ESOP, meet 401(k). (Investment Options).

A combination 401(k) plan and employee stock ownership plan, commonly called a KSOP, can be used to decrease the administrative and legal expenses for employers who maintain both a 401(k) plan and an employee stock ownership plan.

For employers who maintain a stand-alone 401(k) plan and who make contributions of employer stock to the plan, a KSOP also may lessen the fiduciary risk associated with the 401(k) plan holding such stock.

REAPING THE REWARDS

Employers who make matching contributions to a 401(k) plan in the form

of employer stock can reap many benefits.

The first benefit is providing employees with additional motivation to ensure the business' profitability. By enhancing the value of the employer's stock, the employees enhance their own retirement plan benefit.

To realize this benefit, employers must inform employees that the value of their plan benefit that is attributable to employer stock is dependent, in part, on their efforts to make the company more profitable, such as by working more effectively or controlling costs.

A second benefit to employers is a decrease in the cash flow necessary to fund retirement plan contributions by making matching contributions in the form of its stock.

If an employer typically makes a matching contribution in cash, it can retain that cash for other uses, such as purchasing equipment, additional marketing or advertising or developing new product lines.

A matching contribution to a 401(k) plan or a KSOP in the form of newly issued shares of stock is deductible to the employer in the same way as a cash contribution. The amount of the deduction is equal to the value of the stock contributed.

Before deciding whether to make contributions in the form of stock, employers should consider the dilutive effect that action will have on the corporation's other shareholders. Companies should consult with counsel about the application of corporate and securities laws to the issuance of new stock.

A third benefit to a corporation that sponsors an ESOP or a KSOP is the ability of either plan to purchase employer stock from either the employer or from other shareholders.

If an ESOP, or the ESOP portion of a KSOP, holds 30 percent of a C corporation's outstanding capital stock following a purchase of securities from another shareholder, the selling shareholder may defer any gain realized on such sale--and the associated tax liability.

To defer the gain and tax liability, the selling shareholder must file the appropriate elections with the IRS and purchase "qualified replacement property," such as securities issued by domestic operating companies, within 12 months of the sale to the ESOP or KSOP. By doing so, the selling shareholder defers the gain realized on his sale of stock until he disposes of the qualified replacement property. If he holds the qualified replacement property at the time of his death, income tax is never paid on the proceeds of such sale because of the tax rules for stepped-up basis for assets in an estate.

An ESOP or a KSOP is suitable for any corporation engaged in any business, so long as applicable law does not restrict ownership of the corporation's stock to certain types of individuals, such as in the case of professional medical corporations.

An ESOP or KSOP can also be used as an exit strategy for a retiring shareholder. The plan can purchase some or all of the retiring shareholder's company stock. In such cases, the employer should be large enough to have developed management that can effectively run the business after the retirement of the shareholder.

SAVING ADMINISTRATIVE FEES

Forming a KSOP can save employers both legal and administrative fees. Most third-party administrators will charge lower fees for administering a single KSOP, as opposed to two separate plans.

In addition, a single Form 5500 is required for a KSOP, while the two stand-alone plans each will require a separate Form 5500--along with the expenses associated with their preparation. Since these expenses are annual, the savings accrue each year.

Qualified plans carry periodic requirements that they be amended to comply with new legislation. When amended, the plans generally must be submitted to the IRS for a new determination letter. An employer can save a portion of the legal fees associated with making these amendments, and the determination letter application fee payable to the IRS, by maintaining a single KSOP. This will require only one amendment and filing fee.

FIDUCIARY RISK?

In these post-Enron days, trustees or other plan fiduciaries responsible for making investment decisions for qualified retirement plans may be nervous about the fiduciary liability that could materialize as a result of a plan's investment in employer stock.

But a KSOP may lessen the fiduciary concerns connected with maintaining the investment of a portion of a 401(k) plan's assets in employer stock. The Employee Retirement Income Security Act of 1974 provides that retirement plan fiduciaries who make investment decisions are subject to a "prudent expert" standard of care and must act solely in the interest of the plan's participants.

This duty of prudence requires plan fiduciaries to determine that each investment they are responsible for is reasonably designed, as part of the plan's portfolio, to further the purposes of the plan.

In making this determination, fiduciaries are required to take into consideration, among other things, the risk of loss and the opportunity for gain associated with the investment. If a 401(k) plan fiduciary's decision to hold employer securities is challenged, he must demonstrate that he complied with these requirements. If a fiduciary fails to meet these standards, he may be held personally liable for any losses to the plan that resulted from his breach of duty.

In drafting the ESOP provisions of ERISA, Congress intended to encourage employers to provide their employees with an equity interest in their company. To promote this goal, Congress carved out exceptions to certain fiduciary duties in the case of an ESOP.

For example, ERISA provides that an ESOP fiduciary will not violate the duty to diversify plan investments by reason of his investment in employer securities. This exception also applies to other eligible individual account plans, as defined in ERISA, such as 401(k) plans.

Moreover, an ESOP is required, under both ERISA and the Internal Revenue Code, to be primarily invested in employer securities. If the plan document for either an ESOP or a 401(k) plan requires the fiduciary to maintain an investment in employer securities, the fiduciary must comply unless by doing so he would violate a provision of ERISA, such as his duty to prudently invest the plan's assets. Accordingly, while language in a plan document requiring an investment in employer securities will provide some protection to the plan fiduciary, such protection is not absolute.

The two circuit courts of appeals that most recently and directly have addressed the issue have interpreted ERISA as providing an additional protection to an ESOP fiduciary. These courts have said that ERISA grants a presumption of prudence to an ESOP fiduciary that acquires or holds employer securities. A fiduciary of a 401(k) plan does not enjoy this presumption

When matching contributions are made to the ESOP portion of a KSOP, rather than to a 401(k) plan, the fiduciary is afforded more protection if a reviewing court adopted the standard of these courts.

In such cases, the KSOP fiduciary would only be liable for failing to sell employer stock if it is shown that continuing to hold the stock was not prudent in light of information he knew about, or should have known about, the employer. The 401(k) plan fiduciary, however, must only demonstrate that he made a prudent decision to invest in employer securities and that he monitored the performance of those securities to insure the investment remained prudent.

Don Mariotto, Esq., is an attorney at Reish Luftman McDaniel & Reicher in Los Angeles with five years of experience dealing with the installation and maintenance of ESOPs, other qualified retirement plan and fiduciary issues arising in connection with such plans. Mariotto can be reached at [e-mail].