ESOP purchase of another company

[Guest beth beaube]

I have a client (Company A) that wants its ESOP to purchase Company B through a stock acquisition. Company A and B are both closely-held companies. Assume the ESOP is not leveraged at this point. The plan is to have the ESOP purchase the stock of Company B over a ten-year period on an annual installment basis. To finance the purchase, Company A would make an annual contribution to the ESOP which the ESOP would then use to make its annual installment payment to Company B. Assume a total purchase price of $!00,000 with ten annual installments of $10,000. With each annual installment payment to Company B, Company B would remit its stock to the ESOP which the ESOP would then contribute back to the capital of Company A.

Obviously, an independent appraisal of Company B's stock will be needed to assure a fair price. Also, the trustee of the ESOP must determine that the purchase is in the best interests of the participants of the ESOP.

I would like help on the tax consequences of the proposed transaction to Company A and Company B. Any help would be greatly appreciated.

[RLL]

The stock of Company B does not constitute "employer securities" under IRC Sec 409(l) with respect to the Company A's ESOP until both Company A and Company B are at least 80% owned by the ESOP. In addition, if the ESOP were to contribute the Company B stock (which it purchased) to the capital of Company A, it is likely to be a prohibited transaction. There are also many other ESOP and ERISA fiduciary issues to be addressed here.

This is a very complicated area of ESOP practice, and it is difficult to provide guidance without knowing much more about the facts and circumstances involved here.

[RLL]

It's a lot easier to have Company A directly buy the stock of Company B. You'll avoid many technical ESOP issues under the IRC and fiduciary issues under ERISA. You can get the same effect of using "pre-tax" dollars by then having Company A contribute shares of its stock to the ESOP annually (on a non-leveraged basis) equal in value to the amount of acquisition debt you want to "tax shelter." You avoid all the issues relating to leveraged ESOPs, retain greater flexibility in determining annual ESOP contributions, avoid the complication of having the ESOP own stock of two different companies, etc. And you'll still get the same tax benefits for Company A.

If Company A is not currently 100% owned by its ESOP, a purchase of Company B by the ESOP, using resources of Company A, would also raise issues with respect to the rights of the non-ESOP Company A shareholders.

[Guest beth beaube]

Thanks for your response, RLL. As it turns out, we are not interested in the tax consequences to Company B; thus, the fact that Company B cannot get Section 1042 treatment is ok.

The real goal is to allow Company A to purchase Company B with pre-tax dollars (that is, Company A will make a deductible contribution each year to the ESOP which will be used to purchase Company b).

Let me clarify something - rather than having the stock bought each year with each annual payment, the ESOP will give Company B a note up front and get all the stock of Company B immediately. Then, the ESOP will exchange the Company B stock for Company A stock (ie, the ESOP will purchase Company A stock, which is a qualified employer security, from Company A and will use Company B stock to pay for the Company A stock). It seems to me that this purchase of Company A stock by the ESOP would not be a prohibited transaction since the plan is an ESOP.

Any more thoughts?

[Guest beth beaube]

RLL-great solution - thanks for your help!