ESOP has a 404 deduction issue - Case Study
ESOP has a 404 deduction issue by Jackie Salmon an ESOP Advisor.
OneAmerica was involved in a finalist presentation for a prospective 401(k) and DB client (1 401(k) $25mm, 2 DBs totaling $25mm). As it turned out, they also had an ESOP but that plan was not on the table. At the end of the presentation, the CFO mentioned that they had a 404 deduction issue with their ESOP. Their employee base had faced reduction, resulting in a corresponding reduction in their covered compensation, so their ESOP (inside) loan payment was now larger than their maximum 404 deduction limit, generating excise taxes for them. As the ESOP expert in attendance, my initial reaction was to verify S or C Corporation status and suggest on the spot to use earnings distribution (they are an S Corporation) as loan payments, because earnings distributions are “earnings” and not “contributions” so they do not count toward the 404 deduction limit. The CFO already knew about this strategy, and it was not viable because the allocation of share release on loan payments from earnings distributions are made pro-rata on a share balance basis, and they did not want more shares going to those who already had the most shares. After returning home and discussing with our OneAmerica ESOP team, we brainstormed about lowering the interest rate on the ESOP loan, and how that would reduce their loan payments. Even better, if the loan payments were level payments (not level principal but level payments), then lowering the interest rate would not change the share release. Turns out their loan rate was over 4%, and they did have level payments, so we suggested lowering this interest rate. As a result of our suggestion, and after consultation with their ESOP attorney, they were able to lower their interest rate and thus lower their loan payments, which helped them resolve their 404 deduction issue. We did win the 401(k) and DB business, and we continue to work with them on ESOP consulting, hoping to win that plan too.