404 Deduction Limits for ESOP & 401(k)

[Guest SDS]

Facts:

C Corporation has two separate plans; 401(k) and a new MP ESOP, which they are currently attempting to heavily fund in preparation for an upcoming purchase of stock. The 401k has a 1000 hour and year end requirement to receive emloyer match as does the ESOP (to receive stock allocation). The plans have identical eligibility and thus have the same participants in each.

Using the guidance of Rev Rul 65-295, I am fairly safe in assuming two things:

1. If I only had the ESOP, to determine the maximum contribution of 25%, I could not use the compensation of those participants who terminated or did not complete 1000 hours, since they are not eligible for an allocation and thus not "benefitting"; and

2. If I had only the 401(k), to determine the maximum contribution of 15%, I would use the compensation of those participants who terminated or did not complete 1000 hours, because they were eligible to defer and thus "benefitting" (even though they are not eligible for an employer match contribution).

QUESTION:

What compensation would you use to determine the combined 404 limit of 25% when both plans are in place with the same participants in each plan?

(1) Would you include compensation for all participants including those benefitting in the 401(k) Plan but not in the ESOP. If so I would assume you would reduce the maximum contributions to the ESOP by the 401(k) contributions made by those not benefitting in the ESOP.

----- or ------

(2) Would you exclude the compensation of those not benefitting in the ESOP. If so I would assume that you would NOT reduce the maximum contributions to the ESOP by the 401(k) contributions made by those not benefitting in the ESOP.

I can find lots of commentary that addresses the issue of "benefitting" for 404 purposes, but everyone says there is "no guidance from the IRS". I want to hear what stance others of you take.

[RLL]

SDS ---

The 15% of deduction limit under IRC Section 404(a)(3) is an aggregate dollar amount based on compensation of employees participating ("benefitting") under either the ESOP or the 401(k) plan. This 15% limit applies to the contributions to the 401(k) plan and the stock bonus plan portion (but not the MPP portion) of the ESOP.

If the ESOP is leveraged (and the company is not an S corporation), the special 25% limit under IRC Section 404(a)(9) for contributions used to pay loan principal is based on compensation of employees benefitting under the ESOP alone.

If the ESOP is not leveraged (or, if leveraged, the company is an S corporation), there is no specific 25% deduction limit under Section 404(a) applicable to contibutions to the ESOP and 401(k) plan....but IRC Section 404(j) limits the deduction to the amount that can be contributed within the IRC Section 415© limits on annual additions. The 25% deduction limit of IRC Section 404(a)(7) appears to apply only when there is a defined benefit plan and a defined contribution plan.