Section 1042 prohibited allocations and "recycled" shares

[Guest Doug Johnston]

I would appreciate input on the extent to which the prohibited allocation rules apply to "recycled" shares. PLR 9001035 seems to indicate that shares may be allocated to all participants without regard to the section 1042 rules if they are allocated to "permissible participants" and are either distributed and sold back to the ESOP or are simply reallocated because the participant takes a cash distribution instead of stock.

I have seen articles that seem to unanimously say otherwise. How are most administrators handling the recycling of 1042 shares? What about forfeiture reallocations (which aren't addressed in the PLR)?

[RLL]

Shares that are "tainted" under IRC Section 409(n) do not lose that "taint" when they are "recycled" within the ESOP, either by reason of cash distribution/reallocation or forfeiture/reallocation. Shares that are distributed and repurchased by the ESOP will no longer be "tainted" under Section 409(n).

[Guest Doug Johnston]

RLL - Can you give a cite to support your position? Following is the excerpt from the PLR that contradicts you regarding the reallocation to make a cash distribution. If the following is correct, I don't see why forfeiture reallocations would be treated any different.

Letter Ruling 9001035 - Sales of stock to esop’s or certain cooperatives, (Oct. 10, 1989)

Based on the information and representations submitted and the applicable law, we conclude the following:

4. Stock that is allocated to a permissible participant under section 1042(B)(3) of the 1954 Code and again becomes available for allocation because the permissible participant takes a distribution in cash rather than in stock, may be allocated....without regard to the restrictions under section 1042(B)(3);

[RLL]

I have no cite.....IRC Section 409(n) is clear to me. If the PLR says otherwise, the IRS was taking a position that is not supported by the statute. That does happen from time to time....but only the party to whom the PLR is issued may rely upon it.

It's interesting that the excerpt from the PLR refers to the 1954 Code. Aren't we now dealing with the Internal Revenue Code of 1986? Perhaps the situation in the PLR was dealing with a 1042 transaction which occurred prior to the 1986 amendments to Section 1042 [which included placing the "prohibited allocation" provisions in new Section 409(n)]. Maybe the IRS holding in the PLR would not be applicable when dealing with the restrictions under Section 409(n).

[Guest Doug Johnston]

Maybe a new PLR request is in order. COOL!

[RLL]

COOL ????

[BeckyMiller]

It always seems easiest to me to think about the ESOP trust as an entity subject to the normal tax accounting rules. That would mean if the shares don't leave the trust as part of a sale or distribution, all of their original characteristics remain attached to them. This would include their 1042 taint, status as pre-1987 shares, etc.

The internal transactions within the trust are just bookkeeping.

If you apply this theory, it makes the response to these questions somewhat simpler. Though it might be considered to take away some creativity. Sorry.

[RLL]

Accountants (unlike lawyers) sometimes can make things seem so simple and straightforward! If only it were the case more often and with more accountants!

[Guest Doug Johnston]

As accountants we are also trained to evaluate the economic substance over the form of a transaction. What is the difference between the ESOP distributing and repurchasing shares versus reallocating the shares and distributing cash? The IRS found no difference between these transactions in PLR 91001035.

I keep coming back to the same question. Where is the statutory or regulatory support for the position that the shares must leave the trust to lose the taint? From what I can tell this is the interpretation of a few well-known speakers and writers. I appreciate everyones' comments - it helps me evaluate what we're up against. However, my clients require a little more explanation and may want to judge for themselves and/or proceed with a PLR request.

[RLL]

Doug ---

From the excerpt which you cited previously, it appears that PLR 9001035 interprets provisions from Section 1042 which were in the 1954 IRC. Those "prohibited allocation" provisions were superseded by Section 409(n) of the 1986 IRC. You will note that current IRC Section 1042(B)(3) does not include "prohibited allocation" provisions.

Accordingly, the IRS position in PLR 9001035 may no longer be applicable.

A distribution of shares followed by an ESOP repurchase is substantively different from a cash distribution. The distribution of shares in a lump sum has different tax consequences to the recipient (relating to treatment of net unrealized appreciation). The repurchase by the ESOP results in a new cost basis to the ESOP. There also may be different considerations for a fiduciary in deciding on the form of distribution and whether the ESOP should repurchase.

[Guest Doug Johnston]

I agree that the PLR is based on prior law and may have changed (not that we could rely on it in the first place). I also agree about the tax implications, etc. on distributions, but I don't see the connection between those issues and the prohibited allocation rules. Why should it make a difference to the plan whether the participant chooses to take a stock distribution with a put option or to take a cash distribution (essentially excercising his put option immediately). Again, it appears the IRS didn't see any reason under the old law.

I think these are all important issues for the client to understand, but I don't think they are conclusive.

The client certainly doesn't understand the nightmarish recordkeeping requirements to enforce the prohibited allocation rules as interpreted by most practitioners. 10, 20, even 50 years after the initial stock purchase(s) we may have to keep separate "buckets" for each 1042 share purchase and all non-1042 shares. We will have to process forfeitures and other allocations for 1042 and non-1042 shares separately, possibly carving out different groups of participants and family members for each 1042 share allocation. We will spend countless hours and dollars tracking the 1042 shares to the nth degree to enforce a provision that neither Congresss or the IRS has made clear in the law or regulations? Not to mention the impact on the employees subject to the restrictions. If that is the intent, Congress and/or IRS hhave some obligation to provide guidance.

I can agree to disagree though. Thanks!

[BeckyMiller]

Doug - I can relate to your frustration over the tracking exercise. It gets very cumbersome. We have one client whose ESOP allocation file includes 16 sub-accounts.

We have had several discussions with clients about the implications of this letter ruling. To the extent that they conclude that they can "cleanse" shares of the 1042 taint (whether under the ruling or by actual distribution), they need to deal with the other consequences of this action. Those shares are then treated as new shares in the ESOP. They would be post-1986 acquisitions. They would have a different cost basis. They may be purchased shares, not leveraged shares for purposes of IRC Section 415©(6)(A), if applicable, etc.

Thus, they may be exchanging one recordkeeping bucket for another. For a client that does not otherwise have any post-1986 shares (which would be possible for a 1042 transaction under the 1984 provision), this can generate a substantial increase in the administrative complexity of the plan.

[Guest Jim Vogl]

For what its worth, I agree with Ron and Becky but I would like to ask a related 1042 question. Suppose that a client set up a MPP/ESOP (with a minimum contribution requirement of 10%. In the first year, the Employer made a cash contributions to the MPP/ES0P equal to the 10% minimum. In the second plan year, the ESOP used the cash and proceeds of an ESOP loan (excluding the cash in the account of the 1042 seller) to buy qualifying securities from the Seller in which the Seller elected 1042 deferrals. In the future how do you reconcile the 10% required minimum contribution under the MPP provisions and the prohibition of allocations of plan assets to the 1042 Seller in liue of the 1042 stock? If cash is not contributed to the Seller's account we are in violation of the minimum funding requirements and if cash is contributed to the 1042 seller, we are in violation of 409(n). What do you guys think.

[RLL]

The 10% money purchase contribution to the ESOP is not required with respect to a participant who is not eligible to receive an allocation by reason of IRC Section 409(n). A contribution which is not allocable under the terms of the plan document (such as one which would violate Section 409(n)) is not payable under a money purchase contribution formula. Accordingly, there is no violation of IRC Section 412.