So how much can an employer contribute to an ESOP?

So what is the answer to the question I posed this week – how much can an employer contribute to an ESOP?

As you might have guessed, the answer is not exactly straightforward.

Well, it is pretty straightforward if the employer is an S corporation. In that situation, the limit on the amount of employer contributions to all defined contribution plans is 25% of the compensation of those employees eligible for the plans. So any employer contributions to a 401(k) plan or any other plan must be aggregated with the ESOP contributions and limited to 25%.  Let’s call this the general rule.

The general rule also applies to C corporations but there is another rule that applies only to C corporations that sponsor a leveraged ESOP. This special rule allows an employer to contribute up to 25% of eligible compensation to a leveraged ESOP just for the principal payments. The contributions applied to interest payments do not count toward the 25% limit and are generally still deductible. Let’s call this the special rule.

So can a C corporation make deductible contributions under both the general rule and the special rule?

The answer appears to be “yes.”  This is an area that you will want to explore with your advisors but it does appear that a C corporation could contribute 25% to a leveraged ESOP plus interest and then also contribute 25% to another plan such as a 401(k) plan. The 25% contributed under the general rule could possibly also be deposited into the ESOP, not a separate plan. But the IRS ruling on this recent point included a condition that the 25% contributed under the general rule could not be applied to debt payments.

I do have to stress that you should review this with your advisor because the contributions must be allocable under the individual contribution limits to be deductible and the recent guidance from the IRS was in the form of a private letter ruling. Such rulings can only be relied on by the taxpayer that requested the ruling.

So how about another question – what happens if the employer contributes more than allowed under the limits described above?