Seven Reasons Your ESOP Might Be Flagged for Noncompliance
Over the past several years, the U.S Department of Labor (DOL) has increased its scrutiny and review efforts for Employee Stock Ownership Plans (ESOPs). As a plan sponsor, you may have received DOL communications that required you to spend valuable time on routine compliance checks or requests to review annual plan tax filings, governing plan documents, and related ESOP transactions. While some of these communications result from the DOL’s normal review efforts, some may be a result of noncompliance with the Employee Retirement Income Security Act of 1974 (ERISA) identified during review of your plan’s annual Form 5500 filing.
Offering an ESOP can be an effective way to transition business ownership to your employees and provide a future retirement benefit. But, like all plans, it also carries risk if it’s not compliant. One of the best ways to avoid receiving a red flag in the future is to fix these seven common issues.
1. High number of terminated participants who aren’t 100 percent vested
On the Form 5500, plan sponsors are required to report the number of participants who terminated employment during the plan year with accrued benefits that were less than 100 percent vested. If the number you report is high compared to your total plan participants (greater than 15 percent), it may be a red flag that possible layoffs have occurred at the organization level. Most ESOPs require plan participants to complete six years of service before they become 100 percent vested, but high termination could trigger partial plan termination rules where participants become 100 percent vested regardless of their service.
2. Excessive or improper fees paid to plan service providers
Service provider information is reported on Schedule C. This information may raise a red flag if you report excessive fees to certain providers, or fees that may be construed as “settlor” type expenses versus “allowable” plan expenses, which are defined as follows:
- “Settlor” expenses are those expenses which confer a benefit on the plan sponsor as opposed to the plan participants. An example of a “settlor” type expense would be the cost for designing the plan (which benefits the plan sponsor, not participants).
- “Allowable” expenses are those that benefit plan participants, such as be annual plan record keeping and reporting costs.
Determining whether expenses are “settlor” types expenses to be paid by the plan sponsor or are “allowable” to be paid by the plan is tricky and requires a thorough understanding of the rules and services provided. If the expenses are found to be prohibited, these can become costly corrections.
3. Plan not primarily invested in employer securities
ERISA requires that ESOPs be designed to invest primarily in stock of the employer. If you do not meet this requirement, the DOL may be in touch after reviewing your investment in employer securities on the Schedule H, Schedule I, or Form 5500-SF.
4. Plan debt in excess of net assets available for benefits
We have seen recent DOL activity and court cases where the valuation of employer securities has been challenged. An ESOP is leveraged if it borrows funds or uses credit to acquire shares of the employer securities. (Leveraging is allowed and usually occurs during the initial plan set-up and may occur many times during the life of an ESOP.)
An ESOP’s employer securities must be valued annually, at minimum, for annual plan and participant reporting. Sponsors of ESOPs should engage an outside independent valuation professional to best determine the market value. At the time of the initial transaction (and subsequent transactions), market value of employer securities may be less than the outstanding debt of the ESOP, causing plan debt to be in excess of net assets available for benefits. This deficit would be reported on Schedule H, Schedule I, or the Form 5500-SF, and may be a red flag to the DOL that your plan (and its participants) paid more the fair market value for the securities when transacted.
5. No employer contributions reported for consecutive plan years
While employee and/or employer contributions generally comprise defined contributions every plan year, employer-only contributions generally comprise ESOPs. If your organization has not contributed to your plan for several years, it may suggest that your organization is experiencing difficulty and may not be able to pay accrued benefits, and may run into repurchase obligation concerns.
6. Insufficient answers to compliance-related questions
On the Schedule H, Schedule I, or Form 5500-SF, there is a series of compliance questions that ESOP sponsors must complete and file regarding: 1) plan loans that would default, 2) nonexempt transactions with a party-in-interest, 3) reporting employer securities that may not be valued by an independent third party appraiser, 4) reporting plan transactions or a series of transactions in excess of five percent of current value of assets, and 5) failure to provide any benefit due under the plan. Pay close attention to these compliance questions, because this is where the DOL looks for signs of noncompliance.
7. No filing, delinquent filing, or incomplete filing
Plan sponsors must file the Form 5500 series within seven months following each plan year. Your organization may request an extension for an additional 2.5 months to file. Filing for an extension does not trigger a red flag; however, not filing, delinquent filing, or an incomplete filing could mean a lack of plan controls, oversight, or governance for your ESOP, and could potentially cost you significant penalties and interest.
Pull together a risk management plan
A risk management plan can help you meet your fiduciary duty and help mitigate risks and red flags. Your risk management plan should include the following key items to maintain annual reporting and compliance:
- Proper oversight and governance (including consideration of using an external trustee)
- Strong management team that is involved in the ESOP industry and that has proper education related to benefit plans
- Proper internal controls to ensure plan activity is handled in accordance with plan provisions and DOL and IRS regulations
- Maintaining proper documentation to support ESOP activity and corporate decisions (especially related to valuation of employer securities, annual contributions, and any ESOP transactions)
How we can help
ESOPs come with a lot of advantages — but only when your organization is fully compliant. CLA’s employee benefit team works with ESOPs year round and has a deep understanding of the required compliance and reporting. We can help you identify areas of concern, develop a risk management plan, and appraise ESOP-owned stock so that you can focus on your business and not DOL red flags.