If you inherited an ESOP, and it has been in place for more than 5 years, brace yourself. This is when you typically find out why you need one.
Why do people need an ESOP Third Party Administrator (TPA)?
While it may seem self- serving to ask a TPA, “Why do we need a TPA?”, it’s not much different than asking a dentist why you need a dentist. You may have a drill and a pair of pliers, but that doesn’t mean that you’ll do the job as well as a qualified professional expert, such as your dentist. In fact, even dentists don’t do their own dental work, they go to another dentist.
Complications typically arise after an ESOP has been in place for about 6-10 years. If your TPA does not specialize in ESOPs, you may need to look more closely into whether they understand the complexities that are unique to ESOPs.
With Internal Revenue Code Section 1042 transactions, for instance, there are many rules about who gets shares and how they get shares, and several things can go wrong. A lot of non-ESOP TPAs simply do not know how this section of the Code works and its massive and overwhelming impact on a plan if handled incorrectly, which can lead to procrastination and miscommunication, and perhaps even plan disqualification.
And consider this…
Every year there are approximately 500 new laws, regulations, interpretations, opinions, announcements and major court cases impacting employee benefit plans or sponsoring employers. Not all of them will apply to your plan, but do you know which ones do? Will your 401(k) administrator know which ones affect the ESOP? Rest assured, a qualified ESOP TPA does.
Let’s use a fictional company, Billings, which is taxed as an S corporation. Pat, the human resources manager at Billings, has requested that the TPA for their 401(k) plan also administer their new ESOP. Unfortunately, Pat knows very little about the ESOP and what makes it special, and has a difficult time getting answers. She suspects that her 401(k) TPA doesn’t know how the ESOP works either, not to mention the special subset of IRS rules that apply specifically to ESOPs sponsored by an S corporation.
The truth came to light when Pat’s CFO got a letter from the Department of Labor.
A lot of CFOs are worried that they haven’t been operating the plan the way it was written. Many employee benefit plans have highly technical aspects and complex administration requirements that can make using a specialized entity, such as a TPA, more cost effective than trying to do the same processing in house or with your existing 401(k) administrator. An ESOP, for example, must remain in strict compliance with ERISA, Department of Labor (DOL), IRS and Securities and Exchange Commission laws (for publicly traded companies). Failure to remain compliant can result in the ESOP being disqualified. Such disqualifications create very real problems with employees, with corporate accounting, banking relationships as well as with the IRS.
If you can’t fix what’s wrong in time, you’ll most likely be fined and you still have to fix the problem.
The good news is you don’t have to go it alone.
When you have an ESOP TPA they can take care of everything.
For example, if the DOL has come into your business and told you that you’ve done something wrong and it must be fixed, your newly engaged ESOP TPA will work with the DOL to come up with a game plan. They will fix the problem, restate all of the account balances (to put participants in the place they would have been if not for the error(s)), and calculate the earnings or adjustments to make it right.
From that point forward, our recommendation is that you keep your ESOP TPA as a completely different relationship from the administrator of your 401(k) plan. The 401(k) plan administrator is there to keep your 401(k) plan in compliance. Your ESOP TPA, on the other hand, should be part of your management team, more like a consultant to the company.
The ESOP TPA is there to keep your ESOP running smoothly and keep you in compliance, but also to educate you and make suggestions on how to understand the ESOP’s affect on the financial statements, the valuation and repurchase liability. There are things you can do with your ESOP distribution policy through re-leveraging, for example, that a 401(k) expert wouldn’t necesessarily know, because that’s not what they do for a living.
Your ESOP TPA understands these complexities and more, and can help assure the ESOP’s success.