Complexities in ESOP Administration

Transcription

1 Complexities in ESOP Administration Barbara M. Clough, QPA, QKA, Director, Plan Administration, Blue Ridge ESOP Associates Barbara Clough, QPA, QKA Director, Plan Administration, Blue Ridge ESOP Associates Barbara Clough, QPA, QKA is a Director at Blue Ridge ESOP Associates, a nationally recognized third-party administration firm, which provides employee benefit plan administration and related services exclusively to ESOP Companies. Ms. Clough has twenty plus years Administration experience including private and publicly-held plans ranging in size from 20 to 20,000 employees as well as extensive experience with ERISA law, Department of Labor Regulations, IRS code compliance, IRS/DOL audits.

2 Barbara Clough, QPA, QKA Director, Plan Administration, Blue Ridge ESOP Associates Barbara is a member of ASPPA, NCEO, The ESOP Association, TEA Board of Governors, as well as serving at the Current Chair of the Administration Advisory Committee (May 2014), Vice President of The New England Chapter of The ESOP Association, frequent speaker and author. What is an ESOP? Tax Qualified Retirement Plan under Internal Revenue Code ESOPs must invest primarily in employer stock ESOPs may also have investments in cash and other prudent investment vehicles All assets are held in an ESOP Trust

3 Why an ESOP? ESOPs are very specialized and established with specific objectives in mind By investing the plan assets in employer stock the employees may take a more active role in the business and have more loyalty to the company The exempt loan transaction provides a means of buying out existing shareholders and shifting stock ownershiip to employees The corporation can utilize the cash received from the loan for other corporate purposes ESOP provides retirement benefits Leveraged Loan Lender (1) Note Payable (1) $1,000,000 ESOP (3) Unallocated Stock 100% (2) $ (2) Stock Shareholder Allocated Stock 0% (1)Lender makes a 10-year loan to the ESOP for $1,000,000. (2)ESOP purchase shares from shareholder(s). (3)When the stock is purchased it is held by the ESOP, but is not allocated to the participants.

4 Leveraged Loan Year One Lender (2) Debt Payment ESOP Unallocated Stock 90% (1) Contribution Company Allocated Stock 10% (1) The Company makes a tax deductible contribution to the ESOP. (2) The ESOP make its debt payment to the lender. (3) Stock is released from suspense (and as collateral) and allocated to participants as debt is repaid. Share Release Calculation Principal-only Method Current Principal Payment Current + Future Principal Payments * Shares in Suspense Principal-and-Interest Method Current P&I Payments Current + Future P&I Payments * Shares in Suspense

5 Release Methodology Principal-only Method Terms of loan must require repayment within ten years Interest must follow standard loan amortization schedules Loan may not be extended beyond ten years Dividend/S-Corp Distributions Allocated Shares Earned on shares in participants accounts Generally allocated pro-rata based on share balances Dividend may be held in account, reinvested in stock, passed through (C-Corps only) or used to repay loan Unallocated Shares Earnings on shares in the suspense account Generally allocated pro-rata based on compensation Allocation on stock balance or total account balance is permissible but requires additional non-discrimination testing

6 Dividends/S-Corp Distributions Dividends must pass the Fair Value test Essentially participants must receive stock in value at least equal to the amount they would have received in cash. Dividends used for debt payments may only be applied to that tranche of stock to which they are related. Dividends on non-leveraged shares or tranches which are no longer leveraged must remain in the Plan as cash. May be used to fund participant distributions 415 Annual Additions Annual Additions cannot exceed the lesser of $52,000 for 2014 ($51,000 for 2013) or 100% of gross wages Annual Additions consist of: Employer contributions to the ESOP and to any qualified plan sponsored by the employer Reallocated forfeitures of cash and stock (at year end market value) in the ESOP; reallocated forfeitures in other plans 401(k) pre-tax salary deferrals, reduced by catch-up contributions Catch-Up Contributions excluded from test Employee after-tax contributions 401(m) matching contributions

7 415 Annual Additions For C-Corps, if not more than 1/3 of contributions used to pay principal on the ESOP loan are allocate to HCEs then can exclude the following from Annual Additions: Contribution used to pay interest on ESOP loan Reallocated forfeitures of leveraged stock Plan Document can specify that Employer Contributions are tested on the lesser of fair market value of shares released or the actual contribution 401(a)(28) - Diversification Qualified participant has the right to elect to diversify up to 25% of the number of shares in his/her post-1986 ESOP stock account for the first 5 years and up to 50% of the number of shares in his/her post-1986 ESOP stock account for the 6th year after satisfying the diversification eligibility requirements Qualified participant : age 55 and 10 years of ESOP participation Election opportunity not required (but still permitted) if shares in stock account have market value of $500 or less

8 401(a)(28) - Diversification Diversification Election Notice and Implementation Election must be made within 90 days after end of plan year in which participant becomes eligible to diversify and each of the next 5 years Distribution/transfer must be completed within 90 days after end of participant s 90-day election period Election change Participant may revoke, modify or submit new diversification election any time during 90-day election period 401(a)(28) - Diversification Diversification Alternatives Cash distribution Taxed as ordinary income Subject to 10% penalty for pre-age 59½ distributions Stock distribution (subject to put option if closely held company) Taxed as ordinary income Subject to 10% penalty for pre-age 59½ distributions Transfer to company s 401(k) or profit-sharing plan Rollover to IRA Offer 3 or more investment alternatives in ESOP

9 401(a)(28) - Diversification Diversification Election Notice and Implementation Timing Constraints Stock valuation and contribution allocations often are not completed within timeframe imposed by the statute Possible Solutions Consider issuing diversification notice and preliminary election forms for completion within the 90-day election period Implement preliminary election with respect to stock balance from the most recent account update and/or Collect final diversification elections and complete distribution/transfer as soon as possible after valuation and allocations are completed Diversification Example YR BEGIN + NEW SHARES SHARES + PREV DIVRS = SUB TOTAL x 25% - PREV DIVRS = AVAIL DIVRSFY? FOR DIVRS Y/N DIVRS SHARES END SHARE BAL Y N Y N N x 50% , Y

10 Distributions to Plan Participants Death, Disability or Retirement Payment must commence by end of plan year following plan year in which event occurred Distributions may be paid in lump sum or five substantially equal installments Extension for large account balances Accounts over $1,050,050 extend an additional year for each $210,000 of account value Termination for other reasons Payment must commence by end of the fifth plan year following termination of employment Distributions in the Form of Stock Put Option or Immediate Sale Required Net Unrealized Appreciation (NUA) Increase in Fair Market Value over Cost Basis Taxed at Long Term Capital Gains Rate

11 Distributions in the Form of Stock What is the Cost Basis? For C-Corporations it is the cost at which shares were acquired by the ESOP For S-Corporations basis is continually updated Increased for items of income for which shareholder must pay taxes Reduced to extent shareholder receives distributions from the S-Corporation Should be adjusted in same manner as non ESOP shareholder EXAMPLE Participant receives stock distribution of 10,000 shares FMV is $20/share Cost basis $2/share Total Distribution $200,000 Taxation (Ordinary Income) $ 20,000 Taxation (Long Term Cap Gains) $180,000 With updates to Cost Basis $10/share Total Distribution $200,000 Taxation (Ordinary Income) $100,000 Taxation (Long Term Cap Gains) $100,000

12 Recycling Definition: An exchange of Other Investment(s) for Employer Securities so that participants receiving distribution can be paid in the form of cash Recycling Essentially each year participant s with cash balances purchase the shares of the participant s who are receiving distributions from the Trust. Shares remain within the Trust.

13 Recycling Cash Funding for Recycling can occur as follows: Cash in Trust ESOP Contributions Allocated according to Plan Formula, generally pro-rata on compensation Dividends/S-Corporation Shareholder distributions Allocated according to Plan Document Generally on shares balances for allocated shares Generally based on eligible compensation for unallocated shares. Rebalancing IRS Definition: The mandatory transfer of employer securities into and out of participant ESOP accounts, usually on an annual basis, designed to result in all participant accounts having the same proportion of employer securities. Each year the plan accounts are rebalanced so that each participant has the same percentage of his/her account investment in employer stock and other investments (i.e. all participants have 90% stock and 10% cash).

14 Rebalancing IRS Definition: The mandatory transfer of employer securities into and out of participant ESOP accounts, usually on an annual basis, designed to result in all participant accounts having the same proportion of employer securities. Each year the plan accounts are rebalanced so that each participant has the same percentage of his/her account investment in employer stock and other investments (i.e. all participants have 90% stock and 10% cash). Rebalancing Rebalancing can be used when shares are recycled or plan has accumulated cash. Help alleviate Haves vs. Have Nots issue in the plan. Rebalancing takes stock from the long-term participants (the Haves ) for the benefit of new participants (the Have Not ). Cannot be used to correct 409(p) failures but can help avoid future failures. Provides some diversification for all participants.

15 Rebalancing ABC Company ESOP ABC Stock Other Investments Total Trust Balances at the close of the allocation period: $ 400,000 $ 100,000 $ 500, % 20.0% Participant Balances (pre-rebalance): Participant A $ 130,000 $ 35,000 $ 165, % 21.2% Participant B $ 250,000 $ 10,000 $ 260, % 3.8% Participant C $ 20,000 $ 55,000 $ 75, % 73.3% Participant Balances (post-rebalance): Participant A $ 132,000 $ 33,000 $ 165, % 20.0% Participant B $ 208,000 $ 52,000 $ 260, % 20.0% Participant C $ 60,000 $ 15,000 $ 75, % 20.0% 29 Reshuffling IRS Definition: The mandatory transfer of employer securities into or out of ESOP accounts, not designed to result in an equal portion of employer securities in each account.

16 Reshuffling Terminated participants receive other investments from active participants in exchange for stock. Active participants receive stock from the terminated participants in exchange for the other investments. Terminated participants no longer share in the investment experience of the company stock. Careful consideration must be given to the investment of the terminated account balances (fiduciary concerns). Reshuffling ABC Company ESOP ABC Stock Other Investments Total Trust Balances at the close of the allocation period: $ 400,000 $ 100,000 $ 500, % 20.0% Participant Balances (pre-reshuffle/segregation): Active Participant A $ 130,000 $ 35,000 $ 165, % 21.2% Active Participant B $ 250,000 $ 10,000 $ 260, % 3.8% Terminated Participant C $ 20,000 $ 55,000 $ 75, % 73.3% Participant Balances (post-reshuffle/segregation): Active Participant A $ 145,556 $ 19,444 $ 165, % 11.8% Active Participant B $ 254,444 $ 5,556 $ 260, % 2.1% Terminated Participant C $ - $ 75,000 $ 75, % 100.0% 32

17 Redemption Definition: Removal of shares from the Trust either through Distribution to Plan Participants or through a company buy-back from Participants Redemption Distribution to Plan Participants Participants receive their distribution from the Trust in shares of Stock Distribution in the form of shares must be allowed in the Company By-laws Specific Requirements for S-Corporations Participants must be given the opportunity to immediately Put their shares to the company The Cash paid to Plan Participants is from the Company NOT the ESOP Trust Participants must be paid at most recent FMV of Trust

18 Redemption What happens to the stock once it is redeemed? Retire to Treasury No immediate impact on share value PYE MV Redemption Post Redemption Total Value $1,000,000 $100,000 $900,000 Shares Outstanding 1, MV per Share $1,000 $1,000 $1,000 Long term the share value does increase 35 Redemption Releverage the ESOP to buy shares ESOP purchases Treasury Shares The layering of several loans over multiple years can result in a significant block of common equity in a suspense account Loan is repaid with regular annual contributions Allows shares to be allocated into accounts of newer participants based upon compensation Adjusts Have/Have Not issues

19 Redemption Annual Leveraged Repurchase ESOP borrows from Company ESOP distributes shares Shares move from terminated to active based on payroll allocations Contribute Issued Shares Some dilution to previously allocated equity Consider skewing allocations to newer participants Must pass non-discrimination testing 409(p) Anti-Abuse Testing No portion of the assets of the ESOP attributable to (or allocable in lieu of) the stock in an S corporation may, during a NONALLOCATION YEAR, accrue (or be allocated directly or indirectly under any qualified plan) for the benefit of any DISQUALIFIED PERSON.

20 409(p) Anti-Abuse Testing DISQUALIFIED PERSON (DQP): Individuals DEEMED-OWNED ESOP SHARES and/or SYNTHETIC EQUITY are at least 10% of all DEEMED-OWNED ESOP SHARES and/or SYNTHETIC EQUITY Individual and his family s DEEMED-OWNED ESOP SHARES and/or SYNTHETIC EQUITY are at least 20% of DEEMED-OWNED ESOP and/or SYNTHETIC EQUITY SHARES To be a DQP by family attribution, individual must have DEEMED-OWNED SHARES or SYNTHETIC EQUITY 409(p) Anti-Abuse Testing Family Members of an individual are: 1.spouse of individual, 2.ancestor or lineal descendant of individual or individual s spouse, 3.brother or sister of individual or individual s spouse and any lineal descendant of brother or sister, and 4.spouse of any individual in (2) or (3), Stepsiblings or cousins may be included in Family of individual through a person who has no involvement with the ESOP or its sponsor. Family members do not include the parents-in law of the testing subjects descendants

21 409(p) Anti-Abuse Testing NONALLOCATION YEAR: DQPs own 50% or more of stock in S corporation and ESOP holds S corporation stock Ownership includes DEEMED-OWNED SHARES (including SYNTHETIC EQUITY) and shares outside the ESOP owned actually or by attribution. DEEMED-OWNED SHARES: Allocated ESOP shares Pro rata portion of shares in ESOP loan suspense account based on most recent allocation Synthetic equity 409(p) Anti-Abuse Testing SYNTHETIC EQUITY: Stock option Warrant Restricted stock Deferred issuance stock right Similar interest or right that gives holder the right to acquire or receive stock Stock Appreciation Right (SAR) Phantom Stock Similar right to future cash payment based on value of stock or appreciation in value Right to acquire stock or assets of a related entity Nonqualified Deferred Compensation Split Dollar Life Insurance

22 409(p) Anti-Abuse Testing Consequences of Violation Penalties are SEVERE Disqualifed Persons (DQPs) owes income tax on prohibited allocations Prohibited allocations are deemed to be currently distributed to DQPs but no rollover treatment is available 10% excise tax on premature distributions if the DQP is under age 59 ½ Penalties to Corporation owes income tax 50% excise tax on FMV of Prohibited Allocations 50% excise tax on FMV of Synthetic Equity of DQPs Special First NON-ALLOCATION YEAR rule 50% excise tax on FMV of all DEEMED-OWNED SHARES held by DQPs 409(p) Anti-Abuse Testing Plan is considered disqualified due to failure to operate according to it s terms Termination of S-election due to disqualified Plan not being eligible S-Corp shareholder Plan ceases to be an ESOP ESOP loses prohibited transaction exemption on securities acquisition loan. Loan becomes prohibited transaction, excise tax due Plan becomes subject to Unrelated Business Taxable Income (UBTI)

23 Questions? Thank You! 45