Top 10 issues

What in auditing ESOPs

RSMisMcGladrey
up with ESOPs?
Employer Services
RSM McGladrey Champion Training
Becky Miller, CPA
becky.miller@rsmi.com
McGladrey & Pullen, LLP
Confidential
RSM McGladrey, Inc. is a member firm of RSM International – an affiliation Information
of separate and independent legal – For
entities. internal use only.

Discussing

• Current trends in ESOP design and financing

• Financial reporting issues
• Timing differences between participant reporting and plan reporting
• Special prohibited transaction implications for ESOPs
• Additional tax compliance tests unique to ESOPs
• Auditor’s duty with respect to the reported value of non-traded stock
• Common DOL issues upon examination or during their review of
audit work papers

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Objective

• To prepare each audience member to be able to answer

that assertion:

….but no one else has ever asked us

for this
to do this
to justify this
to measure this…..
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Seriously

• The objective of this class is to highlight the unique issues

presented by Employee Stock Ownership Plans in the
context of:
– Stock Value
– Contributions
– Classification as allocated or unallocated
– Prohibited transaction implications
– Additional tax compliance tests
– Common failures
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2
Presenters

• Scott Albert – Employee Benefits Security Administration

• Becky Miller – McGladrey & Pullen, LLP

Disclaimer
Each of us are speaking from our personal perspective.
Our comments should not be attributed to the DOL or
McGladrey & Pullen, LLP.

Current Trends in ESOP financing

• ESOPs and S corporations

– Seller financing
– S distributions applied to debt service
• Indirect loans
– Lender to sponsor / sponsor to ESOP
– First loan is generally inapplicable to the plan’s operation
• Loan terms and rates
– Lender to sponsor – commercial rates and terms recognizing that capital is
leaving the business
– Sponsor to ESOP – market rate loans, term should meet sponsor needs.
• Refinancing is a fiduciary action
• ESOPs and business transactions

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Current trends in ESOP design

• S corporation ESOP sponsors

– Use of “tax distributions”
– Management of accumulated non-stock assets
– Broadly held standard – IRC Section 409(p)
• Management of the “haves and have nots”
• Accelerating distribution privileges in good times
• Creative solutions to include employees of affiliated
partnerships
– See GCM 39880

Financial reporting issues

• Allocated versus unallocated

– Think amounts available for debt service and amounts not so
available
• General fair value concerns
– ERISA says current value of “assets and liabilities”
• How do you fair value the ESOP debt?
– SFAS 157 – see background for pre-existing authority
– Discounted cash flow using market terms
– Collateral
– Floor Price Protection
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Financial reporting issues - cont

• Sponsor guarantee to fund the debt

– SFAS 5, ¶18 – gain contingency
• Release of shares
– Upon accrual – match SOP 93-6?
– Upon actual release – match loan documents?
– IRC Reg. §54.4975-7(b)(8)
• Merger and acquisition issues
– Escrow accounts for holdbacks

Timing differences between participant reporting

and plan reporting
• Grounded in concept of allocated / unallocated
– Remember – unallocated means still available to satisfy the lender
• Contribution for current year debt service is in participant equity on a
full accrual basis, but will be in unallocated column
• Dividends on collateral can remain in unallocated column for an
extended time period, but generally will be allocated to participants at
least annually
– Rev. Rul. 80-155 requires that all amounts in a defined contribution plan be
allocated to participants unless such amounts are in excess of the Section 415
limits.
– Obviously, the ESOP loan suspense account is another exception to this rule.

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Prohibited transaction implications for ESOPs

• Remember, chapter 11 on party-in-interest transactions is

mandatory
• Potential PTs in ESOPs
– Purchase of stock
– Sale of plan’s stock
– Loan to acquire stock
– Failure to follow loan terms
– Failure to follow prohibited transaction exemption conditions on
loan
– Refinancings
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Commonly encountered PTs

• Valuation not as of the transaction date

– No roll forward to the actual date
– Failure to recognize that purchase of stock by sponsor out of the
plan to fund distributions is subject to the transaction date
valuation rule
– Creative approach see PTE 2003-32
• Failure to properly release shares
– Principal only method when not eligible
– Principal and interest method, incorrectly calculated
– Some other disallowed method – e.g. fair market value method
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Commonly encountered PTs

• ESOP loan not adequately documented

• ESOP appraisal not sufficient
• Special S corporation limitations not satisfied -
§4975(f)(6)(B)(ii) only works on a sale to a plan, not a
purchase from the plan
• Application of allocated dividends to debt service fails the
“return for value” standard – IRC §§ 404(k) and 4975(f)(7)
– This is the tax concept of “allocated” meaning dividends on
shares released from collateral and allocated into participant
accounts
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Auditor’s duties on party-in-interest transactions

• Gain an understanding of the transaction

• Gain an understanding of the applicable ERISA exemption
• Compare the two for any inconsistencies
– Reconcile any inconsistencies
• Document such effort in the file
• Document the conclusions in the file
• Report any PTs on the ERISA schedules
• Material PTs will require discussion in the related party
footnote
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Additional tax compliance tests unique to ESOPs
• Chapter 12 of the Guide provides that the auditor is to inquire as to
the plan’s tax qualified status
• For an ESOP such inquiries include all of the regular rules applicable
to defined contribution plans and:
– §409(n) – non allocation rules which limit allocations to certain shareholders in the event
that one or more seller’s elected the tax-deferred sale benefit
– §409(p) – prohibited allocation rules associated with the ESOP of an S corporation
violating the broadly held standard
• It is possible for both rules to apply to a plan
– §404(k) – the limitations on the ability to use allocated dividends for debt service
– §415 – the right to elect to measure the annual addition by the lesser of the employer
contribution made during the year or the FMV of the stock released and allocated due to
that contribution. C corporations may also be able to exclude the interest portion of any
such contribution and forfeitures of leveraged shares from the 415 calculations.
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Additional tax issues unique to ESOPs

• ESOPs of S corporations are generally exempt from Federal and
state income taxes
• Certain plans will pay tax due to issues associated with §409(p) or
the holding of non-voting shares
• Taxable portion of trust pays tax on S corporation income
• Tax is paid at trust rates
– Trust also may owe estimated tax deposits
• Any gain on fair value over tax basis for any taxable shares
distributed is also taxable
• See IRC Section 512(e)(3)

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Auditor’s duty with respect to the reported value of non-
traded stock

• ERISA requires “current value” ERISA §3(26)

• The Guide refers to “fair value”
• Basically this is:
– Fair value of plan investments is the amount that the plan could
reasonably expect to receive in a current sale of assets and
should be measured by quoted market prices when available.
• SAS 101 covers the auditing standards
• New SFAS 157 prospectively applies

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Requirements as to value

• IRC 401(a) requires that value be measured at least annually

– Appraisal is not generally required
– Exception for ESOPs with shares acquired after December 31, 1986 – IRC
Section 401(a)(28)
• Form 5500 encourages an independent appraisal
• MY experience with DOL auditors has been that they expect to see
an independent appraisal report
– They don’t always write up a deficiency on the first audit, but they encourage
the engagement of an appraiser and they come back to see what action was
taken.

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SAS 101
• The auditor evaluates whether fair value measurements and
disclosures as determined by management, are in conformity with
the accounting technical literature guidance.
• Examples of audit steps include an examination of:
– The controls over the process used to determine fair value measurements, for
example, controls over data and the segregation of duties between those
committing the Company to the underlying transaction and those responsible
for determining the valuation.
– The role that information technology has in the process.
– The extent that the entity's process relies on a service organization to provide
fair value measures or data that supports the measurement.
– The integrity of controls and security procedures for valuation models and
relevant information systems.

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SAS 101 – cont.

• Examples of audit steps include an examination of:
– The controls over the consistency, timeliness, and reliability of the data used in
valuation models.
– The expertise and experience of client personnel measuring fair value.
– The extent to which the Company engages specialists.
– The significant management assumptions used in determining fair value.
– The documentation supporting management’s assumptions.
– The process used to develop and apply management’s assumptions, including
whether management used available market information to develop the
assumptions.
– The process used to monitor changes in management’s assumptions.
• See http://www.aicpa.org/download/auditstd/Finaltoolkit.pdf
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Reliance on the work of a specialist
• SAS 73
• Qualifications of the specialist
– Tough for appraisers as there is no certifying organization
• Test the completeness and accuracy of the work performed
by the specialist
– Test data received
– Assumptions applied
• Evaluate the specialist’s report
• Conclude to rely or not
• Document results
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What if auditor concludes against reliance?

• Resolve the problem with the Plan Administrator and the

specialist
• Obtain an opinion of another specialist, unless the
engagement team believes that the matter cannot be
resolved; and/or
• Qualify the audit opinion because of a scope limitation or,
worst case, issue an adverse opinion
• Remember for a benefit plan, one consequence could be a
prohibited transaction
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What if the client did not rely on the work of the
specialist?
• Examples
– ESOP collateral subject to a different value
– ESOP shares subject to floor price protection
• Inquire of client for basis of conclusion
• Test against definition of “current value”
• Document results

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Common DOL findings in ESOP F/S audits

• Failure to test satisfaction of prohibited transaction

exemptions for ESOP – loans, stock sales, stock purchases
• Failure to document such tests
• Failure to satisfy GAAS on stock value
– Rely on related party estimate
– Rely on appraisal without satisfying SAS 73 or SAS 101
• Failure to adequately plan the engagement

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Questions

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