ESOP owns 96% of company's stock; individual who owns the other 4% is

[stephen]

I am currently faced with the following situation:

We have a client who's attorney feels that in an ESOP where 96% of the stock is unallocated and the outstanding 4% is owned by one individual, that the individual owning the 4% is considered a 100% owner because you don't count the unallocated shares in the ESOP.

The attorney is referring to a private letter ruling or some outdated regulation that she says makes this perfectly clear.

(By the way their previous attorney had the same view.)

Can someone please help me explain to her that this person is not a 100% owner? I've been trying but to no avail.

To make matters worse she is advising the client that they include retroactively a controlled group company they acquired Jan. 1, 2000 to help them avoid paying the 10% excise tax for exceeding their 404 Limit (They overdeposited by $1,000,000. $850,000 of which was deposited on the last day of the plan year - March 31, 2000). We tried to explain to her that the IRS would view this as a reduction of benefits to the employees of the original company as their accrued benefits would be "watered down" by the addition of the other employees. Could they possbily claim ignorance on the deposit and say it should have been made the following day? Any suggestions?

(Of course this is a takeover case)

[RLL]

stephen ---

Obviously, attorneys are sometimes wrong!

Why is the ownership an issue? For what purpose is the ownership percentage relevant?

It is clear that the ESOP shares (whether allocated or unallocated) are outstanding under state corporate law, including for the purpose of determining voting rights. The individual is not the owner of 100% of the outstanding shares.

Why is an IRS private letter ruling relevant in this case? What is the tax issue involved? There actually are circumstances under which ESOP shares would be treated as not outstanding for certain tax purposes.

It appears that IRC Section 411(d)(6)(A) would not permit the retroactive amendment to include more participants. Was the 3/31/00 contribution made by reason of a mistake of fact?

It must be difficult to deal with a situation where your new client has counsel that is ignorant. But, then, why is it your problem if the client elects to follow the advice of counsel? You shouldn't be liable for these mistaken interpretations of the law if you're directed by the client and its counsel. On the other hand, maybe you should "fire" the client. Life's too short.....

[stephen]

RLL,

The attorney is referring to 1.1042-1t Questions and answers relating to the sales of stock to employee stock ownership plans. The answer to Question 2 part 3 says "For purposes of this calculation, stock that is owned, directly or indirectly, by or for a qualified plan shall not be treated as outstanding."

In our case it makes a difference as they are considering an employee to be a 25% shareholder under 409(n) based on the above logic regarding unallocated shares not counting.

On the deduction issue it was not a mistake of fact. (nice thought though).

[RLL]

stephen ---

The provision of IRC Section 1042 which is addressed by A-2(a)(3) of the temporary regulations was specifically superseded by Section 409(n)(1)(B) in 1986.

For purposes of Section 409(n)(1)(B), there is a special rule which provides that shares allocated to a participant under the ESOP are taken into account in determining whether he/she is a 25% shareholder to whom 1042 shares may not be allocated. There is no indication whatsoever in the IRC that the rule in the obsolete regulations is to apply.

I agree with you that the proposed interpretation is incorrect. On the other hand, it's always safer to interpret the allocation limitations of Section 409(n) very broadly.....in order to avoid any possibility of the onerous penalties being applied. The "missed" allocation under the ESOP can easily be "made up" to the participant through some form of nonqualified deferred compensation. You should assure that the plan document language and the administrative interpretations thereof are clear as to how this is to be handled.

[BeckyMiller]

Well, it is possible that the attorney is concerned about the controlled group rules and not a specific ESOP or qualified plan matter.

Under IRC Section 1563(e)(3), shares held by a IRC Section 401(a) trust are disregarded for purposes of determining the shares outstanding in measuring control. Thus, for these rules, you 4 percent shareholder would be considered the 100 percent shareholder.

Surprisingly, under IRC Section 414(B), this rule is disregarded. Thus, for retirement plan controlled group of corporations, the 4 percent owner is just that -- a 4 percent owner.

It might help to get the answer to RLL's question about why this is considered an issue.