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Exempt Loan v. Permissible Other Loan


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S Corp has looked at reshuffling allocated shares, but such reshuffling still does not allocate enough shares to newly-hired employees. So S Corp would like its ESOP (wholly-owned S Corp) to allocate shares of retiring participants to be based on compensation. However, the amount shares of retiring participants is expected to be greater than the amount contributed to the plan during a single year. Thus, S Corp would like to spread the allocation of shares of retiring participants over a few years. Because of this, instead of exchanging shares for amounts in the ESOP’s cash accounts, S Corp would like ESOP to obtain a loan and purchase the retiring participants’ allocated shares with proceeds thereof. Loan would be secured by shares acquired. S Corp would then contribute an amount sufficient to repay loan over term. As loan repayments are made, shares would be released from encumbrance under a share release formula (based on principal and interest) and allocated to participants’ accounts based on plan year compensation.

The Plan only permits distribution of cash. If the ESOP, however, allowed stock to be distributed, ESOP could repurchase the stock with an exempt loan and easily accommodate S Corp’s desires.

However, because stock is not actually distributed, we are concerned that the loan to the ESOP is not technically an “exempt loan” under 4975 because the loan proceeds are not used “to acquire” employer stock or repay a prior exempt loan. Despite this, we believe the ESOP could still obtain the loan, purchase the shares, and provide a security interest to the bank in the shares. The only unusual aspect of the loan (at least in our experience) would be that the neither the S Corp nor any other disqualified person could guarantee the loan (otherwise it would be a prohibited transaction without the benefit of the statutory exempt loan exemption).

Any thoughts about the loan being exempt, and therefore, S corp being able to provide a guarantee?

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Thinking out loud here - I've seen this sort of "releveraging" transaction done in the past, with a light difference. I've seen the shares distributed to the terminated participants, redeemed by the Company, and then sold by the Company to the Trust. In this case it seems clear that the Trust is indeed "acquiring" employer stock.

Variation: rather then selling the treasury shares to the Trust, the Company could make its annual contribution to the Trust in the form of these treasury shares at whatever rate it desires, which may lower the transaction cost and reduce fiduciary liability.

Thoughts?

Marcus R. Piquet, CPA

American ESOP Advisors LLC
5995 Brockton Ave Fl 2, Riverside, CA 92506-1833
(951) 779-1124 (v) (951) 346-0896 (fax)

mpiquet@AmericanESOP.com

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Guest vsaper

Actually, this is quite common in my practice. It is correct that to be an "exempt loan" the stock must be "acquired" by the ESOP. Simply having the ESOP borrow funds to shift the stock to other participant accounts will not work.

However, since the ESOP is maintained by an S Corp, the ESOP can provide that stock will be distributed to terminated participants and that the participants are then REQUIRED to immediately sell the stock back to the ESOP. The ESOP may then borrow funds (usually from the company rather than a lending institution) to purchase the stock. The repayment terms of the ESOP loan can be set to allow the stock to be allocated to participants, in the desired amounts, as the loan is repaid. For example, the loan might be paid over 5 years, with 1/5 of the stock being allocated each year.

It is not unusual for an ESOP to make an acquisition loan every year, so that there is a series of these loans outstanding. Care should be taken to be sure the shares allocated each year from the series of loans match the amount the company wishes to allocate to participants on an annual basis.

For a mature ESOP, the same system can be used to provide for allocation of shares which participants elect to diversify pursuant to the age 55/10 year diversification rule.

This system prevents the necessity of immediately allocating all shares purchased by an ESOP in a given year, which would be the case if the ESOP purchased the shares with cash held in the "other investments" account.

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Tot, maybe I'm missing something, but...

If the ESOP could distribute shares, then the S corp status is maintained if the shares that the ESOP distributes are immediately and automatically purchased by the ESOP or by the company.

So, if the company buys the distributed shares and makes its contribution to the ESOP in shares, then the ESOP avoids the need for record keeping of loans. If the plan document says that contributions are allocated by compensation, then the contributed shares are allocated as you want them to be.

By the way, aren't the shares distributed to the retired persons already in (allocated to) their accounts in the ESOP? I don't see why the annual contribution must cover their distributions ... but maybe I'm missing something.

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If plan is amended to provide for distribution of shares, isn't it possible that 100 (75 in past) shareholder limit will be busted? As I read 409(h), 4975-7(b)(4), and Rev. Proc. 2004-14, a participant has right to put shares distributed to company/esop, company (and if esop desires) has obligation to repurchase such shares, and in the event shares are distributed in direct rollover to IRA (i.e., an impermissible shareholder), company/plan can call immediately to avoid disqualifying S corp. status. What gives company/esop right to call shares distributed to participant directly (i.e., an eligible S corp shareholder) (I thought the -7 reg prevented a call right with respect to financed shares, and I thought that the right to repurchase the stock immediately upon distribution would be considered a call or similar right)?

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I have no cites. Sorry. Check with the plan's lawyer.

I believe the 75 (or 100) shareholder limit is not an issue, because the buy-back is immediate (so participants are not shareholders as of the beginning of the day), as noted in this post:

http://benefitslink.com/boards/index.php?showtopic=36021

That post also addresses but does not answer the question of the authority for a call option on a stock distribution to a participant, and my quick search did not come up with the answer. Maybe someone else on these boards will clarify this.

I agree that the -7 regs prevent a call right with respect to financed shares, but in my example none of the shares involved are financed. They are shares already allocated to (and distributed from) participants' accounts and shares contributed by the company.

Sorry I couldn't be of more help.

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The last clause of IRC section 409(h)(2)(B)(i) allows an S corp ESOP to distribute shares subject to a mandatory immediate sale back to the company. This provision was added to the IRC after the ESOP regs were adopted; so the inconsistent provision of the regs has been effectively superseded.

The loan that Tot first described likely could be structured as an interest free loan from the company to the ESOP used to pay benefit distributions in cash. There is a PT class exemption that permits such loans.

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The loan that Tot first described likely could be structured as an interest free loan from the company to the ESOP used to pay benefit distributions in cash. There is a PT class exemption that permits such loans.

I believe that RLL is referring to PTE 80-26, the latest version of which was published in Federal Register Volume 71 Number 67, April 7, 2006. I'll attach a copy.

I have a couple of concerns with vsaper's approach, and I'd love to hear a response. Any time the ESOP is acquiring shares with a loan you've got to have a fairness opinion. At least with the professionals that I work with, the extra valuation and legal fees to do a new transaction potentially every year would get very expensive. Also, every additional leveraged purchase adds more recordkeeping complexity and therefore more opportunity for errors. That's why I like to see corporate redemptions followed by recontributions by the company to the trust. Very simple, no fiduciary risk, no transaction fees, no fairness opinion. Most appraisers I've worked with are willing to "smooth out" the antidilutive/dilutive effect of the changing number of shares oustanding when they understand that the transactions are part of a long-term plan to return all shares to the ESOT.

PTE_80_26.pdf

Marcus R. Piquet, CPA

American ESOP Advisors LLC
5995 Brockton Ave Fl 2, Riverside, CA 92506-1833
(951) 779-1124 (v) (951) 346-0896 (fax)

mpiquet@AmericanESOP.com

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The loan that Tot first described likely could be structured as an interest free loan from the company to the ESOP used to pay benefit distributions in cash. There is a PT class exemption that permits such loans.

I believe that RLL is referring to PTE 80-26, the latest version of which was published in Federal Register Volume 71 Number 67, April 7, 2006. I'll attach a copy.

I have a couple of concerns with vsaper's approach, and I'd love to hear a response. Any time the ESOP is acquiring shares with a loan you've got to have a fairness opinion. At least with the professionals that I work with, the extra valuation and legal fees to do a new transaction potentially every year would get very expensive. Also, every additional leveraged purchase adds more recordkeeping complexity and therefore more opportunity for errors. That's why I like to see corporate redemptions followed by recontributions by the company to the trust. Very simple, no fiduciary risk, no transaction fees, no fairness opinion. Most appraisers I've worked with are willing to "smooth out" the antidilutive/dilutive effect of the changing number of shares oustanding when they understand that the transactions are part of a long-term plan to return all shares to the ESOT.

One concern would be that the use of the redemption method, as opposed to the recycling method, could cause 409(p) problems.

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Guest tmills

Sorry for getting on here late. I'm curious about Tot's original question, which I believe was is a loan to an ESOP that is used to "acquire" shares from participants receiving distributions from the trust, but the shares never actually leave the trust, an exempt loan that would allow the Corp to guarantee it? I don't see that it was ever answered.

I see references to the "-7" regs regarding call options in some responses. Are those references to 54.4975-7? If so, I don't see anything regarding call options there. If not, what -7 regs are tot and GMK referring to and why do we care about call options?

I have seen transactions like vsaper describes. I believe that those are done under 409(h)(2)(B) as RLL points out, but the ESOP instead of the company ends up being the purchaser as permitted under 54.4975-7(b)(10). True?

The 80-26 class exemption says that it does not extend to loans to an ESOP to purchase shares that have been distributed because 4975(d)(3) of the Code and 408(b)(3) of ERISA already permit a party in interest to make a loan to an ESOP for the purpose of purchasing employer securities from any person, therefore expanding the scope of 80-26 is not necessary. 80-26 says the loan must be for a max. of 3 days and be unsecured, in addition to interest free. I don't see how that is too helpful in the normal ESOP distribution situation.

Finally, Marcus says that shares acquired with a loan requires a fairness opinion, etc. but that shares acquired by the corporation and recontributed to the trust don't have all those requirements. In my experience shares are valued at fair market value at the time of contribution, the issue of a loan is not determinative. If so, how does that avoid the valuation expense etc. that Marcus is claiming? I'm obviously missing something.

Sorry for asking a bunch of questions but I think this is an important issue and I want to get it right.

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The 80-26 class exemption says that it does not extend to loans to an ESOP to purchase shares that have been distributed because 4975(d)(3) of the Code and 408(b)(3) of ERISA already permit a party in interest to make a loan to an ESOP for the purpose of purchasing employer securities from any person, therefore expanding the scope of 80-26 is not necessary. 80-26 says the loan must be for a max. of 3 days and be unsecured, in addition to interest free. I don't see how that is too helpful in the normal ESOP distribution situation.

Finally, Marcus says that shares acquired with a loan requires a fairness opinion, etc. but that shares acquired by the corporation and recontributed to the trust don't have all those requirements. In my experience shares are valued at fair market value at the time of contribution, the issue of a loan is not determinative. If so, how does that avoid the valuation expense etc. that Marcus is claiming? I'm obviously missing something.

tmills - there is no 3 day limit to PTE 80-26 in its current form. Please see the amendment that I posted earlier. The limit is 60 days, or no explicit maximum duration if there is written documentation of the loan.

Also, the "recontribution" of shares can be done on the same date as the valuation date, so the regular annual appraisal can do double duty.

As for your other points - I agree, I have the same questions.

Best regards,

Marcus

Marcus R. Piquet, CPA

American ESOP Advisors LLC
5995 Brockton Ave Fl 2, Riverside, CA 92506-1833
(951) 779-1124 (v) (951) 346-0896 (fax)

mpiquet@AmericanESOP.com

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1. Call option prohibition – See 54.4975-7(b)(4) (Except for a right of first refusal or put right as described in the regulation, “no security acquired with the proceeds of an exempt loan may be subject to a put, call, or other option, buy-sell or similar arrangement while held by and when distributed from a plan, whether or not the plan is then an ESOP”)

2. Right to demand securities. 409(h)(1) provides the participant with the right to demand that ESOP stock be distributed to him, and if the stock is not publicly traded, that he has the right that the employer repurchase the stock under a fair valuation formula. 409(h)(2)(B) is an exception to this rule for ESOP sponsors that are either S corps or those whose formation documents restrict the ownership of substantially all securities to employees or a qualified plan. Under the exception, the participant is not entitled to demand securities from the plan. However, also under the exception the plan may allow the participant the right to demand securities but such securities must be subject to a requirement that they be resold to the employer under terms which meet the requirements of general rule (i.e., repurchased under a fair valuation formula). It wasn’t (and still isn’t despite RLL’s citation) apparent to me that the exception allowed a plan to require that the shares be resold immediately upon distribution (an immediate call right). My reading of the statute was that the participant had the right to exercise this repurchase obligation, except that if the S corp status would be busted or entity formation documents would be violated (for example, the 100 shareholder limit would be exceeded or less than substantially all securities would be held by employees), then the employer/plan could have a provision that allowed them to exercise the right to repurchase the shares under a fair valuation method.

3. The potential loan to the ESOP would be loan from a bank (i.e., a non-disqualified person). It would not be used to acquire shares held outside the plan. Rather it would be exchanged for shares allocated to the account of participants requesting a distribution. Because it would not be used to acquire shares, it could not meet the technical requirements of an exempt ESOP loan under -7(b)(4) (unless that reg could be read to allow a loan to acquire shares allocated under the plan and that are not distributed). It is expected that the bank would want a guarantee of the loan by the S corp. However, such a guarantee would cause the loan to be a prohibited transaction for which an exemption is not available (other than going for an individual PT exemption).

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