409(l) Greatest Dividend Rights

[Guest MAS-MN]

FACTS:

The C Corporation maintains an Employee Stock Ownership Plan ("ESOP") and has two types of stock. The first type has special formula dividend rights, no voting, but is convertible to common if dividends are not paid ("Preferred Stock"). The second type has all voting rights and may receive dividends if the Preferred Stock has first received its accumulative formula dividends ("Common Stock"). C Corporation currently maintains an ESOP that holds 25 to 30% of the C Corporation's Common Stock.

ISSUE I: IRC Section 409(l)(2) Compliance.

Is Common Stock held by the ESOP "employer securities" under IRC Section 409(l)(2)? Put another way, when determining whether the ESOP held stock has the greatest dividend rights, do you look only at stock with voting rights, or does the ESOP's stock have to have equal or greater dividend rights than the non-voting "Preferred Stock" has?

Would it make a difference if the outstanding Preferred Stock was not convertible to Common Stock?

ISSUE II: Correcting IRC Section 409(l)(2) Compliance Failure.

Assuming that ESOP held stock must have equal or greater dividend rights than the Common Stock and the Preferred Stock, would the exchange of existing ESOP Common Stock for a new type of stock ("Hybrid Stock") that has the same voting rights as the Common Stock, but has special dividend rights, where it first gets Preferred Stock dividends and than, if the Common Stock also gets dividends, it would get an additional dividend once the amount of the Common Stock dividend exceeds the Preferred Stock dividend.

For Example: Preferred Stock gets formula dividend of $1 per share; Common Stock gets dividend of $0 per share; and resulting Hybrid Stock dividend equals $1 per share. Alternatively, Preferred Stock gets dividend of $1 per share; Common Stock gets dividend of $2 per share; and resulting Hybrid Stock gets dividend of $2 per share. Basically the Hybrid Stock gets a dividend that is equal to the greater of the Preferred Stock and Common Stock dividend amounts, instead of getting both the Preferred Stock and Common Stock dividends.

[RLL]

Read IRC Section 409(l)(2)(B) again!

The common stock is tested only against other classes of COMMON stock in determining whether it has the "best" dividend rights.

If the other class of employer stock (the non-voting stock) is indeed "preferred stock" under Section 409(l), the ESOP's common stock satisfies Section 409(l)(2). I assume that there is no class of common stock which is publicly-traded.

[Guest MAS-MN]

RLL

Is what you are telling me is that if a stock does not have voting rights, it by definition is not "common stock" under IRC Section 401(9)(l)(2)(B) and thus you ignore that stock in determining whether the stock held by the ESOP meets the requirements of 401(9)(l)(2)(B)??

[RLL]

No.....I said that the test for "best dividend rights" under IRC Section 409(l)(2)(B) is based only on classes of common stock. Classes of "preferred stock" are ignored.

The class of non-voting stock which you referred to in your facts as "Preferred Stock" would be included in testing under Section 409(l)(2)(B) only if it were, in fact, common stock.