ESOP: Interplay between Section 1042 and Rebalancing Requirement

[Yesrod5]

ESOP has a rebalancing provision that requires year-end reallocation so that each participant's account is made up of the same ratio of company stock to other investments.

For the first time, there is an ESOP participant who wishes to sell company stock he/she owns outside the ESOP.  The ESOP Trustees believe it would be in the best interest of participants and beneficiaries for the ESOP to purchase the stock.

IRC Section 409(n) provides in part that:

"no portion of the assets of the plan . . . attributable to (or allocable in lieu of) employer securities acquired by the plan . . . in a sale to which section 1042 applies may accrue (or be allocated directly or indirectly . . . ) . . . for the benefit of . . . any taxpayer who makes an election under section 1042(a) with respect to employer securities."

Assume that the ESOP's acquisition of the stock is completed in May of 2020.  When the "regular" calendar year 2020 allocation is done (in the spring of 2021), certainly the selling shareholder cannot receive an allocation of any portion of the stock the ESOP acquired from him/her.  So, such participant receives a smaller allocation than that received by a similarly situated participant who had not sold company stock to the ESOP in a sale to which section 1042 applied.

Immediately after completing the "regular" allocation for 2020, the rebalancing provision is addressed.  May the selling shareholder's account receive the allocation of additional company stock needed to bring his/her account into balance (ratio of company stock to other investments) assuming the reallocation calculations would so require?  Inasmuch as the rebalancing would likely affect virtually all participants in one way or another, it would seem that the prorata portion of the stock initially acquired by the ESOP in the 1042 transaction that might find its way to the selling shareholder's account would be minimal. 

Is the answer any different for the rebalancing that would be completed for 2021 (in the spring of 2022) - assuming no additional 1042 transactions?

[ESOP Guy]

In all my years of working on  ESOPs I am not sure I have seen a 1042 and rebalancing.   But my initial reaction is your on very dangerous ground.   409(n) reads:

In generalA plan to which section 1042 applies and an eligible worker-owned cooperative (within the meaning of section 1042(c)) shall provide that no portion of the assets of the plan or cooperative attributable to (or allocable in lieu of) employer securities acquired by the plan or cooperative in a sale to which section 1042 applies may accrue (or be allocated directly or indirectly under any plan of the employer meeting the requirements of section 401(a))—

Getting any of the 1042 shares is a problem.  I think even non-1042 shares strike me a possible problem.  You will note this talks about "allocable in lieu of" and "directly" or "indirectly".  I have always understood this to mean any kind of backdoor attempt to get this person made whole isn't allowed.   

My initial reaction would be to rebalance the non-1042 shares and 1042 share in a separate calculation that gets this guy equal to the rest of the people for those shares.  It could mean his ratio is different that others or some other kind of provision.   But I would be very wary of anything that makes the plan act like he is basically getting 1042 share directly or indirectly with the rebalancing.  if there is no difference in the total number of shares he gets if there was or wasn't a 1042 allocation would seem to point to the idea this person has been given shares in lieu of or indirectly for the 1042 shares.  And rebalancing seems like that is happening. 

Cautious thinking might make the two provisions not workable which might be why I haven't seen it.  Although with so many of the ESOPs being S Corp ESOPs and cap gain rates having been so low for so long there are simply less 1042 transactions. 

I am not going to pound the table and say I know for sure you can't do it but those are the issues I see.  

[Yesrod5]

ESOP Guy,

Thank you for your thoughts.