Bad ESOP loan

[Dawn Hafner]

DOL audit of ESOP determined ESOP loan note contained impermissible provisions. Loan note was fixed. DOL letter states that the Secretary of Labor is required to transmit to the IRS information indicating that a PT has occurred.

The 15% excise tax is substantial. Obviously they will be involving an ESOP attorney. What are suggestions - 1) file the 5330 and pay the tax now 2) wait for IRS notice 3) contact IRS to negotiate settlement. The note provided for a call of the entire balance immediately, but in operation, nothing like that happened, it was just a documentation issue of the loan note.

Also, it gets more interesting. This is an S corp, using distributions on allocated shares to service debt. The DOL interestingly enough, did not make any comment in regards to this issue.

Since the loan notes were already bad, is there anything to fix in regards to the use of distributions on allocated shares? Once the loan became nonexempt, don't these issues go out the door? Now that the loans are clean again, they should ensure they are not using impermissible distributions going forward. Do you think there is any correction to make relating to this issue? Isn't it interesting that the DOL, with responsibility for enforcement relating to PTs, made no issue relating to this matter, despite the IRS's interpretation in a PLR that this is a PT?

Any comments or insights appreciated.

[RLL]

Hi Dawn ---

It's not surprising that some DOL folks were unaware of an IRS position regarding ESOP loans. They may not know what an S corporation is. Some DOL folks don't even know their own agency's positions on certain issues.

The fact that DOL is notifying IRS of the PT indicates that the IRS might be coming around to audit. I'd follow the advice of the ESOP lawyer. You may want to consider fixing ALL aspects of the ESOP loan, including the possible "improper" use of S corp distributions (on allocated shares) for loan payments. Under IRC section 4975, you must retroactively "correct" all defects to avoid the 100% excise tax. Also, if the defects are "corrected" now, you stop the addition of more years of 15% excise taxes.

Why voluntarily contact IRS? They may lose (or never get) the notice from the DOL and never show up to audit.

Also, you should note that the 15% per year excise tax on a "non-exempt" ESOP loan is based on the annual loan interest, not on the principal amount.