Employer Securities Defined

[Guest GBMcGrath]

I have a C Corp that is, for all intents and purposes, converting to an LLC. The LLC is going to check the box, that is, make the election to be taxed as a C Corp. The two owners of the C Corp want to establish an ESOP and do a section 1042 transaction in a few years. I have no issue with them converting back to a C Corp at that time and establishing an ESOP. I'm comfortable they can tack holding periods. However, do they have to go through that conversion? Can an LLC that checks the box sponsor an ESOP and can the owners of the interests sell those interests to the ESOP as "employer securities." I'm aware of the line of PLRs that discuss LLCs as members of a controlled group of corporations for purposes of ESOP participation, but am looking for something more definitive.

[RLL]

Hi GBMcGrath ---

Employer securities for purposes of funding an ESOP must be "stock," per IRC section 409(l). Also, see ERISA section 407(d)(5)(A).

An ownership interest in an LLC is not stock....only corporations issue stock to represent ownership interests. Accordingly, an LLC cannot issue stock which would constitute "employer securities" under the IRC or ERISA.

[Guest GBMcGrath]

But under Code section 7701 and its regulations, if an LLC elects to be taxed as a corporation, it's to be treated as a corporation for all purposes of the Internal Revenue Code. Are you aware of any rulings, etc., that would except 1042 transactions from that general line of thinking?

[RLL]

GBMcGrath ---

Treating an LLC as a corporation for tax purposes does not change its ownership interests to stock. Furthermore, even if the IRC were to treat LLC interests as stock, ERISA section 407(d)(5) would not treat the LLC ownership interests as stock....so an ESOP could not own such LLC ownership interests.

[jpod]

What is basically the same issue comes up in the context of incentive stock options. I have been told that the IRS is sympathetic to the view that equity interests in a check-the-box entity should be treated as "stock" for ISO purposes; maybe they feel the same way about ESOPs. However, I'm pretty sure the IRS has not issued any guidance on the issue in either context. Also, insofar as ESOPs are concerned, coordination with DOL is necessary because I believe the applicable PT exemption contemplates that the employer securities must be "stock." However, I would think that if IRS and DOL were prepared to allow this they would have said something by now, because check-the-box has been around for quite some time and they have been asked the question many times. (It also came up from time to time prior to check-the-box in the case of associations that were taxable as corporations.)

Obviously, the issue under the existing 7701 reg. is whether it is broad enough to equate equity in a check-the-box entity with "stock." I'm not sure it is borad enough, and I would advise a client that any assumption that it is would be very risky.