United States

ESOP loans and share allocations require close review


In general, a loan between an employer (or sponsor) and a qualified retirement plan is a prohibited transaction subject to excise tax under section 4975(c)(1)(B). An exception is provided, though, in section 4975(d)(3) and ERISA section 408(b)(3) for a loan to an employee stock ownership plan (ESOP) if the loan meets certain requirements. When such a loan exists, the rules need to be carefully followed to ensure the exception is met, as both the IRS and the U.S. Department of Labor (DOL) will be quick to assert that a prohibited transaction exists.

Shares in a leveraged ESOP are allocated to participant accounts as the loan is repaid, in relation to the amount of loan repayment. Exceptions to the prohibited transaction rules allow for either a principal-only or a principal and interest method to be used, depending on the terms of the loan. In a recently issued technical advice memorandum (TAM 25019), the ESOP allocated shares using the principal-only method, but the loan documents indicated the principal and interest method was to be used, resulting in an operational failure. The DOL determined that the allocation at issue did not meet the requirements of the exception and, thus, was a prohibited transaction. The DOL required the plan sponsor to redo the allocation of the ESOP shares. The IRS concurred with that conclusion and asserted that the employer owed the 15 percent excise tax under section 4975(a)(1).

Of particular note in the TAM was the statement that the, "requirement [in the prohibited transaction exception for ESOP loans] includes both an operational and a documentary component." In other words, not only does the ESOP loan document need to be stated correctly to meet the exception to the prohibited transaction rules, but also, the related allocation of shares in the ESOP that results from the loan payment needs to be correct in operation. This statement may indicate that the IRS and DOL are taking a more critical stance regarding ESOP compliance. In the past, companies that had loan documents that were properly structured to meet the exception, but that allocated the shares incorrectly in operation, could often treat the allocations as clerical errors and simply reallocate correctly, without the allocation being labeled a prohibited transaction.

Although a TAM does not allow for broad reliance, it does indicate the IRS's temperature and points out the importance of carefully reviewing ESOP loans. Not only do the initial loan terms need to be carefully considered at implementation, but each year's share allocation should also be reviewed to ensure compliance with the loan documents and the regulations, because any calculation error may be enough to cause a prohibited transaction.




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