Ex employees and company stock

[Richard Anderson]

IRC code section 409(h)(2) in part states: "In the case of an employer whose charter or bylaws restrict the ownership of substantially all outstanding employer securities to employees or to a trust described in section 401(a), a plan which otherwise meets the requirements of this subsection or section 4975(e)(7) shall not be considered to have failed to meet the requirements of this subsection..."

Can the ESOP restrict stock ownership to only current employees? Client wants to transfer stock ownership of terminated participants to the accounts of current employees accounts.

The part of 409(h)(2) that bothers me is that ownership can be restricted to employees or 401(a) trust. Stock allocated to a terminated employees account is in the trust until distribution. Does the employer stock have to remain in the account of a terminated participant until distribution?

[RLL]

Many ESOPs are designed to transfer employer stock out of the accounts of former employees (with a reallocation to current employees' accounts) pending distribution of benefits. This can be done even when there is not a Sec. 409(h)(2) "ownership restriction." The ESOP must have sufficient assets other than employer stock to allocate to the accounts of the former employees.

If the ESOP keeps the accounts of former employees in employer stock, the stock is still owned by the ESOP and is treated as "employee-owned" for purposes of a Sec. 409(h)(2) ownership restriction.

[Dawn Hafner]

RLL, do you know where I might be able to review some sample language for this arrangement? I have never seen an ESOP designed in this way, but I know of one client that would be interested in designing their plan this way. Are there any nondiscrimination issues concerning terminated employees to be aware of? Thank you.

[RLL]

The regulations under IRC Sec. 401(a)(4) permit former employees to be treated (and tested) separately from current employee-participants.

The language that you request is included in many ESOPs. It is common for ESOPs in closely-held companies to provide for the transfer of former employees' accounts out of company stock (so long as there is a sufficient amount of "other assets" in the ESOP).

I recommend that you have the ESOP amended by your client's counsel. Also, you might check out the "model" ESOP published by the National Center for Employee Ownership (www.nceo.org).

[Dawn Hafner]

Could this restriction be applied to employees that have gone on a casual basis employment. I have only heard of it applied to terminated employees.

I have a client that has several employees that are not working in their normal capacity, but may be called back on as as needed basis for casual employment (one to two days per month). They would like to include this group of employees as terminated and restrict their investments under the plan to only non employer stock investments. Could the plan specify terminated employees and casual employees and then define casual employees by the number of days or hours worked per month?

Comments, suggestions?

[pjkoehler]

Code Sec. 409(h)(2)(B)(ii)(I) provides an exception to the designed-based requirement that the plan provide a participant entitled to a distribution with the right to demand payment in employer securities. The issue you raise is whether or not an ESOP can provide that the share accounts of terminated vested participants (not subject to the involuntary cashout rules) can be automatically disinvested in employer securities, leaving their accounts invested in nonemployer securities until they elect to receive a distribution. I don't see how this Code Section gives you much comfort. It's all about distribution of the account. What about the accounts of terminated vested participants that may defer distribution for a considerable period of time, i.e who do not consent to an immediate distribution within the meaning of Code Section 411(a)11)? What about their potential loss of future appreciation in the shares?

Reg. Sec. 1.411(a)-11©(2) says that the requisite element of "consent" to a distribution that is not subject to automatic cashout is not satisfied if a "significant detriment is imposed under the plan on any participant who does not consent to a distribution." Rev. Rul. 96-47 held a plan in which terminated participants who did not consent to an immediate distribution and who chose to leave their account balances in the plan were automatically disinvested from their investment fund choices and invested in a money market fund until distributed were subject to "significant detriment." Therefore, the IRS ruled that the loss of the right to maintain their investments was tantamount to an immediate distribution without a valid consent.

[RLL]

An ESOP does not violate the "consent" rule of IRC Section 411(a)(11) merely by providing that the account balances of all former employees will be invested in assets other than company stock. Many ESOPs of closely-held companies provide for this treatment without regard to whether the participant is eligible for a benefit distribution at the time of the "disinvestment" out of company stock. There is no provision of the IRC which makes an investment in company stock a "protected benefit" under an ESOP.

IRC Section 409(h)(2) provides some comfort in that it reflects the general intent of Congress that certain ESOPs may limit stock ownership interests to current employees.

[Kirk Maldonado]

I think that PJK is right on this one.

It isn't a question as to whether the investment in company stock is a protected benefit under Section 411(d)(6); it is whether there is a significant detriment imposed upon individuals who elect not to receive a current distribution following termination of employment, in violation of Treas. Reg. Section 1.411(a)-11|©(2).

I seem to recall that this specific question was posed to the IRS by the ABA several years ago, and the unequivocal response that the ABA received was that such mandatory "disinvestment" is prohibited by Section 411(a)(11). While there may be practitioners who are willing to challenge this position of the IRS, I think that we are on notice to expect a fight from the IRS on this point.

[RLL]

I think that both of you are wrong. The "disinvestment" is NOT a consequence of failing to consent to a current distribution under IRC Sec. 411(a)(11). It is an automatic provision, applicable to all ESOP participants following termination of service, without regard to whether a distribution is available at that time.

The accounts of such participants are not "frozen," but rather are invested in other assets that will benefit from investment return (which may be more or less than the return that would have resulted from continued investment in company stock).

IRS representatives have "unofficially blessed" such a provision in Q & A sessions at The ESOP Association's Annual Conferences in recent years. In addition, there are countless ESOPs that include such a provision and have received IRS determination letters (post-Rev.Rul. 96-47). I've never heard of a situation where IRS has challenged this provision in an ESOP.

[Dawn Hafner]

RLL,

Assuming this disinvestment is permissible, do you think this disinvestment could be applied on some other basis than full termination of the employee? Then I assume we get into discrimination issues. Would this be a benefit, right or feature that would have to be nondiscriminatory? If all HCEs are covered then we would just have to cover the safe harbor ratio based on the ABP test.

All of these employees that work on a casual basis would be nonhighly compensated. The percentage of employees in this category is very small, probably less than 2% of their workforce. These employees are basically quitting, but are willing to work one or two days a month for closing the books. This client has very limited amounts of stock in the ESOP and is concerned with providing the stock to motivate current employees to perform.

Any thoughts are appreciated.

[pjkoehler]

RLL, the involuntary disinvestment in employer securities that you're describing is the direct result of an employee (not subject to automatic cashout) failing to "consent" to an immediate distribution when his/her account first becomes immediately distributable. That, RR 96-47 seems to say, imposes "signficant detriment" on such participants who fail to consent to a distribution. Sec. 411(a)(11) requires a plan to obtain the participant's "consent" to a distribution in the form of a voluntary decision by the participant. The logic of the ruling is that a plan that imposes a "signficant detriment" on a participant who fails to consent effectively coerces the participant to elect a distribution. Coercion is obviously inconsistent with the notion of consent. You've made no argument other than the mere admininstrative convenience of the plan sponsor that would justify such a provision. That was certainly the case on the facts considered in RR 96-47.

I assume that you aren't arguing that a plan containing such a disinvestment provision, but to which the Sec. 409(h)(2) exception doesn't apply, could possibly satisfy the general requirement that an employee have the right to demand distribution in the form of employer securities. Your position, therefore, would seem to that a very small percentage of ESOPs, whose sponsors are governed by bylaws that contain the necessary restrictive language, are not only exempt from the requirement that it provide the right to demand distribution in employer securities (which we agree on) under Sec. 409(h), they are also exempt from the consent requirements of Code Sec. 411(a)(11). I can't imagine what policy reasons Congress would have had for exempting such a narrow population of ESOPs from a basic qualification requirement. In view of the holding in RR 96-47, that seems like a very aggresive tax filing position based only on anecdotal evidence and unpublished, informal remarks.

[RLL]

Dawn, my thoughts (which I hope you'll appreciate)----- if the client REALLY wants to "motivate current employees," why not provide more than "very limited amounts" of stock in the ESOP? And aren't these so-called "casual employees" worth motivating?

As to the technical issue, the "casual" employees aren't former employees, so IRC Section 401(a)(4) testing probably would be required. Subject to testing, however, it is likely that the ESOP could be amended (subject to receipt of an updated IRS determination letter) to provide for the desired treatment. But why bother? You say that these folks are "willing to work".....so why not treat them as active employees and avoid having to amend the ESOP and test, etc.,?

On the other hand, why not amend the ESOP to provide for full benefit distributions to these "casual" employees? That might very well eliminate the "problem." Note that termination of service is NOT the only event that permits the offering of benefit distributions from an ESOP.

[RLL]

PJK ----

I think that you don't understand what I said above.

The "disinvestment" takes place automatically, following (and by reason of) termination of service, not by reason of a participant's failure to consent to a distribution. Note that most closely-held company ESOPs provide for some period of deferral for a benefit distribution following pre-retirement termination of service. I'm not suggesting that the "disinvestment" take place merely by reason of a failure to consent under IRC Section 411(a)(11).

In addition, the "disinvestment" (pursuant to a specific provision of the ESOP) during the deferral period (following termination of service) is not intended to deny a participant the right to demand distribution in company stock, if it's required under IRC Section 409(h). At the time benefits become distributable, company stock is offered to the participant, unless an exemption under IRC Section 409(h)(2) is applicable. If the participant then demands stock (which is HIGHLY UNUSUAL in a closely-held company ESOP), shares are made available for distribution at that time. There is nothing in IRC Section 409(h) (or anywhere else in the IRC, ERISA or applicable regulations) that requires the account of a former employee to remain invested in company stock (during the deferral period) merely because the participant may have the right to demand a distribution in company stock at a future date.

Reliance here is not based on anecdotal evidence or informal remarks, but rather on numerous determination letters issued by the IRS since 1996. Are you suggesting that the many ESOPs that do this (pursuant to specific plan provisions) cannot rely on their own determination letters?

This isn't taking "aggressive tax filing positions" .....it's designing (and drafting) ESOPs with creative provisions that accomplish the objectives of the sponsoring companies and rely on the informed "approval" of the IRS through the determination letter process.[Edited by RLL on 08-02-2000 at 07:44 PM]

[pjkoehler]

RLL, the disinvestment that took place on the facts in RR 96-64 was also automatic. What you may be struggling with is the meaning of "consent" as that term is applied in Sec. 411(a)(11). If a participant terminates employment and is faced with the choice of either taking an immediate distribution or suffering the automatic disinvestment of his account (i.e. the loss of the potential appreciation in the employer securities), then even if he elects a distribution, the logic of RR 96-64 is that the plan is paying it without his "consent," which I think you'll agree does not comport with Sec. 411(a)(11).

Besides, any disinvestment takes that portion of the plan assets outside the ESOP exception under ERISA from the prudent expert and diversification fiduciary standards. How will the investment of the proceeds on the sale of the employer securities be handled. Does the plan just leave the fiduciaries exposed, or does the document create a ERISA Sec. 404© plan within the ESOP to permit limited participant self-direction? Isn't that either going to (1) expose the fiduciaries to significantly greater fiduciary liability for handling assets of a plan that they probably thought was virtually fail-safe from a fiduciary liability standpoint because it was an ESOP, or (2) significantly increase the administrative expenses of the plan for the terminated vested employees by operating their accounts on a self-directed accounts in compliance with ERISA Sec. 404©?

Regarding ESOPs that don't qualify for the Code Sec. 409(h)(2) exception, are you really suggesting that it makes administrative sense to disinvest the accounts of deferred vested participants, subject to reinvestment in employer securities if the participants subsequently demand distribution in employer stock? It seems that you aren't achieving very much in exchange for the risk that the plan is violating 411(a)(11). As a practical matter, where are those shares going to come from, sense they aren't in the participant's account?

If you really want to chill terminated vested participants from hanging around, it is better to design the plan so that they have a limited election period (e.g. 90 days) from date of termination to elect a distribution, otherwise, they can't take a distribution until a specified distribution event occurs (death, disability of attainment of early retirement age). While qualified plans can't involuntarily cash out all terminated vested employees, they aren't required to give them the unfettered discretion to take a distribution any time. Such a plan provision is probably more responsible for the phenomenon than the prospect of obtaining future appreciation in employer securities.

Sec. 411(d)(6) will make it difficult to amend existing plans that permit terminated employees to elect a distribution any time, but employers sensitive to this issue that are adopting new plans would be better advised to draft them with highly restricted distribution dates as an incentive not to defer distribution.

[RLL]

PJK ---

I think you don't understand how these ESOPs work. The participant is NOT given an election to receive a benefit distribution upon termination of service. Distributions following pre-retirement termination of service are automatically deferred (aren't available to commence) for all such participants for periods of as long as six years. No issue of "consent" under IRC Section 411(a)(11) is involved until the participant is offered a benefit distribution at the end of the applicable deferral period.

It is clear that the "disinvested" account balances of former employees with deferred vested benefits are not exempted from the general fiduciary requirements of ERISA Section 404(a)(1)....but there are many relatively simple ways for fiduciaries to comply with such requirements (and, as you know, there are MANY MANY retirement plans which are subject to, and comply with, those rules).

As far as administrative complexities, it is the choice of the employer to design the ESOP benefit distribution provisions in a particular way, after being advised about the various alternatives available. If the employer chooses to "disinvest" former employees (during the deferral period) and understands the minor complications involved, why recommend otherwise if the law permits that particular course of action? Frankly, I don't think that the administration of these provisions is very complicated.

Also, it is extremely rare for a participant in a closely-held company ESOP to demand a distribution in company stock, especially after a distribution deferral period of up to six years. In the case where such a request is made, it is usually easy to allocate shares which are currently contributed or forfeited for the purpose of making a required benefit distribution in company stock.

With regard to amendments to distribution provisions and IRC Section 411(d)(6), note that Section 411(d)(6)© provides an exception (to the anti-cutback rule) that allows ESOPs to "modify distribution options in a nondiscriminatory manner."

Do you really think that there's any "risk" under IRC Section 411(a)(11) in following specific plan provisions which have been the subject of an IRS determination letter?

[Dawn Hafner]

Just to answer some of the earlier questions regarding this situation:

The only reason there is limited stock is the unwillingness of existing shareholders to sell. The sponsor buys back stock every chance they get to get more stock to the plan, but they feel stongly that this should be an employee benefit. This is an S corporation ESOP, so the employees are paid out in cash only, no right to take shares. This ESOP also has a 401(k) provision. The nonESOP portion of the plan is invested in a menu of mutual funds, over which the employees have investment direction on a daily basis. When a participant is disinvested in stock they are invested in their selection of mutual funds and continue to have complete control over those funds, except for the ability to invest in employer stock.

I would view the ability to invest in employer stock as a benefit right or feature, that as long as coverage passes would be permissible. It is easier if the employer would just apply this to terminated employees, but if not covering these casual employees under this plan feature would pass coverage I think it would be a permissible plan design.

[RLL]

Dawn....can the employer contribute or sell treasury shares (or authorized but unissued shares) to the ESOP? The ESOP does not have to acquire its shares from the shareholders.

I think the plan design that you suggest is permissible, subject to testing; but get an IRS determination letter before implementing it.

[pjkoehler]

RLL, I don't think anyone reading this thread could devine what you mean by "these ESOPs." It's taken some time to find out that "these ESOPs" impose a unique 6-year deferred distribution provision for pre-retirement severance, which is just a discretionary, plan design feature. I've drafted and advised on many ESOPs and never encountered such a feature, which seems particularly inappropriate in an K-SOP, such as Dawn has described, because it would probably adversely impact the participation rate of NHCEs. The administrative cost of maintaining records on all terminated participants for up to 6 years, including those subject to an involuntary cashout, is obviously not a selling point for such plans. For many middle market companies, the pool of former participants terminating during the last 6 years could well approach or even exceed the pool of current participants. If the employer experiences significant turnover, such a provision would result in a significant percentage of plan assets invested in nonemployer securities, which is clearly inconsistent with the basic ESOP requirement that the plan be "designed to invest primarily in Employer Securities."

I suspect that the Service is issuing favorable determination letters because with the 6-year deferred distribution period the disinvestment occurs before the account becomes immediately distributable. So on these new facts there is no 411(a)(11) issue, just the negative effects described above.

If, as you argue, participants in ESOPs sponsored by closely held corporations not subject to the Code Sec. 409(h)(2) exception don't elect distributions in stock, then why disinvest their accounts and lock them into the plan for 6 years? Why not design the plan to allow them to elect an immediate cash distribution, i.e. to disinvest themselves voluntarily, and get rid of them.

[Edited by PJK on 08-03-2000 at 02:24 PM]

[pjkoehler]

Dawn, the right to invest in employer securities is clearly within the class of "other rights and features" subject to the requirement that it be both (i) currently available (satisfies the ratio percentage test of Reg. Sec. 1.410(B)-2(B)(2)) and (ii) effectively available (satisfy the "smell" test on a facts and circumstances basis) to a nondiscriminatory group of employees. Reg. Sec. 1.401(a)(4)-4(e)(3)(iii)©. If you're plan allows for immediate distribution on termination of employment and further allows employees who defer distribution to continue to hold employer securities in their deferred vested acccounts, an amendment the imposes the disinvestment feature would have to grandfather the existing terminated participants, as well as the accrued benefits of current participants, to satisfy the special testing rule set forth in Reg. Sec. 1.401(a)(4)-4(B)(3).

[RLL]

PJK ----

It's very common for ESOPs of closely-held companies to defer the distribution of benefits for periods of one to six years following termination of service. The purpose of the "disinvestment" is to shift the potential appreciation in value of company stock from former employees to current employees...clearly reflecting the objective of employee ownership.

One reason that some companies decide to defer benefit distributions is to eliminate the "problem" of employees quitting "to get the money." I question whether this is good policy in light of today's job environment, but it's important to many ESOP companies.

Another reason to defer benefit distributions is to allow for better management of the ESOP "repurchase" obligation. But in this situation, "disinvestment" is unlikely (as liquidity is probably limited).

Where a KSOP is involved, deferral of benefit distributions is usually limited to the account balance(s) attributable to company contributions.

[pjkoehler]

If you believe the standard mantra in ESOP literature, you'd think that employers establish ESOPs in order to align the interests of participants with the shareholders. I think you'll find that the public policy considerations underlying the favorable treatment of ESOPs in the Code, as expressed in JCT Committee Minutes, is that it's intended to be a tool for providing employees with equity interests in their employers. An ESOP provision that disinvests the employee in company stock automatically and then makes the employee wait for up to 6 years to obtain a distribution, while the proceeds of the sale of his shares are subject to indefinite investment restrictions, in order to accomodate the business purposes of the employer of not incentifying employees with substantial balances to terminate (and perhaps commence competition with the employer) is utterly antithetical to any reasonable notion of "equity." Any rational investor would think that such an arrangement doesn't compensate him for the risk of holding the security in the first place. Aside from insider trading and other regulatory restrictions, shareholders generally possess the unfettered right to dispose of their equity position and reinvest in another security. While ESOPs don't provide that much latitude to dispose of the employer securities, imposing more stringent distribution restrictions erodes any alignment of participant and shareholder interests. I question how common this arrangement really is. Perhaps other commentators have a view on this. By the way a quick check of the model ESOP in the BNA Tax Management Portfolio on ESOPS (No. 354) (Workpaper No. 1), which is designed for closely held corporations, provides that the vested company stock and cash accounts are immediately distributable on termination. The mandatory distribution deferral period that you've described isn't even included as an option.

[RLL]

PJK ----

The objective of EMPLOYEE ownership is not really accomplished by providing company stock to FORMER employees...it is better done by providing greater stock ownership interests to CURRENT employees...those whose efforts can still affect shareholder value. This is one of the reasons that the "ownership restriction" exception was added to IRC Section 409(h)(2) in 1981.

There is no reason for me to defend the practice of deferring ESOP benefit distributions following termination of service. The issue raised in this thread was whether "disinvestment" during the deferral period was a violation of the "consent" requirement of IRC Section 411(a)(11). It appears that you no longer disagree with my position on that.

Just because it's legal to defer ESOP benefit distributions doesn't make it the right thing to do. But if an employer wants to have such a deferral provision in its ESOP, after carefully considering all of these issues, why not? I'm not necessarily recommending it as good plan design and/or policy, but I can certainly support the legality of the provision.

Also, many ESOPs which include such deferral provisions use a deferral period of less than six years. Note that the six-year deferral period comes right out of IRC Section 409(o)...a clear reflection of Congressional intent to permit such a deferral period (as you know, the law allows non-ESOP retirement plans to defer to retirement age).

Once a plan design decision has been made to defer the ESOP benefit distributions (which may or may not be a good policy decision), I think it's very consistent with ESOP objectives to "disinvest" the former employees and shift additional stock ownership to the current employees.

Your reference to the BNA Tax Management portfolio model is interesting, but it's only one model and doesn't reflect the world of closely-held company ESOPs as I know it. Have you checked the model ESOP of the National Center for Employee Ownership (NCEO)? I wonder what provisions it includes? What about other models?

Maybe we should ask the NCEO or The ESOP Association to poll their closely-held ESOP company members as to their distribution practices!

As you may have noticed, BenefitsLink has made this thread a feature in its daily newsletter and on the Benefits Buzz page. Do you think this is a "particularly interesting" subject? Don't we each have better things to do with our time? Does anyone else care about this?

[RLL]

PJK ---

What a coincidence! The NCEO E-Mail Bulletin for August 2000 (sent on 8/3/00) includes a reference to an article (dated May/June 2000) on the NCEO web site entitled "Converting ESOP Stock to Other Investments for Former Employees." See http://www.nceo.org/columns/news20.html

The article says, in part, that "it is increasingly

common for ESOPs to provide that employees

who terminate before death, retirement, or

disability have their account balances

transferred out of stock into other

investments until a distribution is actually

made. To discourage people from leaving just

to cash out, however, distributions are often

deferred, often to the legal limit. Companies

can have tiers in their plan, providing that

only accounts over a certain balance will be

treated this way."

Apparently, RLL is not the only person who has found such a feature to be common in ESOPs of closely-held companies. With your obvious interest in ESOPs, you might want to join the NCEO and The ESOP Association in order to better keep current on what's actually happening in the ESOP world. [Edited by RLL on 08-04-2000 at 02:23 PM]

[pjkoehler]

RLL,

Golly - I'm sure it was a pure oversight, but you forgot to mention that right there in the lead in to the article you cite, a reader would find the following:

"Providing this conversion feature raises a number of important legal and practical considerations, just some of which are described here. [i wonder which legal and practical considerations aren't discussed in this wonderfully authoritative article.] There is no guidance from the IRS or the Department of Labor on whether such a conversion is permissible (even though it is common) or how best to do it."

The author doesn't cite to any verifiable evidence that the disinvestment provison is "common," even though his parenthetical remark is, of course, problematic in light of his admission that he's unaware of any guidance that it's "permissible." If I'm corporate general counsel and I find that the corporation adopted an ESOP with a provison that raises "important and practical considerations" for which there is no authority, my first reaction is to find out if someone did the appropriate risk-management assessment in adopting this provision and, if not (because, for example, it's buried in boilerplate language of a standardized plan document) then I'm going to question the competence of the advisor responsible for this provision.

RLL, if an ESOP is going to align the interests of participants with the shareholders, then it's going to have transfer to the participants the incidents of stock ownership, among which is the right to time the disposition of the shares to the shareholder's view of the market. What could be more fundamental to stock ownership? This is precisely why Code Sec. 409(h) requires an ESOP of a closely held corporation (not subject to any applicable exception) to give participants (including former employees) the right to demand employer securities subject to a put option, when the benefit becomes immediately distributable. The disinvestment provision you advocate causes the participant to forfeit the most basic incident of ownership, the right to determine when to sell the shares, even when they've satisfied the plan's vesting requirements. Apparently, you're of the view that it is "common" for ESOP sponsors to want to transfer all incidents of ownership to employees, subject to their termination of employment only for death, disability or retirement.

By the way, you've misinterpreted Code Sec. 409(o). That section provides that an ESOP must provide that UNLESS THE PARTICIPANT ELECTS OTHERWISE, the distribution of his vested account balance will not begin later than one plan year after the end of the fifth plan year following termination due to quit or discharge (unless reemployed). The notion that Code Sec. 409(o) supports a provision that imposes a nonelective minimum distribution deferral period of up to six years is utterly bogus.

Lastly, the reason that 411(a)(11) is no longer an issue in this thread, is because in advocating you're position you intially failed to disclose a material plan provision (the six-year distribution deferral period), which meant that the account balance was not immediately distributable on termination of employment. In the absence of this disclosure, both Kirk and I assumed that the plan was disinvesting at the time the account became immediately distributable. Since he and I each have more than 25 years of equity-based benefits and compensation experience, that reaction, based on your nondisclosure, might be an indication of how frequently practitioners encounter ESOPs with disinvestment and 6-year mandatory deferred distribution provisions.[Edited by PJK on 08-07-2000 at 06:17 PM]

[RLL]

PJK ---

I think that the existence of many IRS determination letters on ESOP deferral/disinvestment provisions is significant evidence of their legality. The legal concerns that you have raised all seem to be qualification issues under IRC Section 401(a) and related requirements. A determination letter from the IRS as to a specific ESOP is certainly sufficient assurance for that employer to proceed with the implementation of these provisions.

With regard to aligning the interests of employees with those of shareholders, I seriously doubt that the "disinvestment" of former employees creates a problem. In closely-held company ESOPs, it is an extraordinary event for a participant to demand a benefit distribution in the form of company stock...most participants clearly want benefits in cash. When benefits are distributed in stock, almost all distributees exercise their put options to receive cash. There are also an increasing number of ESOPs that rely on the "ownership restriction" or S corporation exceptions of IRC Section 409(h)(2)(B). The inclusion of the put option requirement in Section 409(h)(1)(B) was to assure that participants could "cash out" their closely-held company stock to provide retirement benefits. The purpose of "employee ownership" through ESOPs is to provide beneficial ownership of company stock to CURRENT employees, not former employees. Very few closely-held companies want former employees as shareholders....including employees who have terminated service by reason of retirement....and very few former employees want to own stock in their former employer if the company is closely-held.

Also, an ESOP by design generally defers most benefit distributions until after termination of service. If ESOPs were going to provide full incidents of stock ownership to the participating employees, there would be provisions for participant elections for full in-service distributions; there would be full voting "pass-through" rights for participants; and there would be full dividend "pass-through" rights. I certainly don't oppose many of these features, but the law doesn't require them and most ESOPs don't include them.

I am not the one who has misinterpreted IRC Section 409(o). Section 409(o)(1)(A)(ii) clearly permits an ESOP to provide for a deferral of distributions for a period of up to six years following termination of service for reasons other than retirement, disability or death.....subject to Section 401(a)(9) and (14), if applicable. The participant election in Section 409(o)(1)(A), to which you refer, relates to a participant election to further defer distribution, such as under Section 411(a)(11). Section 409(o)(1)(A) permits an ESOP to defer distributions [but not as long as is permitted for other qualified plans under Section 401(a)(14)] and does NOT require a participant election for an immediate distribution. Have you read the Senate Finance Committee report under the Tax Reform Act of 1986 relating to this provision? Have you checked the BNA Tax Management portfolio on ESOPs (to which you previously referred)? What's the authority for your position (which is certainly contrary to that stated by most ESOP professionals and literature)?

Regarding my so-called "non-disclosure" of a material plan provision, I incorrectly assumed that folks with such significant ESOP experience would understand what I meant when I referred to those provisions that you think are so unique. I believe that an experienced practitioner should be aware of ALL the various options for ESOP plan design that are available under the law (even if he/she is not aware that many ESOPs are utilizing such features). Perhaps you should request sanctions against me under BenefitsLink's equivalent of SEC Rule 10b-5.

And why are you not a member of The ESOP Association or the NCEO if you have such an long-term intense interest in ESOPs and employee ownership? [Edited by RLL on 08-07-2000 at 11:19 PM]

[pjkoehler]

RLL,

You argue that it is "common" for ESOPs to include an automatic disinvestment and six-year deferred distribution provision even though you're generally talking about ESOPs that qualify for a very narrow exception from the general requirement that employees have the right to demand distribution in shares. Since the vast majority of ESOPs are not sponsored by S Corps or C-corporations with restrictive language in their bylaws, you're view is problematic on just an empirical level. On the one hand you say that "very few former employees want to own stock in their former employer if the company is close-held," but on the other hand you argue that the risk of this outcome justifies a draconian plan provision which strips the vast majority of terminating employees of fundamental incidents of stock ownership, even though they were CURRENT EMPLOYEES when they earned a vested right to their company stock account. It's difficult to imagine a scenario in which the management of a company (not eligible for an applicable exception) is so paranoid about the risk of sharing equity with former employees, that it would still contemplate establishing an ESOP. It seems that you've simply designed a plan provision that's in search of a market.

[RLL]

PJK---

I think that my various posted messages on 8/2/00 made it clear that any ESOP (which so provides) can "disinvest" the accounts of all former employees, even an ESOP which permits participants to demand benefit distributions in the form of company stock.

I really don't understand your concerns about this. Are you actively involved on an ongoing basis in working with ESOPs ("employee stock ownership plans") in closely-held companies? You aren't interested enough in ESOPs to be a member of the NCEO or The ESOP Association. To my knowledge, you don't attend any of the many NCEO or ESOP Association conferences; you don't publish articles about ESOPs. Your postings here have demonstrated a misunderstanding of many of the special technical rules that apply to ESOPs. Are you at all "plugged into" the real world of closely-held company ESOPs or are you just speculating here?

I do know, both from first-hand experience and from networking with many other experienced ESOP professionals, that many closely-held companies want to limit ownership (and beneficial ownership) of company stock to CURRENT employees. And many of those companies "disinvest" the ESOP accounts of former employees out of company stock after termination of service. The law permits it. And if a particular ESOP company wants to utilize this feature in the design of its ESOP, why not?

An ESOP is not the same as direct ownership of stock. There are a number of incidents of stock ownership that are not required to be provided to ESOP participants. An ESOP provides a limited form of beneficial ownership to current employees. Employees who participate in a closely-held company ESOP usually understand and accept the differences between an ESOP and direct ownership of company stock. An ESOP participant is entitled by right to all the benefits provided for under the terms of the ESOP and under applicable law, but not more than that.

I think it's very good when an ESOP company opts to include features that make ESOP participation more like direct ownership of company stock. But that's a choice of the company, after considering all the alternatives available in the design of an ESOP....it's not something that should be determined by the personal preferences of professional advisers.

[Edited by RLL on 08-13-2000 at 01:44 PM]

[pjkoehler]

The only thing we've managed to make clear is that an ESOP with an automatic disinvestment provision must impose a deferred distribution period to avoid violating the "consent" requirements of Reg. 1.411(a)-11©(2). See Rev. Rul. 96-47. (I know this thread is much too long when we start repeating ourselves.) Furthermore, unless the plan sponsor is among the small class of corporations that qualifies for an exemption under Code Sec. 409(h)(2) from the general requirement regarding the right to demand distributions in employer securities, then the plan must have language that provides for the reinvestment of the proceeds of the previous disinvestment to avoid violating Code Sec. 409(h)(1). Now, if you want to make the case that this a "common" provision among ESOPs generally, let alone a desirable plan design feature, that's cool . . . live long enough and you'll see just about everything.

You seem to place a great deal of emphasis on the National Center of Employee Ownership, as if mere membership in some annointed special interest group qualifies you as an expert. As a practical matter, my active membership in the American Bar Association, the State Bar of California, the International Foundation of Employee Benefit Plans, the National Association of Stock Plan Professionals and the American Society of Pension Actuaries takes up all my free time.

[RLL]

PJK---

Reinvestment in company stock at the time a distribution is payable would be needed only when that distribution is actually going to be made in shares of company stock....which is often not the case in a closely-held company ESOP (even when the Section 409(h)(2)(B) exceptions are not applicable). Including the necessary language in an ESOP plan document is a very simple matter for an experienced draftsman.

It's obvious from reading your postings here (and seeing your listing of current professional memberships) that ESOPs are not an important part of your professional practice.....so membership in the NCEO or The ESOP Association (and the networking opportunities they provide) would not be significant for you.

My involvement in these organizations does not make me an expert, just as membership in your professional organizations does not make you an expert in anything. Pay your dues and you can become a member of many of these groups. But active membership in the NCEO and in The ESOP Association does reflect a professional interest in (and commitment to) the subject and a desire to keep current on what's happening in the real world of ESOPs and employee ownership.

[pjkoehler]

RLL, I hope you know more about ESOPs that you appear to know about professional organizations. Instead of participating in an organization that demonstrates to the public its members know how to write checks, you should consider the organizations that I mentioned, which have distinct eductional missions. For example, membership in the Society of Certified Employee Benefit Specialists of the International Foundation of Employee Benefit Plans requires passing 10 exams and the Certified Pension Consultant membership in the American Society of Pension Actuaries requires passing 4 exams. Membership in the American Bar Association and the State Bar of California require somewhat more than that.

[RLL]

PJK---

As a longtime member of both the American Bar Association and the State Bar of California, I certainly can say that membership in these two organizations does not make me (or any other member) an "expert" in any subject. It takes a lot more than membership in a professional organization (and passing membership exams, if required) to be an "expert."

Very few members of the ABA or the State Bar are true experts in their fields, including employee benefits; and very few employee benefits experts can be considered experts in ESOPs and employee ownership.

If I did have a professional interest in the work of SCEBS/IFEBP or CPC/ASPA, I am certain that I too could pass their entrance exams. But that alone would not make me an expert.

[pjkoehler]

RLL, that said, hopefully, we've dispelled the myth about membership in NECO as somehow buttressing your arguments. By the way, the primary function of professional certification exams isn't to reassure the testee, it's to assure the public that the testee took its role as an advisor sufficiently serious to undergo the educational regime.

[RLL]

PJK----

I never said (and do not believe) that membership in the NCEO or The ESOP Association (or any other professional organization) makes someone an expert. You were the one who first brought up that issue in your posting this morning.

Memberships in both the NCEO and The ESOP Association demonstrate a professional interest in, and commitment to, the field of ESOPs and employee ownership. There is no better way for an ESOP professional to network and keep up with current developments and innovations in ESOPs. It's clear from this thread that you have not had that benefit.