Lesson 2 of Retirement Planning: Pension Plans and Profit Sharing Plans Flashcards

Question

Actuary

Answer 1

Defined benefit plans require the use of annual actuarial services to determine the proper funding of the plan. - Use of an actuary allows for some limited discrimination in benefit. - Actuarial costs can drive up the administrative costs of a plan. The **target benefit pension plan, a defined contribution plan, uses actuarial assumptions** only at the inception of the plan and does not require annual actuarial work. The **money purchase pension plan has no need for actuarial services** because the annual contribution is predefined in the plan documents.

Answer 2

**Defined benefit pension plans use commingled investment accounts** but send individual summaries to participants showing what benefits they have accrued to a certain date. Most **defined contribution plans,** including target benefit and money purchase pension plans, **use separate, individual accounts** and require that the individual participant invest in his own retirement asset.

Answer 3

In a **defined benefit plan**, the plan sponsor bears the investment risk. In a **defined contribution plan**, the individual plan participant generally maintains their own account and bears the risk of investment.

Answer 4

For a defined benefit pension plan, the forfeited funds can only be used to reduce future plan costs for the **employer**. The **plan sponsor** of a defined contribution pension plan, however, can choose to utilize plan forfeitures one of two ways, **either to reduce future plan costs or the forfeitures can be allocated to other remaining participants in a nondiscriminatory manner.**

Answer 5

If Antoine terminates employment today, the $1,200 of nonvested assets in the defined benefit plan will be used to offset future plan costs. ( $6,000 - $4,800 )= $1,200

Answer 6

The plan sponsors of **defined benefit** pensions plans pay premiums for insurance coverage designed to pay the **"promised pension"** in the event the plan is underfunded or unfunded. The PBGC pays only a limited retirement benefit (**$6,750 per month or $81,000 per year (2023)**) in the event of a plan completely or partially terminating with an **unfunded or underfunded liability.** **The PBGC does NOT insure defined contribution pension or profit sharing plans,** AND it does not insure **defined benefit pension plans of professional service corporations with 25 or fewer participants.** The PBGC does insure that all other defined benefit plans and covered plans are required to **pay a flat-rate, per participant premium.**

Answer 7

A participant in a defined benefit plan has an accrued benefit roughly equal to the present value of the expected future payments at retirement discussed further below). Accrued Benefit Account Balance

Answer 8

A defined benefit plan is subject to the mandatory funding requirement as calculated by an actuary. An employee who terminates participation in the plan, usually through termination of employment before full retirement age, will be entitled to a benefit payable from the plan equal to the retirement benefit earned to date. **This benefit is the actuarial equivalent of the benefit that would have been provided to the participant had the participant waited until retirement to receive the payments.** In contrast, a participant in a defined contribution plan has an **accrued benefit equal to the account balance of the qualified plan consisting of any combination of employer and employee contributions plus the earnings on the respective contributions reduced by any nonvested amounts.**

Answer 9

The benefit in a defined contribution plan is simply the participant's **account balance reduced by any non-vested amounts**. The participants account balance is the sum of the **employer contributions to the plan and the employee contributions to the plan plus or minus any investment earnings or losses.**

Answer 10

An employer who establishes a defined benefit plan **may elect to give employees credit for their service prior to the establishment of the plan.** This means that an employee will receive "accrued benefits" in a DB plan based on his service prior to the start of the DB plan. Granting credit for prior service must be nondiscrminatory, but may **benefit an older owner-employer** who does not have many long-term employees. A **defined contribution plan cannot** grant credit tor prior service

Answer 11

Seth started Snazzy Stereos 12 vears ago. His company is finally profitable, and he would like to establish a defined benefit plan to benefit himself and his employees. The plan will provide the employees with a benefit equal to 1.5 percent x years of service x final salary. If Seth elects when he establishes the plan to give credit for prior service, immediately Seth 's benefit would be based on 12 years of service; however, the plan must then count prior years of service for all employees. Alternatively, Seth could choose not to count prior years of service in the calculatior of the benefit, but then his benefit would only be calculated on years of service after the estab- lishment of the defined benefit plan

Answer 12

**Permitted disparity (often referred to as Social Security Integration)** allows a *higher contribution or allocation of benefits to employees whose compensation exceeds the Social Security wage base for the plan year*- a sort of "reverse discrimination." All qualified pension plans may utilize permitted disparity (Social Security integration) as a method of allocating benefits to plan participants. **Permitted disparity allows the qualified plan to consider the Social Security benefits** that will be provided to plan participants in the calculation of the participant accrual of benefit or contribution amount. Integration was designed to resolve this conflict. There are two methods of permitted disparity: - 1) the excess method and - 2) the offset method. - Defined benefit plans can use either method. Defined contribution plans are only permitted to utilize the excess method.

Answer 13

The excess method provides an increased percentage benefit, referred to as the excess benefit, to those plan participants whose **earnings are in excess of an average of the Social Security bases** over the 35-year period pror to the individual's Social Security Retirement Age. **This wage average is called the covered compensation limit.** The increased percentage benefit only applies to income that exceeds the covered compensation limit and is limited to the lesser of: - (1) 0.75 percent per year of service or - (2) the benefit percentage for earnings below the covered compensation limit per year of service. **This additional benefit only applies up to 35 years.** Therefore, the maximum increase In benefits for compensation over the covered compensation limit is **26.25 percent**, which is found by multiplying 0.75 percent by 35 years | The 2nd or for less than, meaning?

Answer 14

Maggie is a participant of Dress Depot's defined benefit pension plan, earns $150,000 per year, and has been employed with Dress Depot for 30 years. The base funding formula for Dress Depot's defined benefit plan is one percent per year of service multiplied by final salary. Under this formula, Maggie would have a benefit equal to $45,000 (1% x30 x$150,000). In addition, Dress Depot also provides an additional benefit of 0.75 percent per year of service for income that exceeds the covered compensation limit. Assuming that the covered compensation limit is $100,000, Maggie would be entitled to an additional benefit of $11,250 (0.75% x30* 550,000). (150,000 - 100,000) Therefore, by integrating the plan with Social Security, Maggie receives $11,250 more during retirement than she would have received if the plan had not been integrated. Note: the $100,000 in this problem is an assumed covered compensation limit, which represents the annual covered compensation limit over a 35-year period.

Answer 15

To provide an increased benefit to those individuals whose earnings are in excess of the covered compensation limit, the **offset method applies a benefit formula to all earnings and then reduces the benefit on earnings below the covered compensation limit.** The reduction of the benefit is limited to the lesser of: - (1) 0.75 percent per year of service up to 35 years or - (2) 50 percent of the overall benefit funding percentage per year of service. As with the excess method, the total reduction is limited to 26.25 percent of the earnings below the 35 year covered compensation limit. | The 2nd or for less than?

Answer 16

In this case, Maggie would receive a benefit equal to $56,250 [(1.75% x 30 x $150,000) - (0.75% x 30 × $100,000)]. The above examples were designed to illustrate that the same outcome could be reached whether you followed the excess benefit method or the offset method. The important concept, however, is that **defined benefit plans can be structured in such a way as to provide higher benefits to those employees who have compensation above the 35 year covered compensation limit.**

Answer 17

A defined benefit plan does not maintain separate accounts for each participant, although each participant is entitled to a calculated accrued benefit. The assets of a defined benefit plan are managed as a group, and it is impossible to segregate any individual participant's funds. Benefits are paid from the pool of assets.

Answer 18

A defined benefit plan is generally considered to benefit older participants because at the creation of the plan, the largest percentage of the overall contribution to the plan will be attributable to the older participant(s). In addition, defined benefit plans can consider prior service.

Answer 19

**Defined benefit plans** follow the eligibility, coverage (including the extra 50/40 test), and vesting rules as described in the previous section.

Answer 20

Establishing the Formulas for Benefits: - To determine the retirement benefit provided under a defined benefit plan, the plan's funding and allocation formula must be established. The most common benefit formulas are: - (1) the flat amount formula, - (2) the flat percentage formula, and - (3) the unit credit formula

Answer 21

The flat amount formula provides an amount that each plan participant will receive at retirement, such as $250 per month. The formula is not based on years participant's salary. **From the highest paid participant to the lowest paid plan participant, each participant will receive the same amount at retirement.**

Answer 22

The flat percentage formula provides all plan participants with a benefit **equal to a specific percentage** of the participant's salary, - **usually the final salary or an average of the participant's highest salaries.** The percentage remains the same throughout participation in the plan and **does not increase based on additional years of service or age.**

Answer 23

The unit credit formula utilizes both a participant's years of service and salary to determine the participants accrued benefit. Unit credit formulas provide a fixed percentage of a participant's salary multiplied by the number of years (the unit) the participant has been employed by the employer. **The salary may be average of the final three years, highest average three years or some iteration of that the employer chooses. ** The multiplier is chosen by the plan sponsor and is typically between 1 and 2 percent

Answer 24

Answer? D All of the above are benefit formulas used by defined benefit plans.

Answer 25

What Are They, Cateogirzed as, More Info? Contributions and Earnings Quasi-Seperate Accounts Younger/Older Eligibility/Coverage/Vesting Conversions to a Cash Balance Plan

Answer 26

A cash balance plan is a **defined benefit pension plan** that shares many of the characteristics of *defined contribution plans* BUT provides specific defined retirement benefits. From the participant's perspective, a cash balance plan is a qualified plan that consists of an individual account with guaranteed earnings attributable to the account balance. HOWEVER, the account that the employee sees is merely a hypothetical account displaying **hypothetical allocations and hypothetical earnings.** Because the cash balance pension plan is a defined benefit pension plan, it is **subject to all of the requirements of defined benefit plans and pension plans.**

Answer 27

When a cash balance pension plan is established, the plan sponsor develops a formula to fund the cash balance hypothetical allocation. This formula consists of a Pay Credit and an Interest Credit. The pay credit may be integrated with Social Security to produce a higher benefit percentage to those participants who earn a salary above the Social Security wage base or may be based on a combination of age and years of service - **thus rewarding participants for longer service.** The plan sponsor is responsible for the investment performance of the plan's assets and earnings. The benefit, which is a guaranteed return and is determined under the plan document, will be payable to the participant at retirement regardless of the plan's true earnings, whether greater than or less than the benefit provided by the plan formula. Therefore a cash balance formula might be structured as follows: - 5% pay credit with a guaranteed interest credit of 2%. - Each year, a hypothetical contribution of 5% of salary is contributed to the plan and the balance earns a guaranteed 2% rate of return.

Answer 28

A cash balance pension plan **does not have separate accounts for each participant** even though the plan participant receives a statement detailing a separate account in his name. A cash balance pension plan consists of a **commingled** account that has a value equal to the actuarial equivalent of the present value of the expected future benefits that will be paid from the cash balance pension plan to the participants (the promised contribution and earnings).

Answer 29

A cash balance pension plan is generally more beneficial for **younger** participants because the formula is generally based on the number of years the participant is employed by the plan sponsor with a guaranteed rate of return. Younger participants have more years of contributions and earnings than older participants.

Answer 30

The cash balance pension plan follows the rules and requirements for eligibility, coverage, and vesting previously described. Remember that a Cash Balance Plan uses **3 year cliff vesting.**

Answer 31

A cash balance "conversion" occurs when an employer changes from a traditional defined benefit pension plan into a cash balance plan. Under the PPA 2006, a hybrid plan must meet three main requirements. - The first requirement is that a participant's accrued benefit, as determined as of any date under the terms of the plan, would be equal to or greater than that of any similarly situated, younger participant. For this purpose, an individual is similarly situated to a participant if the individual and the participant are (and always have been) identical in every respect (including period of service, compensation, position, date of hire, work history, and any other respect) except for age. - The second requirement is that the **interest rate** used to determine the interest credit on the account balance in the hybrid plan must **NOT** be **greater than a market rate** of return, to be determined under regulations to be issued. - The third requirement is that for plan years beginning after 2007, the hybrid plan must provide **100 percent vesting after three years** of service. The PA 2006 also addresses the "whipsaw effect" by providing that the distribution of a participant's hypothetical cash balance account is sufficient to satisfy his or her benefit entitlement from distributions after the date of enactment. Thus, employers are no longer penalized for using a higher interest credit.

Answer 32

Cash Balance plans are a popular choice to get rid of old expensive DB plans.

Answer 33

Answer: C A basic component of a cash balance plan is the guaranteed minimum investment return.

Answer 34

Why are they, defined as, more information? Contribution Limit Seperate Accounts Younger/Older Impact on the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001) Eligibility/Coverage/Vesting

Answer 35

A money purchase pension plan is a **defined contribution pension plan** that provides for a contribution to the plan each year of a **fixed percentage of the employees' compensation.**. Specifically, the employer promises to make a specified contribution to the plan for each plan year, but the **employer is not required to guarantee a specific retirement benefit.**

Answer 36

An employer cannot deduct contributions to the plan in excess of 25 percent of the employer's total covered compensation paid. Defined contribution plans are limited to contributing, on behalf of each participant, the lesser of 100 percent of the participant's compensation or $66,000 for 2023 to the plan.

Answer 37

Contribution to a money purchase plan are made to a separate account on behalf of each participant.

Answer 38

A money purchase pension plan, like all defined contribution plans, **benefits younger participants** more than older participants because of the increased number of contributions and compounding periods.

Answer 39

EGTRRA 2001 increased the contribution limit for profit sharing plans to 25 percent (from 15 percent) putting defined contribution pension and profit sharing plans on "equal contribution levels" - Since profit sharing plans do not require mandatory funding (more flexible), this law virtually ends the creation of new money purchase pension plans.

Answer 40

The money purchase pension plan is subject to all of the eligibility, coverage, and vesting rules applicable to **defined contribution pension plans** described previously. As defined contribution plans, they are subject to the **shorter vesting requirements** established under PA 2006 (2-to-6 year graduated or 3-year cliff vesting schedule).

Answer 41

Answer: A Employers generally contribute to money purchase pension plans, ESOPs, and profit sharing plans. Employees contribute (thus contributory plans) to 401(k)s and thrift plans.

Answer 42

A special type of money purchase pension plan, known as a target benefit pension plan, determines the contribution to the participant's account based on the **benefit that will be paid from the plan at the participant's retirement.** The plan formula may be written to provide a contribution to each participant during the plan year that is actuarially equivalent to the present value of the benefit at the participant's retirement. This will provide a greater contribution for **older participants.** An actuary is required at the establishment of the target benefit pension plan, but unlike a defined benefit plan or a cash balance pension plan, **an actuary is not required on an annual basis.** This plan does not fund the plan with the amount necessary to attain the target at retirement rather the employer promises a contribution to the participant's individual account based on the original actuarial assumptions. Once the contribution has been made, the **participant is responsible for choosing investments.** Like any defined contribution plan, the participant, at retirement, is entitled to the plan balance regardless of its value, be it greater than or less than the intended target benefit. The target benefit pension plan is a form of money purchase pension plan; consequently, the target benefit pension plan is subject to all of the same contribution, eligibility, coverage, vesting, and distribution limitations as the money purchase pension plan. Like the money purchase pension plans, EGTRRA2001 has generally eliminated their usefulness. Instead, employers are establishing age-weighted profit sharing plans so that the **contributions to the plan each year are discretionary rather than mandatory but still favor older employees.**

Answer 43

A profit sharing plan is a plan e**stablished and maintained by an employer** to provide the participation in profits **by employees or their beneficiaries.**

Answer 44

- Profit Sharing Plans - Stock Bonus Plans - Employee Stock Ownership Plans - 401(k) Plans aka CODA - Thrift Plans - Age-Based Profit Sharing Plans - New Comparability Plans

Answer 45

There is no mandatory funding of a profit sharing plan. Contributions to profit sharing plans are generally discretionary but funding must be *"substantial and recuring."* There is no requirement that a company must contribute to the plan in a year in which it has profits nor is there a prohibition against contributions to the plan in years in which the company does not have profits. Profit sharing plans generally have an employer plan contribution limit of 25 percent of covered compensation. Profit sharing plans can be established and funded as late as the federal income tax due date plus extensions. - October 15th for sole proprietors or - September 15th for all entities of the following year if all extension have been filed.

Answer 46

A profit sharing plan must provide a definite predetermined formula for allocating plan contributions to employee's accounts. Different Kinds are: - Standard Method of Allocating - Permitted Disparity (Social Security Integration) - Age Based Profit Sharing Plans - New Comparability Plans - Other Allocation Methods - Forfeitures

Answer 47

The standard method of allocating contributions to a profit sharing plan is to simply allocate the contribution based on a percentage of each employee's compensation. Typically this type of formula **benefits the highly compensated more than the nonhighly compensated** in terms of absolute dollars but is **nondiscriminatory with regard to percentages** of the total contribution because the contributions are based on a straight percentage of total covered compensation.

Answer 48

Permitted disparity. as previously discussed in the Pension Plan section. is a technique or method of allocating plan contributions to employees accounts so that a higher contribution will be made for those employees whose compensation is in excess or the social secunty wage base. Profit sharing plans only allow the excess method to be used. Basically two profit Sharing plan contribution rates are established. the base contubution percentage rate and the excess contribution percentage rate. - The base rate is applied on income earned up to the integration level (usually the Social Security wage base), while the excess rate is applied to income earned above the integration level BUT only up to the maximum covered compensation limit for the year, $330,000 for 2023 - The excess rate is limited to the LESSER of twice the base rate or a difference of 5.7 percent. As a result, the excess rate is generally 5.7 percent higher than the base rate. | EXAM TIP: Know the Basics Here

Answer 49

Know that the excess rate is generally 5.7% higher than the base rate.

Answer 50

Base Rate + Permitted Disparity = Excess Rate. so "BP = Exxon" where Permitted Disparity equals the lesser of the Base Rate or 5.7%

Answer 51

Age-based profit sharing plans use both **age and compensation** as the basis for allocating contributions to an employee's account. An age-based plan is chosen when the employee census is such that the **owner or key employee is older than most or all other employees** and the company wants to tilt the contribution toward those older employees Use of an actuary would allow for this "tilting" of contributions.

Answer 52

A new comparability plan is generally a profit sharing plan in which **contributions are made to an employee's account based on their respective classification** in the company as defined by the plan sponsor (employer). To meet the nondiscrimination rules, new comparability plans, like age-based profit sharing plans, must comply with the cross-testing rules. - Cross-testing rules dictate testing of defined contribution plans on the expected benefits to be received by employees at retirement. These plans are more expensive to administer.

Answer 53

A highly compensated owner **can fund his plan with the annual additions limit, $66,000** for 2023, using profit sharing plans with or without a cash or deferred arrangement. In many cases, the use of a Cash Or Deferred Arrangement (CODA) may enable an owner to reach the maximum contribution limit of $66,000 (2023) with **a lower total employer contribution.**

Answer 54

Forfeitures for a profit sharing plan may either **be used to reduce plan contributions** or be **reallocated to the remaining participants accounts.** An such reallocation of the forfeiture amounts, however, must not be discriminatory in favor of highly compensated employees, owners, or officers. Forfeitures can be allocated based on current year compensation - the same as normal contributions to the plan. - **Forfeitures cannot be reallocated to participants' accounts that have already reached their annual additions limit for the year.** A forfeiture policy of reallocation can be **combined with integration or an age-based approach** to assist the owner in receiving the maximum contribution allowed.

Answer 55

Profit sharing plans are subject to standard eligibility rules of other qualified plans.

Answer 56

The vesting rules for profit sharing plans are the same as for defined contribution plans. The standard **3-year cliff or a 2-to-6 year** graduated vesting apply unless the plan requires a **two-year eligibility/waiting period**, in which case all contributions must then be 100 percent vested.

Answer 57

Answer: A As a result of the PPA 2006, qualified profit sharing plans must use a vesting schedule that provides participants with vested benefits at least as rapidly as either a 2-to-6 year graduated vesting schedule or a 3-year cliff vesting schedule. This requirement applies without regard to whether the profit sharing plan is a top-heavy plan. Options B, C, and D all vest less rapidly than the required schedule.

Answer 58

Generally, profit sharing plans do not permit employees to receive distributions from the plan **except** upon termination, hardship, disability, or retirement. Profit sharing plans, however, may permit in service withdrawals after the participant has fulfilled **two years** of service in the plan.

Answer 59

A Cash Or Deferred Arrangement (CODA), generally referred to as a 401(k) plan, is a **feature that attaches to certain types of qualified plans to create a contributory component.** - Specifically, a CODA is permitted with **profit sharing plans and stock bonus plans.** - The CODA permits employees to **defer** a portion of their salary on a pretax basis to the qualified plan, **thereby reducing their current income tax liability.** - These employee elective deferral contributions are tax - deferred - meaning the earnings are not subject to income taxation until such time as the employee takes a **distribution from the plan.**

Answer 60

Which entities may establish a 401(k) plan? - Only certain types of entities are permitted to establish and sponsor a 401(k) plan. - A 401(k) plan is typically a profit sharing plan (although it may be arranged as a stock bonus plan) that permits employees to make contributions from their salary to the plan on a pretax or Roth basis. - Because of its qualified status, 401(k) plans must comply with the rules previously discussed regarding eligibility, coverage, nondiscnmination, vesting, etc. HOWEVER, there are some restrictions that come with the addition of a 401(k) as provided below.

Answer 61

- Corporations - Partnerships - LLCs - Proprietorships - Tax-exempt entities

Answer 62

An employee cannot be required to complete more than one year of service as a condition of participation in a Section 401(k) arrangement. The reason for this is that the employee elective deferral contributions are already 100 percent vested.

Answer 63

July 1, 20x2

Answer 64

All employee deferral contributions and the earnings on those contributions are always **100% vested.** The **employer-matching contributions, employer discretionary profit sharing contributions, and the earnings on employer contributions** must vest under a schedule at least as generous as the **2 to-6-year graduated or 3-year cliff** schedules.

Answer 65

The most popular form of election under a CODA is a **salary reduction agreement** in which the employee agrees to reduce compensation in exchange for the elective deferral contribution into the plan. ***Employee chooses Reduce compensation for elective deferral contribution.***

Answer 66

Contributions to 401(k) plans can be made as: - (1) employee elective deferral contributions (either as a traditional elective deferral or as a contribution to a Roth account), - (2) employee after-tax contributions, - (3) employer matching contributions, - (4) employer profit sharing contributions,or - (5) employer contributions used to solve an ADP/ACP problem (discussed below).

Answer 67

Employee elective deferral contributions are limited in 2023 to the following amounts: - Annual Elective Deferral Limit - $22,500 (including traditional or Roth) - Catch-Up Contribution (Age 50 or older) - $7,500 - Total Elective Deterral - $30,000 Note that the same annual deferral limits apply to SARSEPs, 403(b) plans, and 457(b) plans. Tax Impact: - Besides the mere accumulation of benefits towards retirement, funds deferred in a 401(k) plan are not currently subject to federal income tax (although payroll taxes are still paid). - Exception: Roth 401(k) and thrift plan contributions are subject to all taxes (discussed below). Catch-up contributions - Employees who are at least 50 years old during the plan year may increase their elective deferral limit by up to $7,500 for 2023. There must be sufficient earned income to make the catch-up contribution. - Catch-up contributions are not limited by plan limits, limits on annual accumulations, or by the ADP/ACP testing (discussed below).

Answer 68

Thrift plans **allow employees to make after-tax contributions**. Generally these plans are utilized by individuals who want to **save more than the elective deferral limit** or more than the amount allowed under the ADP/ACP test (discussed below).

Answer 69

A plan may permit an employee who makes elective contributions under a qualified cash or deferred arrangement to designate some or all of those contributions as Roth contributions. The **same dollar limits that apply to employee pretax deferrals** also apply to Roth contributions in total. Therefore, for 2023, an employee could contribute up to $22,500 to a Roth 401(k) account, **but not to both.**

Answer 70

(3) Matching Contributions Non-elective Contributions (4) Profit Sharing (Stock Bonus) Contributions

Answer 71

Plan sponsors often provide a matching contribution available only to those who contribute to the **401(k).** Employer matching contributions must **vest** at least as rapidly as either a three-year cliff vesting schedule or a 2-to-6 year graduated vesting schedule.

Answer 72

As an alternative, plan sponsors may elect to contribute to ALL eligible employees, whether they elect to defer or not, such contributions are called non-elective contributions.

Answer 73

Because 401(k) plans consist of a CODA attached to a profit sharing plan or stock bonus plan, employers may also make a contribution to the profit sharing (or stock bonus) plan. The employee elective deferral contributions do not count against the plan contribution limit **of 25 percent** so the employer does have the flexibility to make profit sharing plan contributions. - The annual additions limit (415(c)), however, still limits contributions to $66,000 per person for 2023 (**$73,500** if the participant is age 50 and over).

Answer 74

All qualified plans are required to meet certain nondiscrimination tests, but qualified plans with CODA provisions MUST meet two additional nondiscrimination tests. These special tests are known as the: - Actual Deferral Percentage (ADP) test - Actual Contribution Percentage (ACP) test Because of the burdensome nature of annually complying with these rules, the IRC provides a safe harbor provision that eliminates the need for annual testing. In addition, the Pension Protection Act of 2006 has provided an optional nondiscrimination safe harbor for automatic enrollment plans. Thus, after December 31, 2007, employers will have three options with respect to 401(k) nondiscrimination testing. They can: - (1) perform the ADP and ACP tests and take corrective action if the plan fails the test, - (2) institute a qualified automatic enrollment feature and comply with the new safe harbor, or - (3) comply with the old safe harbor.

Answer 75

Answer: C Both statements are correct.

Answer 76

The Actual Deferral Percentage (ADP) test is designed to test the elective deferrals of the employees to ensure that the nonhighly compensated employees are not being financially discriminated against. The goal is to either limit the Highly Compensated employees (HC) from deferring significantly more than the Non-Highly Compensated employees (NHIC) or to raise the amount being received by the NHC. IRC section 401(k)(3) states that the actual deferral percentage for **eligible highly compensated employees** for the plan year is limited by the actual deferral percentage for all other eligible employees for the preceding plan year and must meet either of the following tests: - Test 1: The actual deferral percentage for the group of eligible highly compensated employees is not more than the actual deferral percentage of all other eligible employees multiplied by 1.25 (the 1.25 requirement). - Test 2: The excess of the actual deferral percentage for the group of eligible highly compensated employees over that of all other eligible employees is not more than two percentage points, and the actual deferral percentage for the group of eligible highly compensated emplovees is not more than the actual deferral percentage of all other eligible employees multiplied by 2 (the 200%/2% test).

Answer 77

The Permissible ADP for HC Employees is: - 2 times ADP for NHCs - 2% plus ADP for NHCs - 1.25 times ADP for NHCs

Answer 78

The Prior Year Method **calculates the maximum permissible deferral** for highly compensated employees by using the nonhighly compensated employee's ADP from the previous year. While not as certain about the deferral limits, the Current Year Method will **usually provide a greater deferral percentage to the HC**. The Current Year Method also provides more flexibility to the plan sponsor in the event of ADP failures.

Answer 79

1. Separate the eligible employees into HC and NHC groups. 2. Calculate the Actual elective Deferral Ratio (ADR) for each of the eligible employees by dividing the elective deferral contribution by the employee's compensation. 3. Once the ADR is determined for each eligible employee, the amount of the ADP is calculated by averaging the ADRs for the employees within each group (HC or NHC). 4. Plug the ADP for the NHC into the chart above and calculate the maximum ADP allowed for the HC. 5. Compare the "desired/required" ADP to your actual ADP. If the HC are higher, employer failed the ADP Test. | EXAM TIP: You must be able to do at least 4 & 5.

Answer 80

Failing the ADP or ACP test puts the plan at risk for disqualification. Corrective action must be taken and the plan sponsor has several options to choose from or to use in conjunction with the other. The four alternative remedies available to bring the plan into compliance are: - (1) corrective distributions, - (2) recharacterization, - (3) qualified non-elective contributions (QNEC), or - (4) qualified matching contributions (QMC).

Answer 81

**Following Alternative A** (without the top 20 percent election), the ADP of the HCs is 7.5 percent, while the ADP for the NHCs is 4. 5 percent. Referring to the table above, with the NHCs ADP equal to 4.5 percent, the ADP for the HCs should be no greater than 6.5 percent - two percentage points more than the ADP for the NHCs. Therefore, the plan fails the ADP test. **Following Alternative B** (with the top 20 percent election), the ADP of the Hs is 6.25 percent, while the ADP for the NHC employees is 5.19 percent. Based on these figures, the plan complies with the ADP test because the HC could defer as much as 7.19% (5.19 + 2) but are only deferring 6.25%. Notice that in this example, the difference between passing the ADP and not passing is how the plan defined the definition of highly compensated. By electing the top 20 percent of paid employees, Employee C shifted from the HC category to the NHC category. This example illustrates one reason an employer might choose the 20 percent election as the definition of highly compensated.

Answer 82

Answer: B Jeff is highly compensated because he is more than a five percent owner, so the maximum that he can defer to satisfy the ADP test requirements is 5.5 percent (3 .5% + 2%) and because he is over 50, he can defer the additional $7,500 (2023) as a catch-up contribution. Jeff can defer $5.500 (5.5% x $100,000) and $7,500 (the catch-up) for a total of $13,000.

Answer 83

When a plan fails the ADP test, the easiest (and usually cheapest) solution is to reduce the elective deferrals of the HCs by **distributing or returning funds to the HCs.** This distribution is referred to as a corrective distribution. Corrective distributions must be completed within **2½ months** after the end of the plan year; otherwise, a **10 percent excise tax** is imposed on the amount that should have been distributed. In addition to the excess contributions being returned to the HC employees, **any earnings on those contributions** must also be returned or distributed to the HC employees.

Answer 84

Another solution available to the plan sponsor is to recharacterize the **excess deferrals (pretax) as after-tax employee contributions.** Recharacterization must be completed **within 2½ months after the end of the plan year**, at which time these recharacterized contributions are taxable to the employee. If the excess contributions are not recharacterized within 2.5 months of the plan year end, then the employer is subiect to **a 10 percent excise tax** (penalty) on the amount of excess contributions (the amount that should have been recharacterized). Recharacterization of the pretax contributions to after-tax contributions may cause a problem for the plan's ACP test (see below).

Answer 85

An employer may choose to make a qualified non-elective contribution (QNEC) to all eligible NHC employees CODA accounts to** increase the ADP of the NHC employees** for purposes of passing the ADP test. The QNEC is made by the employer to all eligible NHC employee covered by the plan. No consideration is given to the employee's election to participate by electively deferring. QNEC's are considered to be elective deferrals made by the employee for purposes of the discrimination testing. Because the contribution is treated as an employee elective deferral, it is also **100 percent vested** when contributed.

Answer 86

The ADP of the HC employees is six percent and the ADP of the NHC is 3.75%. To pass the ADP test, the NH employees must have an ADP at least equal to 4%. To increase the ADP of the NHC, the plan sponsor may elect to make a QNEC to all eligible employees that will increase the ADP of the NHC to 4%, The amount of QNEC contributions made will be considered 100% vested in the NHC employees.

Answer 87

A Qualified Matching Contribution (QMC), like a QNEC, is a contribution made by the plan sponsor that increases the ADP of the NHC employees. Unlike the QNEC, however, the QMC is only made to those eligible NHC employees who **participated in the plan during the plan year.** Essentially, the QMC is also treated as an additional deferral by the employees to increase the deferral percentage of the NHC's and, as such, it is **immediately vested**

Answer 88

The ADP of the NHC employees was 6% for the plan year, and the ADP of the HC employees was 8.20% for the year. To pass the ADP nondiscrimination test, the plan sponsor could make a QMC to all NHC employees who had elected to defer during the plan year to increase the ADP of the NHC to 6.20%. Those employees who had not deferred during the year would not receive any QMC. The QMC is 100% vested in the employee.

Answer 89

The ACP test calculates a contribution percentage for both the HC and the NHC for the express purpose of determining if the NHC are subject to financial discrimination. The ACP **tests the sum of the employee's after-tax contributions and employer-matching contributions.** The ACP is calculated exactly the same way as the ADP testl After calculating the ACP for both NHC employees and HC employees, should the employer fail the ACP test, the same corrective measures may be used to bring the plan back into compliance.

Answer 90

Safe Harbor Provision + Elections Can be Made Minimum Contribution Must be 100% Vested 100% Match for Safe Harbor 401(k) Automatic Enrollment Safe Harbor 401(k) Plans - Pension Protection Act of 2006 - To Satisy the Automatic Deferral Requirement

Answer 91

The IRC provides a safe harbor provision whereby the **employer is not required to comply with the ADP test, the ACP test, or the top-heavy testing.** For plan years beginning after December 31, 2019, an **election can be made at least 30 days prior to the close of the plan year** to convert a 401(k) plan to a non-elective 401(k) safe harbor status. If the elections is made to convert within 30 days of the plan year end, then: - The non-elective contribution must be at least 4% for all eligible employees. - The plan bust be amended no later than the last day for distributing excess contributions for the plan year.

Answer 92

To comply with safe harbor status, the plan must provide a **minimum contribution that must be immediately 100 percent vested.** The permissible contributions can either be a **three percent minimum non-elective contribution or a matching contribution** (discussed below). Under the non-elective contribution, all eligible employees would receive a 100 percent vested contribution equal to three percent of their compensation from the employer each year.

Answer 93

If the employer elects to use a match rather than the non-elective contribution, the standard safe harbor match formula requires the employer to match **100 percent of the first three percent of employee elective deferrals** and 50 percent of employee elective deferrals **greater than three percent and less than five percent.**

Answer 94

Answer: D Both the Safe Harbor Test and the Ratio Percentage Test are certainly passed. The plan covers 208 of the nonexcludable NHC employees which is 75.6%-greater than the 70% required to pass the Safe Harbor Test. The ratio of the NHC covered to the HC covered is 75.6% (75.6% ÷ 100%, so the plan passes the Ratio Percentage Test also. The information does not provide the average benetit percentages of the employees to determine whether the plan passes the Average Benefits Test.

Answer 95

Many safe harbor 401(k) plans provide a 100% match up to 4% of compensation in lieu of the standard match formula. The standard match is 100% on the first 3% of deferral and 50% on the next 2% of deferral. - An election must be made to become a Safe Harbor 401 (k), simply providing an employer match equal to the Safe Harbor rules does not make a plan a Sate Harbor 401(k)

Answer 96

Some 401(k) plans have an **"automatic enrollment" or "negative election**" feature. Such plans provide that elective contributions by the employee are made at a specified rate **unless the employee elects otherwise**(i.e., elects not to make contributions or to make contributions at a different rate). The employee, however, must have an effective opportunity to elect to receive taxable wages in lieu of contributions

Answer 97

After one year of service, Phil meets the eligibility requirements for the ABC company 401(k) plan. The plan provides for a negative election in which the employer will deposit five percent of participants' compensation to the 401(k) plan. If Phil earns $40,000, the plan sponsor will contribute $2.000 of her compensation to the plan unless she aftirmatively elects to increase or decrease the contabuton

Answer 98

Answer: C A negative election clause can assist a 401(k) plan in meeting the ADP test because it automatically deems that an emplovee defers a specific amount unless he elects out of the automatic deferral amount. Answers A and D do not exist and answer B is a clause commonly found in a will.

Answer 99

Under the Pension Protection Act of 2006, plans that contain a "qualified automatic enrollment feature" are eligible for a new nondiscrimination safe harbor and are treated **as meeting the ADP test and the ACP test**, and are not subject to the top-heavy rules. This safe harbor option is also known as a **Qualified Automatic Contribution Arrangement (QACA**). A qualified automatic enrollment feature must meet certain requirements with respect to: - automatic deferral; - matching or nonelective contributions; - notice to employees.

Answer 100

To satisfy the automatic deferral requirement, a qualified automatic enrollment feature must provide that, unless an employee elects otherwise, the employee is treated as making an election to make elective deferrals equal to a stated percentage of compensation not in excess of 15 percent after the first year and at least equal to: - three percent of compensation for the first year the deemed election applies to the participant, - four percent during the second year; - five percent during the third year; and - six percent during the fourth year and thereafter. - The stated percentage must be applied uniformly to all eligible employees. - Matching Contribution Requirement - A plan must provide a non-elective contribution of 3% or a matching contribution, as described below: 1. a plan generally satisfies the matching contribution requirement if, under the arrangement - ii. the employer makes a matching contribution on behalf of each nonhighly compensated employee that is equal to 100 percent of the employee's elective deferrals up to one percent of compensation and 50 percent of the employee's elective deferrals between one and six percent of compensation; and - ii, the rate of match with respect to any elective deferrals for highly compensated employees is not greater than the rate of match for nonhighly compensated employees. 2. the non-elective or matching contributions must vest no later than a two-year cliff vesting

Answer 101

Answer. A Negative elections are approved by the IRS, and they are available for both current and new employees. Negative elections do not require 100% immediate vesting. All employee contributions, however, are 100% vested.

Answer 102

Qualified plans are **permitted, but not required, to provide loans** from the plan to participants However, plan **loans must be made available to all participants** and beneficiaries on an effectively equal basis, must be limited in amount, must be paid back within a certain time period, must bear a reasonable rate of interest, must be adequately secured, and the administrator must maintain proper accounting for the loans - see Lesson 1.

Answer 103

Oualified plans may permit loans up to the lesser of: - One-half of the vested plan accrued benefit up to $50,000 (Reduce by the highest outstanding loan balance within the prior 12 months), OR (for balances of $20,000 or lower) the greater (I think Lower) of $10,000 or the vested accrued benefit. - Loans are usually associated with 401(k) and 403(b) plans. - Loans must generally be repaid within five years with an exception for loans associated with the purchase of personal residences, which must be reasonable and could be as long as 30 vears

Answer 104

Loans from qualified plans to a taxpayer residing in **$100,000** and up to the full value of their nontorteitable balance. - Loan repayment for qualified individuals taking qualified disaster loans are allowed additional repayment time. Payments due during the period beginning on the first day of the incident period, and ending on the date 180 days after the last day of the incident period may be **delayed up to one year.** - The provision is effective for disasters occurring (retroactively) on or after January 26, 2021

Answer 105

Loans from qualified plans are usually **repaid through payroll deductions** and must generally be **repaid within five years** from the date the loan commences. - The five-year repayment rule does **not apply to loans that are used for the purchase of a principal residence; **the terms on these loans are generally more flexible. **Failure** to repay the loan in accordance with the plan's term will result in the loan being treated as a **distribution** as of the date of the original loan. Loans are not only required to be repaid within a specific period of time, but are also r**equired to be repaid in a specific manner over the repayment period.** Substantially level amortization of the loan is required over the term of the loan. Impact of Loans When an Employee is Terminated: - Most plan documents require that loans be repaid upon termination of employment: however, this is not a requirement under the law. Plans may also provide a grace period for repayment. - If loans are not paid back ratably, then they violate the exception for loans and must be treated as a deemed distribution (subject to income tax and possible **10% penalty)**. Loans not repaid at termination follow the same rules in that they will be treated as a deemed distribution. - Plans may, however, provide that the outstanding loan balance reduce the amount of a direct rollover distribution. This is known as a plan offset amount, which can be subsequently rolled over to another qualified plan or IRA within the standard 60-day period. The 2017 TCJA has extended this rollover pend in certain circumstances from 60 days to the due date of the return (including extensions)

Answer 106

Answer: D Option C is incorrect. It describes "sham" repayments. Sham repayments are the reason that the rules were designed so that the $50,000 loan limit is reduced by the highest outstanding loan balance during the one-year period ending the day before the loan date. The rules also added a restriction that requires level amortization of loan repayments of principal and interest being made at least quarterly.

Answer 107

Answer: C The maximum loan is the lesser of 50% of a participant's vested account balance, or $50,000, reduced by the highest outstanding loan balance within the last 12 months. Thus, the maximum loan Jill could take would be $50,000 less $19,000, or $31,000. Diana can only borrow $50,000. Laura can borrow up to $10,000 from her 401(k) plan based on her accrued balance being under $20,000. Since Lara's outstanding loan balance is $2,000, she can borrow an additional $8,000. John will not have to repay the loan within 10 years because the loan proceeds are being used for a home purchase

Answer 108

All CODA-type plans, including 401(k) plans, provide that in addition to the normal distribution options, plan participants may take distributions for hardships. Specifically, distributions may occur after: - The retirement, death ^ or separation of service of the participant and attainment of age 55 ^ - The termination of the plan without the establishment of another plan; - Certain acquisitions of the company or company assets - The attainment of age 59½ by the participant ^; or - Certain hardships. Distributions on account of any of these items are taxable as ordinary income to the extent the participant does not have an adjusted basis in the 401(k) plan and may also be subject to a 10% penalty. ^Note: not subject to 10% penalty.

Answer 109

Distributions on account of hardship must be limited to the maximum distributable amount. The maximum distributable amount is equal to the employee's total elective deferral contributions as of the date of distribution, reduced by the amount of previous distributions of elective contributions. Effective January 1, 2020, the maximum distributable amount can also include (but is not required to), Qualified Non-elective Contributions (QNECs), Qualified Matching Contributions (QMCs) and safe harbor contributions and earnings on these amounts regardless of when contributed or earned. Hardship distributions are taxed as ordinary income and may be subject to the **10%** early withdrawal penalty. **Distributions are not subject to the 20 percent** statutory withholding requirements since hardship distributions are not eligible for rollover treatments. SECURE 2.0 Act of 2022 allows for hardship distributions from a 401(k) or 403(b) used to purchase or build a home in a federally declared disaster area can be recontributed and **treated as a rollover contribution** if the initial distribution was received between 180 was before the first day of the incident period and 30 days atter the last day of the incident period.

Answer 110

In some instances, an organization or company may wish to establish a profit shanng plan, but be unable to contribute large amounts of cash. In such an instance, both stock bonus plans and Employee Stock Ownership Plans (ESOPs) are available as **alternative qualified plans to profit sharing plans.** A stock bonus plan is a plan established and maintained by an employer to provide benefits similar to those of a profit sharing plan except that contributions to and distributions from a stock bonus plan are generally in the **form of employer stock.** An Employee Stock Ownership Plan (ESOP) is a qualified plan that invests primarily in **"qualifying employer securities"** typically shares of stock in the corporation creating the plan.

Answer 111

Stock bonus plans are defined contribution protit sharing plans that allow employers to contribute stock to a qualified plan on behalf of their employees. Generally, stock bonus plans must satisty the following requirements: - Unlike profit sharing plans, stock bonus plan participants must have pass through voting rights on employer stock held by the plan. - Participants must have the right to demand employer securities on plan distributions - Participants must have the right to demand that the employer repurchase the emplover's securities if they are not publicly traded (the put option). - Distributions must begin within one year of normal retirement age, death, or disability, or within five years for other modes of employment termination. - Distributions must be fully paid within five years of commencement of distributions

Answer 112

Similar to profit sharing plans, stock bonus plans are designed to provide benefits to both employers and to employees: * Advantages to the Employees * Advantages to the Employer * Disadvantages to the Employees * Disadvantages to the Employer

Answer 113

Employer's reduced cash outlay may encourage regular contributions. Employee's efforts mav be rewarded at retirement by increased stock value. Employee's are eligible for preferred Net Unrealized Appreciation (NUA) tax treatment on lump-sum distributions of emplover stock.

Answer 114

There is the risk associated with the non-diversified investment portfolio of employer stock.

Answer 115

The fair market value of contributions of employer stock are tax deductible to the employer which can result in decreased income tax costs for the corporation with virtually no cash outlay since the contribution is made with employer stock. The employees now share a vested interest in the success of the companv. which irrevocably binds their financial well-being to the employers.

Answer 116

One disadvantage to the employer is that the ownership and control of the corporation is diminished or "diluted" as shares are granted to the employees. With stock bonus plans, the required "repurchase option" (put option) could deplete the cash of the corporation. - A repurchase option allows a terminating employee the choice to receive the cash equivalent of the employer's stock if the stock is not readily tradeable on an established market.

Answer 117

Stock bonus plans are a particular type of profit sharing plan and share profit sharing characteristics and requirements. Like profit sharing plans they are subject to all the eligibility, coverage and vesting requirements. If a CODA provision is attached, then they must comply with the ADP/ACP testing also. There are special issues unique to stock bonus plans, which include: - Portfolio Diversification - Voting Rights - Distributions

Answer 118

Unlike profit sharing plans, stock bonus plans are usually funded with 100% percent employer stock. The Pension Protection Act of 2006 requires that stock bonus plans of publicly traded companies allow plan participants to diversify their pretax deferrals, after-tax contributions, and employer contributions that have been invested in emplover securities

Answer 119

Participants in a stock bonus plan must have pass-through voting rights on employer stock that is held by the plan on their behalf. "Pass-through" voting rights means the participant can vote the shares of stock allocated to his stock bonus plan account.

Answer 120

Stock bonus plan distributions are generally made in the form of employer stock, but the plan may provide the employee with the choice of receiving the cash equivalent. - If a cash equivalent is received, however, the deferral of income tax on the stock's appreciated value until the stock is sold is lost (the NUA benefit). Distributions of employer stock or securities from stock bonus plans are taxed depending on whether the distribution is a lump-sum distribution or an installment distribution. - If a lump-sum distribution is made, the employee is subject to ordinary **income tax in the year** of the distribution based on the securities' fair market value at the time of the contribution. - The Net Unrealized Appreciation (NUA) of the stock (i.e., the appreciation of the stock while being held in the plan) is **not taxed at the time of the distribution but rather follows the stock as deferred long-term capital gain until the stock is ultimately sold.** (See Lesson 3 for more details on NUA treatment.) On the other hand, if the distribution of the employer stock or securities is made in installments, the employee may only defer recognition of the appreciation on the stock purchased with **after-tax emplovee contributions;** everything else will be subject to ordinary income tax rates.

Answer 121

Answer: B Because Drew is taking a lump-sum distribution from a qualified plan of employer stock, he will not have to recognize the net unrealized appreciation until he disposes of the employer stock. At the time of the distribution, however, the value of the stock, as of the date of contribution to the plan, will be taxable as ordinary income. Any gain on the subsequent sale of the stock will be taxable as long-term capital gain, In this case, Drew will recognize $165,000 of ordinary income at the date of the distribution (20x1) and long-term capital gain of $235,000 ($400,000 - $165,000) at the date of sale (20x3).

Answer 122

Answer: A Sean will not be subject to ordinary income at the date the stock is sold. At the date the stock was distributed to Sean, $20,000 ($20 x1,000) would have been subject to ordinary income tax. At the date of sale, Sean would have had $0 of short-term capital gain (the gain after the date of distribution) and $20,000 of long-term capital gain (NUA of $15,000 plus LTCG of $5,000 based on the time from distribution to sale of the stock)

Answer 123

Employee Stock Ownership Plans, referred to as ESOPs, are a special form of stock bonus plans that reward employees with both ownership in the corporation and provide owners with substantial tax advantages. An ESOP is controlled through a trust. The sponsor company receives tax deductions for contributions of stock from the corporation. The ESOP then allocates the stock to separate accounts for the benefit of individual employee-participants. A key characteristic of the ESOP is that the trust may borrow money from a bank or other lender to purchase the employer stock. The corporation generally repays the loan through tax-deductible contributions to the ESOP. Both the interest and the principal repayments for the loan are income tax deductible. The ESOP can thus be "leveraged" (aka LESOP). Just like any other qualified plan, the ESOP must satisfy applicable rules of employee vesting, participation, eligibility, and coverage.

Answer 124

The establishment of ESOPs allow owners of closely held businesses to sell all or part of their interest in the corporation and defer recognition of the capital gain. **In order to qualify for nonrecognition of gain treatment, the following requirements apply**

Answer 125

The ESOP must own at least **30 percent** of the corporation's stock immediately after the sale. The seller or sellers must **reinvest the proceeds** from the sale into qualified replacement securities **within 12 months after the sale and hold such securities three years.** - Qualified replacement securities are securities in a domestic corporation, including stocks, bonds, debentures, or warrants, which receive no more than 25 percent of their income from passive investments. The qualified replacement securities can be in the form of stock in an S Corporation. The corporation that establishes the ESOP must have **no class of stock outstanding** that is tradable on an established securities market. The seller or sellers, relatives of the seller or sellers, and 25 percent shareholders in the corporation are **precluded from receiving allocations of stock acquired by the ESOP** through the rollover. The ESOP may not sell the stock acquired through the rollover transaction for **three years.** The stock sold to the ESOP must be **common or convertible preferred stock** and must have been owned by the seller for at least three years prior to the sale. NOT A REQUIREMENT: If the seller purchases and retains qualified replacement securities, there will be no taxable event.

Answer 126

Answer: A. A major advantage for an ESOP is the ability of the owner to diversify his interest in a closely held corporation. In this case, if Gordon reinvests in qualified replacement securities within 12 months of the sale to the ESOP, he will not recognize capital gain or ordinary income on the sale to the ESOP. If Gordon dies the heirs will receive the securities with an adjusted taxable basis equal to the FMV at Gordon's date of death or the alternate valuation date.

Answer 127

Advantages to the Employer Advantages to the Employees Disadvantages to the Empolyees Disadvantages to the Employer

Answer 128

From the employees' perspective, the ESOP provides them with a type of retirement vehicle as well as ownership in their employer. Provides a vehicle to acquire a business when employees may have little or no cash available to do so - job preservation. The employee-participant may also benefit from Net Unrealized Appreciation (NUA) at the time of stock distributions because of favorable capital gains rates and deferred recognition.

Answer 129

There is an inherent lack of diversification of the individual "investment' portfolio because ESOPs must invest primarily in the stock of the corporation. There is some limited relief on this, once employee reaches age 55 and 10 years of service, the emplover must offer some diversification options.

Answer 130

The shareholder is often the owner who is looking to retire. The ability to sell shares to the plan, which is a ready and available buyer with deferred income tax consequence is a HUGE benefit. Without the ESOP, there may not be a market for the privately held corporate stock. The corporation or trust is allowed to borrow money in order to provide contributions resulting in funds being provided immediately to the ESOP, while the employer repays the loan to the ESOP with tax-deductible contributions.

Answer 131

From the shareholder's perspective, ESOPs "dilute" ownership in the corporation by reducing the concentration of shares from the sellers to broaden the employees' holdings. Moreover, the repurchase option for stock (put option) that is not readily tradable can create cash flow problems and administrative concerns. Plan administration can also be costly, and the annual appraisals create significant and recurring expenses for closely held corporations. These appraisals are necessary to determine the value of the tax deduction for the employer and to determine the price that an employer or trust would pay for the repurchase of ESOP distributed shares.

Answer 132

Generally, ESOP participants have the same voting rights with their allocated shares as other shareholders, including the right to vote the shares, and the right to earn dividends.

Answer 133

Employer contributions to ESOPs are deductible by the employer just like any contribution to a qualified profit sharing plan or stock bonus plan, and are subject to the 25 percent limit of covered compensation. If the employer's stock is obtained by virtue of a loan (leveraged ESOP), however, then the employer is allowed to deduct all interest paid on the loan over and above the 25 percent deduction of total eligible payroll of the plan participants. The interest deduction is unlimited.

Answer 134

An ESOP is subject to **minimum distribution requirements.** HOWEVER, plan participants can elect to receive substantial equal periodic payments of their account balance not less than once per year after the participant separates from service. - The substantially equal periodic payments must be for a period no longer than five years, unless the participants account balance is valued at more than $1,330,000 for 2023, in which case the distribution period may be extended one year for each additional $265,000 for 2023 of account value up to a total of ten years. An distribution from an ESOP that is not a lump-sum distribution of the emplover securities will not be eligible to receive NUA treatment and will be taxed as ordinary income. These distributions may also be subjected to the 10 percent early withdrawal penalty.

Answer 135

Valuations are necessary for various reasons, which include: - When contributions are made to an employee's account, the employer must know the value of the contribution for the corporation's tax deduction purposes. - When contributions are made to an employee's account, the employee must know the value of the contribution for future NUA calculation. - If a lender lends money to leverage the ESOP, the lender must know the value of the stock to determine if and how much money to lend to the corporation. - If an employee exercises the put or repurchase option, the value of the stock must be determined. - Valuations are needed for financial statements and reports.

Answer 136

ESOPs are permitted to hold 100 percent of the corporate stock in the trust. Under the IRC, qualified participants may force diversification of their holdings if they are at least 55 years old and have completed at least 10 years of participation in the ESOP. - The qualified participant must be offered a diversification election within 90 days after the close of each plan year beginning with the year after the employee becomes qualified. - The participant may elect to diversify up to 25 percent of the account balance into one of the plan's alternate investment options. - In the final year of the 6-year election period, the cumulative diversifiable percentage is, increased to 50%.

Answer 137

Once a plan meets the distribution requirements and a participant is entitled to a distribution from the plan, the participant has the right to demand that the benefits be distributed in the form of employer securities. - If the employer securities are not readily tradable on an established market, the participant has the right to require that the employer repurchase the employer securities under a fair market valuation formula. This is referred to as a "put option" or "repurchase option." The rank-and-file employees are protected with the put option because the employee may force the corporation to "buy back" the stock at the fair market value.