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● Best Practices: ESOP errors and how to avoid them. See
At our recent Fall Forum, Jamie Kwiatek of Polsinelli and Antony Brunsvold of Blue Ride ESOP Services discussed some of the most common errors in ESOP plan administration and how to avoid them. Some errors can only be corrected through compliance programs set up by the IRS or the DOL, but many others can be selfcorrected if they meet the criteria for doing that. Of course, it is even better if you can avoid making the errors in the first place.
Kwiatek and Brunsvold laid out several common issues:
Failing to Report or Value Synthetic Equity for Section 409(p) Testing:
Section 409(p) of the tax code was created to help prevent too much of the benefit in an ESOP from being allocated in any plan year to certain individuals who own more than 10% of the fully allocated equity in the company (or a combined 20% for family members). Ownership includes both what is allocated in the person’s ESOP account, direct ownership, and synthetic equity. That includes stock appreciation rights, phantom stock, deferred compensation, split dollar life insurance, and any other claim on future assets or income.
An error can occur because the third-party administrator (TPA) did not ask or was not told about any synthetic equity the company offers. Maybe the plan sponsor left the question blank, or did not understand that things other than equity awards count. You cannot self-correct this, and it could result in plan disqualification. To prevent it, the TPA should inquire each year if are any changes in synthetic equity or other factors included under the 409(p) test (such as family relationships) that have changed. The ESOP trustee and the board of directors should review the test annually. If your company is an S Corporation, make sure the test is being performed and reviewed annually, but remember that the 409(p) test is a “daily test,” so make sure the test can be passed before synthetic equity is issued. Another synthetic equity issue is when and how these rights are valued. If the stock value drops, the percentage of ownership attributable to SARs and phantom stock may go up. Similarly, the value of deferred compensation and similar synthetic equity will constitute a larger percentage claim on total equity. To help prevent this, specify a date in the plan document to determine the value of employer stock and therefore the number of synthetic equity shares. The date can be an annual date, such as the value as determined as of the last day of the prior plan year, or it can be set for some number of years, which would give the most stability to the determination. Diversification Errors: In a worst-case scenario, a new TPA discovers that the client has never offered diversification elections to plan participants even though the plan has been in existence for well over 10 years. Diversification is required after 10 years of participation, so this can end up as a plan operational failure. A key issue will be how significant the failure was—who was affected and by how much. The problem is not eligible for self-correction if the amounts are significant and the correction occurs two years or more after the plan year in which the failure occurred. The company now needs to enter a formal voluntary compliance program, identify the participants not provided an opportunity to diversify (and for what years, what number of shares, and at what stock price). Participants will need to be offered an opportunity to diversify at a price the appraiser and trustee determine is appropriate.
To prevent this, make sure diversification is part of the TPA’s engagement letter and that the company and TPA have the correct procedures in place to keep track of the obligation. Compensation: ERISA place limits on what counts as eligible pay for making contributions. In addition, if sellers take advantage of the Section 1042 rollover, the seller, family members, and any 25% owners cannot get allocations, so their pay is not eligible. Compensation definitions can also vary (do bonuses or fringe benefits count, for instance). The TPA and company need to be on the same page on this issue.
Companies that have a 401(k) plan and an ESOP may not use the same definition of pay in both plans, especially if they were drafted by different attorneys. It is easy to report inaccurate compensation data under this scenario. However the compensation error occurs, the result can include inappropriate allocations, violating nondiscrimination rules, or contributions greater than allowed limits.
If there are errors, the company needs to redo annual allocations for all the years there is an error or compensation nondiscrimination testing problem. This could mean people who were paid their balances could have more due to them or were overpaid. This causes a new error that has to be properly corrected.
Exceeding Annual Contribution
Limits: In companies with both an ESOP and 401(k), there is a combined annual limit for what the company and employees contribute. This is especially true if higher paid people contribute enough to the 401(k) to push them over the maximum annual allowed level. If this happens, the company has to give the money back. Limits in a plan where a loan is being repaid can also be exceeded if there are significant layoffs, now making the eligible pay lower. To correct for this, the loan term might be extended or dividends used to repay part of the loan. Dividends: Dividends to repay a loan can only be applied to the shares acquired by that loan. Errors can cause a lot of reallocating, which can in turn cause other problems. Make sure the TPA is clear on this issue beforehand. n
