Before 2020, the IRS historically mandated that an employer must adopt an employee stock ownership plan (ESOP), and any other retirement plan, no later than the end of the first tax year in which the employer wanted to claim a deduction for plan contributions.
Effective December 31, 2019, Section 201 of the Setting Every Community Up for Retirement Enhancement Act of 2019 (“SECURE Act”) extended this deadline from the end of the applicable tax year to the due date, including extensions, of the plan sponsor’s income tax return for the applicable tax year. As a result, under the SECURE Act, if a plan is adopted by the extended due date, the IRS will treat it as adopted as of the last day of that year.
As a result, a company on a calendar year tax year that establishes an ESOP on or before September 15, 2022, may still make a 2021 ESOP contribution, provided that the contribution is made before the tax deadline for its 2021 income tax return.
The capability of a business taxpayer to take advantage of a prior-year tax deduction is substantial since existing tax law allows an ESOP sponsor to make an annual contribution, equivalent to 25% of its eligible payroll, to its ESOP.
A business with a $5 million annual payroll can make an annual ESOP contribution as large as $1.25 million while taking an equivalent income tax deduction. Using the example above, an ESOP established before September 15, 2022, may make a 2021 ESOP contribution up to 25% of its eligible payroll for 2021 and receive a corresponding tax deduction.
While the extended deadline provides flexibility, the following two key points are noteworthy:
- First, an employer must adopt any tax-advantaged plan qualified under Code Section 401(k) (including an ESOP with a 401(k) feature) prior to any deductions or contributions segregated from employees’ pay.
- Second, the SECURE Act didn’t extend any other deadlines, such as the 5500-filing deadline, which could have otherwise created a situation where the deadline for filing a 5500 would be earlier than the deadline for adopting the plan. As a result, the IRS announced filing relief in August of this year for plans established in 2020. These plans are not required to file a Form 5500 for the 2020 year. Instead, the plan would make its first filing for 2021, checking a box that reflects that the plan was adopted effective for 2020.
The SECURE Act’s extended deadline allows companies greater flexibility in establishing an ESOP. Prospective ESOP sponsors are no longer required to act expediently to establish an ESOP before the end of the tax year. Instead, they now have sufficient time to consult with legal and accounting advisors on transaction design, plan design, and the implementation process, thus allowing them to make the best decision possible.
However, any company considering the adoption of an ESOP must allow for adequate time to design and draft the plan document, establish a qualified trust for the plan, and implement an administrative scheme for allocating contributions to individual participant accounts. While there is an extended period to adopt the plan under current law, companies should consider starting the process sooner than later.
HBL has experience in all areas of benefits and employment law, offering a comprehensive solution to all your business benefits and HR/employment needs. We help ensure you are in compliance with the complex requirements of ERISA and the IRS code, as well as those laws that impact you and your employees. Together, we reduce your exposure to potential legal or financial penalties. Learn more by calling 470-571-1007.
Hall Benefits Law, LLC
