Blue Ridge ESOP Associates Industry News

Tips on Coordinating ESOP/401(k) Plan Design and Administration

Posted by ESOP Association

Apr 24, 2014 3:16:00 PM

Plan_Design_ESOP_401kMost companies with an ESOP also sponsor a 401(k) plan for their employees. However, the designs for these two plans are not always coordinated. The administration of the plans may lack coordination as well. It’s not uncommon to find ESOP and 401(k) plans sponsored by the same employer with differing definitions of compensation, differing eligibility exclusions, etc. Differences “by design” are fine, but unintentional differences can result in operational errors. The following real life examples (and commentary) illustrate the importance of coordinated design for paired ESOP and 401(k) plans.


Example 1: ABC Company adopts a new ESOP. Per the ESOP document, “Compensation” is gross compensation paid, less reimbursements, expense allowances, and fringe benefits. The corresponding definition in the 401(k) plan is gross compensation including fringe benefits. ABC Company provides the same census data to its 401(k) and ESOP administrators. After year end, the plan auditors discover that the ESOP third party administrator (TPA) has used the wrong compensation definition in allocating contributions.


Example 2: The annual additions limit under IRC Section 415 defines the maximum contributions and forfeitures that can be allocated to a participant’s plan accounts during a limitation year. During the 2012 limitation year, the allocations to Joe Participant’s ESOP and 401(k) accounts exceed the maximum limit of $50,000. The ESOP plan document is vague as to how 415 violations are to be corrected, other than to refer to the Employee Plans Compliance Resolution System (EPCRS). The 401(k) plan erroneously states it is not necessary to address 415 corrections in multiple plans because the company only sponsors a 401(k) plan.


Example 3: ABC Company adopts a new ESOP. Its existing 401(k) plan excludes temporary and seasonal employees from participation. The ESOP does not. Upon receiving the first year ESOP statements for participants, ABC Company questions why temporary and seasonal employees are receiving contributions.
When creating a second plan or restating existing plans, we suggest a review of the core provisions in each plan to ensure that they work well together. If a plan sponsor is using different providers for the administration of each plan, copies of both plan documents should be provided to each provider. One provider, generally the ESOP TPA, should be designated with the responsibility for providing all combined plan limit calculations and nondiscrimination tests. For example, contribution deduction limits are determined on a combined plan basis. The calculation is based on eligible compensation paid in a company’s fiscal year. The provider who takes responsibility for the deduction calculation must know the company’s fiscal year, the plan year for each plan and the contributions being made to both plans. In addition, 415 limits and top heavy testing are done on an aggregated basis.


Example 4: ESOP TPA requests 401(k) data for top heavy testing. The 401(k) TPA is unaware of the existence of the ESOP and provides a yearend report to the plan sponsor that states top heavy testing is not applicable because the plan sponsor made only safe harbor contributions to the plan. At that point, the ESOP TPA would need to request detailed 401(k) balances and distribution history to determine if the combined plans are top heavy.


The lesson here is that there is a reason why your ESOP TPA asks for 401(k) data. For Section 415 testing in particular, it is important that all contributions and all forfeiture allocations in the two plans be considered. If the plans have different plan years and different “limitation years” for 415 testing, your plans may actually require 415 testing two times per year, once for each limitation year.


Plan sponsors should also recognize that funding large contributions to their plans may inadvertently cause some participants to have excess contributions, even though contribution deduction limits have not been exceeded. Assume a participant earns $250,000, contributes $17,000 of his compensation to the company’s 401(k) plan in 2012 and receives a matching contribution of $10,000. That leaves room for $23,000 in other contribution or forfeiture allocations for that participant’s accounts before the 2012 annual addition limit is exceeded.* What if the ESOP contribution equals 10% of eligible compensation for all participants (a contribution of $25,000 for this participant)? A Section 415 excess contribution will be created, and will require correction. Therefore, when a company is considering making large contributions to its plans, it is also a good idea to ask if the proposed funding might produce Section 415 side effects. What if the $25,000 contribution is used to make an ESOP loan payment that releases $20,000 worth of shares to the participant? If the ESOP document allows the lesser of the contribution or the fair market value of shares released to be used for 415 purposes, then the 415 violation is avoided.


Plans with integrated design features require additional coordination. For example, an ESOP may provide that a company’s safe harbor matching contribution is funded in the ESOP rather than the 401(k) plan. If the match is, for example, 100% of the first 4% that a 401(k) participant contributes as a salary deferral to the 401(k) plan, who is responsible for preparation of the annual safe harbor notice that must be delivered to participants no less than 30 days before the beginning of a plan year? Who calculates the match? Who explains to participants that deferrals are deposited in the 401(k) plan but the related match is in the ESOP? Who ensures that both plans are drafted to support the match being funded in the ESOP, with no conflicting language? What about participants who are K-eligible due to liberal eligibility and entry rules, but who are not yet eligible to become ESOP participants? Is their safe harbor contribution or other match funded in the ESOP? All of these questions need answers before the matching provisions are added to the ESOP. Additionally, what if the match is used to make payments on an ESOP loan and shares released from suspense have a fair market value less than the matching dollars used to pay debt? Will there be a provision for providing a supplemental match that ensures participants receive cash or shares worth the dollar value of their safe harbor matching contributions? These questions need answers as well, and ESOP professionals are not all of the same opinion as to whether a supplemental contribution is required or whether it is even a good idea.


Last example taken from a real life situation:


Example 5: ABC Company directs the drafting of its new ESOP document. The ESOP provides for eligibility upon attainment of age 21 and completion of 1 year of service (1,000 hours in a 12-month eligibility computation period.) The ESOP draft states that ABC Company will contribute a safe harbor match to the ESOP, with the calculation to be based on annual compensation and annual salary deferrals. ABC Company’s 401(k) plan provides for participation upon completion of 3 months of service with the employer. The 401(k) plan says that ABC Company will contribute its safe harbor match to the 401(k) plan and matching contributions will be made each pay period. MANY plan differences need to be worked out and resolved before the ESOP document can be finalized. Both the ESOP draft and the 401(k) plan will require revision.


Given the potential for missteps with multiple plans, a team approach to plan design should be considered when adopting a second plan, or making substantial changes to existing plans. At a minimum, the team would include legal counsel, the company’s accountants and third party administrators.
*Note that the Section 415 annual addition limit for defined contribution plans for limitation years beginning in 2012 is $50,000. The annual addition limit can be exceeded to the extent that the excess consists of age 50 catch up deferral contributions.

This article originally ran in a 2012 ESOP Report newsletter, the newsletter of The ESOP Association. Reprinted with permission from The ESOP Association. © The ESOP Association. All Right Reserved 2012

Topics: Plan Design, ESOP & 401(k) Plans