Maximizing Your Defined Contribution Plans - SES Advisors
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Maximizing Your Defined Contribution Plans

Author: Mike Bertrand

Most companies that sponsor an Employee Stock Ownership Plan (ESOP) also sponsor a 401(k) plan. The Company may be making contributions to both plans per the terms of the plan document. For a company’s 401(k) plan this may be in the form of a matching contribution and/or profit sharing formula. In a leveraged ESOP, minimum company contributions may be needed to repay the ESOP debt. If the plan is not a leveraged ESOP, company contributions may be needed to fund the repurchase obligations of the plan or to meet the IRS’ requirement that contributions to a qualified plan be recurring and substantial. In many cases though, companies that sponsor both an ESOP and 401(k) plan treat these contributions as separate and distinct obligations even though they do not have to be. Employer 401(k) contributions required by the plan document do not have to be deposited into the 401(k) plan, but instead can be contributed to the ESOP.

When an ESOP is established using a leveraged transaction to purchase shares, the company sponsoring the plan will have a new obligation of cash each year to make the required debt payments on the ESOP loan. A company may think the easiest way to offset this new expense would be to remove the matching component of the 401(k) plan. However, this could end up having a much more complicated result than the company anticipated. If a company decides to no longer match employee deferrals to the 401(k) plan, employees may not see the benefit in continuing to defer to the plan. This may lead to employees lowering their deferral percentage or even stopping deferrals completely. A number of issues may arise from this, with the most common being failure of the Average Deferral Percentage (ADP) test. Failure of the ADP test could end up costing the company money, because of a possible excise tax that could be imposed depending on the timing of the correction or additional administrative costs to correct the failure. And in addition to the compliance issue, removing a benefit that employees have been used to receiving may be hard to sell to the employees.

Instead of removing the matching component from the 401(k) plan, it may be better to instead put that contribution into the ESOP. It is essential that each plan allow for this type of contribution arrangement. If the plans do not currently allow for this, it can be accomplished by amending each plan document. The 401(k) plan needs to state that company matching contributions will be made to the ESOP and the ESOP needs to allow for the contributions and describe how those contributions will be allocated. If the company has chosen to make the 401(k) plan a “safe harbor” plan, the required safe harbor contributions could be put into the ESOP and still meet the requirements to be deemed to satisfy the ADP test. These safe harbor contributions bring with them the same requirements as if they had been deposited into the 401(k) including 100% vesting and distribution restrictions.

The Company determines the amount of the required matching contribution using the formula listed in the 401(k) plan document. While the plan’s documents determine the formula for allocating the match, the company can choose to contribute this match in the form of cash or stock. Each participant that is required to receive a matching contribution will have their own account set up in the ESOP. This includes those participants who may not yet be eligible for the ESOP, but are eligible for the 401(k) plan. This account for each participant will be separate from their normal ESOP account. If the contribution is made in the form of cash, this amount can be used as a payment on the ESOP loan or for repurchasing stock from participants who received a distribution from the plan. The participant will then be allocated shares based on either the shares released from the loan or from the amount of stock their matching contribution repurchases.

One issue that arises when matching contributions are used to pay ESOP debt is how to determine if the matching formula has been satisfied. For example, if the matching formula is 4% up to 100% of deferrals and that amount is used to make debt payments which releases shares, is the participant due the 4% cash contribution, or should the fair market value of the shares released be equal to 4%? If the latter methodology is used and the value of shares released is higher than the cash contribution, then the additional release would be allocated as a discretionary allocation. However, if the value of the shares released is less than the cash contribution, the cash contributed would need increased so the fair market value released is equal to 4%. The plan document should be reviewed to determine which methodology above should be used, and if not specified ESOP counsel should be consulted.

Another way to accomplish putting 401(k) matching contributions into the ESOP would be through issuing new company stock. Company stock with a value equal to the required matching contributions is deposited into the participants’ matching accounts within the ESOP. If this method is used it is important to coordinate this with the valuation firm responsible for determining the stock price so that the proper number of shares is issued.

The real advantages of using either of these methods are the cost savings to the company while not eliminating a benefit employees are used to, or even adding a benefit if a 401(k) match is not currently in place. When the contribution is in the form of cash, you are simply reclassifying some of the cash that was already going to be deposited into the ESOP anyway. If shares are being contributed, there is a cash savings since the company is issuing new shares with no cash outlay.

This is just a basic overview on the how-to of making your ESOP and 401(k) match work together. This is a strategy that should be considered for companies who have both an ESOP and 401(k) plan. The strategy could save the company money, help with compliance testing, and increase participation in the 401(k) plan, among other advantages.

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