another S-Corp potential txn

[AlbanyConsultant]

Here's the situation I was presented:

HR Manager ("D") wants to use his self-directed brokerage account in the 401(k)/profit sharing plan to purchase "between 5% and 10%" of his company's stock. Company is an S-Corp, and the company president (and plan trustee) is currently the 100% owner. Owner is making this available to D because he needs to generate cash to put back into the business, but he does not want to make this available to all participants.

I've read a bunch of the threads here about the problems of S-Corps doing this kind of thing; it sounds like this would be a prohibited transaction. Is there any way it wouldn't be?

I mentioned that if they're so cash-strapped, how are they going to pay for a valuation of the company to determine fair-market value? That didn't thrill them.

Even if we get past that (and that's a big "if", I know), then it looks like we run into a discrimination issue, as D is getting the opportunity to make an investment that the other participants are not, and because he's buying more than 5%, it's an HCE/NHCE issue. Would limiting D to purchaing only 5.00000% take the sting out of it?

Are there any other issues I'm not addressing? I'm not looking to give them an iron-clad legal response - I'm willing to refer them to an ERISA attorney for a final answer, but I'd like to prepare them for what the issues are and what they can expect. Thanks.

[ESOP Guy]

If it is a 401(k)/PS plan and not an ESOP any flow through income from the company will be subject to Unrelated Business Income Tax (UBIT).

I know 100% of the people will not agree with me on this, but my personal opinion is someone who owns >5% of stock in an account of a qualified plan is not a HCE by ownership. After all that person isn’t a 5% owner. The trust owns the stock. And the person with the stock in their account doesn’t actually have full rights of ownership. The trust and trustee can have many of the voting rights for example. If anyone has a cite to prove me right or wrong on this point please share it. I have not found anything one way or the other that I can point to.

Also, while it is a VERY bad idea to not get an annual stock appraisal only an ESOP is required to get one. If this is a 401(k)/PS the trustee can use any method they believe to be reasonable to value the assets. You would have to check the box on the 5500 that says you have unappraised assets whose value is not set by a market. This seems like an audit flag to me. But I have met ERISA attorneys who are prepared to defend their client’s not getting an annual appraisal as client currently. Not getting one with the buy/sell is reckless in my mind as it could create an expensive PT.

But allowing only one person to make this kind of investment is the part that is going to be the most problematic.

Have they thought about a loan to the company with warrants/phantom stock right/stock appreciation rights – ie a form of non-qualified plan tied to the price of the stock. It would seem like that might work better then a qualified plan. Unless the only place the buyer had enough money to make the investment is in the 401(k)/PS plan.

Sorry, should have added the PT issues is most likely a deal killer besides issues listed above.

You just don't see Employer S corp stock outside of an ESOP.