This past June, the IRS released Technical Advice Memorandum (TAM) 201425019, which addressed the tax consequences of an ESOP failing to use the proper method of calculating the annual release of company stock from the loan suspense account.
ESOPs often acquire shares of company stock through a leveraged transaction, which allows the ESOP to borrow the cash necessary to fund the stock purchase. The shares acquired with the loan proceeds are initially held in a suspense account within the ESOP, and are not allocated to participant accounts right away. The company contributes cash or pays dividends to the ESOP each year, which the ESOP uses to make regularly scheduled loan payments. As the loan is paid down, a portion of the shares are released from suspense and allocated to participant accounts as of the end of each Plan year.
There are two methods of calculating the annual release of shares. The first method, known as the “General Rule” or principal and interest method, is shown below:
(Current Year Principal & Interest Payment) |
* |
(Shares in Suspense at Beginning of Plan Year) |
(Current Principal & Interest Payment) + (Future Prinicpal & Interest) |
(Current Year Principal Payment) |
* |
(Shares in Suspense at Beginning of Plan Year) |
(Current Principal) + (Future Prinicpal) |
The principal-only method is only permitted to be used if the loan provides for annual payments of principal and interest at a cumulative rate not less rapid than level annual payments over 10 years. If the loan’s scheduled duration exceeds 10 years, then the principal and interest method is required to be used. In addition, the term of the loan cannot exceed 10 years (including any renewal, extension, or refinancing) and the interest included in any payment is disregarded only to the extent that it would be determined to be interest under standard loan amortization tables.The release method is usually specified in the stock pledge agreement, and should also be specified in the plan document.
The IRS TAM discussed a case in which an ESOP incorrectly used the principal-only method to determine the release of shares over a 5 year period. In this case, the loan’s original scheduled duration was 5 years. The loan was subsequently extended, with a new maturity date that was 10 years after the original loan date. However, this new maturity date was only attained after several pre-payments had been made on the loan. Had a level payment schedule been followed, the extended loan actually would have taken 15 years to pay in full – longer than the 10 year period required for a principal-only method of release. Additionally, the pledge agreement specified that the principal and interest method was to be used, and not the principal-only method.
The IRS concluded that the release method used in the operation of the ESOP did not align with either the statutory requirements or with the parameters of the pledge agreement and Plan document. Therefore, the ESOP loan constituted a prohibited transaction under section 4975(c) of the Internal Revenue Code, and the company was liable for excise taxes.
The TAM illustrates several important points, including:
- It is vital that the release method prescribed in the pledge agreement and plan document aligns with the statutory requirements. An experienced ERISA attorney will be familiar with these requirements and should ensure that they are correctly integrated into the Plan’s documentation.
- The actual release calculation used in administering the Plan must be in accordance with statutory requirements, the pledge agreement, and the plan document. Your ESOP TPA should be well-versed in applying these requirements when administering your ESOP.
- Trustees should be aware of the distinction between the two release methods and should make sure that in cases where the principal-only method is used, any proposed modification to the ESOP loan does not cause the loan to violate the requirements for a principal-only method of release.
