25% of pay. a clear 415 violation (if allocated?)

[Tom Poje]

I did not say they were paying off the loan according to any schedule. You are allowed to pay off the loan faster if you so desire. A larger payoff results in a larger release of shares. Yes, you are correct, if they made 'equal' payments every year that would work.

This is not the case this time. so now what?

[Guest ndt123]

Maybe I'm missing something...

If your employer contribution to principal was 65,500, and that also is your maximum 415 allocation, where is the problem? Why are you going back to the value of the shares for 415 purposes? I realize that under certain circumstances you might want to do that, but it's certainly not the norm. Most plans discuss including employer contributions as annual additions, and excluding the interest portion, your ER contribution equaled your 415 maximum.

[Guest ndt123]

That is not the standard method for calculating the portion of a leveraged ESOP contribution that is considered an annual addition.

The annual addition is the ER contribution to release the shares, not the value of the shares released. If you contribute $2,500 to release shares, your Annual Addition will be $2,500 regardless of the value of the shares allocated.

There is one PLR that allows a plan to switch from the contribution to the value of the shares, but most documents are written to just look at ER contribution. Check the Annual Addition section of your document - if it just references ER contributions, you would use the $2,500 in your above example. If it references the value of the stock allocated (which is unlikely), amend your definition of Annual Additions.

[Guest Beavis]

I agree that it is most usual for the plan doc to define the annual addition as the amount of the contribution. Some do go as far as to say that you can use the lower of the contribution amount or the fair market value of the shares released. It seems to me that the exception to the rule would be the plan that used FMV as the only option for coming up with the annual additon amount. That would put a serious hurt on the possibility for allocations if the stock went up in future years.

I'm going to go back to my earlier comment about the 1/3 test. You said that all of your HCEs were disqualified because of a 1042 election? If that's the case it sounds like you've passed the 1/3 test easily. If your're a C-corp, you don't have to count interest on the loan as an annual addition. The way I read your scenario that would put you right at the annual additions limit.

Is there something else in this scenario that we are not aware of?

[Guest Larry Goldberg]

The ESOP regulations contain a clear answer to the Section 415 issue.

Treas. Reg. Sec. 54.4975-7(B)(8)(iii) provides that " . . . for purposes of applying the limitations under section 415 to these allocations, under Sec.54.4975-11(a)(8)(ii) contributions used by the ESOP to pay the loan are treated as annual additions to participants' accounts."

Moreover, Treas. Reg. Sec. 54.4975-11(a)(8)(ii) states that ". . . an ESOP will not fail to meet the requirements of Section 401(a)(16) merely because annual additions under Section 415© are calculated with respect to employer contributions used to repay an exempt loan rather than with respect to securities allocated to participants."

In addition, as noted above, PLR 9625045, as well as the IRS Audit Guidelines permit the use of fair market value under some circumstances, if the plan sponsor elects to draft the ESOP to so provide.

Finally, our firm has also obtained favorable determination letters for ESOPs that permit the Trustee to choose between using employer contributions and the fair market value of shares released.

------------------