The Unique Alternative to the Big Four ESOP
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 (pete. shuler@crowehorwath. com) Justin Stemple – Warner Norcross & Judd (jstemple@wnj. com)
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 2
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 3
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 4
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 5
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 6
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 7
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” Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 8
The Unique Alternative to the Big Four® Service-based Allocation § Example Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 9
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 10
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? Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 11
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* Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 12
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* Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 13
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 14
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/2013 ACreport 3. html § No “Mr. Forfeiture” Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 15
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 16
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 17
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 18
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 1099 R § Benefits § § Allows participants to get current income from the ESOP Can make the ESOP more meaningful, especially to younger participants Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 19
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 20
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 21
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 22
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 Interest Total Payment 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. 53 418, 832. 90 418, 832. 90 6, 282, 493. 53 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. 00 Audit | Tax | Advisory | Risk | Performance Balance 5, 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 - Denominator 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, 6667 6, 6666 6, 6667 6, 6666 100, 0000 © 2013 Crowe Horwath LLP Remaining Shares 100, 0000 93, 3333 86, 6666 79, 9999 73, 3332 66, 6665 59, 9998 53, 3332 46, 6665 39, 9999 33, 3332 26, 6666 19, 9999 13, 3333 6, 6666 - 23
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 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. 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. 90 116, 314. 96 6, 179, 975. 59 Audit | Tax | Advisory | Risk | Performance Balance Denominator 5, 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 1, 882. 1265 100, 0000 Remaining Shares 100, 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 24
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 25
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) Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 26
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 $ Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 27
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 28
The Unique Alternative to the Big Four® Diversification § Statutory Diversification § Enhanced diversification § Longer period § Higher percentage § Mandatory diversification Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 31
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? Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 33
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 34
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 35
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 36
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 37
The Unique Alternative to the Big Four® Questions? Thank you! Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 38
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 Audit | Tax | Advisory | Risk | Performance © 2013 Crowe Horwath LLP 39
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