Try not.

As parents we often tell our kids to try their best (or harder or again). After all, in many things, it is effort that matters. But, as the great philosopher Yoda reminds us of in Star Wars: Episode 5 –The Empire Strikes Back sometimes effort is not enough.

“Try not.  Do…or do not.  There is no try.”


Yoda not so gently reminds Luke that results matter. Granted, most of us are not trying to save the entire galaxy from the evil empire; it does not diminish the fact that results matter.

Results very much matter when it comes to the compliance tests that Employee Stock Ownership Plans (ESOPs) must pass. Similar to tests on other qualified retirement plans, these tests ensure that the plan is operating for the benefit of a significant portion of the company’s employees and that the plans do not disproportionately benefit a few individuals.

Although not an exhaustive list, some of the compliance tests that need to be met (depending upon plan design) include:

  • Coverage test. The purpose of coverage testing is to demonstrate that the plan provides benefits to a significant percentage of the company’s Non-Highly Compensated Employees (NHCEs). All qualified retirement plans need to demonstrate that they are including broad groups of participants. The rules around coverage testing are found in Internal Revenue Code (IRC) Section 410(b).
  • Nondiscrimination test. While the coverage test is designed to make sure that a large percentage of NHCEs participate in the plan, the nondiscrimination test is designed to make sure that they receive meaningful contributions relative to the highly compensated employees (HCEs). There are safe harbor allocation formulas that can be used to satisfy the requirements of this test.  The nondiscrimination testing requirements are found in IRC 401(a)(4).
  • Anti-Abuse test. Anti-abuse testing, also known as Section 409(p) testing after the IRC section it is found in, is designed to prevent S Corporation ESOPs from being used as abusive tax shelters. This test includes not only the ESOP but also other synthetic equity that the company has issued. The penalties for failing this test on any day of any plan year can be significant.

Careful design can make complying with the various tests a much simpler process.  An ESOP consultant can model the tests prior to implementation so that this does not have to be a daunting task. Failure to design with testing in mind may lead to a situation that Yoda also references in the same movie:

“That is why you fail.”


In addition to blogging here, I also tweet regularly about topics of interest to ESOPs. Click to follow me on Twitter –  @jlripperger.

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Affiliation Disclosures

While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the member companies of The Principal are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.

Insurance products and plan administrative services are provided by Principal Life Insurance Company a member of the Principal Financial Group® (The Principal®), Des Moines, IA 50392.