RLL

Allocations of stock representing current employer contributions to an ESOP may be used as 401(k) safe harbor contributions if all applicable requirements for the safe harbor are satisfied.

Probably not. "Years of participation" for purposes of the ESOP diversification requirement of IRC Section 401(a)(28)(B) may be limited to years of "active participation." This generally means years in which the participant is entitled to accrue a benefit (receive an allocation of employer contributions, if any) under the ESOP. The definition of "Credited Service" under your ESOP is likely used for purposes of determining participants' vesting. Someone will have to interpret what standard the ESOP uses for determining "participation" for diversification purposes. If it's not clear in the ESOP document, the lawyer who drafted the ESOP and the parties at the company who were involved with the design of the ESOP should be asked what was intended. It may be necessary to amend the ESOP to clarify this matter. [This message has been edited by RLL (edited 04-21-2000).]

I strongly agree with hapa123, especially in the case of an ESOP or KSOP. Many "model plan" peddlers don't really understand the unique fiduciary, investment, transaction, allocation, administration, benefit distribution and other special provisions appropriate for an ESOP or KSOP. It's very different from a profit sharing, 401(k) or pension plan. Caveat emptor (is that right?).

Hi mspencer! Welcome to the ESOP message board. Under IRC Section 415©(2), "annual additions" is defined to include employer contributions, forfeitures and employee contributions.....although Section 415©(6) excludes certain contributions and forfeitures in the case of a leveraged ESOP. Dividends on employer stock owned by an ESOP constitute earnings on trust assets, and such earnings are not "annual additions" under the IRC. However, the IRS regulations under Section 415©, at Reg. Sec. 1.415-6(B), provide that certain transactions between an employer and a plan may give rise to annual additions. This would apply to dividends only in an extraordinary circumstance when the IRS could "recharacterize" certain dividends as employer contributions. For example, if the ESOP were the only holder of a certain class of employer stock and an extraordinary amount of dividends were paid on that class, this may be an appropriate circumstance for such a recharacterization. The IRS would have to establish that the dividends were designed as a means to avoid the Section 415© limitation. If the dividends are "reasonable" in amount and/or if the ESOP is not the only shareholder receiving such dividends, the dividends cannot be recharacterized as "annual additions" under Section 415©(2).

Partial distributions are very common in ESOPs of closely-held companies. These ESOPs often allow the establishment of a policy for making benefit distributions in installments, usually as a means of managing "repurchase obligation." ESOPs of publicly-traded companies usually provide for lump sum distributions (other than for "diversification" distributions under IRC Sec. 401(a)(28)(B). I'm somewhat surprised that Mr. Maldonado says he has never seen such a provision. Administration of an installment distribution policy is not very difficult, but there are added burdens which should be weighed against the benefits to be obtained.

Hi HIPAAdrome! First-Who can complain if each of the former participants is given the opportunity to be advised of the updated value? Your client is taking a risk, however, that one individual may "waive" such right and then later find out (next year) that the value had been much higher, but had then dropped. Would it be safer to establish an estimate of value to communicate? Maybe. Second-how can Sec. 401(a)(28)© apply to an ESOP that no longer exists? There is no longer a plan to disqualify. Presumably, the ESOP complied with the independent appraisal requirement while it was operating. There are no longer any plan activities to which the requirement can still apply. I have no IRS or other "authority" for this position, only that I think I'm right (I usually am!).

Yes. There must be be an updated valuation of the stock for purposes of the second put option, if a former participant, who is entitled to receive payment pursuant to a "fair valuation formula" under IRC Sec. 409(h)(1)(B), wishes to exercise the put option. However, the independent appraiser requirement of IRC Sec. 401(a)(28)© no longer applies after the ESOP has been terminated. Accordingly, the updated valuation may be determined by some other means in the event that any of the former participants requests notice of the updated value and/or wishes to exercise the second put option.

The forfeitures may not go back to the company, as this would constitute an improper reversion of plan assets to the employer (although there may be a minor exception to this rule for certain forfeitures under some terminating plans). The forfeitures may be applied to reduce the amount of employer contributions to the ESOP; for example, the forfeitures may reduce the amount of a contribution required under a formula, such as a % of compensation or a % of profits, etc. The company's tax deduction, however, would be limited to the net amount contributed. The forfeited amounts may not be applied to payments on the ESOP loan. [This message has been edited by RLL (edited 03-29-2000).]

You want it for free?

The seller has to purchase qualified replacement property ("QRP") within 12 months after the sale to completely avoid current taxation. There is no requirement that the seller use the actual proceeds received from the ESOP. If the seller does not have other assets available for purchasing QRP, he/she should borrow the necessary funds. In addition, the 1042 election does not require a 100% reinvestment.....so the seller can do a partial reinvestment in QRP and recognize some capital gain. The computation of taxation in an installment sale combined with a 1042 election is a bit complicated....as there is current taxation based on the amount "realized" (not "recognized") in the sale (including the installment note) to the extent it exceeds the cost of QRP.

I'm not aware of any "official" IRS position on this point.....although there is a mid-1990's TAM (involving an ESOP corporate reorganization) which states that the voting pass-through requirement of IRC Sec. 409(e)(3) is triggered only when the applicable corporate law requires a shareholder vote on a matter. It is clear that consent to an S corporation election is not a shareholder vote.....for example, each shareholder must consent, consent is by each individual shareholder not on a per share basis, etc.

I wonder why someone would adopt or draft an ESOP plan document that provides such an election to the participants. And why wasn't this repurchase obligation issue addressed years ago? VERY BAD PLANNING AND/OR ADVICE. I'd suggest amending the ESOP to change the benefit distribution provisions, to the extent permitted under IRC Sections 409(h) & (o) and 411(d)(6)©. As an alternative, find another source of liquidity...such as additional debt or equity capital, an IPO (if possible) or a sale of the company. Or get the 5 employees to waive their rights (but why would they without some compensation?).

The shareholder consent required for an S corporation election is not a corporate matter presented to shareholders for a vote. Each shareholder of record makes an individual decision as to whether to consent. The corporation's decision to elect S corporation status is made made by the board of directors. Accordingly, as there is no matter presented for a shareholder vote, there is nothing to "pass-through" to ESOP participants under IRC Sec. 409(e)(3).

Very good question, LDH1. The 1977 ESOP definitional regulations (Sec. 54.5975-11) have a concept called "non-terminable rights" which will continue to apply even if the plan ceases to be an ESOP. It would seem that the voting rights required under IRC Sec. 133 should be subject to a similar requirement....that they must continue to apply even after the Sec. 133 loan has been repaid. But the IRS has never included such a requirement in regs under Secs. 133, 409(e), or 4975(e)(7). In addition, the voting rights required under Sec. 133 were merely a condition for the lender to receive the partial interest exclusion for certain ESOP loans. There was no Sec. 401(a) or 4975(e)(7) requirement beyond what Sec. 409(e) required. So long as there is no longer any possibility for the lender to retroactively lose the 50% interest exclusion (if the statute of limitations has passed on the lender's tax return for the final year of the loan), there is no sanction for amending the ESOP to remove the full voting rights required by Sec. 133.

What you propose doing is OK. It is not uncommon for an ESOP of a closely-held company to "convert" the accounts of former employees into assets other than company stock. This can be done even when participants have the right to demand distributions in company stock.

Check with The ESOP Association (www.esopassociation.org) and The National Center for Employee Ownership (www.nceo.org). Both have lists of institutional trustees with ESOP experience.

I don't understand what you mean by "Company wants to have the sale effective as of 1-1-2000." What's wrong with having it effective as of the date the sale occurs? When an ESOP purchases closely-held employer stock from a party-in-interest, the purchase price must not exceed "fair market value" determined as the purchase date. Mr. RLL

What do you mean by "All of the participants will be fully diversified in Company A stock which they hold in the plan" ? Presumably, Company A will be liquidated following the sale of its assets and the Company A stock will be converted into cash. If the assets of the Company A Plan are transferred to the Company B Plan, the IRS would likely say that Company A Plan is a "predecessor plan" to the Company B Plan and participation in the Company A Plan would count as participation under IRC Sec. 401(a)(28)(B) for purposes of Company B Plan's ESOP diversification election. The law is not totally clear on this point, however, and it may be possible to avoid this result (if that's what you want to do) by obtaining an IRS determination letter on plan provisions which deny such treatment. Note that the diversification requirement of Sec. 401(a)(28)(B) is based on "participation," not "service." [This message has been edited by RLL (edited 03-02-2000).]

IRC Sec. 411(d)(6)© allows an ESOP to have some flexibility in making benefit distributions....so long as there is an established written distribution policy which is administered on a nondiscriminatory basis which treats participants in like circumstances in a like manner, as required by ERISA (decisions regarding the distribution policy will be subject to ERISA's fiduciary standards). The ESOP plan document must specifically provide for such benefit distribution procedures. Please note that the shares available for distribution have already been released from the ESOP loan suspense account and allocated to participants' accounts. Accordingly, they are no longer "encumbered" (pledged as security for the ESOP loan). The shares merely qualify for the delayed distribution provision (applicable to shares purchased with loan proceeds) under IRC Sec. 409(o).

The "newspaper exception" in IRC Sec 401(a)(22) was added to the Code as a "special interest" provision at the request of a powerful member of Congress (not Senator Long) who had a constituent that controlled a family-owned newspaper. There is no other current "hidden" provision of the Code that would require a pass-thru of voting rights. IRC Sec. 133 was repealed a number of years ago.

What your client wants to do is OK. In fact, the January and February principal payments could have been treated as 1999 contributions. What's the problem? [This message has been edited by RLL (edited 02-28-2000).]

Yes.

The ESOP's annual report (Form 5500), as well as the audited financial staements (if required) will reflect the most recent year-end valuation of company stock. The summary annual report may also reflect such information. Also, if annual benefit statements are provided to participants, the year-end valuation will be reflected thereon. Other than these ERISA requirements, there is no specific requirement for periodic disclosure of the valuation of employer stock held by an ESOP. If the employer stock is publicly-traded, however, participants can easily obtain current stock market quotations. You raise a very good point, Letocha. If an ESOP holds employer stock that is not publicly traded, perhaps ERISA should include more specific disclosure requirements regarding the valuation.

The proposed regulation is not "in force and effect." It is not a temporary reg....it is merely proposed, and it will take effect only after it is adopted by the DOL as a final (or temporary) regulation (if that ever happens).

If the trustee violates it's fiduciary responsibilities under ERISA, he, she or it is liable for any resulting loss to the ESOP. There are thousands of ESOPs which hold stock of closely-held companies. A trustee that is experienced in serving as an ESOP fiduciary, or that relies on the advice of competent, experienced legal and financial advisers, should not be incurring unmanageable risks if it follows appropriate procedures and complies with ERISA. Do you have a particular situation which has raised concerns?