Original ESOP Loan not paid - audit results in proposed disqualification

Group:

I may not state this properly.

The facts as I know them.

* ESOP owned by an S Corporation was adopted and set up in 2013 by clients ESOP advisor. (no longer

working with TP)

* The original sale of stock was 100% of corporate stock sold for $20k to the ESOP.  (I'm not concerned about this $20k value, fyi)

Promissory note, loan agreement, security agreement prepared and signed

by Plan trustee.

* Terms state the note will be paid off over 10 years in a balloon payment.

* Client audited for 2013 and 2014 years.  IRS issues no-change letter accepting all filed returns. (final notice issued early 2015.) 

The IRS during that audit didn't address or bring up as an issue the non-payment of the note.  

* A 2nd audit ensued in 2018.  The TP had not paid the ESOP note.

The most recent revenue agent report states part of the rationale for disqualifying the

plan was because the $20k note was not paid.

* TP is not in Court for this plan.  There's a few other IRS issues that are defensible.

* The disqualification of the plan may result in a large tax for a number of reasons not germane

to this inquiry.

Related to the $20k note, my initial argument (I haven't began much research just yet) is that since the TP was

still under audit and the TP asked to pay off the $20k note as a corrective action, the IRS should have allowed the TP the ability

to pay off said note.

Even if the IRS didn't allow the payoff, the TP was still within the terms of the note.

The IRS did not allow TP to pay off the loan. 

Q:  Are there no defenses available to a TP who (for one reason or another) did not pay the

original ESOP note?  even though the terms hadn't come due yet.

Q:  Are having the terms of a 10 year balloon payment in violation of ERISA 4975?

What's odd is I've represented other ESOP's where - during an audit -the TP was afforded the ability make

catch up payments for the original note on the sale of stock. 

Seems like the Govt - which may have the right - can be selective depending on what day of the week it is.

There's no rhyme or reason to which TP's are afforded the right to make catch up payments.

Thoughts and comments are appreciated. Or cases on point or any other regulations that

may assist TP would be much appreciated.

Are you saying the original loan was set up for no payments until the 10th year and then the loan was going to be fully paid in that year?  

Are you also saying by that the 10 years aren't up but the IRS agent wants to disqualify the plan because the loan has only one payment at the end? 

I just want to make sure I understand. 

The facts seem incomplete, but a few thoughts based on the original post:

1.  Confirm the share release method used.  If the plan was using the principal only method, there could be a problem with a balloon payment.  Often the release method is stated in the ESOP loan documents.

2.  If the principal and interest method was used, but no employer contribution or loan payments were made, there would not be any shares released for allocation. An agent might be inclined to think that the loan was not for the primary benefit of the participants (a requirement for such a loan and typically required by the IRS to be stated in the plan document).  The $20K acquisition price might be a factor in the government’s unwillingness to allow catch-up payments if the price was substantially below fair market value.  The agent may view the ESOP as being put in place to avoid corporate taxes and not to provide an employee retirement benefit and promote employee ownership.  The context may matter here.  
 

5 minutes ago, MBESQ said:

The facts seem incomplete, but a few thoughts based on the original post:

 

1.  Confirm the share release method used.  If the plan was using the principal only method, there could be a problem with a balloon payment.  Often the release method is stated in the ESOP loan documents.

2.  If the principal and interest method was used, but no employer contribution or loan payments were made, there would not be any shares released for allocation. An agent might be inclined to think that the loan was not for the primary benefit of the participants (a requirement for such a loan and typically required by the IRS to be stated in the plan document).  The $20K acquisition price might be a factor in the government’s unwillingness to allow catch-up payments if the price was substantially below fair market value.  The agent may view the ESOP as being put in place to avoid corporate taxes and not to provide an employee retirement benefit and promote employee ownership.  The context may matter here.  
 

I wondered about the exclusive benefit rule myself.  Not only for the reason given by MBESQ but it raises the question that only the participants employed the year the one payment is made gets any of the shares released.  

However, the facts given are hard to follow.  You might ask the agent what exactly is the concern.  

There's no requirement that ESOP loans be repaid ratably, but the tax regulations include this statement, which is probably the basis for the threat of disqualification:

Caution against plan disqualification. Under an exempt loan, the number of securities released from encumbrance may vary from year to year. The release of securities depends upon certain employer contributions and earnings under the ESOP. Under § 54.4975-11(d)(2) actual allocations to participants’ accounts are based upon assets withdrawn from the suspense account. . . . At the same time, release from encumbrance in annual varying numbers may reflect a failure on the part of the employer to make substantial and recurring contributions to the ESOP which will lead to loss of qualification under section 401(a) The Internal Revenue Service will observe closely the operation of ESOP’s that release encumbered securities in varying annual amounts, particularly those that provide for the deferral of loan payments or for balloon payments.  [Treas. Reg. §54.4975-7(b)(8)(iii)]

"Substantial and recurring contributions" is a very low bar, but no contributions at all probably falls beneath it.