Transcript Slide 1
The Unique Alternative to the Big Four®
ESOP Features You May Not Have Considered
Michigan Chapter of The ESOP Association
Annual Conference
September 25, 2014
Presented by:
Pete Shuler - Crowe Horwath LLP ([email protected])
Justin Stemple – Warner Norcross & Judd ([email protected])
The Unique Alternative to the Big Four®
Preface
Please fill out a session evaluation form and drop it off at the table outside of the
main room
Your feedback on topics and presenters is important and will be used to develop
subsequent programs
Take a moment to silence your cell phone
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The Unique Alternative to the Big Four®
Coordination with 401(k) Plan
Look for *Coordination with 401(k) Plan* noted throughout presentation
Must be the same
HCE definition/assumptions
Limitation Year definition
Top-heavy contribution coordination
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The Unique Alternative to the Big Four®
“Generous” Entry and Allocation Provisions
Maximum wait to enter:
Service – 12 months (with 1,000 hours), then enter on the following semi-annual entry
date
Age – 21
Maximum allocation provisions
Work 1,000 hours during the plan year
Be employed on the last day of the plan year
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The Unique Alternative to the Big Four®
“Generous” Entry and Allocation Provisions
Why would you want to be more generous?
Can help resolve issues with maximum permissible contribution (25% of eligible payroll)
by increasing the eligible payroll
Can help resolve issues with maximum annual allocation each participant can receive
by spreading the allocation across more participants
Can get employees focused on the ESOP more quickly – they don’t have to wait up to
18 months to enter and up to three years before they get a statement
What is the downside?
Current employees who had to wait a year to enter may not be happy
Most turnover occurs early in employment and with younger employees
Spreads the allocation a bit (less for each existing participant), but not as much as you
may think
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The Unique Alternative to the Big Four®
Dual Eligibility
Different contributions may have different eligibility rules
Why would you want that?
Can allow new hires to starting contributing to the 401(k) quickly but require longer
service to receive ESOP contributions
Different eligibility rules for “fixed” work schedules v. non-fixed/irregular work
schedules
Immediate for fixed; 1 year and age 21 for non-fixed
Attempts to address part-time employees without delaying all employees
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The Unique Alternative to the Big Four®
Exclusions From Eligibility
Certain exclusions have no impact on nondiscrimination testing
Collective bargaining group members
Non-employees
Nonresident aliens without any US earned income
Other nondiscriminatory categories may be excluded
Division
Facility
Subsidiary
Job classification
Students/interns
No hours-based exclusions
Part-time
Temporary
Seasonal
Non-benefitting employees
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The Unique Alternative to the Big Four®
Service-based Allocation
Two methods of allocation for employer contributions are approved without
additional testing
Compensation-based
Per capita
Other methods are generally permissible as long as they don’t discriminate in
favor of “highly compensated employees”
Test must be performed annually to ensure that the allocation is “nondiscriminatory”
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The Unique Alternative to the Big Four®
Service-based Allocation
Example
ABC Company
Employee Stock Ownership Plan
Eligible
Participants
John Smith
Joe Green
Ed Brown
Mary Johnson
Edna Williams
Total
Wages
50,000
30,000
40,000
120,000
75,000
315,000
Years of
Service
10
15
12
1
5
43
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Points
Wages Service
50
100
30
150
40
120
120
10
75
50
315
430
Total
150
180
160
130
125
745
Allocation ($100,000)
Wages
Points
15,873
20,134
9,524
24,161
12,698
21,477
38,095
17,450
23,810
16,779
100,000 100,000
Allocation %
Wages Points
16%
20%
10%
24%
13%
21%
38%
17%
24%
17%
100%
100%
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The Unique Alternative to the Big Four®
Service-based Allocation
Why would you want to use a service-based allocation?
If the desire is to reward participants based at least partially on their service, servicebased allocation works
Lot of flexibility in designing the formula, as long as the allocation is nondiscriminatory
What is the downside?
Desire may be to reward employees based on current compensation, not service
Could adversely impact recruiting
Nondiscrimination testing must be passed
If highly compensated employees have the most service, test may not pass
Repurchase obligation impact
Could put more shares into the accounts of participants who are closer to diversification and
retirement
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The Unique Alternative to the Big Four®
Compensation-based Allocation
Most common allocation method is pro rata by compensation
Most common compensation definition is gross W-2 (includes pre-tax deferrals)
Withholding wages and Section 415 compensation are also pre-approved
Pre-approved exclusion of taxable fringes: “reimbursements or other expense
allowances, cash and noncash fringe benefits, moving expenses, deferred
compensation, and welfare benefits” – must be in the plan
Other exclusions permitted if non-discriminatory
Bonuses
Overtime
Commissions
Others?
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The Unique Alternative to the Big Four®
401(k) plan-based Allocation
Matching allocation
Safe harbor allocation
Nonelective
Matching
QACA
Eligibility rules/compensation definition
Safe harbor notice(s)
401(k) must provide for safe harbor to be satisfied in the ESOP
*Coordination with 401(k) plan*
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The Unique Alternative to the Big Four®
Correction/Avoidance Options for Section 415 Excess
Section 415
Limits “annual additions” participants can receive under all company retirement plans to
lesser of their 100% of pay or $52,000 (adjusted for inflation annually)
Annual additions are generally employee deferrals and Roth contributions, employer
contributions, and reallocated forfeitures
Catch-up contributions (currently $5,500) are not counted for 415 purposes
Correction methods
Return employee deferrals/Roth contributions to the individual
Forfeit associated matching contributions
Reallocate excess amounts to those who have not yet hit the 415 limit
*Coordination with 401(k) Plan*
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The Unique Alternative to the Big Four®
Correction/Avoidance Options for Section 415 Excess
Return employee contributions/forfeit associated match
For participants at least age 50, deferrals that would have been returned can be
recategorized as catch-up contributions, if catch up contributions have not yet been fully
utilized. This means they stay in the 401(k) plan.
Participant receives their own contributions back, less any taxes
Positively impacts the average deferral percentage test if the participant is a highly
compensated employee
Downside – Employees don’t like to get their deferrals back
Reallocating excess
Generally the avoidance of a failure, not a correct
Because the 415 limit is not hit, due to change in allocation, no deferrals are
recharacterized
Any excess is reallocated to those who have not yet hit the limit, so more allocations for
lower paid people
Downside – not financially beneficial for those who hit the limit
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The Unique Alternative to the Big Four®
Forfeitures
Timing
Immediate upon distribution
Five breaks in service
Use of forfeitures
Expenses if cash forfeitures
Reallocate
Reduce next contribution
“Lost” participants
http://www.dol.gov/ebsa/publications/2013ACreport3.html
No “Mr. Forfeiture”
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The Unique Alternative to the Big Four®
Paying ESOP Loan with Contributions v. Dividends
Sources of funds for the loan payment determines how the shares released by
the loan payment are allocated
If employer contributions are used to fund the loan payment, the shares released are
allocated based on compensation/points
If dividends/income distributions are used to fund the loan payment, at least a portion of
the shares released are allocated based on stock account balance
Dividends earned on shares in participant accounts are always allocated on stock account
balance
Dividends earned on suspense accounts shares can be allocated in different ways, but generally
either on stock account balance or in the same manner as the contribution
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The Unique Alternative to the Big Four®
Paying ESOP Loan with Contributions v. Dividends
Not always a choice:
Limits on contributions can necessitate the need for dividends/income distributions to
fund the loan payment
Example - $2 million loan payment, but only $1.5 million can be contribution. $0.5 million
dividend can be used to fund the remainder
404 Limit is 25% of eligible compensation
415 Limit – dividends can be used to avoid a failure
If there are non-ESOP shareholders, and they receive dividends/income distributions,
the ESOP must receive these as well
Generally used to repay the loan
Similarly, some preferred stock (C-Corps only) requires a dividend
Generally used to repay the loan
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The Unique Alternative to the Big Four®
Paying ESOP Loan with Contributions v. Dividends
But if there is a choice:
Use of dividends/income distributions will result in skewing the allocation towards
participants with larger balances – longer-term participants
If too much dividend is used, new participants may get little of the share release
Can impact 409(p) testing (generally adversely)
Can impact the repurchase obligation by putting more shares in the accounts of participants who
are closer to diversification and retirement
Keep in mind that FMV test must be passed
Additional deduction for C-Corps, not for S-Corps
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The Unique Alternative to the Big Four®
Pass-through Dividends
Dividends paid directly to participants based on their ESOP shares
C-Corps only
Can be paid directly from the company to the participant or through the ESOP no later
than 90 days after plan year end
Can include allocated and suspense account dividends
Not considered a distribution, so:
No notice and consent requirement
No mandatory withholding
Not eligible for rollover
No early withdrawal penalty
Reported on 1099-DIV not 1099R
Benefits
Allows participants to get current income from the ESOP
Can make the ESOP more meaningful, especially to younger participants
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The Unique Alternative to the Big Four®
Dividend Reinvestment Election
Very similar to pass-through dividends except that participants can elect to:
Receive a pass-through dividend, or
Have their dividend stay in the ESOP and be reinvested in employer stock
Can be based on vested shares only or on total shares, but all dividends on
which participant is given an election are immediately 100% vested
May be offered to active participants or to all participants
Reasonable opportunity to make election prior to dividend payment or
distribution
Opportunity to change election at least annually and when dividend
allocation/payment affected by plan document
Default elections allowed
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The Unique Alternative to the Big Four®
Prepaying the ESOP Loan
Share release for most ESOPs is calculated as follows:
Current year principal and interest (P&I) payments
÷
Current Year P&I + All Scheduled Future P&I
*
Suspense Account Shares at Beginning of the Year
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The Unique Alternative to the Big Four®
Prepaying the ESOP Loan
Prepaying the ESOP loan means making more than the scheduled payment in a
year or years
Results in shares being released and allocated faster to participants
Why would you want to prepay?
Gets more shares into the accounts of participants in the ESOP at the time of the
prepayment
Why wouldn’t you want to prepay?
Since shares are released faster, there are fewer shares for participants down the road
Affects repurchase obligation by loading up accounts
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The Unique Alternative to the Big Four®
Prepaying the ESOP Loan
ABC COMPANY
EMPLOYEE STOCK OWNERSHIP PLAN
LOAN AMORTIZATION AND SHARE RELEASE SCHEDULE
NO PREPAYMENT
Principal and Interest Method
Fixed Interest Rate: 3.00%
Date of Note: 12/31/13
Original Number of ESOP Shares: 100,000
Payment
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Totals
Due Date
12/31/2013
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
Principal
268,832.90
276,897.89
285,204.83
293,760.97
302,573.80
311,651.01
321,000.54
330,630.56
340,549.48
350,765.96
361,288.94
372,127.61
383,291.44
394,790.18
406,633.89
5,000,000.00
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Interest
150,000.00
141,935.01
133,628.08
125,071.93
116,259.10
107,181.89
97,832.36
88,202.34
78,283.42
68,066.94
57,543.96
46,705.29
35,541.47
24,042.72
12,199.02
1,282,493.53
Total
Payment
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
6,282,493.53
Balance
Denominator
5,000,000.00
4,731,167.10
4,454,269.21
4,169,064.38
3,875,303.41
3,572,729.61
3,261,078.60
2,940,078.05
2,609,447.49
2,268,898.01
1,918,132.05
1,556,843.11
1,184,715.50
801,424.07
406,633.89
-
6,282,493.53
5,863,660.63
5,444,827.73
5,025,994.83
4,607,161.93
4,188,329.02
3,769,496.12
3,350,663.22
2,931,830.32
2,512,997.41
2,094,164.51
1,675,331.61
1,256,498.71
837,665.80
418,832.90
Shares
Allocated
6,666.6667
6,666.6667
6,666.6667
6,666.6667
6,666.6667
6,666.6667
6,666.6666
6,666.6667
6,666.6666
6,666.6667
6,666.6666
6,666.6667
6,666.6666
6,666.6667
6,666.6666
100,000.0000
© 2013 Crowe Horwath LLP
Remaining
Shares
100,000.0000
93,333.3333
86,666.6666
79,999.9999
73,333.3332
66,666.6665
59,999.9998
53,333.3332
46,666.6665
39,999.9999
33,333.3332
26,666.6666
19,999.9999
13,333.3333
6,666.6666
-
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The Unique Alternative to the Big Four®
Prepaying the ESOP Loan
ABC COMPANY
EMPLOYEE STOCK OWNERSHIP PLAN
LOAN AMORTIZATION AND SHARE RELEASE SCHEDULE
PREPAYMENT
Principal and Interest Method
Fixed Interest Rate: 3.00%
Date of Note: 12/31/13
Original Number of ESOP Shares: 100,000
Payment
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Totals
Due Date
12/31/2013
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
Principal
Interest
Total
Payment
468,832.90
282,897.89
291,384.83
300,126.37
309,130.16
318,404.07
327,956.19
337,794.87
347,928.72
358,366.58
369,117.58
380,191.11
391,596.84
403,344.75
112,927.14
5,000,000.00
150,000.00
135,935.01
127,448.08
118,706.53
109,702.74
100,428.84
90,876.71
81,038.03
70,904.18
60,466.32
49,715.32
38,641.80
27,236.06
15,488.16
3,387.81
1,179,975.59
618,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
116,314.96
6,179,975.59
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Balance
Denominator
5,000,000.00
4,531,167.10
4,248,269.21
3,956,884.38
3,656,758.01
3,347,627.85
3,029,223.78
2,701,267.59
2,363,472.72
2,015,544.00
1,657,177.42
1,288,059.84
907,868.73
516,271.89
112,927.14
-
6,179,975.59
5,561,142.69
5,142,309.79
4,723,476.88
4,304,643.98
3,885,811.08
3,466,978.18
3,048,145.27
2,629,312.37
2,210,479.47
1,791,646.57
1,372,813.66
953,980.76
535,147.86
116,314.96
Shares
Allocated
10,013.5169
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
1,882.1265
100,000.0000
Remaining
Shares
100,000.0000
89,986.4831
83,209.2249
76,431.9667
69,654.7085
62,877.4503
56,100.1921
49,322.9339
42,545.6757
35,768.4175
28,991.1593
22,213.9011
15,436.6429
8,659.3847
1,882.1265
0.0000
© 2013 Crowe Horwath LLP
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The Unique Alternative to the Big Four®
Account Segregation/Conversion
Conversion of terminated participants’ accounts to cash prior to their distribution
payment
Can occur in year of termination or any later year, whether or not the participant is
eligible to receive a distribution
Generally done through recycling of shares, although could be done through
redemption (with an updated valuation)
Best to convert all shares, not just the participants vested shares
Segregation/conversion feature needs to be in the plan document
Cannot be discretionary, but the decision to put money into the ESOP to convert shares is up to
the company each year
Need to have a provisions for partial conversion, if company does not want to put full amount in
Generally pro-rata or based on termination date
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The Unique Alternative to the Big Four®
Account Segregation/Conversion
Why would you want to convert shares?
Gets shares (and future appreciation of those shares) into the hands of your active
participants who can still affect the value of the company
Gets risk of owning the shares out of the hands of terminated participants who no
longer have a stake in the company
May not want terminated participants who now work for competitors to see your stock
price
In a rising stock price environment, accelerates cash needed for the repurchase
obligation but reduces the amount paid to the participant overall
Why wouldn’t you want to convert shares?
Accelerates cash flow needs
Fiduciary obligation to invest the proceeds of the conversion
Can’t just stick it in cash
*Coordination with 401(k) Plan* if proceeds to be transferred to the 401(k)
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The Unique Alternative to the Big Four®
Account Segregation/Conversion
ABC Company ESOP
Trust Balances at the close of the allocation period:
$
ABC Stock
Other Investments
Total
400,000 $
100,000 $ 500,000
80.0%
20.0%
Participant Balances (pre-reshuffle/segregation):
Active
Participant A
$
Active
Participant B
$
Terminated
Participant C
$
130,000 $
78.8%
250,000 $
96.2%
20,000 $
26.7%
35,000 $ 165,000
21.2%
10,000 $ 260,000
3.8%
55,000 $
75,000
73.3%
145,556 $
88.2%
254,444 $
97.9%
$
0.0%
19,444 $ 165,000
11.8%
5,556 $ 260,000
2.1%
75,000 $
75,000
100.0%
Participant Balances (post-reshuffle/segregation):
Active
Participant A
$
Active
Participant B
$
Terminated
Participant C
$
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The Unique Alternative to the Big Four®
Rebalancing
IRS Definition: “The mandatory transfer of employer securities into and out of
participant ESOP accounts, usually on an annual basis, designed to result in all
participant accounts having the same proportion of employer securities.”
Each year, the ESOP accounts are rebalanced so that each participant has the
same percentage of his/her account investment in employer stock and other
investments
For example, if the ESOP overall has 90% stock and 10% cash, each participant will
have 90% stock and 10% cash after the rebalancing is completed
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The Unique Alternative to the Big Four®
Diversification
Statutory Diversification
Enhanced diversification
Longer period
Higher percentage
Mandatory diversification
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The Unique Alternative to the Big Four®
Beneficiaries
Designation of Beneficiary Form
Default if no named beneficiary?
Estate?
Surviving Spouse?
If no spouse, what next?
Divorce?
Disclaimers?
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The Unique Alternative to the Big Four®
QDROs
Qualified domestic relations order (“QDRO”)
Alternate Payee
Spouse, former spouse, child, or other dependent
ESOP distributions v. Family Law/QDRO processor
QDRO distribution provisions
When, how much, how paid
QDRO Procedures
Sample QDRO
ESOP
Other qualified retirement plans
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The Unique Alternative to the Big Four®
In-Service Distributions
When?
Age 59 ½?
Normal Retirement Age?
How much?
May accelerate repurchase obligation
May reduce total amount paid
Mitigates incentive to quit to gain access to ESOP account
Acts as additional diversification tool
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The Unique Alternative to the Big Four®
Distributions
Form
Lump sum of cash
Installments of cash
Lump sum of stock
Redeemed by the company
Lump sum
Installments – note / adequate security
Recycled by the ESOP
Lump sum
Installments – note / adequate security
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The Unique Alternative to the Big Four®
Distributions
Timing
Immediate
After plan year end
Up to five year delay
Financed securities delay
Mandatory cashouts
$1,000 direct payment
$1,000-$5,000 IRA rollover
Distribution Policy
Distribution forms
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The Unique Alternative to the Big Four®
Questions?
Thank you!
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The Unique Alternative to the Big Four®
Postscript
Please fill out a session evaluation form and drop it off at the table outside of the
main room
Your feedback on topics and presenters is important and will be used to develop
subsequent TEA programs
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