Investing Company Stock in ESOPs

A number of companies are investigating the feasibility of amending their §401(k)/savings plans to convert all or a portion of the plan that is invested in company common stock into an ESOP. The interest in this idea stems from the potential benefits that could be realized by both plan sponsors and participants under Code §404(k).

• Code §404(k) enables plan sponsors to currently deduct dividends paid on company stock that are passed through directly to plan participants in cash. In effect, this converts what would normally be a nondeductible payment into a deductible payment. What’s more, this feature has several other appealing attributes from the plan sponsor’s perspective, including that the deduction:
  • is available permanently and annually and without having to make an additional cash outlay;
  • has a clearly supportable legal basis; and
  • can encourage greater employee ownership.

• From the participant’s perspective, the §404(k) feature can be structured to offer more flexibility than might otherwise be possible. Consider, for example, the following designs:
  • the arrangement can incorporate a recontribution feature (i.e., participants are allowed to defer—pursuant to a cash or deferred election under §401(k)—an additional amount which does not exceed the dividends paid under §404(k)).
  • the arrangement can incorporate a mechanism whereby participants—on an individual by individual basis—can choose whether to receive a given dividend in cash or not. For all intents and purposes, the result is akin to a cash or deferred election without any strings.

Of course, if every silver lining has a cloud around it, in this case the cloud might be the additional costs and complications associated with incorporating a §404(k) ESOP dividend passthrough feature into a preexisting §401(k)/savings plan. Of particular concern is the effect of the so-called mandatory disaggregation rules—which require that the ESOP portion of a plan be disaggregated from the nonESOP portion of the plan for purposes of running the coverage and nondiscrimination (i.e., the ADP and ACP) tests. In effect, what this means is that the ESOP and nonESOP portions of the plan must be treated as separate “plans” for purposes of running these tests. The fear is that this will not only be costly and cumbersome to administer, but—depending on who elects what—may even turn a testing pass into a failure.

Therefore, a natural question arises: Might a mechanism exist whereby a plan could add an ESOP feature that enables plan sponsors and participants to avail themselves of the §404(k) dividend passthrough opportunity—without incurring the costs and complexities of complying with the mandatory disaggregation rules? Surprisingly, the answer may be yes.

The idea involves taking advantage of the rules that address the circumstances under which a plan sponsor must take a given employee into account when running the coverage and nondiscrimination tests under “plans” required to be disaggregated for testing purposes for a given plan year. The touchstone for making this determination is whether or not a given employee is benefiting under the particular “disaggregated plan” for the plan year in question. The term “benefiting” in this context means that the employee receives an allocation for the year (or in the case of a 401(k) or (m) arrangement, the employee is eligible to receive an allocation under the arrangement for the year).

So, the idea would be to “carve out” from the ESOP the contributions allocated in the current year to company stock and maintain those contributions in a separate non-ESOP subaccount. At the end of each plan year this non-ESOP subaccount would automatically become part of the ESOP (and, as such, the dividends thereon could thereafter be passed through via §404(k)). The thinking behind this approach is that—because allocations made to company stock would always be made under the non-ESOP portion of the plan—no disaggregation would be required.

Note that there would be some recordkeeping implications of an approach along these lines (by reason of the fact that contributions for the current plan year invested in company stock would have to be separately accounted for). However, this would still be much less onerous than the complications associated with mandatory disaggregation.

Of course a company would want to run this idea by outside counsel before proceeding with this approach.

SOURCE: By Dennis Coleman and Marilyn Scalia. Appeared in Kaleidoscope, by PricewaterhouseCoopers, Kwasha, January/February 1999.