RLL

Hi CJS --- It's extremely difficult for anyone to give you meaningful advice based solely upon your quoting one sentence of one article of your "plan document." And a message board such as this is not really the proper place to obtain the type of guidance that you seek. I recommend that you seek the advice of legal counsel experienced in dealing with ERISA and ESOP benefit claims and alleged fiduciary violations. Be prepared to provide copies of all available documents and more precise information regarding this ESOP's loan and administrative practices (including the benefit distribution policy). As an alternative, you might want to contact the local office of the U.S. Department of Labor's Employee Benefits Security Administration (if you don't mind the frustrations of dealing with federal bureaucrats). Good luck.

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.

Hi mab --- A corporate guarantee of an ESOP's purchase money note to a selling shareholder constitutes an extension of credit within the purview of the "ESOP loan exemption" under ERISA section 408(b)(3) and IRC section 4975(d)(3). In such a situation, the selling shareholder is the lender.

Hi Jerry --- For purposes of IRC section 415©(2)©, reallocated forfeitures of employer stock are calculated based on the fair market value of the shares as of the allocation date.

Hi jsample --- The ESOP diversification election under IRC section 401(a)(28)(B) is not governed by the benefit distribution requirements of section 409(o). Accordingly, the deferral for leveraged shares which is permitted by section 409(o)(1)(B) is not applicable in connection with required diversification.

Hi benefitsrus --- If "participation in the plan" is interpreted as "active participation," the answer to your last question is "NO." See the earlier discussion in this thread. This is an example of having a poorly drafted plan document which merely repeats the ambiguous statutory language and gives insufficent guidance as to how the provision is to be administered.

Hi jmlumpkin --- A1: IRC section 409(h)(2)(B) allows an S corporation ESOP to distribute cash without offering distributees the right to demand distributions in shares of employer stock. A2: If benefits are distributed over a five-year period, as permitted by IRC section 409(o)(1)©(i), the undistributed portion of participants' account balances remain invested under the ESOP trust either in shares of employer stock or in other investments, as provided in the ESOP plan documents. To the extent that account balances remain invested in employer stock, subsequent distributions will be based on updated share values.

Hi mcook --- See the following update article (dated 6/11/03) on the NCEO web site: http://www.nceo.org/columns/cr143.html

Harry O --- A portion of the sale consideration for all shareholders can be "held back" in escrow for a period of time to stand behind the reps and warranties that the buyer requests. If there is no liability to the ESOP trustee beyond the escrowed amounts, the ESOP trustee should be in a position to make the reps and warranties subject to it's own knowledge of such matters.

Hi Kirk --- The 1988 proposed DOL reg defining "adequate consideration" [under ERISA section 3(18)] sanctions the use of controlling interest price in limited situations in which the ESOP acquires a minority interest together with an option to acquire control within a reasonable period of time. Without further guidance, it may be difficult for an ESOP fiduciary to get comfortable with utilizing this approach....and the fiduciary can easily be second-guessed if the ESOP does not actually exercise its option and acquire control. Hi Harry O --- The circumstances that you describe cause me concern....there may be a serious problem if the ESOP receives less consideration (on a per share basis) for its stock than non-ESOP shareholders. It is possible to structure an arrangement where all shareholders, including the ESOP, have a portion of the sale consideration placed in escrow to "stand behind" the reps and warranties.

Hi Fourohonekay --- If the ESOP is a "statutory ESOP" under IRC section 409(a) or 4975(e)(7), it must be designed to invest "primarily" (not necessarily "exclusively") in employer stock which meets the requirements of IRC section 409(l). This may include stock of more than one member of the controlled group. These rules can become somewhat complicated in the case of closely-held companies. See section 409(l)(4) for special controlled group rules applicable to such ESOPs. If the ESOP is actually a non-ESOP stock bonus plan, it may invest in any employer stock which meets the requirements for "qualifying employer securities" under ERISA section 407(d).

Hi CitationSquirrel --- If an ESOP is purchasing a controlling interest in a closely-held company, it would be OK for the ESOP to pay a controlling interest price for the stock....although the ESOP fiduciaries have the obligation to bargain for the lowest purchase possible price. When an ESOP already owns a controlling interest and is purchasing minority interests, it is not clear that the ESOP can pay a controlling interest price. For valuation of participants' interests in an ESOP on an ongoing basis, it is appropriate to use a minority interest valuation only if the ESOP has acquired its stock at minority interest prices. If the ESOP has paid a controlling interest price to acquire the stock, that stock should continue to be valued on a controlling interest basis....to do otherwise would deny participants the benefit of the ESOP's having purchased (and paid for) control, and ERISA allows the payment of a controlling interest price only to the extent that the purchase benefits participants. See ERISA section 404(a)(1). If the ESOP acquires control over time through purchases at minority interest prices, continuing use of minority interest valuation on an ongoing basis is appropriate if the ESOP fiduciaries decide that such approach is in the best interest of the participants. When an ESOP company is sold, all shareholders (holding the same class of stock) will receive the same sale consideration...which presumably represents a controlling interest price. When an ESOP sells its stock in a transaction where the entire company is not sold, the ESOP should receive a controlling interest price if it's selling control; if the ESOP is not selling control, the fiduciaries should bargain for the highest possible selling price...which under certain circumstances should be a controlling interest price.

There are quite a few leveraged KSOPs that provide for a matching allocation of employer stock equal in value (as of the allocation date) to a specified % of participants' elective contributions. Once the required matching allocation has been calculated, you work backwards to determine the amount of employer contribution needed to make a loan payment that will "release" the number of shares required to satisfy the defined matching allocation. In such a case, participants will know the exact amount of the stock match that they'll receive (as of each allocation date). If the stock value has declined, a larger employer contribution is required. The negative for participants is that they won't receive the benefit of any appreciation in stock value from the time of the leveraged stock acquisition until the allocation date.

Hi nancy --- An ESOP that provides for the distribution of shares of employer stock that are "not readily tradable on an established market" must provide a "put option" to the distributee, per IRC section 409(h)(1)(B), (4), (5) & (6). The plan document for such an ESOP must include provisions which comply with the put option requirements (see IRS Form 5309).

Hi pjb --- The cost basis of shares of employer stock reallocated or "recycled" within an ESOP remains unchanged so long as the shares are not distributed (or otherwise disposed of) and then reacquired by the ESOP. The basis remains the ESOP's original cost (or acquisition value, in the case of contributed shares); and, if the employer is an S corporation, there will be an annual adjustment to basis to represent the ESOP's share of S corporation income or loss.

Kirk --- The fact that the employer's guarantee of the floor price may adversely affect the value of employer stock for all other ESOP participants MUST be taken into account by the fiduciary in its determination of "adequate consideration" and negotiation of the purchase price for purposes of the new leveraged stock purchase transaction. QDROphile --- Convertible preferred stock designed to provide "floor price" protection may be effective in some situations....but it will complicate the ESOP transaction and subsequent administration by adding in a recapitalization and creating an additional class of stock on an ongoing basis....and it won't eliminate the potential negative effect on valuation of any common stock that the ESOP (or other shareholders) may own. All the ESOP's stock could be convertible preferred stock unless the ESOP was the 100% shareholder. You would not be able to use convertible preferred stock if the employer is an S corporation.

Hi Kirk --- I think that a third-party (including a shareholder) guarantee of the floor price is OK or maybe even better than a guarantee by the employer. One difference may be a slightly enhanced value of employer stock by reason of the fact that it's not the employer guaranteeing the subsidized value. I think that a guarantee by the ESOP itself is a problem, since one group of participants should not be subsidizing ESOP benefits for other participants. What do you think? By the way, Kirk, I'm very impressed that you've become a BenefitsLink Super Moderator.

Hi lolalin --- The use of a "floor price" in an ESOP is usually justified only when the ESOP is acquiring additional shares in a leveraged transaction which will result in a reduction in value of the ESOP's existing shares. In such a case, the ESOP fiduciary may bargain for a floor price as part of its agreement to engage in the transaction. The floor price guarantee usually comes from the employer as part of the put option triggered in connection with ESOP benefit distributions. An ESOP should not subsidize benefit distributions which exceed the fair market value of the "distributable" shares.

Hi D. Lawrence --- A more-than-25% shareholder cannot share in any allocations of shares acquired by the ESOP in a 1042 transaction. See IRC section 409(n)(1)(B). There is no exception under section 409(n) for shares reallocated (as forfeitures or otherwise) following termination of service and "recycling" of shares within the ESOP. The "1042/409(n) taint" could be removed from shares if the ESOP actually distributes (or otherwise disposes of) the shares and then reacquires them.

CMC --- Review that portion of the Senate Finance Committee report under the Tax Reform Act of 1986 which discusses the addition of subparagraph © to IRC section 411(d)(6). What you are proposing has been done frequently, and the IRS has issued many favorable determination letters with respect to ESOPs in which this has been done.

Diane --- A key question here is whether the owner was seeking to sell the company and/or had a "potential buyer" at the time that the ESOP was terminated. If the answer is "yes," there could be liability if the shares are now sold for more than the appraised value upon which the benefit distributions were based.

Hi Brenda Wren --- Such an ESOP would be in violation of the distribution requirements of IRC section 409(o)(1)(A). Note that the exception for financed shares in section 409(o)(1)(B) applies only to loans described in section 404(a)(9), which does not apply to S corporations per section 404(a)(9)©.

Hi DeePA --- I disagree with your conclusion regarding the new 60% shareholder. Pursuant to IRC section 409(n)(1)(B) and (3)(B)(ii), someone who is a more-than-25% shareholder on any date that 1042 stock is allocated cannot share in that allocation....even if that participant was not a shareholder at the time of the 1042 sale. In your situation, the new 60% shareholder will continue to be an ESOP participant but cannot receive additional allocations of any 1042 shares. You are correct that the original 1042 sale itself is not affected by the subsequent sale of stock by the 60% shareholder.

DeePA (a/k/a "a pain!") --- IRC section 409(n)(1) provides that ".....no portion of the assets of the plan....attributable to (or allocable in lieu of) employer securities acquired by the plan....in a sale to which section 1042 applies may accrue (or be allocated directly or indirectly under any plan of the employer meeting the requirements of section 401(a))...." Regarding "recycled" shares in the ESOP, if the cash contributions are used during the nonallocation period solely to cash out 1042 shares allocated to distributees' accounts, the cash could be deemed to be assets allocable temporarily in lieu of such shares. Accordingly, there may be a violation of section 409(n)(1) to allocate such cash to 1042 sellers. The sanctions for violating the section 409(n)(1) provisions are so onerous that it seems foolhardy to take any risks here when it's easy to make up the "lost" allocations outside the ESOP.

Hi DeePA --- The safe reading of IRC section 409(n)(1)(A)(i) is that a taxpayer who elects 1042 treatment for a sale of employer stock to an ESOP is forever prohibited from receiving allocations (under that ESOP) of any employer stock sold in any 1042 sale during the nonallocation period attributable to each sale. It appears that the "taint" of a 1042 election under section 409(n) is not removed from a taxpayer for any future 1042 sales. Section 409(n)(1) applies only to allocations of employer stock (sold under 1042) or any allocation intended to be in lieu thereof.