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Leading Companies Online Magazine
Don’t Shoot Me, I Only Hired the Administrator
By Robert Fuller, Beyster Institure Staff
 After last month's article, which focused on creating an ESOP administration manual, a reader asked how that would apply to someone who is not actually administering the plan. They asked, "What do you have to say for those of us who are small companies who make use of a Third Party Administrator?"
Well, I have some good news and some bad news for you. The good news is that there are a number of very high quality ESOP recordkeeping firms around, and if you are with one of those, it is likely that any problems you may have with administration can and will be appropriately fixed. Note that I did not say you will not have problems. You will. The ESOP is a very complex and highly regulated vehicle that can provide extraordinary retirement benefits for some while, at the same time, playing a critical role in financing a number of important corporate transactions. It is regulated for both of those very different purposes, and it is just reality that sometimes mistakes will be made. The real test of a good administration firm is not that they never make mistakes but how they fix the mistakes they make. The best ones own their mistakes and do whatever it takes to correct them.
But that's just the good news.
The bad news is that there are two versions of plan administrator and you can only pass along one of them. The first version is the one we think of most often. The plan administrator (in lower case) is the firm or person you have designated as responsible (and/or hired) for the purpose of recordkeeping and processing the plan. For most smaller companies (most companies of any size really) that is an outside firm that has been hired for the purpose. The Plan Administrator, though, (notice the capital letters on the proper noun, please), is a bit different. The Plan Administrator is an ERISA-defined role that is the person or entity who is responsible for the accurate communication of benefits and the interpretation of the plan in all matters related to the provision of those benefits. If you read your plan document carefully, you will likely find that the Plan Administrator is defined, and usually defined as the Company - that is, you.
So, even though you may hire an outside firm to take on the lowercase duties of the plan administrator, the uppercase Plan Administrator duties probably belong to you. That means, generally, that you have a responsibility to see that the outside administrator is doing their job correctly for your circumstances. You can't really do that unless you know what is supposed to be going on at every stage of the process.
Nevertheless, the point is well taken. If you are the consumer of these administrative services, how are you to determine that they are being provided correctly? Of course, begin by hiring someone who knows what they are doing. References from other ESOP companies as well as ESOP-related associations (us, for example), are also good sources of information in helping you make the choice.
Beyond that, though, the more you know about the process, the easier it is to effectively do your uppercase job as Plan Administrator.
So, perhaps it will help if we start with a checklist of what has to happen during each cycle of ESOP administration from the beginning to the end (and please don't forget, you asked for this):
- Balance and reconcile the ESOP trust to any transactions that have occurred since the last administration cycle.
A lot of mistakes start even before the actual administration is started because someone failed to notice (or notify someone else about) distributions or transactions that occurred during the year. If you don't have an accurately balanced Trust statement as a starting point, you cannot end up with a correct product.
- Assemble the census for the current year and collect all relevant information (compensation, hours worked, status, etc.)
Often, the trick here is knowing what information is relevant. If you are an ESOP S-corporation, for example, you're going to need a lot more information about family relationships than your C-corporation brethren.
- Identify participants who have terminated and may be eligible for distribution of vested benefits and/or forfeiture of non-vested benefits.
This is going to depend to some extent on the distribution policy your plan contains, but getting a clear picture of participants with deferred vested benefits is necessary even before you start the allocation process. If you leave one terminee in the census who shouldn't be, for example, when your administrator gets done, every account will be wrong.
- Determine who will be eligible to participate in the plan, who will be eligible for an allocation of benefits (not always the same group), and update vesting calculations.
There are a number of essential (and often different) measurement factors during the administration cycle. Who gets into the plan? Which participants are eligible for an allocation of benefits? What service requirement will advance vesting and who qualifies?
- Perform discrimination/coverage tests on the participating census to be sure you are safe to continue.
You should see copies of a number of tests in your annual administration reports. Here you are looking for tests that indicate that the plan's coverage is non-discriminatory. The numbers that go with these tests are Internal Revenue Code Sections 401(a)(4) and 410(b).
- Identify the amount of the annual company contribution and, if your ESOP is leveraged, how it will be applied.
This is almost never as easy as it seems like it ought to be. If you are a leveraged ESOP, for example, you may have bank loan payments that are made through the year, and depending on how your ESOP loan transaction was structured, those may or may not equal the contribution. In addition, accounting for ESOPs (as is the case with all qualified retirement plans) is done on a modified accrual basis that allows contributions to be made and deducted for a given year if they are deposited in the ESOP trust no later than the tax filing deadline for the year (including any extensions). Often, you are deciding after year end whether contributions made after the close of the year but before the tax filing deadline apply to the current year or the last one. If you need a rule, remember, deductions follow allocations. If you mean for a contribution to be deductible for a given year, it needs to cause an allocation of benefits for the same year.
- Identify any dividends or earnings distributions that have been or are being deposited in the plan for the year in question and how they will be applied.
With the advent of the S-corporation ESOP we are seeing even more activity in the area of earnings distributions (or dividends as they are called in C-corporations). Since these additions to the trust do not count as amounts limited by either the deduction or individual allocation limits, they can be very important in fulfilling the funding objectives of your plan. It needs to be very clear, tough, which additions are contributions and which are not.
- Note and incorporate the updated valuation of shares.
In most cases, the last piece of the administration puzzle that becomes available is the annual valuation. It is necessary, though, to complete many of the steps to administration, so the earlier you can arrange for it to be completed and the more of the administration work you can do while it is in process, the better.
- For a leveraged ESOP, perform calculations of released shares and update trust reconciliation.
Just be sure your administrator is using the right formula and that the calculation includes all the amounts that you are planning to deduct or pay as dividends for the year. You should see a detailed report on the process that was employed to compute the release of shares and shares should move from the suspense account to the allocated shares (participants' equity) accounts.
- Allocate the company contribution, dividends and forfeitures to participants' accounts on a preliminary basis.
If you are working with one of the many excellent administration firms around today, you may not see this step at all, but believe that it is being done. The tests that follow in number 11 below are difficult and cannot be done at all until after the allocations are complete. ESOP administration is an iterative process.
- Perform the battery of required limitations, top-heavy, and other special tests that may apply (1/3 test, 1042 exclusions, "deemed owned shares" issues, etc.).
Completely understanding these is probably beyond the amount of time you are willing to invest in learning about your plan, but you should see calculations and reports that all relevant tests have been performed and passed.
- Adjust allocations as necessary and finalize.
Where tests are not passed for some reason, adjustments must be made in allocations to insure compliance (and continuing qualification of your plan). Where there is some discretion as to how a particular problem can be cured, you may need advice in order to understand and select the appropriate alternative. In any case, where any of these sorts of adjustments are made, you should be aware of it and be involved in the decision as to how it should be done.
- Apply any dividends or distributions of earnings that were not applied to repay ESOP loan and allocate those and other earnings as provided in the plan.
If your plan either has dividends (distributions of earnings) that are not intended to be used for debt service or, because of legal restrictions on how they may be applied, may not be used for debt service, there will be cash accounts established to hold the money. ESOP companies often use these reserves as a pre-funding mechanism for repurchase planning.
- Finalize year end balances, update ESOP share value, adjust cost basis if necessary and update vesting.
The sum total of all the above is to create the final ending balances for all participants.
- Prepare and distribute participant statements and summary annual reports.
Although the law does not require the issuance of periodic benefit statements, you are required by law to give a benefits statement within 60 days when someone asks for it (and you can't be required to do it more than once annually). Your annual statements fulfill that obligation, so everyone does them. The summary annual report is provided by your administrator, probably, and must be distributed in exactly the form it is provided.
- Prepare elections and implement the process to pay out termination benefits.
This is the area in which the most confusion seems to arise. There are distributions that are done in a single payment that results in an installment repurchase and there are distributions that are done in installments. There are deferrals of distribution, but there are also a growing number of plans in which terminees' accounts are converted to cash after termination regardless of when the distribution will occur. Keeping track of what is being done and for what reason is critical.
- Prepare other reports as appropriate (e.g., allocations summaries, vote proxy reports, liability projections, trust reconciliation, etc.)
In some ways the things your administrator does after the work is done are most important. There should be a regular menu of such reports that you receive each year and that you refer to throughout the year.
- Prepare and submit form 5500 (or 5500/C/R) and supporting schedules (audited, if necessary).
This is one of the last steps in the process (we fervently hope). It is generally due to be submitted to IRS by the last day of the 7th month after the plan year end. If your company is on a tax extension, the due date is automatically extended to the tax filing deadline (be sure to include a copy of the corporate extension with the return) and if you file a special extension for the plan (Form 5558) you can get the 5500 deadline extended to one month past the corporate deadline. With all the extending that happens sometimes, it is easy to forget to file these forms. Don't do that. The fines are kind of steep.
So, that is the process. If you are not actually administering your ESOP, but you have hired someone else to do it, you can use this list as a checklist. This is what should be happening (in approximately this order). If you are the Plan Administrator (note the proper noun), you should look to your plan administrator for help with all these steps and documentation that shows all these things are done correctly.
Are you sorry you asked yet? If not, we'll continue this sort of exploration in issues to come.
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