include a number of special features:
Leveraging—An ESOP is permitted to borrow money from a related party or guaranteed by a related party without creating a prohibited transaction, as long as the applicable ERISA rules are met.5
This leveraging does not trigger unrelated business income.6
The contribution made to an ESOP of a C corporation can exceed the normal deduction limits. The annual addition limit may be measured by the lesser of the employer contribution or the fair market value of the shares released.
There are many tax incentives, which impose restrictions on the ESOP’s allocation of benefits within the trust. These restrictions are required to be included in the plan terms.
ESOPs are not permitted to be integrated with Social Security.
ESOPs cannot be tested for nondiscrimination using the various “safe harbors” that may be available to more traditional plans.
ESOPs holding nontraded stock are required to have an annual appraisal of any stock acquired after December 31, 1986. For this purpose, with some exceptions, “nontraded stock” includes any shares not listed on a Securities Exchange registered under Section 6 of the Securities Exchange Act of 1934. This position was formally issued by the IRS in 2011 and is generally effective for plan years beginning on or after January 1, 2012. It means that shares that actively traded on the Over-the-Counter Bulletin Board (OTCBB) or through “pink slips” will still need an appraisal.7
The rules for operating an ESOP may vary between ESOPs of S Corporations and those sponsored by C Corporations.
In other words, these are complex plans and the auditor is likely going to have to spend more than average time reading the plan document and becoming familiar with the plan’s operations.
Money purchase pension plans
All of the plans described previously are discretionary defined contribution plans.The employer may establish a contribution commitment in a discretionary plan, but the law does not require one. In contrast, active money Purchase Pension plans require an annual contribution. They are also subject to the joint and survivor annuity rules, discussed in the following sections. Historically, such plans were popular because they were necessary when the employer wished to contribute up to 25 percent of pay. That is no longer the case and, as a result, money purchase plans have declined in popularity.
One form of money purchase plan persists. This is the target benefit plan. It is a hybrid plan that combines features of a defined benefit and a defined contribution plan. It is classified as a defined contribution plan, because participant account balances are maintained. However, the amount of the contribution for each participant is based upon an actuarial formula that takes into account the participant’s age, compensation, and benefit formula. A typical formula is to target a specific percentage of pay as a retirement benefit. The current year’s contribution for that participant would be calculated based upon the amount required to be deposited each year to purchase an annuity at normal retirement age of that targeted percentage of pay. But, there is no promise that the employee will actually accumulate that targeted amount and no requirement that annuity contracts be purchased. The employee bears the gains and losses of investment performance. At retirement age, their balance may fund more or less than that targeted amount.
Defined benefit plans
Traditional defined benefit plans
The press would have you believe that the traditional defined benefit plan is dead. However, many such plans remain and they are among the most complex for the plan auditor to address. Part of the complexity is associated with the nature of the arrangement. Auditing a defined contribution plan is a lot like auditing a bunch of investment accounts. When auditing a defined benefit plan, the auditor has to deal with actuarial concepts and benefits that have accrued over decades. Further, most of the defined benefit plans surviving today are the result of numerous mergers. Thus, a single benefit plan may have multiple layers of benefit accruals under different plan formulas. Finally, because plan assets must be managed to fund these predetermined benefit levels, the investment portfolios frequently include complex financial instruments.
Traditional defined benefit plans build up a promise of a future lifetime benefit to a participant and his or her beneficiary based upon the plan’s benefit accrual formula. Three basic features—the benefit formula, the accrual method, and vesting—affect that future benefit. Vesting is a concept that is common to all plans and will be discussed later, but the other two concepts are unique to defined benefit plans:
Benefit formulas. Defined benefit plans may calculate future benefits based upona simple percentage of pay, say 40 percent;an annual approach, say 1 percent of pay for each year of service;a flat approach, say $1,000 per month at normal retirement age; orthey may combine the last two methods, say $100 per month per year of service. The definition of “pay” for this purpose may be based upon each year’s eligible pay, an average of pay over a career or an average of pay over some period of time. For example, a common defined benefit plan formula would be 40 percent of final average pay based upon the last five years of employment. These formulas may also be combined with Social Security.
Accrual of benefits. In addition to the formula defining benefits, a defined benefit plan will provide a system for employees to accrue these future benefits. Benefits may accrue over an employee’s working career, a fixed number of years or some other method that is defined in the plan document.
Help desk. The way these rules function together is easiest to understand for a simple percentage of pay plan. Assume the plan promises 30 percent of pay at normal retirement age and accrues benefits ratably over 25 years. If John Smith works for 10 years before quitting, he will be fully vested in his benefit, but rather than receiving 30 percent of pay at normal retirement age, his accrued benefit is only 12 percent of pay. That is 10 years of service, divided by 25 required years of service or 40 percent accrued times the 30 percent of pay benefit equals 12 percent of pay.
10 years/25 years required = 10/25 = .4 × 30% = 12%
The calculation of benefits is not the only complexity of defined benefit plans. Funding is based upon actuarial calculations. Fully insured plans—”412(i) plans”—do not require an actuary.
Distributions are required to be made as an annuity, unless the participant elects another form. Spousal consent is required for all preretirement distributions.
These arrangements are generally subject to the jurisdiction of the Pension Benefit Guaranty Corporation (PBGC), which insures a base level of the plan’s benefits. The termination and certain amendments of the plan typically require a notice to and, possibly, the approval of the PBGC before they can be effective. Employees are to be notified in advance of plan amendments, which will reduce future benefit accruals.
As if this was not complicated enough, the Pension Protection Act of 2006 created a concept governing the operation of the defined benefit plan. This is the adjusted funding target attainment percentage, or AFTAP. To the extent that the AFTAP falls below specified levels, limitations or restrictions are imposed upon
benefit increases,
