Before 2020, the IRS had long taken the position that an employee stock ownership plan (ESOP), and any other retirement plan for that matter, must be adopted no later than the end of the first tax year in which the employer wished to claim a deduction for a contribution to the plan. As a reminder, effective December 31, 2019, Section 201 of the SECURE Act extended that 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. Accordingly, under the SECURE Act, if a plan is adopted by the extended due date, it will be treated as having been 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, can still make a 2021 ESOP contribution, so long as the contribution is made prior to the tax deadline for its 2021 income tax return. The ability to take advantage of a prior-year tax deduction can be quite significant. An ESOP sponsor is permitted to make an annual contribution, equivalent to 25% of its eligible payroll, to its ESOP. A company with a $10 million annual payroll, for example, could make an annual ESOP contribution as large as $2.5 million and take an equivalent income tax deduction. Thus, under the example above, an ESOP established prior to September 15, 2022 can 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, there are several points to keep in mind. First, any tax advantaged plan qualified under Code Section 401(k) (including an ESOP with a 401(k) feature) must be adopted 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 scenario where the deadline for filing a 5500 would be earlier than the deadline for adopting the plan. Perhaps recognizing this disconnect, the IRS announced filing relief in August of this year for plans established in 2020, and as a result those plans don’t have to file a Form 5500 for the 2020 year. The first filing would be for 2021, with a box to check reflecting that the plan was adopted effective for 2020.
The extended deadline under the SECURE Act provides greater flexibility for a company wishing to establish an ESOP. No longer do prospective ESOP sponsors have to rush to establish an ESOP prior to a tax year’s end. They now have enough time to comprehensively engage with legal and accounting advisors on transaction design, plan design, and the implementation process; however, any company considering adoption of an ESOP should 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. Accordingly, while there is an extended period to adopt the plan, companies should consider starting the process sooner rather than later.