RLL

The use of an "up-front" leveraged ESOP is likely to be beneficial to your client only to the extent that the seller will agree to a reduced purchase price by reason of the Sec. 1042 tax-deferral available with a sale of stock to the ESOP. If that is not available, your client and the company are probably better off using a "post-transaction" non-leveraged ESOP to provide the same corporate tax deductions and employee ownership. Less complicated, less costly and less dilutive to your client. The situation is not a simple one for designing an ESOP appropriate to accomplish the objectives of your client. I recommend that you engage the services of professionals experienced in designing/structuring ESOPs for closely-held companies. For good information on ESOPs, check out the National Center for Employee Ownership (www.nceo.org/). Also, The ESOP Association (www.esopassociation.org).

If the ESOP purchases the 90% stake, the ESOP will own 90% of the company. Your client's interest will be limited to his share of the ESOP's ownership. Through creative uses of multiple classes of stock, it may be possible to get your client additional stock. Why are you considering an ESOP? What will an ESOP add? Does the company want employee ownership? Are there capital gains to be "tax-deferred" through a Sec. 1042 sale to the ESOP? If your client wants to own as much as possible of the company, an ESOP is probably not appropriate. Consider having your client invest some funds in a purchase of stock, with the company redeeming the major portion of the widow's holding (assuming there is sufficient capital for the redemption). This doesn't sound like a good use of an ESOP.

PLR 199938052 is the one that says that S corporation distributions (dividends) on allocated shares may not be used for ESOP loan payments.

Is the current company stock fund (under the plan) designated as an ESOP? If so, it's subject to the special ESOP rules. With regard to stock attributable to the former (frozen) ESOP, did the plan continue to designate that portion of the plan as an ESOP? If so, the ESOP rules continue to apply.

Angie.....this is hardly a question for which you can expect much guidance from a "short-answer" format such as a message board. I recommend that you seek out learning materials on ESOPs. Good background information is available from The ESOP Association (www.esopassociation.org) and the National Center for Employee Ownership (www.nceo.org).

Angie.....if you're a student, how do you have clients? An ESOP will not reduce his taxable income unless the company is an S corp and he sells a portion of his shares to the ESOP. If he wants to reduce his taxable income, he can reduce his compensation from the corporation. This does not sound like a good situation for an ESOP. A company should establish an ESOP only if it wants to share ownership of company stock with employees. Maybe this "client" would be better served by your suggesting that he reduce his tax liability through charitable contributions....let his money do some good for the rest of the world.

The ESOP's proportionate share of the S corporation income is "allocable" to the ESOP under Subchapter S of the IRC, but the ESOP is exempt from tax on such income per IRC Sec. 512(e)(3). There is nothing to allocate to ESOP participants' accounts except to the extent that the S corp pays a distribution (dividend) to its shareholders. In that case, the "dividend" is allocated among participants' accounts as provided in the plan document.....if shares are allocated, the dividend generally would "follow" the shares. The cash received as a dividend may generally be used in the same manner as other cash received by the ESOP......buy more shares of employer stock, pay benefit distributions, accumulate in "other investments," etc., as provided in the plan document. If there is an outstanding ESOP loan, dividends on "suspense account" shares may be applied to loan payments (assuming the plan documents and loan documents so provide), but it is the position of IRS that dividends on S corp stock allocated to participants' accounts may not be used for loan payments.

The regulations under IRC Sec. 401(a)(4) permit former employees to be treated (and tested) separately from current employee-participants. The language that you request is included in many ESOPs. It is common for ESOPs in closely-held companies to provide for the transfer of former employees' accounts out of company stock (so long as there is a sufficient amount of "other assets" in the ESOP). I recommend that you have the ESOP amended by your client's counsel. Also, you might check out the "model" ESOP published by the National Center for Employee Ownership (www.nceo.org).

Under Title I of ERISA, an ESOP which is a combination of a stock bonus plan and a money purchase plan is still one plan. There can be an intra-plan transfer of stock/cash to pay benefit distributions in cash. The fact that the cash is under the MPP portion makes no difference....the entire plan is an ESOP. The issues would be the same if the ESOP was a stock bonus plan alone. Dowist correctly points out that a distribution of cash, rather than stock, is a decision by a fiduciary to "purchase" stock for the remaining participants. However, this is not a major issue for an ESOP....which is required to be designed to invest primarily in employer stock. ESOPs often use existing cash assets to buy employer stock....that's the purpose of the ESOP under ERISA. If there's a real concern that employer stock is a "riskier" investment, why was the ESOP established as such in the first place? The fact that the ESOP includes a MPP does not change the analysis. Of course, an ESOP fiduciary should not use existing cash to purchase more employer stock (or distribute cash in lieu of employer stock) at a time when it is expected that the value of the stock will decline. The same is true for any other investment by any type of plan. But it is not a major problem for an ESOP to buy more employer stock for participants if the fiduciary acts prudently in making its investment decision and pays no more than fair market value. That's the reason there is an ESOP....to provide stock for participants.

Your original question stated that the ESOP portion would be "frozen" and there would be no additional investments in company stock. Now there is a change....you're allowing participants to reinvest in company stock. Is the reinvestment in company stock under the (now "unfrozen") ESOP portion? If so, the requirements for diversification under IRC Sec. 401(a)(28)(B) and the right to demand distribution in company stock under IRC Sec. 409(h)(1) apply to the new shares. If the reinvestment in company stock is under a non-ESOP portion, such requirements do not apply. On the other hand, it is common for a 401(k) plan of a publicly-traded company to permit participants to receive distributions of company stock from a company stock fund (to the extent their accounts are so invested). What does the plan document say? To the extent that participants elect to "sell" company stock from the ESOP portion of the plan, the amounts reinvested in other funds would be under a non-ESOP portion and would not be subject to the special ESOP rules (unless the entire plan was designated as an ESOP). Scott.....have you yet joined The ESOP Association or the NCEO ? [This message has been edited by RLL (edited 09-24-1999).]

Many ESOPs are designed to transfer employer stock out of the accounts of former employees (with a reallocation to current employees' accounts) pending distribution of benefits. This can be done even when there is not a Sec. 409(h)(2) "ownership restriction." The ESOP must have sufficient assets other than employer stock to allocate to the accounts of the former employees. If the ESOP keeps the accounts of former employees in employer stock, the stock is still owned by the ESOP and is treated as "employee-owned" for purposes of a Sec. 409(h)(2) ownership restriction.

An ESOP under IRC Sec. 4975(e)(7) and ERISA Sec. 407(d)(6) that includes both a stock bonus plan and a money purchase pension plan is two plans under IRC Sec. 401(a), but the IRS permits the filing of one Form 5500 for the combined ESOP (also, one Form 5300, together with Form 5309, is filed as an Application for Determination). For purposes of ERISA Title I, the ESOP is treated as one plan. The money purchase portion of the ESOP is generally subject to the 401(a0 requirements for a pension plan, but there are special ESOP exceptions that may override the pension rules (such as the ESOP exemption from the J&S annuity requirement). Why would the money purchase portion want to purchase employer stock from the stock bonus portion? There is no "ESOP part".....the combination of the two portions is an "ESOP."

You can wait until the IRS releases the PLR to the public.....should be next month. For someone who has so many ESOP questions, you should definitely join The ESOP Association. Membership cost is minimal compared to the benefits. Go to www.esopassociation.org. Also, you should consider joining the National Center for Employee Ownership at www.nceo.org.

Under the current provisions of ERISA, an individual benefit statement need not be provided automatically....but can be supplied only upon request of a participant (and only one such request per year must be complied with). It's surprising that ERISA requires annual distribution of something as unimportant (and meaningless to participants) as the summary annual report, but does not require an annual benefits statement.

To the extent that there remains stock of the new employer allocated to participants' accounts under the frozen ESOP portion, the diversification requirement of IRC Sec. 401(a)(28)(B) continues to apply.

It depends on the state law applicable to incorporated law firms. Many state professional corporation laws would prohibit having a non-lawyer as a beneficial owner of the stock (as would be the case if a non-lawyer were an ESOP participant). You might consider using a non-ESOP stock bonus plan to cover the lawyers, with a comparable profit sharing plan for the non-lawyers. An ESOP under IRC Sec. 4975(e)(7) may not be used in this manner, as an ESOP cannot be combined with a non-ESOP for purposes of testing under Secs. 401(a)(4) and 410(B). A non-ESOP stock bonus plan is not subject to the special ESOP nondiscrimination rule.

The provisions for ESOP distributions which you stated were in the SPD appear to comply with the legal requirements applicable to ESOPs. Presumably, the actual ESOP plan document says the same. It may be possible that the divestiture would constitute a "partial termination" of the ESOP. This would require 100% vesting of all affected participants, but would not require earlier benefit distributions under the law. However, the ESOP plan document may (not likely) provide for earlier distributions in the event of a partial termination. It also may be possible that a buyer of the division could require earlier ESOP distributions (for employees of the division) in connection with the purchase. The employees might consider trying to talk to someone at the buying company to request that it try to negotiate early ESOP distributions for the employees. The buyer would prefer acquiring a division with happy employees. This may be difficult, but why not try?

The PLR is dated 7/2/99, but has not yet been released to the public or assigned a PLR # by the IRS. The PLR is summarized in the "Legal Update" article in the September 1999 issue of ESOP Report, the monthly newsletter of The ESOP Association.

You are correct! The basis of the shares for NUA purposes is the cost (#1 in your post). Even when reallocated (not "redistributed"), the shares retain the $2,000/share cost basis. The old (pre-ERISA) regs under IRC Sec. 402 may be of some help here. But under regular income tax rules for determining basis, basis is generally cost. Here there is no event that would require an adjustment to cost.

Scott....you certainly have a lot of ESOP questions lately! Annual additions under IRC Sec. 415© are contributions and forfeitures allocated to a participant's account. A dividend paid on employer stock held by an ESOP is income of the ESOP trust, not an annual addition....unless, but only under very extraordinary circumstances, the IRS were to recharacterize the dividend as an employer contribution. When dividends are used for payments on an ESOP loan, the shares released are also not annual additions (absent circumstances that permit recharacterization). The same would apply to an S corporation ESOP .....the dividend is not an annual addition so long as it is a true "dividend" (or S corporation "distribution" for tax purposes) and not a "disguised" employer contribution. In a recent PLR, the IRS stated that S corporation dividends may be used for ESOP loan payments if paid out of the company's earnings and profits (accumulated while it was a C corporation) or out of the S corporation "AAA" account. [This message has been edited by RLL (edited 09-13-1999).]

Section 1042 requires, in part, that the employer stock sold to an ESOP in a tax-deferred sale be stock of a C corporation. There is no statutory requirement that the issuing corporation remain a C corporation. After the sale, the ESOP can be one of the shareholders that consents to an S corporation election.

Several thoughts: * The company cannot unilaterally decide to purchase all the ESOP's shares. An ESOP fiduciary must agree to sell the ESOP's shares to the company. * IRC Section 411(d)(6)© and ERISA Section 204(g)(3) provide ESOP exemptions to the "anti-cutback" rule. The terms of the statutory exemptions are very broad and should permit the elimination of the right to demand distributions in stock. Although the underlying IRS regulations seem to not permit elimination of the right of participants to receive distributions in company stock, the legislative history of the ESOP exemption (in the Senate Finance Committee report on the Tax Reform Act of 1986) states that the right to demand stock may be limited when "the plan ceases to be an ESOP." * In my experience, the IRS has often issued determination letters when the participants' right to demand stock was eliminated in a situation where an ESOP sold all its stock, was merged into another plan and ESOP status was terminated. * If the company's stock (held outside the ESOP) is "substantially owned" by individuals who are employees of the company, the charter or bylaws could be amended to limit ownership as described in IRC Section 409(h)(2)(B)(ii)(I), and the right to demand stock could be eliminated, as permitted under the IRS regulations. The right can also be eliminated if the company is an S corporation. [This message has been edited by RLL (edited 09-08-1999).]

Is the ESOP a stock bonus plan alone or a combination stock bonus plan/money purchase plan? If it's just a stock bonus plan under IRC Sec. 401(a), there is no need to ever invest in employer stock so long as the benefit distribution rules of Sections 401(a)(23) and 409(h) and (o) are satisfied with respect to employer stock. A stock bonus plan does not have to be an ESOP under IRC Section 4975(e)(7) to be qualified under Sec. 401(a). It only has to be an "ESOP" to take advantage of the special IRC and ERISA features and tax incentives available only for "statutory ESOPs." The requirement that an ESOP be "designed to invest primarily in employer stock" does not apply to a stock bonus plan which is not an ESOP. If the plan is not investing in employer stock, why is it designated as an "ESOP" ? Is the plan accumulating cash for a future purchase of employer stock? Is employer stock available for purchase? What is the intent of the sponsoring company? Why was the ESOP established? If the ESOP includes a money purchase plan, there may very well be technical problems if no employer stock has been acquired after five years. What's going on here?

The Trustee of the Company B ESOP would be "obligated" to buy Company A stock only if the ESOP were amended to so provide and if there is Company A stock available for purchase (it might not be available to the Trustee if Company A is not publicly traded). The ESOP can be terminated in connection with the transaction, with cash distributions being provided to participants. The ESOP should be amended to eliminate the right of participants to receive distributions in the form of Company stock, as permitted under IRC Sec. 411(d)(6)©.

There is no direct statutory provision that says that a dividend which is distributed to ESOP participants under Sec. 404(k) is not an "eligible rollover distribution" under Sec. 402©. The IRS has taken this position under its regs as being consistent with the concept that the dividend pass-through represents a current payment (of compensation), rather than a payout of deferred compensation for retirement. This position is supportable by reference to the special exemptions for such dividend distributions under Sections 72(t), 411(a)(11) and 3405. It's interesting to note that the current "pass-through" of dividends to ESOP participants was first recognized by Congress in the Tax Reform Act of 1976 (although legislative history included references earlier) and was specifically included in the IRS regs on ESOPs in 1977. The "pass-through" was made deductible under Sec. 404(k) by the 1984 Tax Reform Act. Congress wanted to encourage the treatment of ESOP participants as beneficial shareholders, who can share in current dividends. It's clear that Congress envisioned ESOPs as more than mere "retirement" plans. The objective was to provide stock ownership interests to employees. It was not until the 1986 Tax Reform Act that the deduction under Sec. 404(k) was extended to dividends used for payments on ESOP loans.