Small Business

Creating Nest Eggs for Your Workers


Small businesses can set up both an Entrepreneur Rollover Stock Ownership Plan and conventional 401(k) plans—but make sure you use a tax expert

We have an Employee Rollove Stock Ownership Plan (ERSOP) and used the money to fund the purchase of stock in our new company. Can we set up a 401(k) and have the ERSOP at the same time?

—D.R., Sarasota, Fla.

The answer to your question seems to be a qualified "yes." The reason that experts are hesitant to give you a definite answer is that "ERSOP" is a marketing term rather than a federally recognized stock ownership plan. "This is a plan primarily promoted by one consulting group. It should not be confused with an ESOP (Employee Stock Ownership Plan), which is sanctioned by federal law," says Corey Rosen, executive director of the National Center for Employee Ownership in Oakland, Calif.

Although the ERSOP is designed to be a tax-qualified profit-sharing plan (BusinessWeek.com, 11/18/04), its legality is still somewhat in doubt. While its promoters assure potential investors they have obtained favorable Internal Revenue Service "determination letters" about the plans' legality, critics point out that no binding IRS ruling for or against this kind of plan seems to exist. "The IRS had an opportunity to stop them cold and they didn't," says Larry Goldberg, a tax group partner at the law firm of Sheppard, Mullin, Richter & Hampton.

In the absence of a ruling against ERSOPs, Goldberg says, it would seem there are no firm barriers to your setting up a 401(k) alongside the ERSOP. "The federal pension law (ERISA) and the Internal Revenue Code governing these arrangements permit a company to maintain more than one tax-qualified retirement plan for its employees," he says. "Your employees' salary deferral contributions into the 401(k) plan could be separately invested in mutual funds or other investments that are unrelated to the ERSOP's investment in your company's stock."

Find a Tax Expert

Please confer with a tax expert before you do anything. You need specific advice on how to mesh the two plans, as well as information on the risks associated with the ERSOP structure itself. "Since the rollover feature of the plan is designed to benefit only one plan participant, the structure may be subject to a number of attacks on its qualified status, including its ability to comply with the 'exclusive benefit' rule of Section 401(a) of the Internal Revenue Code," Goldberg says.

Rosen worries about whether the employees in your 401(k) would also have to be allowed to invest in company stock. "If they did—and that logic seems compelling—then your company must at least do a few things that will cost some tens of thousands of dollars," he says. For instance, you might have to file an exemption from securities registration and distribute antifraud disclosure statements to your employees, have an annual appraisal, and have a plan fiduciary monitor the investment to make sure it remains prudent.

It's unclear whether your firm would need to take those costly steps or not. That's why you need to talk to a tax attorney, preferably one familiar with ERSOPs or willing to research them, and ask about whether those provisions apply to your company. At the least, the attorney may advise you to apply for a letter of determination from the IRS before proceeding—just to be on the safe side.

Karen E. Klein is a Los Angeles-based writer who covers entrepreneurship and small-business issues.

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