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ESOP Partially owned C-corp being sold

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Let me state at the outset that ERISA counsel will be involved. That having been said, curious as to thoughts on the following from those who deal with ESOPS.

So, you have a C-corp that is partially owned (about 24%) by an ESOP (no outstanding loan). The owners have an idea that they want to sell their remaining stock to the ESOP, which will own 100% now, and a new unrelated buyer will then purchase 100% of the corporation from the ESOP. Apparently they envision this being sort of one immediate transaction such that the ESOP will not need to borrow any funds to purchase their stock. They are also, by the way, current participants in the ESOP.

First, is such a transaction possible/reasonable? I'd typically expect that the ESOP would actually have to borrow the funds, then pay off the lender as soon as the shares are sold to the new buyer and the ESOP is now all cash. But maybe what they envision is a common transaction - sort of "circular" for lack of a better term?

Also, even assuming such a transaction is otherwise viable, how the heck could you ALLOCATE that much money? It doesn't seem reasonable that this could all be simply classified as "gain."

Also, (not being an ESOP expert, by any stretch!) I have a faint memory that IF a Section 1042 "rollover" is contemplated, that the selling shareholders (who are also participants) cannot receive any allocation attributable to the employer securities that were just sold to the ESOP? That this would be "double dipping" - and that therefore all such sale proceeds could only be allocated to OTHER participants?

Any other special pitfalls, or thoughts about this?

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So are they doing this to generate a 1042 election?

If so, let me know if it works.  I have my doubts but can't cite anything.

I am not sure based on what you said there is an allocation issue.  For example let's say the part not owed by the ESOP is worth $1,000,000.  If the ESOP buys it and sells it 1 second later for the same amount there is nothing to allocate to the people.  There is no gain and no net proceeds. 

But the fact the participants can't benefit is my problem.  While tax law allows you to factor in tax savings into any transaction the IRS is allowed to challenge any transaction whose sole  purpose is tax avoidance.  To me the sale to the ESOP serves no valid economic function besides save taxes. 

Maybe I am missing something here but that is the question that comes to my mind at least. 

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B:  There are a lot of moving parts to your potential transaction.  As always and as you stated, this transaction is going to require ERISA, ESOP, Tax and corporate transaction legal retention.  ERISA counsel is only 1/4 of the legal team.

You did not discuss the timing of the 2 transactions.

ESOP would require independent/transactional trustee,  all of the legal guidance mentioned above, independent appraiser to appraise the sale of the outstanding stock of the existing shareholders to the ESOP, independent appraiser to appraise the value of the ESOP after above referenced  transaction (to ensure that the ESOP is selling for not less than fair market value).  It is not clear to me that one appraisal firm could value each of the transactions. It might take two separate appraisal firms.  That would take the review of the Greatbanc and First Bankers Trust settlements with the DOL.

Bank financing would not necessarily be needed (unless required to take advantage of the 1042 election if that is the goal of the selling shareholders).

Selling shareholders could sell their stock to the ESOP and carry back Shareholder notes for the value of their sale. The stock purchase agreement and seller notes could include the ability to pre pay the notes at any time.  At the sale of the company by the ESOP, the cash deposited to the ESOP for the sale could repay the seller notes.

In addition to the above, I would think consideration would be made to convert the "C" Corp to "S" Corp as part of the transaction (selling shareholders to the ESOP) and before the now 100% Employee owned Company (via the ESOP) sold to the outside buyer(s). 

Allocation of stock to Plan Participants would be an issue. There are not enough details to discuss that issue.

Cash would be allocated pursuant to the share allocated.






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Thank you.

I have a little more information now. The ESOP will evidently use short term promissory notes to finance the purchase of the shares from the current owners. Essentially on the same day, the new buyer will pay cash for 100% of the shares - this cash will be used by the ESOP to repay the short term promissory notes.

There will be an independent Trustee for the ESOP in this transaction.

As currently described, the shares will be purchased from the current owners for a certain price "X." The new buyer will purchase all shares from the ESOP (100% of the shares of the corporation) for price "Y" which will be higher than "X" so there will be "gain" to be allocated. Plan will be terminated as soon as buyer has ownership of the corporation.

Are the selling shareholders allowed to receive an allocation of this gain if they are doing a Section 1042 rollover of their sale proceeds?

Does any of this clarify/change/confuse anything?

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Some things to consider: 

1) The selling shareholders may not receive an allocation of shares if they elect 1042 treatment.

2) I grabbed this from: http://www.esopservices.com/articles-press/articles/the-esop-1042-tax-free-rollover-its-back-savings-may-exceed-30-2/

The ESOP must:

a. Own at least 30% of the company’s stock immediately following the ESOP’s purchase

The Seller Must:
b. Hold the stock for at least 3 years following the purchase, otherwise the company incurs an excise tax of 10% on the proceeds from the disposition of the ESOP stock (exceptions for some tax free reorganizations)

My Comments:

3) It seems like this is a way to avoid taxes without providing a benefit to the ESOP participants.  Here's hoping the DoL and IRS don't discover the ruse (if that's what this is).



If it looks like a duck, walks like a duck, quacks like a duck....



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Stephen is incorrect in what the ESOP must do:

The ESOP is not required to hold the stock for 3 years. It is the seller that must have owned or held the stock for 3 years prior to selling to the ESOP to be eligible for 1042.

If the selling shareholders elect 1042, then they are prohibited from participating in the ESOP to the extent of receiving an allocation of the shares they initially sold to the ESOP.  1042 is an individual election by each selling shareholder.

It seems the basis of this transaction is the sellers are willing to sell the stock for a little less (versus the fair market value) to the ESOP for receiving the benefit of 1042 (the deferment of capital gains) on the sale of their stock.

Your description of the transaction is as I suspected, the sellers are going to hold seller notes (you called them short term promissory notes), which will be paid in full with the proceeds of sale of the stock from the ESOP to the outside buyer.

There will be appraisal pitfalls to watch out for regarding each side of the transaction.  One would assume that the architect of this transaction (ESOP consultant or legal counsel) is aware of the appraisal issues and have worked them out.




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Thanks. It is my understanding that the 4978 10% excise tax still applies in this situation, when the ESOP immediately turns around and sells the shares - agree?

I'm still trying to nail down whether any of the GAIN on the resale of the stock can be allocated to the original selling shareholders?

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1042 treatment would not be available to the selling shareholders under these circumstances.  Under a "step transaction" theory, a pre-arranged deal such as this would be treated as a sale of stock by all shareholders (including the ESOP, with respect to its existing 24% holding) to the unrelated buyer. The intervening "sale" to the ESOP would be disregarded. It's disappointing that professional advisors and trustee would be involved in structuring such a sham transaction.


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FWIW, experienced ERISA and ESOP specialist legal counsel is involved, and apparently has no problem with it. Counsel also said that they would NOT be allocating gain in the ESOP plan, (if any) to the selling shareholders upon the subsequent sale of the shares that the ESOP obtains from the selling shareholders.

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I think that RLL has raised the relevant issue.  Though I am not sure I would word my response as strongly as he did.  I think step transaction is the real risk.  If the sale to the ESOP is an intermediary step SOLELY to get the seller the 1042 treatment, then I would have a hard time writing a tax opinion on the transaction.  BUT, the fact that they are apparently willing to sell for a bit less than fair value might be an argument to overcome the step theory if the bargain element was intentional to create the benefit for the employees and not just a ruse.  There are a couple of old private letter rulings that discuss these kind of deals.  You may want to read those over.

There are also some exceptions from the 10% excise tax for 368 transactions.

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