Historically, ESOPs were custom written documents produced by lawyers, which had to be submitted to the Internal Revenue Service for approval. These documents could be costly to amend and maintain. With the arrival this summer of IRS pre-approved “checklist driven” ESOP documents (similar to 401(k) plans), it is no longer necessary for individual employers to submit these plans to the IRS for approval. As an added bit of flexibility, the due date to decide whether to adopt an ESOP is extended, giving more flexibility for tax deductions.
What’s Changing?
Until this year, all ESOP plan documents were individually designed and drafted and had to be submitted to the IRS for individual determination letters. The IRS has now authorized pre-approved ESOP plan documents (PAPs). These documents are developed by ESOP law firms and submitted to the IRS by the law firm, in advance, as a “standard” plan for use by clients. The documents come with a determination letter that is good for any company that adopts a version of the plan without significant modifications. With the PAP, adopting employers may rely on the document as approved by the IRS eliminating the sometimes lengthy and annoying IRS determination letter process where individual IRS agents review the plan documents one at a time by hand.
Because ESOPs tend to be amended more frequently than other retirement plans, amendments were another issue. Updated provisions and ESOP design changes were often costly to draft, dangled off the main plan document, and were not covered by the plan’s existing determination letter. Between IRS determination letter filing cycles, amendments were subject to challenge by the IRS if the ESOP was audited. Amendments would eventually get approved through the five year IRS determination letter cycle. ESOP companies using PAPs can simply amend their plan documents by selecting new or different provisions on the design checklists that are part of the PAP document system. Each time an ESOP is amended, you will get a clean, completely integrated, and IRS-approved document without going back through the IRS approval process.
Is It Time to Restate Your ESOP?
Should you restate your ESOP to a new pre-approved plan if you already have an IRS determination letter for your current document? The pre-approved plan gives you a plan document that updates itself going forward—just like most 401(k) plans. The pre-approved plan sponsor (the ESOP law firm that created the plan) provides “clip-on” amendments if there are any required law changes. The amendments are provided to all companies that have adopted the PAP. Every six years the PAP sponsor (not the employer) submits the pre-approved document for updated approval by the IRS. This results in a much more efficient and cost-effective process for companies that sponsor ESOPs.
The process of moving to a pre-approved plan document puts ESOP companies through a checklist analysis system, reviewing how the plan is operated. Going through this process helps to eliminate any divots or differences in their individually designed ESOP documents that may have crept in over the years. It is also a chance to reevaluate the plan design if a comprehensive review has not been done lately with opportunities to improve the ESOP that may be new or may not have been considered previously. For some general comments to keep in mind about ESOP plan design, read this article.
Pre-approved documents also include an updated SPD, so that requirement will not be overlooked. SPDs do not require IRS approval and companies can choose to customize or use their own communications pieces if desired.
Talk to your ESOP attorneys to see if this is an option they offer and, if not, consider talking to a firm that does offer pre-approved ESOP documents.
