How to fix incorrect loan payments and share releases?

[Guest TPH]

A plan sponsor leveraged an ESOP with a loan of less than 10 years. The loan amortization schedule was based on variable payments of fixed principal plus interest. The plan released shares based on the principal only method. Therefore, each year the same number of shares were released from suspense as the loan was repaid. No problem so far. However, the plan sponsor then financed an additional purchase of shares with a loan of greater than 10 years. This loan was to be amortized in a normal fashion (i.e., equal payments consisting of varying principal and interest amounts -- like a mortgage). However, the plan and the plan sponsor treated the new loan like the prior loan. The plan sponsor paid the loan using a fixed principal and interest amortization (paying too much each payment) and the plan released the shares using the principal only method. If the plan sponsor had paid the correct loan amount using the normal amortization the release would have been correct since the loan was to provide for equal payments consisting of principal and interest. What issues does this raise? Is there a pt for not following the terms of the exempt loan? If so, can the lender (a related party) remit the overpayment to the plan which would then remit it back to the plan sponsor to cure the pt? Are there potential operational defects? Could the plan be submitted under an IRS correction program? Or, is there a prepayment of the loan (which the loan documents provide for without penalty) and, thus, more shares should be released and allocated (thus resulting in a greater accounting expense to the plan sponsor)? Any thoughts?

[RLL]

Hi TPH ---

Under the 1977 ESOP regulations, a loan of more than ten years requires "release" and allocation of shares under the "principal & interest" method. If the loan payments were made as you described, but the "principal only" release method was used, there is a risk that the ESOP loan will be a prohibited transaction and that the ESOP will fail to meet the requirements for "ESOP status" under IRC Section 4975(e)(7)....thus also jeopardizing the status of the first ESOP loan and any special ESOP tax benefits. In addition, assuming that the ESOP plan document includes the appropriate required principal & interest "release" and allocation method, there is the danger of disqualification under IRC Section 401(a) for failure to follow the document in making allocations to participants' accounts.

The Section 401(a) violation can be corrected under IRS qualification defect correction programs....but this does not "fix" the ESOP status and prohibited transaction problems retroactively. If there were a "submission" to IRS, the plan sponsor may be faced with PT excise taxes.

The loan release and share allocation defects should be corrected to reflect the actual loan prepayments. Correction cannot be effected by the lender's refunding loan payments and the ESOP's refunding employer contributions....there has been no mistake of fact here.

The plan sponsor should retain legal counsel with significant experience in fixing ESOP loan and administrative screw-ups and in dealing with the IRS correction programs.

[Guest JPCMPLS]

I agree with RLL's analysis. I am in the process of a walk in CAP filing on a similar fact pattern that was discovered during a DOL examination of the plan. The DOL has issued a no action letter as a result of the plan sponsor's agreement to release additional shares in accordance with the plan document (and ESOP regulations). There is still an open issue on the IRS application of PT penalties for the period that the loan was out of compliance.