EP42 – Interview with Greg Daugherty, ESOP attorney from Columbus OH to discuss 401(k), ESOPs and KSOPs.

Good afternoon, everyone. This is the ESOP guy, and we are on a journey to an ESOP. I wanted to say thank you so much for joining today's episode and looking forward to going into very, some very specific questions in an interview, but before I do that, I, I wanted to just uh let everybody know that if you, this is your first time joining the podcast that and you had to have an interest in learning more about ESOPs, please go to our website at journey to an ESOP.com. So again, this episode is going to focus on some questions um that are really relevant for 401ks and ESOPs. A lot of times an existing company, as they go through the process of becoming an ESOP an employee stock ownership plan, they're concerned about how do they balance the benefits of a 401k with an employee stock ownership plan. So to do that, we are going to interview ESOP attorney Greg Doherty from Columbus, Ohio. This is now Greg's 2nd visit on the podcast, so I'm excited about having him back. Uh, Greg, if you remember from the other episode, he helps design executive compensation and employee benefit plans for public and private companies, as well as non-profit, non for profit entities. He also, um, Consults with questions related to stock and non-stock based incentive programs as well as employment agreements, severance agreements, changing control parachute agreements, and other non-qualified deferred compensation plans. Greg has assisted companies, fiduciaries, and lenders with the formation of employee stock ownership plans and ongoing ESOP compliance and ongoing ESOP compliance matters. Greg's employee benefit experience includes providing ERISA fiduciary training and as well as compliance services. So with all of that, Greg, I just want to say welcome back to our podcast. Thanks for having me back. I'm excited to be back again. Great. So again, we're gonna, gonna jump into this kind of topic of 401k, kind of like the 401k versus the ESOP. So, let's just start off with um understanding the basics of a 401k versus an ESOP. How are they similar? How are they dissimilar? Sure, and they both have a lot in common. Both of them are qualified retirement plans, so they both have to follow a lot of rules under Internal Revenue Code Section 401A, which basically means, you know, they have to cover, you know, a broad base of employees. The benefits can't be tilted too heavily in favor of highly compensated employees relative to non-highly compensated employees. Um, you know, certain. You know, there's rules with respect to vesting and distributions and don't have complete discretion. You have some flexibility, but there are some guidelines and the and the tax qualification rules you have to follow for both plans. Uh, they're both profit sharing plans, you know, with the 401k, you're not required to make profit sharing contributions, but it is considered a profit sharing plan. Where the employer has discretion to make contributions and 401k just means, and the employees have the ability to put some of their own money in it, and ESOP does not have the deferral feature. But we'll actually kind of get into like kind of a combined 401k plan I think towards the end, but it's also a profit sharing contribution, and they're both subject to ERISA in many of the non-discrimination rules and the tax code overlap with ERISA and then also just kind of the way claims for benefits and and litigation is handled are the same in both plans. Uh, some of the, the differences, uh, kind of we mentioned before, in general, and ESOP does not allow employees to put their own money into it. It's, it's entirely employer contributions, uh. Eligibility to participate can, can vary somewhat because with the 401k plan, a lot of times what you'll see is um You know, an employee will be allowed to defer their own money in right away. Often the match may be immediate or sometimes there's a vesting schedule, but usually they can put their own money in pretty quickly with an ESOP. It may take, you know, a year of service in most cases to be eligible to receive an allocation. Uh, distribution rules differ, um, you know, 401k plans. Most of the time participants can take their money out immediately upon termination or retirement with an ESOP, there's often a delay. Those are some of the key differences, I suppose one other uh similarity kind of going back to that is. It's important not to forget this, especially with a 401k. People who start 401ks sometimes overlook this is that there is an audit requirement once you had, you know, 100 participants, and even if you have fewer than 100 participants, if, if your plan assets exceed $250,000 there is a requirement to still file an annual report on with the IRS and Form 5500 and and that applies to both plans. That's great. So that's a good overview. What, a couple of questions I have just to follow up on what you just said is the, uh, and I get this question from people, the employees that are participating in, in, in a company that it goes through an ESOP, do they have to be a member of the ESOP? They don't, not all of them have to be a member. Again, there's, uh, you know, there's a, there's coverage testing, it comes under code section 410 and There's different ways to pass that test and prove that you're covering a broad enough group of employees, you know, basically the most common way to pass that or the easiest way is if you can say you take the percentage of non-highly compensated employees who are participating and divide that by the percentage of highly compensated employees, and if that percentage is 70% or higher, you pass. Uh, so really, without getting into the math, if there's a group of people you want to exclude, it may be possible. You just need to have a consultant or actuary to perform the, you know, do the math and just confirm that the testing is still passed. Yeah, and that, so that's from the company's perspective. From the employee's perspective, if they say, you know, I just don't want to be part of the ESOP, or do they have to be part of the ESOP? Well, if they're, I mean, ultimately the, the company would decide that when they write the plan. So if they're, you know, if the company says if you're in an eligible group, they're going to probably want you to participate. And frankly, there's not really a cost to the employee because it's not their own money going into it. Usually if you see anybody who wants to opt out of the ESOP, it may be the individual who sold the business. You know, but still remains employed as, you know, a president or vice president afterwards. And sometimes if you have a union company, sometimes the union does not want to be part of the ESOP. sometimes they do, but some some of them like employee ownership. Some of them, I think maybe just think having employees as owners is maybe. And Tears the mindset I don't know. I know that's, yeah, those are probably extreme examples like I, I think for the most part, when I get to talk to a client about this, it's like, and they get to tell their employees that they're an ESOP. I mean, it's, it's always good news. I mean, here you get a benefit. You've not had to pay for it like the 401k, you're putting your own money in it, even though the company might be matching it, but it's really coming out of your own pocket. This is just a direct benefit. And if the company does well, you're gonna do really well. I mean, you know, and so it's just a really kind of logical thing. Right, and it's, it's a way for them. They, they know their, the employees, they know their company, and they're usually excited to say, oh, OK, now I get to enjoy some of the, the wealth that I'm hoping to create. So yeah, they're, they're usually excited. Sometimes it may take a little while. They may need to see a benefit statement or two for that to really sink in, but once they do, then they're genuinely excited and they're, they're all in on that. Yeah, so, so it's great. So going in it's going a little deeper with um now you have a client who says, you know, I'm gonna go become a brand new ESOP. So this is a company. So a lot of our listeners are, you know, thinking about becoming an ESOP and so they have an existing 401k. How do you, and what you do, you know, you definitely are an expert in this area. How do you advise clients when they're looking at coordinating the 401k with their brand new ESOP, and what sort of things come into play there with, with your consulting? There's a, there's a couple of things. There's, you know, one broadly, it's the economics. And so one of that is, so with the 401k they they put their own money in and then. If there are any employer contributions, if, if there's a match, and if the employer's been making profit sharing contributions, you'll need to consider whether you continue to do that. When you have the ESOP, because with the ESOP, you will be making contributions each year and so you might say maybe we suspend the match and the profit sharing contributions to the 401k because we're making contributions to the ESOP now. Maybe you keep the match and suspend the profit sharing contributions. A lot of times what you'll see is, especially if a company is a C Corp, they may make profit sharing contributions to reduce taxable income, but once they become an ESOP, and if they convert to an S corp but they're not paying tax, they may, they may not need to make that profit sharing contribution to the 401k plan. So those are things, you know, kind of the economic things to think about. The other is more administrative and you'll wanna look at your 401k plan terms. You know, how do they define the eligible class of employees? How does the plan define compensation? Does it include bonus or overtime? Is it W-2 or wages for income tax withholding, uh, you know, years of service? Is it based on, you know, how many hours of service performed in a year versus a period of elapsed time, uh, those types of things. Ideally will be the same in both plans. You may have reasons to have some differences, but again administratively it's a lot easier if those uh plan terms line up. Yeah, so, so kind of getting that's where you're getting into the, the, the design of the plan document or the design of the plan. And um and what you're saying is it, it's gonna match a lot of times the 401k plan based on the way the company is looking at. Is it, does it sometimes really differ from that when in the ESOP? It's very rare for that to, to differ, you know, you might, if anything, you might see. A broader group of employees like sometimes you might see in the ESOP. You might, you might see maybe some seasonal employees who work most of the year, you know, especially if it's a contractor or construction type company where maybe you have a group of employees who they work from say March to November and then in the winter, at least up here in Ohio, maybe it's not an issue in Florida, but in the winter months, there's less work to be done. We don't have winter down here. Yeah, I was gonna say, yeah, yeah, well, well in Ohio, like when it starts snowing and you can't really. You do a lot of construction work outside, you may have employees who are temporarily laid off in November, December, but then they get pulled back into work in March. They may not be eligible to participate in the 401k plan because, or at least not receive, they may be eligible to make deferrals, but maybe not eligible for a match or profit sharing contribution because they're unemployed on the last day of the plan here. But you might see, but you might see the ESOPs say, well, you know what, they're here most of the year, they're contributing. We, we want to make them eligible for ESOP contributions. Sometimes you'll see little exceptions like that. Yeah. Yeah, so on the, on the other economics, I would add to what you said too. I think a lot of times we're modeling a cash flow and we're looking at that contribution to the 401k. You know, we're leveraging up a company pretty tight on a 100% ESOP sales. So in the event that that's there and the company is giving this, this benefit of an ESOP, then sometimes when you look at the cash flow, it just makes sense to suspend that match, you know, at least for a period of time for the company to be able to hit those payments and have some comfort level and not really be so tight. And, and I, I think the employees understand that. I think that, hey, they're getting this and it's a different benefit, but they're still, we're still helping them plan for their retirement. I think that's the right thing to do. Yeah. So, so kind of going into the, the next question, um, is kind of like looking along the front of the issue of the ESOP, um. And the company is making this contribution to this app that adds cash outflows. Um, can we talk a little bit about um the, the concept of safe harbor and the way that you, as you go into that, um, you know, a conversation with a client. How do you, how do you help, you know, determine with, you know, you mentioned the highly compensated people, um, and, and looking at the passing the test for Safe Harbor. Can you go, first off, can you go into Safe Harbor a little bit just in, in specific so people understand, you know, I know kind of we assume everybody understands that 40401k account, um, and then how, and then we can talk a little bit about the issues related to, to that for an ESOP company. Yeah, so, let's start, you know, like you said with what does just the Safe Harbor 401k plan mean and we talked in the beginning how qualified plans in general have different non-discrimination rules, and with the 401k plan, it, it's called ADP testing, but basically it means that if you have a 401k plan. The deferrals, even though it's their own money, the deferrals that highly compensated employees are putting into the plan can't be too disproportionately high compared to what the non-highly compensated employees are putting into the plan, uh, and if Sometimes that can be a challenge because often the highly compensated employees are officers, they're financially sophisticated. They understand that the benefits of putting a lot of money in, you know, long-term investing and the tax, you know, deferrals and the benefits of that. Sometimes, especially younger, uh, you know, rank and file employees, maybe. Maybe don't appreciate that or maybe they don't have enough current income to be able to afford that. And so even if An employer is well intentioned, if the highly compensated employees are putting a lot of money in and the non highly compensated employees are not, it may fail that non-discrimination testing, and then the employer either has to make a contribution out of company money to the non-highly compensated. Or it has to refund and pay back some of the deferrals that the highly compensated employees made after the end of the year to get the numbers in a place where they passed testing. That's not really a good option. I mean, it could mean a company expenditure or you go to your CEO and CFO and say, Well, sorry, that money you want to put away on a tax-defered basis has to come back to you and you pay taxes on it now, and they're not always a happy conversation to have. No, that's with the so with the safe harbor. There's a couple of ways to do it. There, there's a, there's a matching formula you can follow, or you can just say pay everybody, whether you put your own money in or not, you get a contribution equal to 3% of compensation. And if you do that Safe Harbor formula, the regulations say you don't have to conduct testing, you're just deemed to be non-discriminatory and so the, the highly compensated employees can. You know, defer as much as they want, you know, up to the stated maximums, and so that. You don't have to worry about testing and you don't have to worry about those conversations with your your top officers. So that's, that's the main reason why people like companies implement a safe harbor. Some of it, you know, there is some altruistic reasons like, hey, we want to help our employees have have retirement income, but a lot of the motivation is also we want to. You know, for president and top officers want to put as much money as they can in the plan, we don't want, we don't want them in that and we don't wanna have to have come back and say, oh, we tested this year and you guys, oh you, we're gonna give you this money back and they've they've plan that's gonna be kind of creating a problem. Um, so kind of going in that the, the drawback of, of having a safe harbor through the ESOP is, is what, when you start thinking about the, the combination of what, 401k with a, with a safe harbor, and then now we add an ESOP to it. Right, so, and maybe to take a step back, you can put, whether you have a safe harbor or not, you can have, uh, you know, you, you can have matching contributions including safe harbor, whether it's a match or the 3% non-elective contribution funded through the ESOP. So the the the benefit of that is you can say, oh, alright, well if we want to. Keep this contribution even with an ESOP maybe. You know there's a cash expense there, but maybe again we want our highly compensated employees, not the Have to get an unexpected refund at the end of the year, you can say, since we're gonna make this contribution anyway, we'll, we'll run it through the ESOP and and company stock and That's a, that's a really good benefit because With an ESOP, you're gonna, at least with the leverage ESOP, you're gonna have to make payments, contributions equal to the principal and interest on the ESOP loan anyway. And so you could say, OK, we'll put the money. You know, we'll put the money into the plan to pay the ESOP loan, and then we'll, let's say that turns out to be 10% of uh compensation, we can say the 1st 3% goes to the safe harbor to fund the safe harbor, and then the balance is, uh, it's just pure, you know, non 401k related ESOP contributions. So that's a great benefit and that the same dollars end up both paying down the ESOP loan. And funding the match, so that's, that's the benefit of doing that. There's a couple. A couple of catches. The, the main one is, uh, it, it gets back to the coordination issue we talked about earlier with the 401k plan, because with an ESOP, most of the time. You know, the ESOP has a vesting schedule, you know, usually over, you know, you invest a little bit over a 6 year period because we want to encourage employees to stay employed a long time to really benefit from employee ownership, but with a safe harbor, they have to be vested right away and so you'll have some shares in the ESOP that relate to the safe harbor that are immediately vested. And then other shares that, you know, follow the traditional six-year vesting schedule. The other potential coordination issue is uh from a distribution standpoint. Uh, you know, with an ESOP, a participant who's aged 55 and has 10 years of participation in the ESOP has the right to diversify a portion of their shares in the ESOP into alternative investments, and that, that can be accomplished, you know, either by allowing them to make alternative investment elections or they could just take an in-service distribution in cash. Well, with the Safe Harbor contribution, uh, Safe Harbor contributions, the participants not allowed to take that money out of the plan until age 59.5. So you have to again make sure you're tracking that separately and say, OK, to the extent that you have the right to diversify the safe harbor shares, that has to be an alternative investment election that cannot be an in-service distribution. That's a great point, yeah. Uh, so, kind of my, my comment there would be, um, first off, number one, I think you're always gonna have a job because it gets so complicated, right, when you, when you start kind of throwing a lot of the, the different um variables. It's not, it's not as simple as just one thing that you're gonna do. But I think you outline the drawbacks pretty well. Um, to talk a little bit about the concept of diversification. Um, within an ESOP, do you, do you know why an an ESOP allows diversification so much earlier than a 401k? Or because the the 40K has already publicly traded stocks or mutual funds, they probably just answered my own question. That's just it, yeah, I mean, I think you might have been asking like why, why the in-service feature, why do the in-service rules differ. You know, I don't know if there was really a policy decision thought about it. I mean, I think, I think you're right that with the 401k, the idea was the investments are diverse, you know, to begin with, and so there's maybe not as much of a sense of urgency of, of getting the cash out of the plan. Uh, the other thing too is because the 401k is, you know, much more common retirement vehicle. I think Congress maybe said we want to make sure it's truly used for retirement and so let's make it harder for people to get their money out of the plan, although we let them borrow money and take out loans, which is a story for a different podcast, I suppose that's right, yeah, we borrow a lot of that right. Well, I say just real quick, you know, with the. You know, because everything is, you know. Because the investments are concentrated in employer stock, I think the thought was the closer, you know, once you start getting close to retirement, we want to allow some diversification and probably because they're going to have a 401k or other retirement vehicle, we can allow people to get their money out earlier than maybe we would in some of those other vehicles. So this, this might be another obvious question, um, when you're, so you're at age 50 in an ESOP and you're allowed to start divesting some of your ESOP shares. Um, is that a rolled, is that rolled into a 401k so you're not gonna have to pay taxes on that right away, or is that, how does that come, how does that, how does that actually comes out in cash, obviously, but where does it go? Yeah, so I mean you can, yeah, so you, you could let the, you can let the participants, uh, yeah, basically invest that into the, into the 401k plan, you could have an alternative investment account. Maintain within the ESOP itself if you wanted to, or they could take a distribution uh and then they either pay tax on it or roll it over so it's still some flexibility it's kind of up to them, yeah, but they'll have the option of, of rolling that into it, into another plan. So, um, no, I think that was excellent. Um, so going into the kind of the next question is, um, first off, I just kind of throw it out like what is a KO. KSOP and how does it work in relationship to an ESOP. So, let's talk about what it is first and then, you know, and then kind of talk a little bit about that option for um companies that are thinking about going ESOP. Yeah, so a KSOP, it's it's a single plan that's a combination ESOP with a 401k deferral feature, or you could say it's an ESOP that allows employees to defer their own money into it and You know, the reason people adopt these plans are We've talked about similarities and differences, and some companies feel that the similarities are close enough that why not put everything in a single document um. Some of the, you know, again like kind of the legal plan design and administrative issues, well, if there's only one document, I guess that makes it easier to coordinate. Uh, you know, we talked about the need to file Form 5500 and get a plan audit. Well, now there's only one audit, one form to file, not, you know, two separate audits, um. If we're going to maintain our match. You know, maybe it is easier to keep everything in a single document instead of having a 401k plan, have to cross reference the ESOP and have the ESOP. Cross reference the 401k. uh, so that You know, that makes it, you know, easier, you know, one set of benefit statements instead of having employees have to look up two separate benefit statements, so there is something to be said to having everything in a single document. Uh, the kind or why. You know, despite those benefits, I still, from what I see, most easily, most companies still maintain separate documents and I really see two reasons for that. One is You know, administering 401k plan money. You know, because we talked like there are some different distribution rules, um, you know, plan loans, for example, you can take planned loans out, you know, on, on the 401k money but often not with the EAP money. Um, You know There's, there's just, there's different administration rules for 401k plans and ESOPs, and you have a lot of good 401k plan, third-party administrators, a lot of good ESOP plan administrators. But a lot of those administrators don't really want to You know, kind of cross over into the other field, you know, it's, it's difficult to find administrators who, who do both. So that's one. And then the other thing, a lot of employers like the idea of the ESOP being a separate plan because that strengthens and makes it more tangible in the employee's mind that hey, this ESOP is entirely a gift of ownership from our employer. You know, if you have a single statement that says, OK, here's my own money and here's a profit sharing contribution. You know, not necessarily to say that maybe there's an expectation that the ESOP contribution is just kind of another. You know, like, like kind of like getting the annual bonus every year, and then if you don't get it, you know, you almost start to feel entitled to it. But, but having a separate ESOP statement that just says. It, it just kind of crystallizes in the employee's mind. Oh wow, yeah, this, I am an employee owner and this is my, my piece of it and this was the employer giving me ownership in the company, uh. That seems to be, you know, pretty powerful for a lot of, a lot of companies. No, I think that, I, I think you're right, and I, and I'm glad we brought up the case up at the end just because it'll be, if it's thrown around you, hopefully, as a listener, have a, you know, a better understanding of it. And as, as Greg said, it's not something that is used as much just because of those issues that he, he addressed. So, um, you know, with that, I wanted to kind of, kind of close out with a couple of comments and I, and I didn't mention this, but I will say, you know, obviously, I think the, the overarching thing here as we talk about a lot of the details, is planning is always critical for any ESOP company or companies going towards an ESOP. One of the aspects of this that That I didn't touch on was the concept of when we are actually doing the feasibility test, we're gonna want to make sure that we look at the 401k contributions with the ESOP contributions and make sure we haven't um gone over the 25% payroll limitation on, on IRS code 404. So, That's part of the feasibility modeling that we do and it's important, you know, when you start thinking about the, the aspects that we talk about related to what you're gonna do with your 401k, what you're gonna do, you know, with this new ESOP, um, all of that needs to be incorporated and, and overall, your planning and making sure that you, you know, whole, you know, thoroughly understand the issues. And ultimately, what we wanna do as advisors is we want to benefit the employees and we wanna really look at the, the responsibility we have in creating this retirement account for, for your people and make sure that it's, it's done in the right way and, and it accomplishes your goals and objectives. So, with that, what other comments would you make on, on kind of close out, Greg? Yeah, I, I think you said it very well. It's just, uh, if you have a 401k plan, uh, it's just important to do that, you know, take that into account upfront with the planning and You know, I think your, your main question is going to be if you've been making a matching contributions and employer contributions, or, you know, if you like the idea of doing a safe harbor or a match, um, maybe economically you decide with an ESOP, you don't need to do that anymore or it doesn't make sense, but there may be times where funding the match through the ESOP. Uh, it does make sense whether maybe it's part of a Kop, a single document, or even if it, if it is part, you know, having two separate documents and having the match go through the separate ESOP document, that's at least worth considering. You may decide it's not worth it, but that's, you know, just one thing you should consider as, you know, part of your feasibility planning. Awesome. It's always good to have options when you start thinking about those things. So thank you so much for your time today, Greg, and your, your perspective and all, everything you've brought to this issue is really gonna be very helpful for, I think for a lot of people to when they listen to this episode. Great, you're welcome. Yeah, I think it was a great discussion and yeah, something that doesn't always get talked about a lot, but yeah, I think it is worth thinking about. It's great. So, as always, I just want to remind you, if you like what you hear, please subscribe to the podcast and share it with a friend. Have a great day and we will look forward to next time.