RLL

Dawn....can the employer contribute or sell treasury shares (or authorized but unissued shares) to the ESOP? The ESOP does not have to acquire its shares from the shareholders. I think the plan design that you suggest is permissible, subject to testing; but get an IRS determination letter before implementing it.

No.....I said that the test for "best dividend rights" under IRC Section 409(l)(2)(B) is based only on classes of common stock. Classes of "preferred stock" are ignored. The class of non-voting stock which you referred to in your facts as "Preferred Stock" would be included in testing under Section 409(l)(2)(B) only if it were, in fact, common stock.

PJK --- I think you don't understand how these ESOPs work. The participant is NOT given an election to receive a benefit distribution upon termination of service. Distributions following pre-retirement termination of service are automatically deferred (aren't available to commence) for all such participants for periods of as long as six years. No issue of "consent" under IRC Section 411(a)(11) is involved until the participant is offered a benefit distribution at the end of the applicable deferral period. It is clear that the "disinvested" account balances of former employees with deferred vested benefits are not exempted from the general fiduciary requirements of ERISA Section 404(a)(1)....but there are many relatively simple ways for fiduciaries to comply with such requirements (and, as you know, there are MANY MANY retirement plans which are subject to, and comply with, those rules). As far as administrative complexities, it is the choice of the employer to design the ESOP benefit distribution provisions in a particular way, after being advised about the various alternatives available. If the employer chooses to "disinvest" former employees (during the deferral period) and understands the minor complications involved, why recommend otherwise if the law permits that particular course of action? Frankly, I don't think that the administration of these provisions is very complicated. Also, it is extremely rare for a participant in a closely-held company ESOP to demand a distribution in company stock, especially after a distribution deferral period of up to six years. In the case where such a request is made, it is usually easy to allocate shares which are currently contributed or forfeited for the purpose of making a required benefit distribution in company stock. With regard to amendments to distribution provisions and IRC Section 411(d)(6), note that Section 411(d)(6)© provides an exception (to the anti-cutback rule) that allows ESOPs to "modify distribution options in a nondiscriminatory manner." Do you really think that there's any "risk" under IRC Section 411(a)(11) in following specific plan provisions which have been the subject of an IRS determination letter?

PJK ---- I think that you don't understand what I said above. The "disinvestment" takes place automatically, following (and by reason of) termination of service, not by reason of a participant's failure to consent to a distribution. Note that most closely-held company ESOPs provide for some period of deferral for a benefit distribution following pre-retirement termination of service. I'm not suggesting that the "disinvestment" take place merely by reason of a failure to consent under IRC Section 411(a)(11). In addition, the "disinvestment" (pursuant to a specific provision of the ESOP) during the deferral period (following termination of service) is not intended to deny a participant the right to demand distribution in company stock, if it's required under IRC Section 409(h). At the time benefits become distributable, company stock is offered to the participant, unless an exemption under IRC Section 409(h)(2) is applicable. If the participant then demands stock (which is HIGHLY UNUSUAL in a closely-held company ESOP), shares are made available for distribution at that time. There is nothing in IRC Section 409(h) (or anywhere else in the IRC, ERISA or applicable regulations) that requires the account of a former employee to remain invested in company stock (during the deferral period) merely because the participant may have the right to demand a distribution in company stock at a future date. Reliance here is not based on anecdotal evidence or informal remarks, but rather on numerous determination letters issued by the IRS since 1996. Are you suggesting that the many ESOPs that do this (pursuant to specific plan provisions) cannot rely on their own determination letters? This isn't taking "aggressive tax filing positions" .....it's designing (and drafting) ESOPs with creative provisions that accomplish the objectives of the sponsoring companies and rely on the informed "approval" of the IRS through the determination letter process.[Edited by RLL on 08-02-2000 at 07:44 PM]

Dawn, my thoughts (which I hope you'll appreciate)----- if the client REALLY wants to "motivate current employees," why not provide more than "very limited amounts" of stock in the ESOP? And aren't these so-called "casual employees" worth motivating? As to the technical issue, the "casual" employees aren't former employees, so IRC Section 401(a)(4) testing probably would be required. Subject to testing, however, it is likely that the ESOP could be amended (subject to receipt of an updated IRS determination letter) to provide for the desired treatment. But why bother? You say that these folks are "willing to work".....so why not treat them as active employees and avoid having to amend the ESOP and test, etc.,? On the other hand, why not amend the ESOP to provide for full benefit distributions to these "casual" employees? That might very well eliminate the "problem." Note that termination of service is NOT the only event that permits the offering of benefit distributions from an ESOP.

I think that both of you are wrong. The "disinvestment" is NOT a consequence of failing to consent to a current distribution under IRC Sec. 411(a)(11). It is an automatic provision, applicable to all ESOP participants following termination of service, without regard to whether a distribution is available at that time. The accounts of such participants are not "frozen," but rather are invested in other assets that will benefit from investment return (which may be more or less than the return that would have resulted from continued investment in company stock). IRS representatives have "unofficially blessed" such a provision in Q & A sessions at The ESOP Association's Annual Conferences in recent years. In addition, there are countless ESOPs that include such a provision and have received IRS determination letters (post-Rev.Rul. 96-47). I've never heard of a situation where IRS has challenged this provision in an ESOP.

An ESOP does not violate the "consent" rule of IRC Section 411(a)(11) merely by providing that the account balances of all former employees will be invested in assets other than company stock. Many ESOPs of closely-held companies provide for this treatment without regard to whether the participant is eligible for a benefit distribution at the time of the "disinvestment" out of company stock. There is no provision of the IRC which makes an investment in company stock a "protected benefit" under an ESOP. IRC Section 409(h)(2) provides some comfort in that it reflects the general intent of Congress that certain ESOPs may limit stock ownership interests to current employees.

Read IRC Section 409(l)(2)(B) again! The common stock is tested only against other classes of COMMON stock in determining whether it has the "best" dividend rights. If the other class of employer stock (the non-voting stock) is indeed "preferred stock" under Section 409(l), the ESOP's common stock satisfies Section 409(l)(2). I assume that there is no class of common stock which is publicly-traded.

If the employer contributions to the ESOP for a plan year are not allocated to participants' accounts, the ESOP would fail to be a tax-qualified employee plan under IRC Section 401(a). In addition, the ESOP fiduciaries would likely be violating ERISA by failing to properly allocate the company stock to the accounts of the participants.

The Journal of Employee Ownership Law & Finance, published by the National Center for Employee Ownership (www.nceo.org), has included a number of excellence articles in recent years on the special rules relating to bank and bank holding company ESOPs. I recommend that you seek out these articles.

If the shareholder/employee continues to provide services as an employee of the company, he/she may still receive an appropriate salary.

Maybe

With a great deal of care.

The DB plan must be terminated. See ERISA Section 403© & (d) and IRC Section 401(a)(2).

If the employer makes a cash contribution to the ESOP, the contribution is allocated among participants' accounts in accordance with the applicable allocation formula. If the cash is used to make benefit distributions to terminated participants, the cash is deducted from the remaining participants' accounts (usually in the same proportions that the cash contribution had been allocated) and is "replaced" in their accounts by the stock which had been previously allocated to the distributees. There is no reason to "sell" such stock...it is merely reallocated under the ESOP as a bookkeeping matter. The employer contribution in cash is deductible under IRC Section 404(a)(3)....404(a)(1), to the extent it represents a money purchase plan contribution to the ESOP....subject to the applicable % of compensation deduction limits (and the Section 415 allocation limits). Note that all employer contributions to an ESOP (or any other tax-qualified 401(a) plan) must be allocated as of a specified date for the applicable plan year and cannot be held unallocated or in suspense.

Kirk--- KJohnson stated that "the employee had previously been offered diversification at the applicable time." I assumed that this meant that he/she had been offered the diversification election for the 6 years in the "qualified election period." If the election had not been offered to the participant six times, he/she might be eligible for additional elections with respect to any allocations attributable to post-reemployment service. [This message has been edited by RLL (edited 06-29-2000).]

The DB plan must be terminated in accordance with Title IV of ERISA in order to recapture the excess assets. IRC Section 4980(d)(2)(B) would apply to the transfer of 25% of the excess assets to the ESOP

What does the ESOP plan document say?

After further consideration, I think that the participant would NOT be entitled to a diversification election under the requirements of IRC Section 401(a)(28)(B). The 6-year "qualified election period" beginning after he/she first attained age 55 and completed 10 years of ESOP participation probably has expired. Was the participant given the election for those 6 years? On the other hand, if the ESOP plan document was drafted to allow diversification in a manner other than as required under the IRC, the participant may still be entitled to elect diversification, as the plan document governs the participant's rights to benefits. What does the document say? [This message has been edited by RLL (edited 06-28-2000).]

No. No.

The objective of providing tax incentives for ESOPs was to enable EMPLOYEES to share in the ownership of company stock. As a general rule, ESOP benefit distributions are made following retirement or other termination of service. It is not inconsistent with this policy to provide for ESOP benefit distributions to FORMER employees in the form of cash. It is clearly inappropriate to permit the employer to exercise a call option with respect to shares still owned by the ESOP for the benefit of current employees.

Crazy? I don't think so. Are you asking whether such a provision is legal or immoral? IRC Section 409(h)(2) permits an ESOP to deny distributees the right to demand receipt of benefit distributions in the form of employer stock in the event (1) the corporate bylaws or charter restrict ownership of substantially all stock to employees and qualified employee trusts; or (2) the employer is an S corporation. It's not a great stretch to provide for a call option in these situations....so long as it is applied in a uniform and non-discriminatory manner. Note that the 1977 ESOP loan regulations have been superceded in part by subsequent ESOP legislation, including IRC Section 409(h). If the IRS issues a determination letter with respect to an ESOP under IRC Sections 401(a) and 4975(e)(7)....Application must include Form 5309....and the plan document includes clear (disclosed) provisions for the call option, who can then object? The provision should also be disclosed in the SPD. Why not try and see whether the IRS will pick up the issue....most reviewers probably won't.

Yes.

Kirk ---- Who is Dave Baker? Does he work for the IRS or the DOL? Does he receive compensation from BNA? And what, if any, is the user fee for such a ruling request? And who will pay the user fee? And what is the Compensation Planning Journal?

If an ESOP enters into a contract with shareholders to acquire a controlling interest in employer stock over a period of years, the use of controlling interest value ought to be acceptable under the "adequate consideration" standard if the terms of purchase meet an "arms-length" standard. Terms of the purchase should require the use of "controlling interest" value for purposes of valuing ESOP participants' accounts and paying benefits. The terms should also be binding on the shareholders without requiring the ESOP to purchase under any circumstance. The employer should guarantee financing for the ESOP to complete the purchase of control. There should also be "come along" and "bring along" rights, as well as rights of first refusal, appropriate to protect the ESOP. In addition, it would be preferable for the ESOP to be given a proxy for the shares subject to the option and for the ESOP to actually designate a majority of the directors. With appropriate provisions such as these, the "adequate consideration" requirement is likely satisfied, whether or not the fiduciary is relying on the proposed DOL regulation under ERISA Section 3(18)(B),