Controlled Group ESOP

[Guest Emiman]

Disclaimer: I am not an expert in ESOPS, so it wouldn't surprise me if there is something I am overlooking. I am having a disagreement with a potential client's CPA on if the client has a controlled group between two companies.

Facts: Company A(C Corp.) is owned 50/50 by Jim and Joe. Company A employs 15 people and is currently sponsoring a 401(k) plan. Company B (C Corp.), a staffing firm, was established by Jim and Joe 50/50. Jim and Joe are the only employees. An ESOP was established for Company B and Jim and Joe sold their stock to the ESOP. The ESOP now owns 100% Company B of which Jim and Joe are the 50/50 accountholders of the ESOP. The ESOP only benefits Jim and Joe and is not setup as a controlled group with Company A. Conversely, the 401(k) plan under Company A does not include Company B as a controlled group either.

The disagreement comes from the attribution rules. The CPA says you use code section 318(a) for ESOPS on controlled group determinations of which the interest in of Company B held by a tax-qualified retirement plan is excluded. Therefore, the companies are not a controlled group for retirement purposes.

I say you use code section 1563(e)(3)(A) for attribution which if a trust has ownership interest in another organization (in this case - Company B) that the interest is attributed to the individuals who have more than a 5% interest in the trust (Jim and Joe). Further, code section 1563(e)(3)© has the same stock exclusion referenced above in section 318(a), however section 414(b) states to disregard this code section in applying the controlled group rules to retirement plans. In affect, Jim and Joe own 50/50 of Company B through attribution of the ESOP stop and the stock exclusion is ignored for a controlled group determination - therefore Company A and B are a controlled group.

Who is right? Do ESOPs have different considerations than 401(k) plans? I know there are CPAs and ESOP experts on this board so I am hoping to have various opinions.

[WDIK]

It is my understanding that 1563(e) would apply for determining ownership in the controlled group setting, while 318(a) applies for attributing ownership in defining highly compensated employees.

[Belgarath]

First, I'll start by saying that I am by no means an expert in the CG arena, and I'd recommend that you place this question before experienced ERISA counsel.

Getting that out of the way, I'm finding this a bit confusing. Although under 1.414©-4(b)(3) there is attribution from ESOP's, it also appears that this may be trumped by the excluded stock rules under 1.414©-3©(2). So it almost appears that while there is attribution in general, it is nevertheless excluded.

(I agree, by the way, that the 318 is for HC and the 1563 rules govern controlled group).

So it is a least possible that the CPA is correct, but for the wrong reasons.

I know this isn't much of an answer, but I'm honestly not sure where I come down on this without a lot of thought. I haven't had a chance to check Derrin Watson's book to see if he addresses this issue.

[Guest Emiman]

First, I'll start by saying that I am by no means an expert in the CG arena, and I'd recommend that you place this question before experienced ERISA counsel.

Getting that out of the way, I'm finding this a bit confusing. Although under 1.414©-4(b)(3) there is attribution from ESOP's, it also appears that this may be trumped by the excluded stock rules under 1.414©-3©(2). So it almost appears that while there is attribution in general, it is nevertheless excluded.

(I agree, by the way, that the 318 is for HC and the 1563 rules govern controlled group).

So it is a least possible that the CPA is correct, but for the wrong reasons.

I know this isn't much of an answer, but I'm honestly not sure where I come down on this without a lot of thought. I haven't had a chance to check Derrin Watson's book to see if he addresses this issue.

Thanks for the response, I agree with your findings on 1.414© but it doesn't circle back to 1563 for a controlled group determination.

In reading IRC 414(b) it is stated "for purposes of section 401 etc. etc. all employees of all corporations which are members of a controlled group of corps (within meaning of section 1563(a), determined without regard to section 1563(a)(4) and (e)(3)© ) shall be treated as employed by a single employer."

If "1563(e)(3)©" were omitted from this code section (therefore it IS regarded) I wouldn't disagree with the CPA. I would conclude the same that although the stock is attributed it is nevertheless excluded. But it is there - what other purpose does excluding 1563(e)(3)© from 414(b) have?

[Guest Emiman]

Oops - I didn't mean to quote Belagarth's post. User error.

[Kirk Maldonado]

Emiman:

I think that both you and the CPA are wrong, at least to the extent that you are looking at the wrong rules. Treasury Regulation section 1.414©-3©(2) provides as follows:

An interest which is an interest in or stock of such organization held by an employees' trust described in section 401(a) which is exempt from tax under section 501(a) shall be excluded if such trust is for the benefit of the employees of such organization.

[Guest Pensions in Paradise]

Sorry, this doesn't related to the OP question. I'm not too familiar with ESOPs, but how can you have an ESOP in which the only two participants are the two owners who sold their stock to the ESOP? I thought they were ineligible for the plan.

[stephen]

As long as it is not an s-corp and they did not elect 1042 I think it is ok for them to sell their stock and allocate it to themselves. I believe they need to have more than just the two of them benefiting though.

The s-corp would be a major problem regarding 409(p). They would fail and the penalties are draconian.

[Guest Emiman]

Kirk,

Thank you for the response. We can't both be wrong on if it is a controlled group, either it is or it isn't. It sounds like you agree with the CPA that it is not a controlled group, it's just that he referenced an incorrect citation.

Looks like I'll take Belgarath's advice - an ERISA attorney will have to settle it for the client. I thought this type of setup may be common in the ESOP arena which is why I came to this website.

Thanks for the help!

[RLL]

The Company B "ESOP" is not a qualified ESOP, without regard to the controlled group issue.

An "ESOP" that benefits only the two shareholders who sold their stock to it is a sham....it does not create capital for the company and does not result in a meaningful transfer of ownership. This so-called "ESOP" constitutes an abusive tax shelter. The IRS can (and should) hold such a plan to be non-qualified, per Reg. section 1.401-1(b)(3).

It is irresponsible for any professional to advise a client to set up an arrangement such as this.

[Guest Emiman]

Thanks RLL,

This reaffirms my decision in which I told the client and CPA "we won't take the plan unless it is reviewed by an ERISA attorney - issues are too complex...." He wasn't happy.

Found out after the call from the financial advisor that the CPA was the one who setup the ESOP for the client. We'll see what happens, but if what you are saying is true then I have a feeling they might stay where they are (current admin did not address these issues) or shop around some more.

[CTipper]

How was this resolved?

[BeckyMiller]

It seems like we all agree that this particular deal isn't attractive. But, we didn't seem to agree on the answer to the aggregation issue. Section 1563 clearly ignores stock held by a 401(a) plan in the calculations of control and in attribution. But Section 414(b) says that determining the members of a controlled group of corporations under Section 414(b), we start out with Section 1563, except:

"section 1563(e)(3)© (relating to stock owned by certain employees' trusts) shall not apply."

This is the provision that excludes stock held by a retirement plan from

attribution

under the general rules of attribution out of trusts. I have always understood this to mean that for 414(b), one did attribute stock out to the ESOP beneficiaries to the extent that such stock was allocated to their accounts under the general rule Section 1563(e)(3)(A) - 5 percent owners only. Shares held as collateral would not be attributed to anyone.

This is kind of a weird provision, as there is no change in the determination of a controlled group member under Section 1563(b) - so stock held by a 401(a) plan is still excluded from the denominator. But, theoritically, if I had someone who owned before attribution 79% of an ESOP company and 100 percent of another corporation, if that person had 5 or more percent of the beneficial ownership of the ESOP, they would be attributed out their ESOP stock. It is not clear that this attribution would count for increasing both the denominator and the numerator in the calculation, but if I am somewhere close to right, they could end up a controlled group under 414 and not one under 1563.

Thoughts?