ERSOPS

[Guest mikeymo]

I have been involved in designing defined contribution plans but I have never worked with ESOPS. I ran into an old friend at a class reunion and he contacted me when he returned home for my opinion.

Bottom line is he has $200,000 in retirement accounts he wants to use for the purchase of his own business and does not want to pay income taxes on this money.

He has been approached by an ERSOP promoter with this concept.

He establishes a C Corp. C Corp. then establishes an ESOP. Once the ESOP is established, he rolls his $200,000 into the new plan. Then, the ESOP purchases the stock of his C Corp. for $200,000.

The C Corp. now has $200,000 in cash to go to the bank and use as a down payment to purchase a new operating business.

I told him I smelled something funny as this would be too good to be true. He has some M and A experience so he knows the operating business he buys would become participating under his ESOP. And the fees for annual financials may add up to making all of the gyrations he going to go through not worth it.

The company that administers these plans for sponsors files and receives for letters of approvals with the Service. But, where I see a problem is how can an ESOP buy employer securities that are worthless on the purchase date but the day the check clears the business is then worth $200,000?

Has anyone else heard of this or help me shoot arrows at it to help my buddy stay out of trouble?

[E as in ERISA]

I agree that the ESOP can't pay $200,000 for a worthless business. But maybe he just has the facts wrong. Maybe the business will be bought first -- on credit -- and then sold to the ESOP?

But I still have a problem with the transaction. When someone says, "[H]e has $200,000 in retirment accounts he wants to use for the purchase of his own business," I say, "You're telling me right there that you can't do it."

ERISA 404 requires that fiduciaries act "solely in the interest of participants" and "for the exclusive purpose of...providing benefits to participants." He has to do the deal because he thinks that the investment is a good idea from the benefit plan's perspective, not his personal interests outside the plan. If the business isn't even in existence yet, he can't possibly make the judgment that this is a good investment for the plan.

[Guest jfp]

1. In order to qualify for the PT exemption for the purchase of employer securities, the ESOP cannot pay more than "adequate consideration" (essentially, fair market value). If a corporation is a shell, and the ESOP will pay $200,000 for 100% of the stock, after which the corporation's only asset is the $200,000, can you make the argument that the stock is worth at least $200,000? Strange, but interesting.

2. If this is a rollover account of the one individual, who would ever challenge the transaction on Section 404 grounds (the individual is not going to sue himself/herself)? I guess, theoretically, the DOL could do it, but why would it bother?

[Guest mikeymo]

Thank you for your replies. There have been numerous reviews of my post already so for informational purposes the web site of the promoter can be found here:

My immediate response to my friend was the 'devil is in the details'and he agreed.

Aren't there some undisclosed accounting fees needed by ESOP's (financials/appraisals) not divulged on the website? Also, in my opinion the additional hoops ESOP's must jump through from a compliance standpoint far exceed the administration fees quoted on their website.

But, I agree with jfp. This concept is slick because it can fly under the radar screen and may never be detected unless a random audit was conducted.

One additional FYI. The business he is considering to buy has 10 employees and there is no qualified plan in existence.

[Guest Pensions in Paradise]

First and foremost, you need to have your friend talk to an ERISA attorney.

The plan described on the promoters website is NOT an ESOP. It sounds like a regular defined contribution plan which invests in employer stock.

There are so many issues with what they propose that it is actually laughable.

[mbozek]

An ESop is a leveraged financial vehicle- the employer or the owners transfer stock to the ESOP which procures a loan from a bank in order to pay the owner for the transfer of the stock. The bank gets the stock as collateral for the loan and also has a personal guarantee of the owner for payment of the loan. The corporation makes dedcutible contributions to the plan each year to pay off the loan and the trustee releases stock to the participants as the payments are made. At the end of the loan the participants own 200k in stock held in the esop.

The Esop cannot go to the bank and use the 200k to purchase a new business because of 1. the unrelated business income tax and 2. an esop can violate the diversification requirements for investing plan assets only for the purchase of employer stock or RE. Otherwise the plan cannot invest more than 10% of the assets in employer property.

Your friend should contact a tax attorney to advise on the only way the deal can be structured- Have an IRA purchase the initial offering of stock when the busines is incorporated so that the dividends will be paid tax free to the IRA. If the business will not pay dividends then the purchase is not viable.

If your friend wants to purchase the business why not just have the IRA buy it- even though that would not be a sound investment decision.

[Guest jfp]

1. The 408(e) exemption is available to a profit sharing plan as well as an ESOP, and the 10% limitation would not apply to a profit sharing plan or an ESOP.

2. If the IRA buys the company there could be PT issues for which the 408(e) exemption is not available. (I'm not saying that there necessarily would be PT issues, but if there are - particularly of the self-dealing variety - there is no exemtpion.)

3. The non-ESOP idea is even better than the ESOP structure. The individual's rollover account owns the stock of the corporation, and the other participants invest in other stuff without any need to comply with the ESOP requirement that the plan be "designed to invest primarily in employer securities."

I agree that this deal raises a million issues, but it does not appear to be dead on arrival.

[mbozek]

An IRA's custodian's purchase of an initial offering of the stock in a newly incorporated business in which the IRA owner is the director of the corporation is not the sale of a security under the PT rules. See Swanson v. Comm, 106 TC 76.

[mbozek]

Do these people provide a legal opinion to support the claims they make about how easy it is to transfer plan asets to a corporation? As I understand it, all that happens is that the IRA assets are rolled into the plan and the plan become the sole owner of the co. While the plan is not subject to the fiducary provisions of ERISA if there are no employees, any scheme to use plan assets for the benefit of the owner of the business in his personal account would violate the PT rules of IRC 4975 and result in a 15% excise tax.

[RLL]

The IRS has recently addressed this situation. On 5/9/03, the Employee Benefits Committee of the Section of Taxation of the American Bar Association held its annual "Questions and Answers" session with representatives of the IRS and Treasury. The report of the session can be found at http://www.abanet.org/jceb/2003/qa03irs.pdf .

In Q & A # 9, the question was asked as to whether an arrangement that seems almost identical to the "ERSOP" described above violates the IRC section 401(a)(4) nondiscrimination requirements. The ABA question included a proposed response that no IRC requirement was violated by the arrangement.

The IRS response disagreed and indicated that various aspects of the nondiscrimination requirements would be violated, including the "effective availability" requirement.

[Guest PORTE]

I'm not sure about that ERSOP.com guy. Wasn't ERISA 1974? They are actually filing for qualification and they are getting it. These are prototypes that they amend and add like two paragraphs to allow for investment in employer securities and that the only investment in the employer securities can be in the rollover account.

If the IRS lets this get by and approves it with the amendments right up front, how can they say in the whitepaper that they don't think this is allowed?

4975(d)(13) allows it.

Are we all missing something? These guys found a loophole for small business owners, the IRS is setting precedent by issuing qualification letters.

I want to hear more about these.

[GBurns]

I notice that on the esop.com website they do not claim that the have actually done these ersops, instead the claim is made that they have put in over 300 of these plans but notice ERSOPs are not listed among the "these".

I also see no mention of IRS or other approval of their ERSOP. And I find it curious that they did not use a sample letter as sales material. The IRS Determination Letter seems to be related to the 401(k) and Trust and NOT to the ERSOP.

To me it is a site well written so as to not be specific.

[IRC401]

Isn't there a requirement that an ESOP have recurring contributions? If all of the contributions are in cash, there will be a 401(a)(4) issue if the other employees don't have the right to purchase stock.

An ESOP must be designed to invest primarily in employer securities. If only one rollover and no employer contributions are invested in employer securities, I question whether that requirement will be met.

[Guest PORTE]

Again!, It's NOT an ESOP, it's a normal DC plan designed to allow for investment in ER securities in the rollover account only.

[Kirk Maldonado]

The requirement of recurring contributions applies whether or not the plan is an ESOP.

[GBurns]

I guess that this ERSOP idea is spreading. This is a recent article that went to many accountants:

http://www.accountantsworld.com/news/currn...spx?q1=43635112

[Guest oxford46105]

I have been searching for more info on these plans frequently referred to as Entrepreneur Rollover Stock Ownership Plans, the last couple of weeks. Here is some of what I have found out on the internet:

http://www.sba.gov/ca/santa/newsletter.pdf

SmallBusinessAdmin Santa Ana finds that ERSOP is covered by ERISA

www.ersop.com

www.benetrendsinc.com

www.guidantfinancial.com

www.rainwatercpa.com

here are the typical steps need as described my several of these internet sites.

Rollover Steps

The Corporation

You will need to incorporate. This can be handled by our service provider, your attorney or you (not recommended). Buyers forming an Illinois corporation are urged to consider the IL Secretary of State’s $300 expediting fee to avoid unreasonable delay.

The ERSOP

Our service provider will prepare the documents with special language to establish your new Profit Sharing 401(k) Plan and Trust. With your new plan documents, corporate resolutions, and Tax Identification Number, your bank will open a checking account for your new “Plan.” The “Plan” is submitted to the IRS for a determination letter. There is a $700 filing fee that may be waived if there is at least one highly compensated employee (non-owner).

The Rollover

In order to be eligible for a rollover from your last employer’s retirement plan, you must have terminated employment with that employer. You are assisted in preparing any forms to secure the “direct rollover” of your retirement assets into your new Profit Sharing Plan & Trust checking account. You, as trustee, will transfer funds from the Profit Sharing Plan and Trust account to the corporate account. Your new corporation will issue share of its stock to the Profit Sharing Plan & Trust. The corporation will now have the cash and the Profit Sharing Plan & Trust will own the corporation’s stock.

Annually

The Plan will require administration, allocations, trust accounting and federal government reporting every year for an $800+ annual fee. Each corporate year-end, our service provider will estimate the tax-deductible contributions that you can make to your new tax-deductible retirement plan.

[mbozek]

Why isnt the sale of stock to the Profit sharing plan trust by the 100% owner of the business a prohibited transaction under IRC 4975©(1)(A)- sale of plan assets to disqualfied person? See SD Cooper ERSOP presentation slide #10. Under IRC 4975(e)(2)(E) a disqualfied person includes the owner of 50% of the stock of a corporation. Is there a PTE for this transaction?

Also ERISA only covers a plan with a least 1 common law employee.

[GBurns]

Note that the SBA (at least not in the Newsletter link provided) did not say why ERISA covered ERSOPs nor in what respect it did. We also do not know what sort of ERSOP they were referring to.

The accepting of ERSOPs for a particular, or even any, purpose by the SBA has no bearing on its acceptance by the IRS etc. What does the IRS have to say? What is in the IRC etc? What has the DoL said about ERSOPs and about Prohibited Transactions?

The fact that an item is being promoted by any number of websites etc does not make it viable, compliant or anything else but "being promoted".

I noted that according to the post by oxford46105, the "Plan" will be submitted to the IRS for a Determination Letter. Has anyone yet received a favorable DT? Can someone explain why a DT rather than a PLR? And if a DT is issuable for an ERSOP what would it cover? If it is like a Qualified Plan DT, isn't there a need for a PLR in this case?

[Guest PORTE]

My client did receive the determination letter from the IRS. I called the IRS in Washington and spoke with them about these specific plans. They are getting favorable determination letters but the IRS has this on a watch list. They know the name of the Company(s) that are selling them. Of course, the determination letter is vague as usual and can certainly be challenged, but they have ok'd amended provisions that allow that individual participants to invest 100% of their funds into employer stock. And really that is the key here. If it is a prohibited transaction or not. I wish someone could give some real guidance on this subject. THe IRS and the DOL have to step out and say you can or can't. All of us that look at this think "NO Way!" But the parties that are selling it are telling us we are not reading the correct law provisions. Frustrating.

[mbozek]

IRS determination letters only approve the form not the operation of the plan. All plans contain a provision forbidding prohibited transactions such as the sale of plan assets to the owner of the business for which there are plenty of PLRs and DOL opinion letters on file and for which no further guidance is needed. Clients who want to to engage in this type of transactions need to hire expert counsel to advise of them of the rules not rely on the advice of promoters who make money off of selling these schemes (e.g., accounting firms who sell tax shelter opinions). As warren buffet reminds us a fool and his money are easily parted. A prohibited transaction must be reported on the 5500 for the plan and the 15% excise tax paid by the person who benefits from the transaction with the plan.

[mbozek]

PORTE: Could you provide the sections that you are being told incorrectly apply to ERSOP transactions. Note that P. 7 of Internal Revenue Manual Section 4.72.11.3 which is listed and linked in the S D Cooper ERSOP materials expressly states that a PT includes a sale or exchange of property between a disqualified person such as the owner of the sponsor and the plan.

[GBurns]

PORTE

Did the IRS tell you why they had a watch list?

Have you seen and read any of these DLs? What is covered?

Yes, the DL might say that you can invest in employer stock, but I bet it does not say who can nor give guidance for situations where the investor is also the employer or sole shareholder of the employer/sponsor etc.

The devil is always in the details and Determination Letters do not go into nor approve the details of design and operation..

[mbozek]

IRS determination letters do not review whether an investment under a plan would be a prohibited transaction under IRC 4975.

A prohibited transaction under 4975©(1) includes the sale, exchange or loan of property between a plan and the owner of >50% of the interest of the employer who sponsors the plan.

4975(d)(13) exempts from the PT rules any acquisition, sale or lease of employer securities between the plan and a >50% owner of the employer for adequate consideration under ERISA 408(e). In order to qualify for this exemption a plan must have at least 1 common law employee and secure an appraisal from an independent third party of the fmv of non publicly traded securites it acquires. The plan cannot purchase stock for an arbitrary amount asked by the owner. If the IRS declares ERSOPS to be a listed transaction as an abusive tax shelter it will get the names of all employers who adopted the plan from the prototype sponsor and will audit the plans to assess the 15%/100% PT tax on the owner for violation of the PT rules if there is no appraisal or if the plan is not subject to ERISA.

A better way to attain investment objectives is to rollover the distribution from the qualified plan to an IRA. Under the Swanson decision, the owner of the IRA can direct the custodian to purchase an initial issue of stock from a C corp in which the owner is the sole director and the purchase price will be the initial capital of the Corp in a tax free transaction in which the IRA owns the corp and will receive all dividends tax free. No appraisal is required because the IRA is not subject to ERISA. The IRA can invest in other businesses subject to the PT rules of IRC 4975. This transaction is recognized by the courts and the IRS and doesnt require a fee to the sponsor to receive a determination letter. However you have to find a custodian who will hold assets of non publicly traded corporations.

[Appleby]

The IRS has issued guidance on ERSOPs - The IRS calls these transactions ROBS.

Guidance available here http://www.irs.gov/pub/irs-tege/rollover_guidelines.pdf.

[IRA]

This is a non-exempt PT, plain and simple. You can't use your qualified retirement plan money to start your own business unless you are acting solely as an investor, and even then there are PT problems you have to work through. Until Bob Doyle or Ivan Strasfield blesses it, I wouldn't do it.

[Guest Eric.]

I absolutely cannot believe that nobody has yet provided you with this link ... which I took from Benfit Link's Retirement Plan Newsletter email. But then again, I can't believe the NJ Devils didn't win the Stanley Cup last year either. Show's you what I know ...

http://www.irs.gov/pub/irs-tege/rollover_guidelines.pdf

[Mike Preston]

Vision not so good, Eric?

[Guest Eric.]

Yes Mike. Luckily, my vision is much better today. Thank you for pointing out that your powers of observation are superior to mine.

[Spencer]

I've gotten a question about ERSOPS. Client wants to do it through this plan http://www.theceoplan.com/

Any recent guidance? or thoughts on these?

[BG5150]

I think the '08 material is still valid

[QDROphile]

It can be done. It is very difficult to navigate. Even under the best circumstances there is some legal uncertainty I would not do business with a promoter who did not up front emphasize (1) the limited ability and the difficulty of pulling it off legally, (2) the very high probability that business failure would wipe out retirement savings as well as current assets and income source, and (3) the heightened IRS scrutiny and animosity with respect to such arrangements. I would not do business with a promoter who who uses "it's" as a possessive. I see only bad signs at the website.

[ESOP Guy]

The ERISA book by Sal says the IRS admits they can be done. There are difficulties, and any research will show the IRS doesn't like them.

But then again the IRS doesn't like S corp ESOPs and there is nothing they can do about it.

The law is clear on both of these topics, difficulties-- but it can be done.

[Peanut Butter Man]

Did the IRS tell you why they had a watch list?

IRS has always had a watch list. It is just a list of firms or individuals whose plans have been flagged (for whatever reason) so the agents know if they receive one of these plans to review, they should notify their manager first before spending time reviewing the plan.

Thanks for the link to the ROBS guidance. As I was reading through the posts, I kept thinking this sounded like ROBS with an ESOP twist.

ERSOPs sound like a great topic for ASPPA Annual Conference this year.

[Spencer]

so it can be done, but is anybody in TPA industry recommending them? I can only find people who are selling ERSOPs pushing them.

[Peanut Butter Man]

I'm not sure it does still work. See IRS webpage on certain ESOP structures as abusive tax transactions - http://www.irs.gov/retirement/article/0,,id=120107,00.html

[mbozek]

so it can be done, but is anybody in TPA industry recommending them? I can only find people who are selling ERSOPs pushing them.

Why would any reputable TPA or advisor recommend toxic waste to a client?

ROBS are sold to unsuspecting entrepreneurs as legitimate tax free way to get money from a retirement plan into a business because the 401k plan established by the start up gets an IRS determination letter which makes the transaction "legal". What the promoters dont tell these fools is that the determination letter does not protect the plan in operation if any of the following rules are violated.

1. nondiscrimination .ROBS plans must comply with the benefits, rights and features provisions to prevent discrimination against non owner employees. Most ROBS plans are set up to provide for issuing of stock in the start up company only to the owners at the inception of the company and never include non owner employees.

2. use of plan assets to benefit the promoters. Promoters want to get paid up front so they request their fee from the plan assets which can be a prohibited transaction subject to the 15/100% excise tax.

3. failure to get a legitimate appraisal as to the value of the company purchased with plan assets. Most appraisals for the the value of the shell company purchased with ROBS plan assets base the company value on the cash that will be transfered to the company by the plan in exchange for the stock. From what I understand the IRS does not accept this appraisal of as a fair value for an ESOP stock.

Other violations include failure to file a 5500 5500-EZ if the plan assets are below $250,000 or failure to file a corporate tax return.

The biggest reason against transferring personal retirement assets to a ROBS 401k is because 80% of all start up businesses fail in the first few years leaving the owner with a loss of the retirement assets and a big tax liability from the IRS for violating the above tax laws. The fall 2010 edition of IRS Employee Benefits news has an article on ROBS and their risks.

[ESOP Guy]

I'm not sure it does still work. See IRS webpage on certain ESOP structures as abusive tax transactions - http://www.irs.gov/retirement/article/0,,id=120107,00.html

This is a different topic. Your link relates to S corp ESOPs which is not the same as this topic.

[GBurns]

Well then this link does not:

http://www.irs.gov/retirement/article/0,,id=231594,00.html

What difference does it make whether S or C Corp etc?

[Spencer]

mbozek, thanks. I advised against it and detailed why. But client is still really interested it. Aapparently, this guy with the "CEO Plan" has a answer for everything.

[ESOP Guy]

Well then this link does not:

http://www.irs.gov/retirement/article/0,,id=231594,00.html

What difference does it make whether S or C Corp etc?

This is the very short version of the answer to your question. An ESOP that owns 100% of the stock of a S Corp sets up a tax free entity. The S corp does not pay taxes because it is an S Corp and the income passes to the stockholder(s). The ESOP being the sole stockholder is a non-tax paying entity in this case.

People were setting up ESOPs and making the S corp election to avoid taxes and not offering broad base ownership to the company employees. These rules were intended to encourage broad base ownership of the company.

Classic example a Dr. or lawyer in a sole practice was setting this up and their practice was not paying taxes. This was not the intent of the S corp ESOP rules.

The link on abusive S corp ESOPs is about trying to avoid the various rules that are trying to stop those abuses.

As for the link to ROBS that is the IRS’ position, but read it carefully. They never say it can’t be done. I agree with the problems outline here. The objection that new businesses go under and people will lose their retirement funds is a “nanny state” objection, not a legal one. I know plenty of people who have been laid off since 2007 who have spend all of their retirement saving supporting themselves while trying to find a job. Why shouldn’t they be able to take the risk of starting a business or franchise with this money? The “nanny state” somehow thinks they will be better off staying a wage slave, sorry that is not a valid objection.

[Guest bitadvisors]

Speaking of bending the rules, I have a new client who has a leveraged esop and who advised he refinanced the esop. The documents provided appear to show the original esop finance remained in placed, and now the company has a new loan for company equipment where he used the esop shares to secure a loan as collateral. I do not believe he can do this and have done research everywhere to find proof but cannot find anything. Any suggestions?

[ESOP Guy]

My first suggestion is to make sure your fee agreement with the client is very clear what is out of scope. There is an excellent chance they are going to have to pay you a lot of money to help them get out of this problem. They may have to pay their attorney a bunch of money also. This is a classic case of someone being penny wise to end up a dollar foolish. His not coming to you guys up front is going to hurt.

For an answer along the lines you were expecting and needing.

1) Whoever gave this loan and thought they had shares securing the loan is most likely wrong. The anti-alienation rules are going to stop them from ever getting those shares if the loan goes into default. Although if the loan goes into default that may mean the company isn’t worth anything anyway.

http://www.ecrllc.com/safequalifiedplans.asp

2) A problem I see here this is a prohibited transaction.

http://www.irs.gov/retirement/participant/...=211437,00.html

This seems like a self dealing that violates these rules.

3) Maybe a violation of the exclusive benefit rule is bigger than the PT. I believe they have disqualified the plan. By the way in case it isn’t obvious since the securing of the loan was for the benefit of the sponsor and not the plan that is the violation.

http://www.clausen.com/index.cfm/fa/firm_p...iary_Duties.cfm

I think they have little choice but VCP to fix the problems with the IRS and I think there is a similar program with the DOL to fix the FT problems.

I don’t see how they get out of that radical fix. This seems too big to be a self correction.

[jpod]

It sounds to me like the lender really doesn't have the security interest it thinks it has. The client may also wish to consult a good lending law attorney and possibly a criminal defense attorney because there may be issues of fraud vis a vis the lender.