March 3, 2010
IRS website

Sample Language for Section 409(p) Transfers - Non-ESOP Portion of Plan


1. Non-ESOP Portion. Assets held under the Plan in accordance with this Section are held under a portion of the Plan that is not an employee stock ownership plan (ESOP), within the meaning of section 4975(e)(7) of the Internal Revenue Code. Amounts held in the portion of the Plan that is not an ESOP (the Non-ESOP Portion) shall be held in accounts that are separate from the accounts for the amounts held in the remainder of the Plan (the ESOP Portion). Any statements provided to Participants and/or Beneficiaries to show their interest in the Plan shall separately identify the amounts held in each such portion. Except as specifically set forth in this Section, all of the terms of the Plan apply to any amount held under the Non-ESOP Portion of the Plan in the same manner and to the same extent as an amount held under the ESOP Portion of the Plan.

2. Transfers from ESOP Portion to Non-ESOP Portion of Plan to Avoid Nonallocation Years. (a) In the case of any event that the Plan Administrator determines would otherwise cause a nonallocation year (as defined in section xxx of the Plan) to occur (referred herein as a “nonallocation event”), shares of employer stock held under the Plan before the date of the nonallocation event shall be transferred from the ESOP portion of the Plan to the Non-ESOP portion of the Plan as provided in (2)(a). Events that may cause a nonallocation year include, but are not limited to, a contribution to the Plan in the form of shares of employer stock, a distribution from the Plan in the form of shares of employer stock, a change of investment within a Plan account of a disqualified person (as defined in section xxx of the Plan) that alters the number of shares of employer stock held in the account of the disqualified person, or the issuance by the employer of synthetic equity as defined by section 409(p)(6)(C) of the Internal Revenue Code and section 1.409(p)-1(f) of the Treasury Regulations. A nonallocation event occurs only if (i) the total number of shares of employer stock that, held in the ESOP account of those Participants who are or who would be disqualified persons after taking into account the Participant’s synthetic equity and the nonallocation event exceeds (ii) the number of shares of employer stock equal to 49.9% of the total number of shares of employer stock outstanding after taking the nonallocation event into account (causing a nonallocation year to occur as described in Section xxx of the Plan). The amount transferred under this section shall be the amount that the Administrator determines to be the minimum amount that is necessary to ensure that a nonallocation year does not occur, but in no event is the amount so transferred to be less than the excess of (i) over (ii). The Administrator shall take steps to ensure that all actions necessary to implement the transfer are taken before the nonallocation event occurs.

[The plan may provide for a stated percentage not less than 40% instead of 49.9% as used in (ii) above. If this is chosen use the following language instead of the above section:

2. Transfers from ESOP Portion to Non-ESOP Portion of Plan to Avoid Nonallocation Year. (a) In the case of any event (referred herein as a “nonallocation event”) that the Plan Administrator determines would otherwise cause the total number of shares of employer stock held in the ESOP account of those Participants who are or who would be disqualified persons after taking into account the Participant’s synthetic equity and the nonallocation event to exceed the number of shares of employer stock equal to [a stated percentage not less than 40% but not exceeding 49%] of the total number of shares of employer stock outstanding, shares of employer stock held under the Plan before the date of the nonallocation event, shall be transferred from the ESOP Portion of the Plan to the Non-ESOP Portion of the Plan as provided in this section. Actions that may cause a nonallocation event, include, but are not limited to, a contribution to the Plan in the form of shares of employer stock, a distribution from the Plan in the form of shares of employer stock, a change of investment within a Plan account of a disqualified person (as defined in section xxx of the Plan) that alters the number of shares of employer stock held in the account of the disqualified person, or the issuance by the employer of synthetic equity as defined by section 409(p)(6)(C) of the Internal Revenue Code and section 1.409(p)-1(f) of the Treasury Regulations. A nonallocation event occurs only if (i) the total number of shares of employer stock that, held in the ESOP account of those Participants who are or who would be disqualified persons after taking into account the Participant’s synthetic equity and the nonallocation event, exceeds (ii) the number of shares of employer stock equal to [the previously stated percentage] of the total number of shares of employer stock outstanding after taking the nonallocation event into account. The amount transferred under this section shall be the amount that the Administrator determines to be the minimum amount that is necessary to ensure that no nonallocation event occurs, but in no event is the amount so transferred to be less than the excess of (i) over (ii). The Administrator shall take steps to ensure that all actions necessary to implement the transfer are taken before the nonallocation event occurs.]

(b)(1) Except as provided for in (b)(2), at the date of the transfer, the total number of shares transferred, as provided for in (a)(1), shall be charged against the accounts of Participants who are disqualified persons (i) by first reducing the ESOP account of the Participant who is a disqualified person whose account has the largest number of shares (with the addition of synthetic equity shares) and (ii) thereafter by reducing the ESOP accounts of each succeeding Participant who is a disqualified person who has the largest number of shares in his or her their account (with the addition of synthetic equity shares). Immediately following the transfer, the number of transferred shares charged against any Participant’s account in the ESOP portion of the Plan shall be credited to an account established for that Participant in the Non-ESOP portion of the Plan.

(2) Notwithstanding (b)(1), the number of shares transferred shall be charged against the accounts of Participants who are disqualified persons (i) by first reducing the account of the Participant with the fewest shares (including synthetic equity shares) who is a disqualified person and who is a Highly Compensated Employee (as defined in Section xxx of the Plan) to cause the Participant not to be a disqualified person, and (ii) thereafter reducing the account of each other Participant who is a disqualified person and a Highly Compensated Employee, in order of who has the fewest ESOP shares (including synthetic equity shares). A transfer under this (b)(2) only applies to the extent that the transfer results in fewer shares being transferred than in a transfer under (b)(1).

(c) (1) If two or more Participants described in (b) have the same number of shares, the account of the Participant with the longest service shall be reduced first.

(2) Beneficiaries of the Plan are treated as Plan Participants for purposes of this section.

3. Income Taxes. If the Trust owes income taxes as a result of unrelated business taxable income under section 512(e) of the Internal Revenue Code with respect to shares of employer stock held in the Non-ESOP portion of the Plan, the income tax payments made by the Trustee shall be charged against the accounts of each Participant or Beneficiary who has an account in the Non-ESOP portion of the Plan in proportion to the ratio of the shares of employer stock in such Participant’s or Beneficiary’s account in the non-ESOP portion of the Plan to the total shares of employer stock in the non-ESOP portion of the Plan. The Employer shall purchase shares of employer stock from the Trustee with cash (based on the fair market value of the shares so purchased) from each such account to the extent cash is not otherwise available to make the income tax payments from the Participant’s or Beneficiary’s ESOP accounts or his or her other defined contribution plan accounts.



Page Last Reviewed or Updated: March 03, 2010

A. LEGAL REQUIREMENTS
1. Definition of an ESOP (Plan and Trust)
a. An employee stock ownership plan (“ESOP”) is a tax-qualified retirement plan which is designed to invest primarily in employer securities (of the employer sponsoring the ESOP) and, therefore, provide participants in the ESOP with a beneficial ownership interest in their company. An ESOP can acquire employer securities by purchasing stock directly from existing shareholders or the employer, or the employer may contribute stock directly to the ESOP. Unlike other tax-qualified retirement plans, an ESOP may also borrow money and enter into other transactions with a related party in transactions that would otherwise be prohibited under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) and the Internal Revenue Code of 1986, as amended (the “Code”). Like other tax-qualified retirement plans, an ESOP is subject to ERISA and the qualification rules under the Code.
b. An ESOP typically incorporates a stock bonus plan (which is a qualified retirement plan under Section 401(a) of the Code); however, an ESOP may also be a combination of a stock bonus plan and a money purchase pension plan. A stock bonus plan is similar to a tax-qualified profit sharing plan except that the benefits in a stock bonus plan are distributable in employer stock.
2. Advantages of an ESOP
a. Tax-qualified retirement plan
(1) Employer contributions are tax deductible (so-called “principal and interest deduction” in C corporation ESOP situations).
(2) Earnings are tax-free.
(3) No tax on employee-participants until they receive distributions of their ESOP accounts.
(4) S corporation ESOPs.
b. Business perpetuation.
c. Provide market for closely-held stock and therefore liquidity for closely-held corporation shareholders.
(1) An ESOP can provide an exit for a shareholder who may not want to sell his or her shares to a third party. For example, a shareholder may not want to sell stock to a competitor, a foreign-owed buyer, a publicly-traded corporation, etc., or may only want to sell a portion of stock owned.
d. Business acquisition.
3. General Requirements of ESOPs
a. Code Section 401(a) Requirements. The Code groups all tax-qualified retirement plans into two categories, defined contribution plans and defined benefit pension plans. An ESOP is a defined contribution plan where a participant’s benefit is based solely on the sum of employer contributions to his account under the ESOP, forfeitures (if any) allocated to the participant’s account, and the participant’s share of income, loss and expenses. In contrast, in a defined benefit pension plan an amount of benefits is paid upon retirement pursuant to a formula in the plan, regardless of contributions to and earnings of the plan. An ESOP must meet all of the qualified plan requirements under Section 401(a) of the Code.
b. Designed to Invest in Employer Securities. An ESOP must be designed to invest primarily in qualifying employer securities as described in Section 4975(e)(8) and Section 409(l) of the Code. “Employer securities” are defined as common stock issued by an employer which are readily tradable on an established securities market. If such common stock does not exist, the term “employer securities” generally means common stock issued by an employer having the voting power and dividend rights equal to or exceeding that class of common stock of the employer having the greatest voting power and the class having the greatest dividend rights. Employer securities also include preferred stock that is convertible into common stock which meets the above requirements (the conversion price must be reasonable). Employer securities issued by a member of a controlled group of corporations are treated as employer securities for all members of the controlled group.
While there is no specific definition of “invest primarily in employer securities,” the general guidelines are that an ESOP must permit the plan trustees to invest or hold the majority of the plan’s assets employer securities.
c. Voting Rights. Voting rights with respect to an ESOP relate to whether a participant has the right to direct the vote of employer stock allocated to his or her ESOP account. These rights differ depending on whether stock is considered to be securities required to be registered under the Securities Exchange Act of 1934 or a class of securities that would be required to be registered except for an exemption (commonly referred to as publicly-traded stock). If the stock does meet that description, then the ESOP must permit each participant to direct the voting of the securities of the employer allocated to his or her ESOP account. If the ESOP does not have registration-type class of securities described above (commonly referred to as closely-held stock), the only voting rights required to be passed through to participants is that the participants must be allowed to direct the vote of stock allocated to the account with respect to any corporate matter involving the voting of shares for or against corporate mergers, consolidations, sale of all or substantially all the employer corporation’s assets, recapitalization, reclassifications, liquidations, dissolutions, or such similar transactions as the Internal Revenue Service (“IRS”) designates through the issuance of regulations.
After October 21, 1986, an ESOP established by an employer without registration-type securities may permit each participant to have one vote on each issue which the participant is entitled to direct the trustee to vote, without regard to the actual number of shares allocated to the participant’s account. In this situation, the trustee may vote the shares held in the ESOP in proportion to the directions given by the participants.
It should be noted that participant vesting is not relevant to the issue of voting employer securities. Whether or not stock has been allocated to a participant’s ESOP account, not whether the participant is vested in his or her ESOP account, determines whether and the extent to which a participant may direct the vote such employer stock.
The extent that employer securities in an ESOP are not allocated (such as shares acquired since the last allocation date, or shares acquired with loan proceeds and not yet released from the ESOP’s loan suspense account, discussed below), the trustee of the ESOP (or other ESOP fiduciary, such as an ESOP committee) generally exercises its discretion in voting such unallocated shares.
d. Put Option. A participant must be given the right to receive a distribution from the ESOP in the form of employer securities, except in limited circumstances. In C corporation ESOPs, the participant must be given the right to demand distributions from the ESOP in the form of employer securities. Absent such demand, ESOP accounts may be distributed in cash.
Unless employer stock is traded on an established securities market, the participants must be given the right to require the employer to repurchase the shares at fair market value. It is important to note that the ESOP itself is not required to purchase the shares. Participants have a put option to force the employer stock distributed to them from the ESOP during two different time periods.
It should be emphasized that distributions of employer securities which are readily tradable on an established security market are not subject to this requirement. In this event, participants receiving a distribution of employer’s stock may simply sell the stock on the established securities market.
e. Right of First Refusal. An employer sponsor of an ESOP which holds non-publicly traded stock, may provide that the employer has a right of first refusal on stock held by the ESOP or distributed from the ESOP to participants. This right may not apply to stock which is publicly traded. The right of first refusal may be in the favor of the employer adopting the ESOP, the ESOP or both. However, the right of first refusal may not be in the favor of any other person.
The selling price and other terms under a right of first refusal must not be less favorable to the seller than fair market value of the stock or purchase price and other terms offered by a buyer making a good faith offer. The right of first refusal must lapse no later than fourteen days after the holder of the stock has written notice to the holder of the right of first refusal that a third party offer has been received.
f. Distribution Requirements. An ESOP contains provisions that allow distributions to a participant of the vested interest in their ESOP account to begin not later than one year after the end of the plan year during which the participant terminates employment because of retirement on or after the plan’s normal retirement age, disability or death. Further, if a participant is terminated (either voluntarily or involuntarily) distributions are to be made not later than one year after the end of the fifth plan year following the plan year during which the termination occurs. A participant may elect to leave their account balances in the ESOP. In addition, unless the participant elects otherwise, the participant’s account balance generally must be distributed in substantially equal periodic payments (not less frequently than annually) as rapidly over a period not exceeding five years. (For large account balances, distributions may be made over a longer period of time.)
The distribution requirements discussed above do not apply to a participant’s account balance which consist of employer securities acquired with the proceeds of an ESOP securities acquisition loan until the end of the plan year in which the entire loan is repaid.
The cash distribution option and Put Option requirements discussed above effectively create a market for employer stock which is not publicly traded. A closely-held company that adopts an ESOP considers the liquidity requirements that these provisions will impose on it at the time a participant either retires or terminates employment with an account in the ESOP, and then plans accordingly.
g. Independent Appraiser. An ESOP that holds employer securities which are not readily tradable on a securities market must have all valuations of those securities made by an “independent appraiser.” The independent appraiser should be a person who does not perform any other services for a party whose interest may be adverse to the ESOP and who would be impartial.
h. Diversification. An ESOP is required to provide “qualified employees” an opportunity to diversify their employer securities credited to their ESOP accounts. Basically qualified employees must be allowed to have a portion of their account invested in assets other than employer securities. “Qualified employees” are those employees who are at least 55 years of age and who have at least 10 years of participation in the ESOP.
The extent of diversification is set forth in the Code which provides that ESOPs must permit qualified participants to diversify their investment of at least 25 percent of their ESOP account during five years of the six year period commencing with or after the plan year in which the participant reaches age 55 (or if later, the plan year in which the participant completes ten years of participation). This period is referred to as the “qualified election period.” In the final sixth year of the qualified election period, the ESOP must allow their participants the opportunity to diversify the investment of at least 50 percent of the balance of the participant’s account, less any portion of the account which was previously diversified.
Participants are entitled to one election per year during the qualified election period.
An ESOP may satisfy the diversification requirement in two ways. The ESOP may distribute, in stock or cash, the portion of participant’s account subject to the diversification requirements to the participant within ninety days of the period in which the diversification election may be made. If the ESOP distributes stock, the put option requirement applies or the stock may be rolled over into an IRA. If the distribution is in cash, the participant may roll the cash over into an IRA. To satisfy the diversification requirements, the ESOP may offer at least three investment options (other than employer stock) to qualified employees.
There is a “de minimus” exception to the diversification requirements. If the fair market value of the employer securities acquired by or contributed to an ESOP and allocated to a participant’s account is $500 or less, the employer securities will be considered de minimus and therefore not subject to the diversification requirements.
i. Requirements that Plan be Designated as an ESOP. The ESOP plan document must specifically provide that a plan is an ESOP.
The plan document must also provide that participants have certain protections with respect to assets acquired with the proceeds of an exempt loan (discussed below). No security acquired with the proceeds of an exempt loan may be subject to a put, call or other option while held by the ESOP. An exception to this rule is for the put options and for the rights of first refusal discussed above.
j. Allocation Requirements. At the end of each plan year, a leveraged ESOP must allocate to participant accounts employer stock representing the participants interest in the employer securities released from an exempt loan suspense account (discussed below). If part of a participant’s ESOP account is forfeited (for example when a participant terminates employment with the sponsoring employer prior to full vesting), stock allocated as of the end of the plan year to the participant’s ESOP account must be forfeited only after all other assets (if any) are forfeited.
k. ESOP Loan Requirements. The prohibited transaction provisions of the Code generally prohibit any tax-qualified retirement plan from receiving a loan from a disqualified person or from receiving a loan which is guaranteed by a disqualified person or collateralized by assets of a disqualified person. An exception to this rule is granted for leveraged ESOPs. In order to qualify for this exemption, the following requirements must generally be met:
(1) the loan proceeds must be used within a reasonable time after their receipt to acquire qualified employer securities or to repay the loan of a prior exempt loan;
(2) the loan must be without recourse against the ESOP, except to the extent of employer securities acquired with loan proceeds, contributions made to the ESOP’s obligations under the loan and earnings attributable to such employer securities and contributions (if ESOP assets are pledged as collateral, the collateral must be released in installments over the loan’s term in accordance with a schedule that meets the requirements of IRS regulations);
(3) the loan must be a term loan, not a demand loan; and
(4) the loan’s terms must be at least as favorable to the ESOP as the terms of a comparable loan resulting from arms-length negotiations between independent parties and it must bear a reasonable rate of interest.
B. TAX BENEFITS
There are distinct tax benefits provided to the parties to transactions involving an ESOP. Specific provisions of the Code benefit an employer that establishes an ESOP, participants of an ESOP, and shareholders selling stock to an ESOP. The benefits include the deductibility (in effect) of principal and interest payments on ESOP loans, the deferred recognition of gain on the sale of stock of a closely held company to an ESOP, and the deductibility of certain dividends on stock held by an ESOP.
1. Leveraged ESOP Buy Outs. There may be a limited market for stock in a closely held corporation. Often owners of a closely held corporation consider establishing a leveraged ESOP to purchase their shares to overcome this obstacle. Although leveraged ESOP buy outs may be complex, proper planning can produce significant tax benefits.
a. A leveraged ESOP essentially is an ESOP that finances the acquisition of the employer stock with borrowed money. With a closely-held corporation, a leveraged ESOP may be used to finance the sale of large shareholder interest. An ESOP buy-out frequently provides the following benefits:
(1) It permits the transfer of the non-ESOP shareholders’ C corporation ownership interest without recognition of taxable income; and
(2) Provides employees with both retirement benefits and added incentive in holding an ownership interest in their employer.
b. A leveraged ESOP buy out often includes the following steps:
(1) The employer establishes an ESOP (a plan and trust).
(2) The majority shareholder(s) enter(s) into an agreement with ESOP to sell his or her/their shares to the ESOP at an agreed upon price (which may not be in excess of fair market value as determined by the ESOP’s independent appraiser).
(3) The ESOP borrows money either (i) from a financial institution (this loan may be guaranteed by the corporation establishing the ESOP and the stock and the employer need to be purchased with the loan proceeds may be pledged as collateral); or (ii) the employer may borrow money from the lender and, in turn, lend the loan proceeds to the ESOP (this is the scenario generally preferred by lenders since the repeal of Code Section 133, the so-called 50 percent exclusion of interest income ESOP loan, over a decade ago). The leveraged ESOP uses the loan proceeds to pay the selling shareholder(s) for the shares it has purchased.
(5) Over time, the employer makes contributions (and/or cash dividend payments) to the leveraged ESOP in the amount needed to repay principal and interest in the loan. The employer receives, in effect, a deduction of principal and interest on the loan since the employer’s contributions to the ESOP are deductible.
(6) The shares purchased by the ESOP are held in an ESOP “loan suspense account” and allocated to participant accounts in the plan as the loan is repaid by the ESOP.
2. Deduction of Employer Contributions. Within limits imposed by Section 404 of the Code, employers may deduct contributions which they make to qualified retirement plans. These limitations also apply to contributions made to an ESOP. The Code provides that an employer may contribute to an ESOP and deduct up to 25 percent of the compensation of all participants for that plan year (reduced by the contributions made by the employer to any other tax-qualified defined contribution plan(s) of the employer).
In addition, employer contributions to a C corporation ESOP that are used to repay interest on a loan used by the ESOP to acquire employer securities are fully deductible.
3. Deduction of Employer Dividend Payments. Corporations are generally not permitted to deduct dividends to shareholders. An exception to this rule are dividends paid on shares held by an ESOP. Dividends paid on shares held by an ESOP may be deducted if they are paid in cash to plan participants, paid to the plan and passed through to participants within ninety days after the end of the plan year or used to repay the loan incurred to purchase employer securities.
4. Allocation of Contributions. Since an ESOP is a tax-qualified defined contribution plan, the plan document must provide a definite formula for allocating employer contributions and forfeitures to individual participant accounts. The allocation formula may not discriminate in favor of highly compensated employees and must disregard annual compensation in excess of $230,000 (for 2008, indexed for inflation). Similar rules apply to the allocation of employer securities released from an ESOP loan suspense account and allocated to accounts of participants.
5. Tax-Deferred Rollover Treatment. The tax-deferred treatment of gain realized in the sale of stock to ESOP is often the critical factor (generally when long-term capital gains rates are in excess of the current 15 percent) in deciding to proceed with a leveraged ESOP buy out. Under Section 1042 of the Code, a shareholder realizing gain from the sale of stock to a C corporation ESOP may elect to defer recognition of the gain if the requirements set forth below are satisfied.
Under Section 1042, if a stockholder sells “qualified securities” to a C corporation ESOP and makes the appropriate election, gain is generally not recognized if all of the following conditions are met:
a. The ESOP must own at least 30 percent of either (a) each class of outstanding stock or (b) the total value of all the corporation’s outstanding stock (excluding nonvoting nonconvertible preferred, immediately after the sale).
b. The sale must otherwise qualify for long term capital gain treatment.
c. The shareholder held the securities for at least three years prior to the sales of the ESOP.
d. Within the 15-month period beginning three months before the sale date, the seller purchases “qualified replacement property” and complies with IRS filing requirements.
6. Making the Code Section 1042 Election. A Section 1042 election is made by a shareholder on a timely filed Form 1040 return (including extensions) filed for the year of sale. The taxpayer must also file a written statement in which the employer whose employees are covered by the ESOP consents to the application of Code Sections 4978 and 4979A.
7. 30 Percent Ownership. The 30 percent threshold (discussed above) may be met by several shareholders as a part of a single transaction under a prearranged agreement among the shareholders. For purposes of the 30 percent rule, the Code applies the Code’s attribution rules with this. This provision is intended to preclude evasion of the 30 percent rule through the use of options, warrants or other devices which would ultimately dilute the ESOP’s proportional equity interest below 30 percent.
8. Gain and Holding. Code Section 1042 provides that any long term capital gain realized in a sale of stock to a C corporation ESOP is recognized only to the extent that the proceeds exceed the cost of the qualified replacement properly purchased with the proceeds of the sale. The deferred gain of the stock sold to an ESOP is preserved through an adjustment to the basis of the qualified replacement property. If more than one item of replacement property is acquired, basis is allocated among the items purchased. The holding period of the employer securities sold to the ESOP will be tacked to the holding period of the qualified replacement property.
a. Premature Disposition of Securities. If within 3 years after acquiring a qualified security under a Code Section 1042 transaction, the ESOP disposes of them, the employer may be liable for a 10 percent excise tax on the amount realized.
b. Prohibited Allocation Rule. A C corporation ESOP acquiring securities in a Code Section 1042 transaction is prohibited from allocating plan assets attributable to the securities to:
(1) An electing seller;
(2) The electing seller’s family; and
(3) Any more than 25 percent shareholder.
Further, a comparable qualified plan for the primary benefit of such persons (or the equivalent cash contributions to the ESOP which are not used to purchase stock or repay ESOP debt) to “make up” for lost ESOP allocations cannot be established. Lineal decedents of the seller are eligible for such allocations if they would not, absent the family relationship, be ineligible for such allocations, provided the total amount of allocated to all such lineal decedents of all sellers is no more than 5 percent of the Code Section 1042 securities attribution to such sellers. There is a 10 year period, beginning after the allocation of all Code Section 1042 securities, beyond which allocations to a selling shareholder (any family members) will not cause the C corporation ESOP to fail to satisfy Code Section 4975(e)(7) or be subject to the excise tax of Code Section 4979A.
C. S CORPORATIONS AND ESOPs
Prior to 1997, ESOPs could not hold stock in S corporations. The Small Business Job Protection Act of 1996 and subsequent legislation amended the Code to allow qualified retirement plans, including ESOPs, to hold stock in S corporations. This opened a tremendous tax planning opportunity for certain corporations. However, not all tax benefits available to ESOPs holding stock in C corporations are available to ESOPs holding S corporation stock.
1. Benefits of S Corporation ESOPs.
a. In General. S corporation status allows a corporation to avoid paying federal income tax at the corporate level (most states tax the income generated by ESOP-owned S corporations). Therefore, all earnings of the S corporation allocated to S corporation shares held by an ESOP go untaxed (i.e., federal, not state, income tax) since the ESOP is a tax-exempt entity (under Code Sections 401(a) and 501(a)). Elimination of the federal income tax liability obviously enhances the cash flow of an S corporation owned by an ESOP.
b. Cash Flow.
(1) If an S corporation has shareholders in addition to the ESOP, the non-ESOP shareholders generally need distributions from the S corporation sufficient to cover payment of the taxes on their share of K-1 income.
If such distributions are made to non-ESOP shareholders, an equivalent distribution must also be made to the ESOP.
i. Even though the ESOP does not pay income taxes, the economic rights relating to the S corporation stock owned by the ESOP must be the same—otherwise the one-class-of-stock rule for S corporations will be violated and the S corporation election automatically terminated.
(2) ESOP can use its K-1 distributions in numerous ways.
i. Purchase of additional employer stock;
ii. Additional payments on ESOP loan(s).
iii. Liquidation of stock in ESOP accounts of participants entitled to distributions.
iv. Other investments in ESOP participants’ accounts.
2. Disadvantages of S Corporation ESOPs
a. No Code Section 1042. Shareholders of an S corporation cannot utilize the Code Section 1042 deferral of gain provisions described above.
b. Anti-Abuse. The Economic Growth and Tax Relief Reconciliation Act of 2001 amended the Code to provide that, in general, for plan years beginning after December 31, 2004, an ESOP established by an S corporation must comply with certain anti-abuse rules relating to “disqualified persons.” Congress intended these rules to limit the establishment of ESOPs by S corporations to those that provide broad-based employee coverage and that benefit rank and file employees. Further discussion of Code Section 409(p) is beyond the scope of this outline; however, failure to comply with the Code Section 409(p) anti-abuse rules can result in significant penalty taxes, and ESOP tax-qualification and S corporation status issues.

By: Robert B. Webb, III
Squire, Sanders & Dempsey L.L.P.

Overview

The use of the "Leveraged ESOP" as a means of providing for a "buyout" of existing corporate shareholders is often extremely advantageous as a result of several factors. The basic transaction generally involves the following fact pattern and steps:

1. Closely held corporation (the "Corp.") has significant blocks (if not all) of stock held by a few (or one) individuals ("Founders") who desire to liquidate a substantial part, if not all, of their holdings. Founders generally have held their stock for an extended period of time, often since formation of the Corp, thus face potentially significant tax upon gain in a sale. Founders generally have a substantial portion of their personal wealth tied up in stock of Corp. and desire to diversify into a broader investment holdings base as part of retirement from the business

2. Corp. establishes an "Employee Stock Ownership Plan" ("ESOP"), which is a qualified ERISA plan, the principal feature of which is that the ESOP's principal investment asset consists of stock of the Corp. Plan assets are, as with other ERISA plans, held by a "trustee" under a trust agreement. The Corp. funds annual contributions to the ESOP and treats these as an employee benefit expense, receiving tax deductions, and, in many cases, with cost reimbursable contracts, obtaining reimbursement of the cost of this employee benefit. Annual contributions (an employee benefit by Corp. to employees) are allocated among employees of the Corp. and used to buy stock of Corp. which is then held by the trust but specifically allocated to individual employee accounts. The ESOP can be a "pension" type ESOP where the Corp. is obligated to make certain annual contributions or a "profit sharing" type ESOP where the Corp.'s contribution obligation is discretionary each year based on Corp. profits.

3. ESOP buys stock of Corp. at fair market value, as determined by bona fide appraisal, to hold as its plan asset; thus the value and return to employees are in large part dependant upon growth in value and dividends from Corp. stock held by ESOP. In a "Leveraged ESOP," the ESOP obtains a loan (the "ESOP Loan") from a lending party (generally a financial institution) and uses the loan proceeds to buy a large block of stock in a single transaction (generally from the Founders, but this purchase can also be on the open market or from the Corp. itself). The shares purchased serve as the sole collateral for the Loan and initially are not allocated to individual participant (employee) accounts. The loan is otherwise nonrecourse to the ESOP or to other Trust assets and individual employee accounts.

4. Over the course of years, as the Corp. makes annual contributions to the ESOP, the contributions fund the amortization of the loan (thus are applied to both principal and interest on the Loan). As the Loan is amortized, unallocated shares held as collateral security for the Loan are released and allocated to ESOP plan accounts of individual participants (employees). ERISA requires that shares be released from the lien securing the loan once allocated to individual participants.

5. When employees retire, they either receive their shares of stock or, more typically in the non public corporation, sell their stock back to the Corp. at appraised fair market value, receiving a payout either in cash or over time. Employees may be permitted to receive and retain their stock in kind, however, this is generally not desirable in the context on private companies because of the lack of liquidity.


Possible Advantages of the Leveraged ESOP

Although each situation is unique and not all of these advantages can be obtained in every case, the Leveraged ESOP often offers the following advantages to the Corp. and to the Founder:

1. Tax Advantages to Founders. Under Section 1042 of the Internal Revenue Code, if Founders reinvest the proceeds in qualified securities (stocks and bonds) of a United States corporation, the proceeds can be reinvested tax free (gain is deferred, not avoided). This tax advantage often results in significantly higher net after tax proceeds to the Founders than a sale to another corporation or a public offering. This advantage is not available if the Corp. is an S corporation (prior to the sale), but if the Corp is a C corporation (i.e. subject to corporate level tax) prior to the sale, it may elect S corporation status once sale is consummated). Stock received pursuant to options or in connection with the performance of services is also not eligible for this tax-free rollover.

2. Cost Advantage to Corp. The Corp. can gain three potential advantages:

(a) possible reimbursement of cost via contract pass throughs.

(b) possible tax savings if the Corp., is eligible for "S Corporation" status as a result of post transaction ownership and then so elects, thereby eliminating corporate level federal and Virginia state income tax (with some possible exceptions) entirely. As an S corporation, income is passed through to the shareholders and escapes income tax entirely to the extent of ESOP ownership. This results because since the ESOP trust is not subject to tax, the Corp. income allocable to the ESOP escapes taxation altogether. Other S corporation shareholders remain subject to taxation.

(c) employee motivational and morale benefits of being an "employee owned company."


Issues

The implementation of a leveraged ESOP transaction involves a number of issues and hurdles, the more significant of which are as follows:

1. Loan Financing - The leveraged ESOP involves a loan, thus a third party financing commitment must be obtained upon terms that are financially acceptable to the Corp. The maximum that the Lender is willing to lend generally defines the maximum price that can be paid to the Founders. Often times to support a larger loan and permit the purchase of more shares at a time when the market valuations are high (i.e. "lock-in" today's value), the Founders will agree to pledge back a part of the securities they reinvest their sales proceeds in as additional collateral for the bank financing. Generally these pledged back securities are bonds valued, for collateral purposes, at 90% of value, and are held in a brokerage account under a collateral account control arrangement until the loan is curtailed substantially (but are generally released prior to payoff in full). Often an interest hedge derivative product is put in place to protect the lender against a decline in value and the Corp. and selling Founder against a "margin call."

2. Appraised Fair Value - Under ERISA, the stock cannot be sold to the ESOP at a price that exceeds appraised fair value, as determined by qualified third party appraisal. Generally, two independent appraisals are obtained to assure that the plan is paying fair value and to protect the Corp. and the Founders against liability.

3. Terms of Sale - The Founders, the ESOP trustee, and the Corp. must agree upon mutually acceptable terms of sale for the stock being purchased. If the sale is all cash, this can be straightforward, but if the Founders are not selling all of their stock or will also be receiving deferred notes (not eligible for 1042 tax free rollover), then other material issues may need to be negotiated.


4. Plan Design - Because the ESOP is an employee benefit plan, decisions must be made with respect to plan design, scope of coverage, participants, and communication of the plan to employees in a positive manner that achieves the desired employee motivational benefit. The plan must, of course, be designed and maintained in compliance with applicable ERISA (Department of Labor and Internal Revenue Service) requirements.

The above summary is intended to provide introductory information and should not be relied upon as legal advice for any actual transaction without further consultation with counsel. For further information, please contact Bob Webb, Attorney-at-Law, Squire, Sanders & Dempsey L.L.P., 8000 Towers Crescent Drive, 14th Floor, Tysons Corner, Virginia. Tel: (703) 720-7855; E-mail: rwebb@ssd.com

Annual Conference
ESOPs: When The Going Gets Tough We Grow Stronger
33rd Annual ESOP Conference
May 12 & 13, 2010
Renaissance Washington Hotel
Washington, DC

Info available at
http://www.esopassociation.org/meetin ... ngs_annual_Conference.asp

The IRS issued final regulations regarding Section 108 - Reduction of Tax Attributes for S Corporations, and the IRS preamble to the final regulations confirms that disallowed losses and deductions under section 1366(d)(1) of a shareholder that is an employee stock ownership plan (ESOP) are included in the S corporation’s deemed NOL. The IRS stated position is that Section 108(d)(7)(B) provides that any loss or deduction that is disallowed for the taxable year of the discharge under section 1366(d)(1) is treated as a deemed NOL of the S corporation. Accordingly, section 108(d)(7)(B) applies to any shareholder, including an ESOP shareholder, that has disallowed losses and deductions for the taxable year of the discharge under section 1366(d)(1).