Tax reform alters ESOP landscape; CPAs can help clients maximize new plan features.

EXECUTIVE SUMMARY

* PROVISIONS IN THE ECONOMIC GROWTH AND TAX RELIEF Reconciliation Act of 2001 raised ESOP contribution limits and liberalized companies' combined use of ESOPs and 401(k) plans. The new law raises the contribution limits that can be added annually to an individual employee's account--from both employer contributions to ESOPs and other defined plans. It also raises the maximum amount an individual can defer into a 401(k) plan to $11,000 from $10,500.

* EMPLOYEES' ELECTIVE DEFERRALS INTO their 401(k) plans will no longer reduce the tax-deductible limit on the amount the employer can contribute to a defined contribution plan (ESOP) or combination of plans. CPAs should explain the wide-ranging implications of these changes to their clients so they can incorporate them into their benefit plans and take full advantage of these provisions.

* NEW PROVISIONS IN THE TAX LAW address some S corporations' abuse of ESOP tax benefits by closing previously existing loopholes. The law requires plan managers to perform a two-step process to determine whether the S corporation and the ESOP participant will be subject to punitive tax treatment by identifying "disqualified" persons and determining whether the disqualified individuals own at least 50% of all shares.

* C CORPORATIONS ARE NOW ALLOWED to deduct dividends paid on allocated and unallocated shares that employees voluntarily reinvest in company stock in the ESOP. Dividends that are reinvested by the employee into company stock are taxable to the employee. But the company can create a dividend "switchback" program that will provide the equivalent of a pretax dividend.

Although employee stock ownership plans have existed for more than 25 years as an employee benefit and a retirement tool, their legal structure continues to evolve. With the Economic Growth and Tax Relief Reconciliation Act of 2001, Congress enacted significant changes, effective in 2002, to employee benefit plans which raised the total dollar amount of contribution limits and liberalized companies' combined use of ESOPs and 401(k) plans (for more information on the tax bill, see "Making Sense of the New Tax Legislation," JofA, Sep. 01, page 22). This article discusses how the legislation has affected ESOP use and recommends CPAs and plan sponsors review the changes with their corporate and small business clients so they can realize tax benefits associated with the new rules.

NEW CONTRIBUTION LIMITS

Public companies often use ESOP contributions to match employee deferrals to a 401(k) plan; private companies tend to use them to supplement diverse retirement plans. The new law raises the allowable combined total of employee deferrals to 401(k) plans plus employer contributions to ESOPs, 401(k) and other defined contribution plans to $40,000 from $35,000 and to 100% of an individual's eligible pay from 25%, whichever is less. The maximum amount that an employee can defer annually to a 401(k) plan has been increased to $11,000 from $10,500 (see exhibit 1, page 39). These dramatic changes allow lower- and mid die-income employees to save more money for retirement.

These revisions provide a solution for companies that in the past sometimes found they had to terminate their 401(k) plans after creating an ESOP program because their ESOP contributions already were approaching the limits. "Telling employees they could no longer have a 401(k) plan could be a significant disadvantage for companies," says Dennis Long, president of Appleton, Wisconsin-based BCI Group, the country's largest ESOP/401(k) administration company. Formerly, companies contributing the maximum to an ESOP (25% of each employee's pay per year) were precluded from having a 401(k) plan; companies that neared the maximum were confined to 401(k) plans with limited funding. The tax law of 2001 virtually eliminates this problem.

Two kinds of contribution limits now affect businesses. The first, IRC section 404, governs how much a company can deduct from its taxes for its contributions to a retirement plan; the second, IRC section 415, stipulates how much employers and employees can add to individual employee accounts. Employees' elective deferrals to their 401(k) plans will no longer reduce the tax-deductible limit on the amount the employer can contribute to a defined contribution plan (ESOP) or combination of plans. CPAs should explain the wide-ranging implications of these changes to their clients so they can incorporate them into their benefit plans and take full advantage of these provisions.

Under prior law if a company did not borrow money through an ESOP (or if the company was an S corporation ESOP), the maximum annual contribution limit to the ESOP was 15% of total eligible pay. The new limit is 25% of pay for all ESOP plans. Moreover, companies can take a tax deduction for "reasonable" dividends--which the IRS defines as those "that are justified by earnings and in line with standard industry practice"--paid on ESOP shares that employees voluntarily reinvest in the plan to buy more company stock (for an example of how the changes work, see exhibit 2, page 40).

SCRUTINY OF S CORPORATIONS

By closing previously existing loopholes, the legislation also addresses some S corporations' abuse of ESOP tax benefits. New provisions essentially prevent very small companies controlled by only a handful of people from setting up ESOPs primarily for their own financial gain. The law requires plan managers to perform a two-step process to determine whether the S corporation and the ESOP participants will be subject to punitive tax treatment:

* Identify "disqualified persons." Under the law a "disqualified person" is an individual who owns 10% or more of the allocated and unallocated shares in the ESOP or who, together with family members (spouses or other family members, including lineal ancestors or descendants, siblings and their children or the spouses of any of these other family members), owns 20% or more of such shares. Synthetic equity, broadly defined to include stock options, stock appreciation rights and other equity equivalents, is also counted as ownership for this purpose.

* Determine whether disqualified individuals own at least 50% of all shares. In order for plan managers to calculate the total number of shares disqualified individuals own, they must count shares held directly, shares owned through synthetic equity and allocated or unallocated shares owned through the ESOP.

If disqualified individuals own at least 50% of the company's stock and receive an allocation from the ESOP during the current year, they will incur a substantial tax penalty. An allocation occurs when ESOP shares are added to a participant's account; the allocation will be taxed as a distribution to the recipient, and a 50% corporate excise tax will apply to the fair market value of the stock allocated. If the recipient owns synthetic equity, an additional 50% excise tax will apply to its value. In the first year this rule applies, there will be a 50% tax on the fair market value of shares allocated to disqualified individuals even if no additional allocations are made to those individuals during that year. Thus, the tax applies if disqualified individuals own more than 50% of the company in the first year.

These regulations apply to existing plans, regardless of when they were established, if their purpose is to avoid or evade the prohibited allocation rule (see "S Corporation Election Rules," page 38). David Johanson, a specialist in employee stock ownership plans at Johanson Berenson LLP, a Napa, California, law firm, observes that to ensure compliance with the new law and to minimize adverse tax consequences, advisers will have to carefully review situations in which a small number of related people will receive substantial allocations of company stock under an S corporation ESOP. Donald Israel, CPA, principal of Benefit Concepts Systems Inc. in New York City, concurs. "The new law prevents individuals from trying to establish S corporation ESOPs for their own gain, rather than for the exclusive benefit of the ESOP participants and their beneficiaries, as Congress originally had intended," he says.

DIVIDEND TREATMENT FOR C CORPORATIONS

Certain ESOP incentives available to C corporations are not available to S corporations. For example, unlike S corporations, C corporations are allowed to have a different class of stock and are able to deduct dividends. The new law allows C corporations to deduct dividends paid on allocated and unallocated shares that employees voluntarily reinvest in company stock in the ESOP. Under prior law C corporations could deduct dividends they paid on allocated or unallocated ESOP shares to repay an ESOP loan. C corporations also were able to deduct dividends passed directly through to employees. Dividends an employee reinvests into company stock are still taxable to the employee but the company can create a dividend "switchback" program that will provide the equivalent of a pretax dividend to the employee.

The new law allows for a simple procedure under which both the employer and the employee can avoid tax on the dividend. "The C corporation can now deduct the dividend if the employee reinvests it as employer stock directly in the ESOP," says Nancy K. Dittmer, CPA, of RSM McGladrey Inc. in Des Moines, Iowa. "There is no need for the dividend switchback program unless the employee wants to reinvest on a pretax basis in the 401(k) for investment diversification purposes." Dittmer notes that if the employee decides to reinvest the dividend as employer stock into the ESOP, the reinvestment does not apply toward the employee's 401(k) deferral limit ($11,000) or other contribution limitations. To create a deductible dividend under the old law, companies had to obtain letter rulings from the IRS for dividend switchback arrangements. (Recent IRS rulings have made it clear, however, that S corporation ESOPs can use dividends paid only for unallocated shares as repayment for an ESOP loan and even then such dividends are not deductible.)

The new approach may be of particular interest to public companies because they are allowed to deduct the dividend. For private companies it could mean considerable expense to comply with regulations the SEC imposed. For example, a private company could spend $10,000 to $25,000 to file for an exemption to the dividend laws and to file an antifraud disclosure statement, with no guarantee of obtaining the exemption. If the company does not receive an exemption and then wishes to register its shares for public trading, it faces significant initial and ongoing expenses related to registration, administration and reporting.

WATCH WHAT CONGRESS DOES

An ESOP is a flexible financial vehicle for corporate growth, and like other tax-qualified retirement plans, it must comply with participation, benefit allocation and distribution rules (exhibit 3, at right, lists some of the available plan resources). As a result of the publicity surrounding Enron because its employees lost retirement savings, proposals to address the vulnerabilities in defined contribution retirement plans have appeared from Congress, regulators and employee/investor associations. President George W. Bush proposed his own series of legislative controls and a number of other plans are on the table. As of this writing none of the proposed bills would affect private-company ESOPs in any way (by requiring earlier diversification in ESOPs). Public company ESOPs integrated with 401(k) plans, however, could be subject to new rules on diversification rights and other issues.

Exhibit 3: ESOP Resources

* Buck Consultants, www.buckconsultants.com. International employee
benefits consultants with headquarters in New York City.

* The ESOP Association of America, www.esopassociation.org. A trade
association that lobbies for ESOP companies and tracks legislation.

* The Foundation for Enterprise Development www.fed.org. The foundation
focuses on entrepreneurial employee ownership with a particular
emphasis on technology businesses.

* The Global Equity Organization, www.globalequity.org. GEO is a
worldwide membership organization of companies and consultants dealing
with international and multinational equity compensation concerns.

* The National Center for Employee Ownership, www.nceo.org. The
NCEO is a nonprofit membership and research organization offering a
newsletter, legal journal, publications, conferences and seminars on
broad-based employee stock ownership plans.

The new tax law makes ESOPs more attractive and makes it much easier for companies to combine ESOPs with 401(k) plans. Despite a recession and negative perceptions of employer stock in pension plans brought about by the collapse of Enron, these plans are here to stay--private company ESOPs continue to emerge and public companies are standing behind their ESOPs and 401(k) plans. CPAs need to be familiar with the reforms and their timing to maximize the new plan features for their clients.

As of 2001 approximately 8.5 million employees participated in about 11,400 employee stock ownership plans with an aggregate value of more than $400 billion. Although no precise data are available, experts believe 5% to 10% of ESOPs are in publicly traded companies and this group contains the majority of plan assets.

Source: The National Center for Employee Ownership, Oakland, California, www.nceo.org.

S Corporation Election Rules

Grandfather rules apply to existing plans t only where the ESOP was established t by March 14, 2001, and had an S corporation election in place by that date. The legislation clarified that although an election to be an S corporation was effective as of the date the election first applied, a company could not make a retroactive election after March 14 and qualify for grandfather treatment.

Exhibit 1: Snapshot of Plan Changes

                     2001            2002        2003        2004
                     (Old law)

Employee elective    Yes             No: 2002 through 2009
deferrals counted                    (Note: employee deferrals will
as employer                          still count toward annual
contributions                        addition limits)

Employee deferrals   No              Yes: 2002 through 2009
counted as
compensation
for calculating
maximum amount
of employer
contribution

Maximum deduction    15% of pay      25% for combined contributions
for contributions    for combined    to all defined contribution
to all defined       contributions   plans for 2002 through 2009
contribution         to all
plans combined       defined
under IRC section    contribution
404                  plans; 25%
                     where there
                     is a C
                     corporation
                     leveraged
                     ESOP or ESOPs
                     combined with
                     money
                     purchase
                     pension plan

Catch-up             None            Additional  Additional  Additional
contributions                        $1,000      $2,000      $3,000
for individuals
50 and older

401(k) deferrals     $10,500         $11,000     $12,000     $13,000

Covered              $200,000
compensation
eligible for
contributions

Annual additional    $35,000         $40,000 or 100% of covered
dollar limits        or 25% of       compensation, whichever is less
(employer            covered
contributions plus   compensation,
employee deferrals   whichever
plus forfeitures)    is less
under IRC section
415

                    2005            2006         2007-2009

Employee elective
deferrals counted
as employer
contributions

Employee deferrals
counted as
compensation
for calculating
maximum amount
of employer
contribution

Maximum deduction
for contributions
to all defined
contribution
plans combined
under IRC section
404

Catch-up            Additional      Additional   Additional
contributions       $4,000          $5,000       $5,000
for individuals
50 and older

401(k) deferrals    $14,000         $15,000      Indexed in annual
                                                 $500 increments
                                                 for inflation

Covered             Indexed in annual $5,000
compensation        increments for inflation
eligible for
contributions

Annual additional   Indexed in annual $1,000
dollar limits       increments for inflation
(employer
contributions plus
employee deferrals
plus forfeitures)
under IRC section
415
Exhibit 2: Example of Plan Changes on Employees Contributions

Assumptions:

* Total payroll of eligible plan participants: $2 million.
* Target leveraged ESOP contribution: 20% of eligible pay.
* Total annual payroll over $170,000/year per person: $200,000.
* Total annual payroll over $200,000/year per person: $50,000.
* Amount employees defer annually to 401(k) plan: $200,000.
* Sample employee's annual gross earnings: $50,000; annual 401(k)
  contribution: $5,000.

Maximum Allowable Contribution to ESOP

                       2001 Law               2002 Law

Eligible pay for       $2 million minus:      $2 million minus:
ESOP contributions     $200,000 in pay over   $50,000 in pay over
                       $170,000 per year      $200,000 per year
                       per individual         per individual

                       Employee 401(k)
                       deferrals

Maximum deductible     25% of remaining       25% of remaining
corporate ESOP         amount (Number to be   amount ($1.95
contribution           determined when        million x .25)
                       deferrals are made)

Limit on annual        $12,500 (25% of pay)   $40,000 (the lesser
addition to            Includes both ESOP     of $40,000 fixed
employee's account     contributions and      ceiling or 100% of
in leveraged ESOP      401(k) deferrals       pay)

Dollar limit on        $2,500 (limited to     $11,000 (fixed
employee's 401(k)      5% of pay if ESOP      ceiling)
deferral               contribution is 20%
                       of pay)

Deductible corporate   .20 x [$1.8 million    .20 x $1.95 million
ESOP contribution in   minus employee
dollars if company     deferrals to 401(k)]
contributes 20% of
aggregate eligible     ($1.8 million          Reflects only the
pay                    reflects $200,000      $50,000 of ineligible
                       ineligible pay over    payroll (pay over
                       $170,000 per year      $200,000 per year
                       per person. Size of    per individual)
                       deferrals depends on
                       how much employees
                       defer, which may be
                       reduced by limits on
                       maximum allowed,
                       that is, 5% of pay
                       per individual)

BRYAN GIRARD is director of communications for the National Center for Employee Ownership in Oakland, California. His e-mail address is [e-mail].