1042 transactions and shares allocation

[Guest DeePA]

Owner A&B sell shares to esop and utilize 1042. Therefore they do not get allocation of shares released.

Owner C sells shares to esop under different transaction 5 years later and utilizes 1042. Therefore he does not get allocation of shares released.

Question #1-can owner A&B get allocation of shares from 2nd transaction because they did not partake in that specific transaction for 1042? Likewise can owner C get allocation of shares from 1st transaction? Basically i'm asking if one 1042 transaction prohibits the owner from receiving any shares from any release of shares? Also, what if ESOP puts in cash contribution once loans are paid off? Can all owners receive the cash contribution?

Thanks.

[RLL]

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.

[Guest DeePA]

RLL-

Do you have any reg/code cite that would allow cash allocation (that was not in place of stock, but rather in addition to?)

Thanks

[Guest DeePA]

One more question (call me a pain!)

If this esop "recirculates" shares, that is, the cash contribution is used to fund repurchase liability and thus remaining participants receive shares and give up cash to fund distributions, then would you agree that giving 1042 owners a piece of the cash may be tricky?

Since they won't be able to give up their cash for shares when someone else needs paid out?

[RLL]

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.

[Guest D. Lawrence]

RLL--

If the ESOP has a significant cash investment element, and a 25% shareholder has a significant cash balance, is he prohibited from participating in the repurchase from terminated participants of shares of ER stock that are from a 1042 transaction?

Also, if there are forfitures in such a plan, some of the forfeited amounts come from the cash investments and some from the ER stock. Can the 25% shareholder share in only the forfeitures from the cash investments?

We have a plan which holds S-Corp. shares from a 1042 transaction and does not allow distribution of shares to terminated employees. We exchange the terminated employee's shares for the cash investment. Each of the remaining participants share in the repurchase, porportionately based on cash investment account balances. At that point all forfeitures are in the cash account. Forfeitures are then reallocated as an additional employer contribution to the cash account. Should forfeitures from cash investments be allocated separately (including an allocation for a 25% sharehholder) from forfeitures of the proceeds of the repurchase (excluding the 25% shareholder)?

This is complicated!

[RLL]

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.