Conventional wisdom says that a plan sponsor cannot generally deduct more that 25% of eligible compensation to a qualified retirement plan. But “generally” means in ERISA terms that there are exceptions. And here’s a very interesting one. A C corporation – let’s call it “C” for short – that sponsored an ESOP wanted to deduct more than 25% of compensation. In fact, it wanted to make three types of contribution.
- The first to pay the principal on the ESOP loan.
- The second to pay the interest on the ESOP loan.
- The third would be been unrelated to the ESOP loan (that is, the ESOP would not have used the third contribution to pay either the principal or interest on the ESOP loan).
So taxpayers do what taxpayers do when they want assurance that they will not suffer adverse tax consequences from a specific transaction. They apply for a Private Letter Ruling – a written decision by the Internal Revenue Service in response to taxpayer requests for guidance. In C’s case, the IRS ruled in Private Letter Ruling 2007320028 (PDF) that:
- Tthe first contribution to pay the ESOP loan principal is deductible provided it does not exceed the aforementioned 25% of eligible compensation limit.
- The second contribution is deductible to pay the interest on the ESOP loan.
So far “conventional wisdom”. Now here’s that real interesting part. The IRS also ruled that C may deduct the third contribution that is unrelated to the ESOP loan as long as the contribution does not exceed the 25% of compensation limit. Useful, for example, if an employer wanted or needed to pay off terminating participants who elect cash while the ESOP is paying off an ESOP loan.
Thus, contributions of up to 50% of eligible compensation could be deductible in addition to the unlimited deduction for interest. Another example of why we should “never assume”.
Note: Private Letter Rulings are not considered as precedent for use by taxpayers other than for the taxpayer who requested the ruling, but they do give an indication of the IRS’s current attitude as to a particular type of transaction.