ESOP & cross testing

[Guest Stacey L Miller]

Can anyone provide some perspective on why benefits under an ESOP can't be tested for nondiscrimination using cross testing? I am trying to get a handle on both ESOPs and cross testing and struggling some. I'd appreciate insight.

[Guest Larry Goldberg]

Treas Reg. §1.401(a)(4)-8(B)(1) expressly prohibits ESOPs from being cross tested.

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[Guest Stacey L Miller]

I have that regulation and know that it forbids cross testing. I am looking for the reasoning behind the rule, so I can start to develop a feel for ESOPs. Any help for that?

[RLL]

The legislative history of ESOPs, going back to 1973, indicates that an ESOP is designed to provide stock ownership interests to employees "substantially in proportion to their relative compensation."

In the 1977 ESOP "definition" regs., at Sec. 54.4975-11(e), the IRS took the position that an ESOP could not be combined with a non-ESOP in order to meet the 410(B) and 401(a)(4) requirements. The prohibition against "cross-testing" is just an extension of this historical special nondiscrimination rule for ESOPs, and it appears to reflect Congressional intent relating to ESOPs. If a company wants to utilize the special tax incentives for ESOPs, it must be willing to meet these (and other) more stringent rules.

[Guest Stacey L Miller]

Thanks for the perspective, RLL. That helps.