Erroneous Release of Collateral for Exempt Loan

[Guest mmflaw]

We work with a client that sponsors a leveraged ESOP with a loan term in excess of 10 years. The client erroneously directed the trustee to release suspense account shares based on the principal-only method. The loan is a fixed principal plus interest loan which obviously would have front-loaded the release of shares. We are contemplating a VCR submission to address this issue. However, we are concerned about the implications of this operational violation under the prohibited transaction rules since arguably the violation may have caused the loan to lose its exempt loan status. Does anyone have experience with a similar situation, particulary in the context of VCR?

[BeckyMiller]

I suggest you get legal counsel to look at the loan agreements. If the rights of the lender are properly established, the fact that the employer directed the trustee to release the collateral in incorrect amounts probably does not result in the collateral actually being released.

If that is the case, I would argue that there is no violation of the loan agreement or resulting prohibited transaction. It is merely a clerical error in doing the participant accounting. (That is, the correct number of shares remain as collateral, the wrong number of shares were reported as released.)

In the event that counsel agrees with that approach, then you have to look at your options for correcting the participant accounting. Can you put everyone back where they should have been had the clerical error not occurred? Do we have issues in measuring dividends on allocated and unallocated shares because of the error in the number of shares assumed to be unallocated? Does this trigger a misuse of cash for debt service based upon plan terms, IRC Section 404(k), prohibited transaction implications for an ESOP of an S corporation, etc.

If we have no issues on dividends, can the "clerical" error be corrected under the APRSC program? Were excess distributions made to former participants because too many shares appeared to be in their accounts?

Lots of issues, but, possibly much more mundane and mechanical than dealing with a prohibited transaction.

Having said all that, realize, I am not a lawyer. I just see a lot of ESOPs. Getting the lawyer's input on the first point about the validity of the apparent release from collateral is the foundation to the whole discussion.

[RLL]

This issue may not eligible for correction under VCR as it specifically involves violation of the ESOP loan regs., Sec. 54.4975-7(B), and the ESOP definition regs., Sec. 54.4975-11, but not IRC Sec. 401(a).

The IRS may take the position that failure to follow the plan document (assuming it specifies the correct release method) is a violation of Sec. 401(a) which can be corrected under VCR. But you'll probably have to pay the Sec. 4975 excise tax for failure to comply with the ESOP loan exemption.

Also, other special ESOP tax benefits which may have been utilized....such as the dividend deduction under Sec. 404(k) and the special leveraged ESOP deduction limit under Sec. 404(a)(9)....may be in jeopardy for the loan repayment years by reason of the failure to fully comply with the ESOP requirements.

[Guest Larry Goldberg]

You are correct that the impermissible use of the principal-only method would cause the ESOP loan to fail to meet the prohibited transaction exemption. When a loan is prohibited, the 15% excise tax is applied to the amount of interest accruing on the loan, rather than the amount of the entire loan balance. To stop the excise tax from continuing to accrue, the prohibited transaction must be corrected. If you are completing such a correction for the VCR program, then it is should be relatively easy to correct for prohibited transaction purposes. Check IRS Form 5330 for information and instructions on the excise tax.

Also, I wonder if the VCR program will be available. If the plan only permits the principal-only method, then you did not violate the plan document, and may not have an event that qualifies under VCR. Moreover, you may not have an operational defect. On the other hand, if your plan has language that tracks the regulation, then you are in operational violation of the plan document, which can qualify you for VCR. Also, you should consider whether the correction can be completed under APRSC. This would avoid going to IRS with the qualification problem, although you are still left with the excise tax liability.

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

[BeckyMiller]

But Larry - If the loan terms specify how the collateral is to be released, does a clerical error by the employer in calculating the number really serve to release that collateral?

In the event of any right to claim collateral, wouldn't the lender have a defensible position to take back the correct amount without regard to what had been reported as released and allocated?

I am attempting to build an argument that the collateral was not released. Thus, no PT and merely an administrative error in reporting what shares are in the participant accounts. If this would work, then we would have a failure to follow the terms of the plan and something that we could arguably submit under the VCR program. (Unless it is just one year, I would not be comfortable with APRSC on this.)

So - being the devil's advocate - tell me why this won't work. I will admit that I don't know precisely how the lender's rights to collateral are established, protected, etc. I am just trying to build a case to avoid the PT.

[This message has been edited by BeckyMiller (edited 01-12-2000).]

[Guest Larry Goldberg]

I think you are assuming too many shares were released from collateral. However, under the facts posed by MMFLAW, the improper use of the principal-only method resulted in too few shares being released in the first years of the loan, rather than too many shares. I agree that the Company and the ESOP could correct the prohibited transaction. They would have to agree to release additional shares and to allocate those shares to the accounts which should have originally received them. However, the prohibited transaction provisions impose both an excise tax and a duty to correct the prohibited transaction. Therefore, it seems difficult to argue that by correcting the problem, the excise tax liability is eliminated. In addition, since the ESOP may be able to enforce its loan agreement as written, the Trustee may have an obligation to force the release of the additional shares. Otherwise, a participant may have a claim under Title I that he did not receive the full benefit he was entitled to under the ESOP. Also, the clerical error could result in a loss to the ESOP if the loan went into default and a lender chose to keep the "extra" unreleased shares as a remedy.

Let's consider the case where too many shares are released. For example, assume the ESOP was supposed to use the principal only method but erroneously used the principal plus interest method. Shares would be released too quickly. However, no prohibited transaction would occur because it is always permissible under the regs to use the principal plus interest method to release shares (there could be a qualification issue, however, depending on the plan language). I suppose I would agree with you that the lender ought to be able to enforce the loan agreement as written and require the ESOP to return the erroneously released shares (although consider the administrative difficulties identified earlier in this string).

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