RLL

I think IRS is wrong. If the corporation is paying the interest, Form 1099-INT should be used inasmuch as the interest is not a benefit distribution from the ESOP (but is a payment of interest on the corporation's note).

Form 1099R is used to report benfit distributions from retirement plans....so it is NOT to be used for payments of interest by an ESOP to a lender.

The best alternative might be for the ESOP to exchange its shares for the class of employer stock that will be publicly traded. The exchange should be at the respective fair market values of the shares on the exchange date (presumably, immediately prior to the effectiveness of the IPO). With publicly-tradable shares, ESOP benefit distributions will be greatly simplified (distribute the shares, no "put option" required).

IRC Sec. 404(a)(9) permits contributions to be deducted for a taxable year if made to an ESOP and applied by the ESOP for payments on an ESOP loan by the due date (including any extension) for filing the company's federal income tax return for that year. It is the position of the IRS, however, that contributions paid after the close of the taxable year can be deducted for the prior year only to the extent applied to loan principal or to interest accruing during the taxable year. Such contributions which are deducted for a taxable year must be treated under the ESOP as having been made on the last day of that taxable year, thus resulting in additional allocations to participants' accounts. Prepayments on an ESOP loan will result in a reduction of future loan payments in the manner set forth in the loan documents. [This message has been edited by RLL (edited 02-06-2000).]

Will the class of stock now owned by the ESOP become publicly-traded? If the ESOP now owns convertible preferred stock, will it be convertible into the class of common stock that will be publicly-traded? Is the ESOP leveraged (is there still an ESOP loan which has not been fully repaid)? Are there dividends intended to be deductible under IRC Sec. 404(k)? Does the ESOP include a money purchase pension plan? Is there another reason for the ESOP to continue to be a "Sec. 4975(e)(7) ESOP" or is "simple stock bonus plan" status enough? I guess I have more questions than answers for you, RMM. But your question can only be accurately answered if you give more facts. It is correct that a "statutory ESOP" under IRC Sec. 4975(e)(7) must be invested "primarily" in employer stock satisfying the requirements of IRC Sec. 409(l). [This message has been edited by RLL (edited 02-04-2000).]

If the insurance policy is an asset of the ESOP trust and has value, that value must be allocated to participants' accounts at least annually, just as in any other type of defined contribution plan. The fact that the ESOP has been leveraged does not permit having a "suspense account" for an asset other than employer stock. There is an old revenue ruling (probably from the 1960's or 1970's) in which the IRS set forth its rule that defined contribution plans must annually allocate all trust income and assets to participants' accounts. The "non-allocation" which you've described is a qualification defect under IRC Sec. 401(a), as well as a violation of the ERISA fiduciary rules. I would also question the propriety of an ESOP's owning keyman life insurance. Is the use of plan assets to pay premiums in the best interest of (and for the exclusive benefit of) ESOP participants? I think this "investment" raises many problems under ERISA's fiduciary rules, even if the cash value gets allocated to participants' accounts. Wouldn't it be better for the keyman policy to be owned by the company? [This message has been edited by RLL (edited 02-01-2000).]

The proposed regulation has never been formally withdrawn by the DOL. For several years, it has been listed on the DOL reg agenda in the catagory of items for which there will be no action in the coming year. The fact is that DOL has taken no further action on this reg for at least 12 years....does such inaction result in withdrawal under the Administrative Procedures Act? The 1995 Fed register posting was an error.....is it so hard to believe that a government agency would make a mistake? I think it's outrageous that the DOL has not pursued finalizing this reg. Sec. 3(18)(B) of ERISA specifically contemplates that DOL would provide such guidance, and several federal courts have chastised DOL for its failure to comply with this requirement. It's ironic that DOL has repeated challenged folks over valuation issues in ESOPs of closely-held companies while at the same time failing to work on this reg.

I don't think an ESOP can use prior accumulated funds attributable to employer contributions to make payments on a subsequently incurred ESOP loan. How can the contributions be "made for the purpose of repaying a loan" that doesn't exist (and may never exist) at the time of the loan? Reg. Sec. 54.4975-7(B) would make such use of prior employer contributions a violation of IRC Sec. 4975 and ERISA Sec. 406.

The board of directors of Company X probably can grant the options if there are authorized but unissued shares (or treasury shares) available. If the options are intended to be "incentive stock options" (ISOs) under the IRC, shareholder approval is required. In some states or under some corporate charters or bylaws, shareholder approval may be required even if ISOs are not being granted. The big issues here are whether the options represent "reasonable" levels of compensation for the grantees and who will be approving the grants. Is there a board of directors (or compensation committee) composed of independent directors? Or are management directors granting options to themselves? Is there an independent compensation consultant advising the board of directors as to the propriety of the option grants? Who is looking out for the ESOP participants' interests? Is it in the best interests of the shareholders (including the ESOP) for the options to be granted? The decision is one of fiduciary responsibility of directors under corporate law. But the fact that the ESOP owns 70% of Company X brings ERISA fiduciary responsibilty into the picture. No company would adopt a stock option plan that was unacceptable to the 70% shareholder. Accordingly, the ESOP of Company X must "approve" the plan....and who will be providing this approval on behalf of the ESOP? Independent trustee or fiduciary? There is a need for independent safeguards under both ERISA and corporate law to protect the interests of shareholders and ESOP participants. Check out the DOL's interpretive bulletin on corporate governance for ERISA guidance. DOL made it clear that ERISA fiduciaries must concern themselves with matters such as executive compensation in companies in which the plan invests, particularly when the plan owns a significant interest. [This message has been edited by RLL (edited 01-25-2000).]

The annual additions under IRC Sec. 415© include the contributions used to pay loan principal, any contributions that are not used for loan payments (but not the contributions used to pay loan interest), and any reallocated forfeitures (other than forfeitures of leveraged shares). If the fair market value of the "released" shares is less than the amount of contributions used to pay loan principal, you can use the lesser amount to determine annual additions if the ESOP plan document so provides.

Use $60,000 for determining 415 annual additions, per IRC Section 415©(6). Also, the allocations under a leveraged ESOP should be in shares (or other non-monetary units), as required under Reg. Sec. 54.4975-11. Accordingly, the $90,000 current fair market value of the released shares is not a relevant factor in determining the 1999 allocation. [This message has been edited by RLL (edited 01-21-2000).]

It depends on whether the 401(k) plan documents provide for the "pass-through" of voting rights on employer stock to the participants. If not, the shares would be voted as determined by a named fiduciary, such as the trustee or investment manager. If the employer stock is in an "ESOP portion" of the 401(k) plan, "pass-through" of voting rights would be required as provided in IRC Sec. 409(e).....on all issues if the employer is publicly-traded and on certain "major issues" if the employer is closely-held. If the 401(k) plan does not include an "ESOP," the law does not require a "pass-through" of voting rights to participants unless the plan document (adopted by the employer) so provides. The summary plan description for the plan, as well as any prospectus provided to participants in connection with the offering of employer stock, should specify whether there is supposed to be a "pass-through" of voting rights.

What is the role of the Custodian? To hold the stock certificate(s) for the shares purchased by the ESOP? To hold the ESOP shares pledged as collateral? Why not just serve as lender and let the ESOP trustee(s) hold the ESOP's non-pledged assets?

A PAYSOP is a payroll-based tax credit ESOP. That tax credit was available during the period 1982-86. A TRASOP is a Tax Reform Act (of 1975) investment tax credit ESOP. The additional investment tax credits were available during the period 1976-81. Both the PAYSOP and the TRASOP are subject to the same tax credit ESOP requirements of IRC Section 409, as well as the general qualification requirements of Section 401(a).

This issue may not eligible for correction under VCR as it specifically involves violation of the ESOP loan regs., Sec. 54.4975-7(B), and the ESOP definition regs., Sec. 54.4975-11, but not IRC Sec. 401(a). The IRS may take the position that failure to follow the plan document (assuming it specifies the correct release method) is a violation of Sec. 401(a) which can be corrected under VCR. But you'll probably have to pay the Sec. 4975 excise tax for failure to comply with the ESOP loan exemption. Also, other special ESOP tax benefits which may have been utilized....such as the dividend deduction under Sec. 404(k) and the special leveraged ESOP deduction limit under Sec. 404(a)(9)....may be in jeopardy for the loan repayment years by reason of the failure to fully comply with the ESOP requirements.

It sounds like you're talking about an employee stock option plan, not an ESOP. An "ESOP" is an employee stock ownership plan, which is a type of deferred compensation plan qualified under Sec. 401(a) of the Internal Revenue Code and which is a "pension benefit plan" under ERISA.

The preferred "tracking" stock arrangement might be treated by the IRS as having no substance other than for tax savings (as it is designed to generate tax deductions greatly in excess of the benefits being provided to ESOP participants). The preferred stock might be treated as not having a "reasonable conversion price," as required under IRC Sec. 409(l). The ESOP loan might be treated as not being "primarily for the benefit of participants," as required under IRC Sec. 4975(d)(3) and ERISA Sec. 408(B)(3). I could go on and on about this....... Bottom line is that it's using an ESOP primarily as an abusive corporate tax shelter rather than as a vehicle for providing employee stock ownership. [This message has been edited by RLL (edited 12-29-1999).]

The ESOP could be terminated, frozen or converted (or merged) into another type of plan (e.g., profit sharing/401(k)). ESOP participants would likely be vested in the value of their ESOP accounts, and would receive benefit distributions in cash if (and when) the ESOP is terminated. The biggest issue here is the price to be paid to the ESOP for its company stock. A significant premium over "fair market value" should be paid. Who is the fiduciary that will make the ESOP's decision to sell (or not to sell) and at what price? The management shareholders (and others who will own stock in the surviving company) clearly have a conflict which should preclude their serving as ESOP fiduciaries in the transaction. An independent fiduciary should be retained to represent the ESOP in this transaction. It's not enough to merely pay the ESOP a price that an independent appraiser says is "fair market value." The ESOP fiduciary is obligated to negotiate for the highest possible price. What would a third party pay to buy company? What's it worth to the management to buy out the ESOP? This appears to be a "buyer-driven" transaction....it's not the ESOP which wants to be bought out. Accordingly, the buyers should pay "top-dollar" to buy out the ESOP. [This message has been edited by RLL (edited 12-28-1999).]

Gibson.....why not have the bank lend to the company, with the company lending to the ESOP in a "back-to-back" loan arrangement? The bank loan can then include any provisions for default, etc., without raising any issues under the ESOP loan regs. The only real difference for the bank would be a limitation on its ability to get at the ESOP shares, if there is is an assignment of the shares pledged to the company. The bank is probably comfortable lending on the company's credit, with company assets as the collateral. Is this transaction involving the ESOP's purchase of a controlling interest in the company? If not, the value of a minority interest in the stock as collateral is not significant.

Gibson.....what are the "certain circumstances" that permit the bank to call the loan? Does the occurrence of such circumstances constitue a "default" under the loan? If so, the provision is permitted under the ESOP loan regs. Can the loan enforce the "call" against the ESOP or merely require the company to pay?

No.....an ESOP loan may be accelerated and payable on demand in the event of default. The fact that the company (as guarantor) is required to pay off the loan does not affect the liability of the ESOP to the bank lender, except that the company will become the ESOP's creditor when the bank loan has been paid. Is the ESOP pledging the "suspense account" shares to the bank? Or to the company? The disposition of this collateral will be an issue under the ESOP loan regulations. [This message has been edited by RLL (edited 12-24-1999).]

I've seen it, and I don't like it. This is an area where employee ownership intersects with abusive corporate tax shelter. Upon audit, the IRS is likely to "look through" and disallow such a scheme. There are also significant issues under ERISA's fiduciary rules. The folks promoting this kind of arrangement are not friends of employee ownership. This is the kind of abuse that can lead to anti-ESOP regulatory actions and legislation.

An S corporation which is 100% ESOP owned can contribute or sell additional shares to the ESOP, assuming that there are authorized but unissued shares or treasury shares available. In addition, management can be provided with stock-based incentive programs which do not require the actual issuance of shares to them....such as phantom stock or stock appreciation rights. It is also possible to issue actual shares to management employees if a decision is made by the board of directors to dilute the ESOP's 100% interest (and if permitted under the corporate charter and bylaws). A board of directors does not violate its fiduciary responsibility by providing for appropriate compensation arrangements (including stock-based incentives) to attract and retain key employees.....so long as the arrangements provide for reasonable compensation and appropriate corporate procedures are followed. IRC401.....it sounds like you have some kind of "ESOP-phobia." Certainly not every business is a candidate for 100% ESOP ownership. Many businesses should not have any ESOP. But it absurd to take the position that 100% ESOP ownership is bad for any business. There are hundreds of very successful 100% ESOP-owned companies...and most have very satisfied management. You might want to do some homework on the real world of ESOPs.

IRC401.....are you aware that an S corporation that is 100% owned by its ESOP can be totally exempt from federal income tax (and most state income taxes) under current law? I wonder about the "strong business reasons" to which you refer. Having a business which is wholly owned by its employees (through an ESOP), and which is also tax-exempt, sounds like a great arrangement! EMC....I don't see any big problems in making low employer contributions to the ESOP in the early years of loan repayment, while paying a relatively high level of S corp. dividends which are used for loan payments. The contributions may be increased in later years. There may be a problem in paying an extraordinarily large S corp. dividend in one year to pay off the entire loan balance. An S corp. which is 100% owned by an ESOP faces the possibility of IRS recharacterizing a very large dividend as an employer contribution (under the IRC Sec. 415 regs). The UBIT issue is not the problem under current IRC Sec. 512(e)(3). The key is to figure out how best to pay off the loan....using employer contributions and dividends. Consider corporate cash flow, desired level of annual ESOP stock allocations, the need for cash to satisfy benefit distribution obligations (repurchase obligation), etc. Note that the dividends on allocated shares may be accumulated in the ESOP for use in paying future benefit distributions in cash. [This message has been edited by RLL (edited 12-13-1999).]

The folks responsible for administering the ESOP are obligated to operate in accordance with the plan documents, as amended. It is a violation of ERISA for a fiduciary to fail to act in accordance with the plan. Being "unaware" of plan amendments is a lame excuse. You (and the others similarly situated) may very well have a valid ERISA claim against plan fiduciaries if they failed to provide benefits to participants as required under the terms of the plan documents. You may wish to retain legal counsel to provide specific advice as to your rights. Another option for you and the others would be to contact the nearest office of the Pension and Welfare Benefits Administration of the U.S. Department of Labor....but remember, federal bureaucrats usually don't act very promptly in these situations (especially in December when they have to finish their Xmas shopping).