100% ESOP-Owned S Corp. - Can ESOP Buy Additional Stock?

[Yesrod5]

We are trying to clean up a situation involving an S corporation that was hit hard by the recession. The S corporation has been 100% ESOP-owned since 2004.

Due to the reduction in payroll resulting from the recession, contributions to the ESOP to enable it to meet its debt service back to the S corporation have for several years been roughly double the 415 limitation.

We have considered treating the excess contributions as S corporation distributions, but the stock value has dropped so much that it's virtually impossible to allocate enough stock (at its fmv) to participant accounts to meet the dividend-make-whole requirements of IRC Section 4975(f)(7).

We are likely to recommend that the loan be refinanced. We would also like to increase the amount of the loan but feel that this can be done only if additional shares are purchased by the ESOP. Although it seems counter-intuitive, I believe I have read or heard somewhere that an ESOP that already owns 100% of an S corporation can still buy more shares (and borrow the purchase price from the company).

Any thoughts would be greatly appreciated.

[ESOP Guy]

The short answer is "yes". An ESOP can buy more shares even if 100% owned.

The hard issues here are the fiduciary issues.

You can't make any of these changes for the benefit of the corporation. You need to be able to show that the CURRENT participants are benefiting in order for the fiduciaries to be able to sign off on of this. The DOL takes the position the participants need to be better off. They do not count future participants.

You will want to study up on this in regards to the loan refi:

http://www.dol.gov/ebsa/regs/fab_2002-1.html

This talks about how you might want to give "sweeteners" to the current participants to show that it is in their best interests-- in regards to the loan refi. Such as better diversification rights, more match in the 401(k) plan.... I have also seen where the plan was required to stop using the S corp earnings distributions (dividends) to pay the loan and had to leave the cash in the plan for the participant's benefit as the "sweetener".

By the way other ideas to think about is you could seek to have the loan principle written down to a level that doesn't cause an issue with 415. This would be most easily down if the loan is an internal loan with the company.

Not sure why you want to increase the amount of the loan here as that would seem to work against what your primary problem is but I guess if the term of the loan is long enough it doesn't matter.

Lastly, there is growing debate on how long you can go out with the term of an ESOP loan. We are seeing more and more 40 to 50 year loans. There is growing concern that is never a sound fiduciary decision. For example since this is a refinance and let's say you are going from 10 years to 50 years (to be extreme) a current participant is going from could realistically work the whole time to share in every share release to that no longer being true. Is such a change in terms ever really in the current participant's best interests?

I would strongly recommend you get an ERISA attorney that knows ESOPs and not just any ERISA attorney before you do this.

(edit was a few changes to make more readable)

[Yesrod5]

ESOP Guy,

Thank you for this wealth of information.

[Marcus R Piquet]

I take a minority view that it generally makes no sense for an ESOP that already owns 100% of the stock to buy more. The employer can continue to provide a stock benefit through recycling or simply contributing additional shares.

That said, I don't see how this would be a solution to your problem anyway. The obvious solution seems to be a loan write-down as was already suggested. This would solve your 404 issues.

For some guidance on this, you can read PLR's 8612081, 9447057, and 9237037.

[Yesrod5]

Marcus,

Thank you. We are planning an extension of the loan and the company's write down of a portion of the loan. We are also contracting with an independent trustee - - to look out for the interests of the participants, among other duties.