What a DOL Auditor is Looking For When Auditing an ESOP

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Sun, Apr 20, 2008
Find me on:

Paul Windsor, an investigator from the Employee Benefits Security Administration (EBSA) of the Department of Labor (DOL), presented What to Expect from an Employee Benefits Security Administration Investigation on April 15, 2008, at the Spring Conference of the ESOP Association – Wisconsin Chapter. Here are some highlights of the presentation:

  • Not Official Views of the DOL – The presentation started with the caveat that the presentation represents the views of the presenter only and not the official views of the DOL.

  • What does the EBSA Investigate – What does the EBSA investigate?

  • How Investigations are Identified – Investigations are identified through computer targeting (off of the IRS Forms 5500), referrals from the IRS and other agencies, information from the media, bankruptcy and other filings, complaints (participants, fiduciaries, informants, attorneys, etc.), and private lawsuits.

  • Objective of Investigation – It is better to cooperate during the investigation. The purpose of the investigation is as much for educational purposes as it is for compliance. They try to not penalize voluntary compliance whenever possible. Their goal is to fix and move on. However, they are required to notify the IRS of the investigation.

  • ESOP Specific Information – In addition to the standard information request, they will interview the fiduciaries and may ask for the corporate information such as the Board of Directors minutes, articles of incorporation, and the financial statements. They are looking for conflicts of interest and making sure the ESOP is behaving like an owner and seeking the maximization of profits.

  • ESOP Fidelity Bonding Requirements – One of the biggest problems is the failure to comply with the ESOP Fidelity Bonding Requirements. Typical problems include not having enough coverage, not having the bond in the name of the plan, and not providing the required coverage for each plan of the company.

  • Disclosures – They are checking to make sure that you have satisfied the Summary Plan Description (SPD) and Summary of Material Modifications (SMM) requirements. ERISA requires that you update the SPD every 10 years, assuming there are no plan changes. Most likely, your plan will have made some changes and you will need to update it every five years. In addition, you must provide a SMM "not later than 210 days after the close of the plan year in which the modification or change was adopted."

  • Decision-making – Who is actually acting as the plan administrator (or administrative committee) and trustee? Is it the same individuals that are defined in the plan documents or is someone else (such as the CEO) actually making the decisions? If there is a third-party involved (e.g. directed trustee or TPA), are the fiduciaries reviewing and taking responsibility for the work?

  • Conditions of ESOP loan in event of default –They review the loan documents and the conditions of loan in the event of default. They will sometimes find draconian penalties and other collection and call provisions that do not comply with 29 CFR 2550.408b-3(e) - Loans to Employee Stock Ownership Plans:

    An exempt loan must be without recourse against the ESOP. Furthermore, the only assets of the ESOP that may be given as collateral on an exempt loan are qualifying employer securities of two classes: Those acquired with the proceeds of the exempt loan and those that were used as collateral on a prior exempt loan repaid with the proceeds of the current exempt loan. No person entitled to payment under the exempt loan shall have any right to assets of the ESOP other than:

    (1) Collateral given for the loan,
    (2) Contributions (other than contributions of employer securities) that are made under an ESOP to meet its obligations under the loan, and
    (3) Earnings attributable to such collateral and the investment of such contributions.

    If the documents do not comply, the solution will be to rewrite the loan documents and there will most likely not be a penalty. However, they are required to inform the IRS, who may assess an excise tax or other penalty.

  • Release of Shares – He discussed math errors, using the correct release method, and the most current amortization schedule.

    • Math errors – They find a lot of mistakes with the math and stressed the importance of being responsible for the work of TPAs.
    • Using the correct method – They discussed making sure that the release method is provided in the plan and loan documents and that the release method meets the requirements of 29 CFR 2550.408b-3(h) - Loans to Employee Stock Ownership Plans. When using the special rule (a.k.a. principal-only method), the term of the loan must not exceed 10 years and the repayments must be at least as rapid as level payments over 10 years.
    • Using the most current amortization schedule – An important component of the general rule (a.k.a. principal and interest method) is the future principal and interest payments. The balance as of the last day of the plan year on the amortization schedule should coincide with the actual loan balance and the future payments should be re-amortized according to the terms of the plan document and the interest rate as of the last day of the plan year. You cannot automatically use the original amortization schedule every year.

  • ESOP Loan Refinancing – As provided for in Field Assistance Bulletin 2002-1, which discusses the fiduciary obligations in connection with the refinancing of an exempt ESOP loan, the DOL is looking to confirm that the refinancing of an ESOP loan is solely in the interest of the plan participants and beneficiaries.

  • Valuation of shares – This is an area that they have not historically looked at enough, but have identified it as an area that they will watch more closely.

    • Selection process of choosing valuation firm – What is the selection process for choosing the independent appraiser (see Hiring a Qualified, Independent Valuation Firm and Reviewing and Approving the Valuation Report)? Is due diligence performed on a regular basis? Did you go through the Request for Proposal (RFP) process or have you done any other comparison shopping?
    • On-Site Visit – When is the last time your valuation firm made an on-site visit?
    • Information Used by the Valuation Firm – Who looks at the information provided to the valuation firm? Is it reviewed internally before it is sent? How many people are involved in the process?

  • Corporate governance – They look closely to income paid to and company contracts with officers and other key employees of the company. They are looking to understand why the arrangements exist and whether they are in the best interests of the participants.

  • Put Option – 29 CFR 2550.408b-3(k)(4) - Loans to Employee Stock Ownership Plans requires that participants receiving a distribution of employer stock of a company that is not readily tradable on an established market must be given a put option. It also provides that the put option may be satisfied with a promissory note if certain requirements are met:

    The provisions for payment under a put option must be reasonable. The deferral of payment is reasonable if adequate security and a reasonable interest rate are provided for any credit extended and if the cumulative payments at any time are no less than the aggregate of reasonable periodic payments as of such time. Periodic payments are reasonable if annual installments, beginning with 30 days after the date the put option is exercised, are substantially equal. Generally, the payment period may not end more than 5 years after the date the put option is exercised. However, it may be extended to a date no later than the earlier of 10 years from the date the put option is exercised or the date the proceeds of the loan used by the ESOP to acquire the security subject to such put option are entirely repaid.

    If a plan is using promissory notes, they are looking to make sure that the note is properly secured (i.e. there is adequate security provided) and note that the fiduciary could be held personally liable.
  • Topics: ESOP Corporate Governance, ESOP, employee stock ownership plan

    Aaron Juckett, CPA, CPC, QPA, QKA
    Written by Aaron Juckett, CPA, CPC, QPA, QKA

    Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

    Keep Your ESOP On Track and On Time
    New Call-to-action

    Recent Posts