ESOP Plan Administrators reveal their best advice for utilizing 401(k) matching contributions in this downloadable eBook (PDF). There are two traditional practices for getting cash into the ESOP trust: (i) using employer contributions and/or (ii) using income distributions/dividends. We would like you to consider using a third mechanism – the employer matching ESOP contributions that are contributed to your 401(k) plan.
In many cases when an ESOP is established, the employer matching contribution that has historically been made to the companys 401(k) plan will cease due to the companys redirection of that cash to pay the newly created ESOP debt. While this change to the 401(k) plan contribution may be a financial necessity for the Company in the post ESOP environment, it is not always received by employees as a popular decision. It takes time for employees to understand the potential benefit levels of the new ESOP, while the loss of traditional 401(k) benefits is understood immediately.
An additional problem with eliminating the matching ESOP contribution is the effect on the 401(k) plans annual actual deferral percentage test (ADP test). Many companies adopt a matching contribution not only as a benefit for their employees but to aid in passing the ADP test, which then permits highly compensated employees (HCE) to make higher deferrals to the 401(k) plan than they would otherwise be permitted. If a company has traditionally used a safe harbor contribution  to automatically satisfy the ADP test upon ceasing the match the plan will again need to have this test prepared, and as a result, some HCE deferrals may be capped at a lower level. Even where a company made a non safe harbor matching contribution but traditionally passed the ADP test there still could be potential issues.
The employer matching contribution provides an incentive for employees to utilize their right to contribute to the 401(k) plan. Without this incentive, a company can expect participation in the 401(k) plan will likely drop, and as a result, cause potential ADP testing issues. Failing the annual ADP test results in the highly compensated employees receiving taxable refunds from the 401(k) plan as well as taxable earnings on the refunds, and potential excise tax is also possible depending on the timing of the distributions.
Instead of eliminating the matching contribution, you should consider redirecting the matching contribution to the ESOP. The following describes how a 401(k) match contributed to the ESOP Trust works.
Allocation of Employer Matching Contribution in the ESOP Trust
The employer matching contribution is allocated in the ESOP Trust per the formula selected in the 401(k) plan document. The matching contribution could be a safe harbor (utilizing the safe harbor formula provides the same testing advantages in the 401(k) plan to which you are traditionally accustomed), discretionary, or a fixed formula. The matching contribution to the ESOP trust is allocated using the same per participant basis as it would otherwise be calculated if it were being allocated inside the 401(k) plan trust.
Each participant eligible for an employer matching contribution would have an account set up in their name in the ESOP trust – even those employees who are not yet eligible to otherwise participate in the ESOP. The account balance in the ESOP associated with the employer matching contribution would be allocated to a separate account such as the Employer 401(k) Match Account within the ESOP trust.
Advantage of Employer Matching ESOP Contributions in a Leveraged ESOP
The advantage of using employer matching contributions in a leveraged ESOP is the ability to apply the contribution as payment of the ESOP loan. If the ESOP loan is between the company and the ESOP trust, using the matching contribution to offset a portion of the loan payment has no effect on company cash, but allows the benefits of the matching contribution to the 401(k) plan to continue. The company still makes annual contributions to the ESOP trust to fund the ESOP debt payment per the ESOP promissory note. However, a portion of that contribution is characterized as the employer matching contribution. In that case, the ESOP trust receives the contribution and matching contribution and then immediately transfers the cash back to the company to pay the annual ESOP loan payment and trigger the release of shares.
The matching contribution amount in participant accounts would be replaced with the applicable number of released shares. The number of shares allocated to each individual participant would be on a pro rata basis. Below is an example of the share allocation of the number of shares released on the employer matching contribution and on a per participant basis.
If the ESOP loan is instead between the ESOP trust and a third party (e.g. selling shareholder), the impact on company cash is still consistent with the existing annual ESOP contributions for the ESOP debt repayment. The shares would still be allocated to participants as outlined above.
In short, the cash impact on the Company is exactly the same whether the match is continued or discontinued.
Advantage of Employer Matching Contribution in a Non-Leveraged ESOP
Utilizing the employer matching contribution in a non-leveraged ESOP may be beneficial to the company as well. The matching contribution could be used to help with repurchase obligations; the contribution might be used by the ESOP trust to fund the payout of company stock accounts.
Plan Document Review & Revisions
In order to take advantage of the benefits of using the employer matching contribution in the ESOP trust, it is essential that someone first make sure both plans allow for this form of employer contribution. The 401(k) plan document(s) and ESOP plan document may need to be amended to allow for the contribution to be deposited into another plan, and the ESOP plan document must include the details of the new Employer 401(K) Match Account.
Using the employer matching contribution in the ESOP trust is a strategy that should be considered. It creates an extra benefit to the employees and will encourage them to continue to defer into the 401(k) plan. In some companies it also might allow highly compensated employees to continue their deferrals at any level if a safe harbor formula is utilized, and gives the company flexibility in how to manage the benefits in both plans.
Is an ESOP right for your company?
Use our ESOP self-assessment tool to find out.
If you would like further information about ownership transition options, please contact us. SES Advisors welcomes the opportunity to provide complimentary and confidential advice.