On July 17, 2003, the Internal Revenue Service (“IRS”) issued proposed regulations that update and modify the regulations related to 401(k) plans. Hidden in the proposed 401(k) plan regulations is an important change that involves the interaction of employee stock ownership plans (“ESOPs”) and 401(k) plans. The new set of regulations would be effective no sooner than the first plan year beginning 12 months after the publication of the final regulations in the Federal Register. At hearings before the IRS in November 2003, however, various interested parties commented that the effective date for the changes should be as soon as the regulations are finalized.
Elimination of ESOP Mandatory Disaggregation for ADP/ACP Purposes
Under present law, the actual deferral percentage test (“ADP”) that is performed with respect to elective deferrals, and the actual contribution percentage test (“ACP”) that is performed with respect to employer matching contributions and employee after-tax contributions, must be conducted on the same plan, or portion of a plan, to which the nondiscriminatory coverage requirements of Section 410(b) of the Internal Revenue Code (the “Code”) are applied. In applying the requirements of Section 410(b) of the Code, the portion of a plan that is an ESOP must be disaggregated from the portion of a plan that is not an ESOP. In other words, because the ESOP portion of a plan must be tested separately from the non-ESOP portion of a plan (e.g., the 401(k) portion) for purposes of coverage testing, the ESOP portion must also be tested separately from the non-ESOP portion for the ADP and ACP tests.
The proposed regulations would permit aggregation of ESOPs and non-ESOPs solely for purposes of the ADP and ACP tests. This change will greatly simplify ADP and ACP testing for 401(k) plans that include an ESOP feature, and will likely make passing such tests easier for the plan. Please note that the changes set forth in the proposed 401(k) regulations would not change the way that ESOPs and non-ESOPs are tested for the nondiscriminatory coverage requirements of Section 410(b) of the Code. For the purposes of testing for coverage, the portion of the plan that is an ESOP would still be tested separately from the portion of the plan that is a 401(k) plan.
Why Include an ESOP Portion in a 401(k) Plan?
Often a 401(k) plan will offer a company stock fund as an investment option or as the required form of investment for employer provided matching contributions. Converting to or maintaining the company stock fund as an ESOP will permit the fund to benefit from:
- the exception to the fiduciary rules regarding diversification of plan assets that applies to all eligible individual account plans, including ESOPs;
- the exception for ESOPs to the 10% limitation on the required investment of elective deferrals in company stock; and
- the deductions under Section 404(k) of the Code for dividends paid on company stock held by an ESOP.
Fiduciary Rule Exception for ESOPs
The primary duties of a fiduciary under ERISA are to:
- act for the exclusive benefit of plan participants and beneficiaries;
- act prudently;
- diversify the investment of plan assets; and
- act in accordance with plan documents.
In the case of an eligible individual account plan, such as an ESOP, the diversification requirement and the prudence requirement (to the extent that it would require diversification) are not violated by the acquisition or holding of “qualifying employer securities.” “Qualifying employer securities” generally means common stock issued by the sponsoring company (or by a corporation that is a member of the same controlled group of corporations) that is readily tradable on an established securities market. If the sponsoring company is closely held (i.e., no readily tradable stock), “qualifying employer securities” means common stock issued by the sponsoring company (or by a corporation that is a member of the same controlled group of corporations) having the greatest voting power and greatest dividend rights.
Accordingly, if a 401(k) plan with a company stock fund converted that fund to an ESOP, it could lessen the fiduciary’s liability with respect to its decision to permit investments in company stock.
10% Limitation on Required Investment in Company Stock
Beginning in 1999, a 401(k) plan may not require that more than 10% of the assets attributable to elective deferrals held under the plan be invested in company stock unless the plan is an ESOP (or the amount in question is equal to 1% or less of each participant’s compensation). Please note that this rule does not affect the amount of matching contributions that may be invested in company stock under a plan. If a 401(k) plan with a company stock fund converted that fund to an ESOP, then the plan could require that more than 10% of the assets of the plan attributable to elective deferrals be invested in company stock.
Plan sponsors and fiduciaries that are considering the required investment of elective deferrals or matching contributions in company stock should bear in mind the substantial risks associated with such mandatory investment.
An ESOP may provide that cash dividends on employer securities held by the ESOP trust will be:
- distributed currently by the ESOP to ESOP participants (or their beneficiaries); or
- paid directly to ESOP participants (or their beneficiaries) by the employer.
An ESOP may also provide that participants may be given the right to elect either to receive the dividends in cash or to reinvest the dividends in company stock in the ESOP.
These cash dividends may be tax-deductible to the employer under Section 404(k) of the Code. If the cash dividend is distributed by the ESOP, it must be distributed no later than 90 days after the end of the plan year in which the dividend was paid. In this case, the deduction is allowable for the employer’s taxable year in which the dividend is distributed, which may differ from the employer’s taxable year in which the dividend was paid.
Accordingly, if a 401(k) plan with a company stock fund converted that fund to an ESOP, the plan sponsor may be able to deduct cash dividends attributable to shares of company stock held by the ESOP.
Please note that the proposed regulations provide that an election by a participant or by a beneficiary to receive a distribution of ESOP dividends or to reinvest ESOP dividends in company stock in the ESOP is not considered an elective deferral under a 401(k) plan; reinvested dividends may not be taken into account for ADP testing.
Company X has 3,000 employees, of which 1,000 are highly compensated employees (“HCEs”) and 2,000 are non–highly compensated employees (“NHCEs”). Company X maintains a 401(k) Plan that includes a company stock fund that is an ESOP. All employees are eligible to participate in the 401(k) portion, but only 1,000 employees participate in the ESOP (i.e., elect to have their elective deferrals made to the ESOP portion of the plan and invested in the company stock fund), of which 600 are HCEs and 400 are NHCEs.
Under the current 401(k) regulations, the two portions of the plan—the 401(k) Plan portion and the ESOP portion—must be tested separately both for purposes of nondiscriminatory coverage under Section 410(b) of the Code and for purposes of ADP testing. Testing just the group of participants under the 401(k) portion of the plan, the ADP for HCEs is 4.2% and the ADP for NHCEs is 4.0%. Because the difference in ADPs for HCEs and NHCEs is less than 2.0% and the ADP for HCEs is less than 125 percent of the ADP for NHCEs, the 401(k) portion of the plan passes the ADP test.
However, when testing just the group of participants under the ESOP portion of the plan (i.e., those participants who directed that their elective deferrals be contributed to the ESOP portion of the plan and invested in qualifying employer securities), the ADP for HCEs is 4.25% and the ADP for NHCEs is 2.0%. This difference in ADP levels is due to the fact that more HCEs than NHCEs have chosen to invest their elective deferrals in company stock. Because the difference in ADPs for HCEs and NHCEs is greater than 2.0%, tested separately the ESOP portion of the plan would fail the ADP test, and corrective actions (such as returning elective deferrals to plan participants) would be necessary.
Under the proposed regulations, the ADP testing for the plan is done on an aggregate basis, and therefore only one test is performed using the ADPs for participants in both the 401(k) portion and ESOP portion of the plan. Because all of the elective deferrals are included in the aggregate test, it is far more likely that the 401(k) plan will satisfy the ADP test. In our example, when all elective deferrals are tested together (i.e., elective deferrals under both the 401(k) portion and the ESOP portion) the results are that the ADP for HCEs is 4.23% and the ADP for NHCEs is 3.6%. Accordingly, the entire plan when tested together passes the ADP test because the difference in ADPs for HCEs and NHCEs is less than 2.0% and the ADP for HCEs is less than 125 percent of the ADP for NHCEs.