OVERVIEW OF THEIR OPERATION AND APPLICABLE REQUIREMENTS

TAX-FREE ROLLOVER TREATMENT FOR SALES OF STOCK TO AN ESOP

JAMES T. RAUSCHENBERGER
ARNALL GOLDEN GREGORY LLP
1201 WEST PEACHTREE STREET, SUITE 2800
ATLANTA, GEORGIA 30309-3450
Phone: 404-873-8738
Fax: 404-873-8739
james.rauschenberger@agg.com

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What is an ESOP?

A qualified retirement plan which meets certain additional requirements and is entitled to certain special benefits that are not accorded other types of qualified retirement plans.

I. Requirements to be Satisfied for a Qualified Plan to be an ESOP.

A. Stock Bonus Plan.

1. Qualified retirement plans are divided into two general categories: defined contribution plans and defined benefit plans. A participant’s benefits in a defined contribution plan are determined by contributions, allocations of forfeitures and the participant’s allocable share of the related trust’s investment income. By contrast, benefits in a defined benefit plan are determined independent of contributions by reference to a scheduled level of benefits. A stock bonus plan is a type of defined contribution plan.

2. A stock bonus plan is a plan maintained and established to provide benefits similar to those of a profit-sharing plan, except that benefits are distributable in the form of employer stock.

3. Contributions to a stock bonus plan.

a. Contributions can be discretionary, independent of profits.

b. They can be in the form of employer securities, cash or both.

c. Contributions are allocated to participants’ accounts in accordance with a definite formula set forth in the plan. Normally, contributions are allocated in proportion to each participant’s compensation.

B. Designed to Invest Primarily in Qualifying Employer Securities.

1. Qualifying Employer Securities are common stock issued by the employer which are readily tradable on an established securities market.

2. If the employer’s common stock is not readily tradable, then qualifying employer securities are common stock having a combination of voting power and dividend rights equal to or exceeding that class of common stock of the employer having the greatest voting and dividend rights.

3. Noncallable preferred stock can be qualifying employer securities if the stock is readily convertible at any time into stock described in B.1. or B.2. above and the conversion price is reasonable (as of the date the preferred stock is acquired by the ESOP).

4. There is no fixed percentage of assets of a plan which must be qualifying employer securities to satisfy the "primarily invested" requirement. A bright-line test does not exist. It is a qualitative test which looks to the purpose of the ESOP. It would be very risky, however, to have employer securities be less than 51% of ESOP assets.

C. Passthrough Voting Requirements.

1. If the employer has a class of securities that are required to be registered under Section 12 of the Securities Exchange Act of 1934 (or the employer securities are an interest in a bank or insurance company that is subject to certain special exemptions from registration under Section 12), then participants must be able to direct the voting of all securities of the employer allocated to the participants’ accounts on all matters for which the shares are entitled to vote.

2. If the employer is not described in C.1. above, the participants are only required to direct the voting of employer securities allocated to their account on certain "major" corporate matters.

a. The matters for which passthrough voting is required are the approval or disapproval of any corporate merger or consolidation, recapitalization, reclassification, liquidation, dissolution, sale of substantially all the assets of a trade or business or "such similar transactions" as may be specified in regulations. No additional transactions have been specified in regulations.

b. On all other matters (such as electing directors) passthrough voting is not required and, therefore, the shares are voted by the trustee of the ESOP.

3. Passthrough voting is only required for matters for which voting of the shares in a participants’ account are entitled to vote. If, as a matter of state corporate law, they are not entitled to vote, there is nothing that is required to be passed through to participants. For example, a tender offer to purchase all the stock held by an ESOP is not a matter which requires a "vote" and, therefore, the decision to accept or reject the tender offer need not be passed through to participants and can be exercised by the trustee of the ESOP.

4. The passthrough voting requirements only apply to stock allocated to participants’ ESOP accounts. If permitted by the ESOP document, any unallocated stock can be voted by the trustees of the ESOP, as can shares allocated to participants’ accounts for which timely instructions are not provided by participants.

D. Special Distribution Requirements.

1. Mandatory Commencement of Distributions.

a. Unless the participant elects otherwise, distribution of vested benefits from an ESOP must commence no later than one year after the end of the ESOP plan year:

i. during which employment terminated due to retirement after the ESOP’s normal retirement age, disability or death;

ii. which is 5 years following the ESOP plan year in which employment terminates for any other reason.

b. Period over which distributions must be made by an ESOP:

i. substantially equal periodic payments (no less frequent than annually) over no more than a 5 year period;

ii. but, one additional year for every $100,000 (or fraction thereof) of total vested benefits in excess of $500,000 up to a maximum of 10 years total. (The $100,000 and $500,000 amounts are adjusted annually for inflation.)

2. Right to Demand Distribution in Employer Securities.

a. While benefits may be distributable in cash, participants must have the right to demand that they receive their distributions in the form of employer securities.

b. Cash-only distributions are permitted for ESOPs sponsored by S corporations, and for corporation’s whose articles of incorporation or by-laws restrict ownership of "substantially all" outstanding employer securities to employees or a qualified retirement plan.

3. Put Option required for employer securities that are not readily tradable on an established securities market. (Note: Special rules apply to banks, which are prohibited by federal law from acquiring their own stock.)

a. If the employer securities distributed by an ESOP are not readily tradable on an established securities market, persons distributed the securities must have a limited "put option" to require the employer (not the ESOP) to repurchase the employer securities. If desired, the ESOP can elect to purchase all or a portion of the securities subject to the exercise of a put option. The purchase price for the put option is based on the most-recent appraised value of the securities.

b. The put option must be exercisable during two periods of at least 60 days:

i. Following the distribution of the securities;

ii. If the put option is not exercised during the first period, a second 60-day period must be provided following completion of the annual valuation of employer securities for the ESOP plan year in which the securities were initially distributed.

Example: Securities are distributed from a calendar year ESOP on July 15, 1999. The put option must be exercisable for at least a 60-day period following July 15, 1999. If not then exercised, there is a second put option period of at least 60 days that begins in 2000 when the appraisal of the employer securities as of December 31, 1999 is completed. Note the purchase price for the put option during the first 60-day period will be normally based on the appraisal of the securities as of December 31, 1998, while a purchase during the second 60-day period would be normally based on the appraised value as of December 31, 2000. Payment requirements when the put option is exercised.

i. If a participant takes a total distribution of all his vested benefits in a single year, the employer has the option of paying the purchase price in a lump sum or in substantially equal installments over a period beginning no later than 30 days after exercise of the put option and lasting no more than 5 years.

A. If the installment option is elected the employer must pay a "reasonable rate" of interest and provide "adequate security."

B. The IRS takes the position that "adequate security" requires a pledge of specific assets of the employer (and not simply a general obligation or an obligation secured only by the employer securities purchased). This position often forces employers whose assets are already pledged to other lenders to obtain a surety bond or some other form of insurance.

ii. If the put option is exercised with respect to an installment distribution, the employer must pay the entire purchase price for the installment in a lump sum within 30 days of exercise of the put option.

4. Right of First Refusals Also Permitted for Employer Securities that are not Publicly Traded.

a. While not required, it is permissible to have a right of first refusal apply to employer securities distributed by an ESOP where the securities are not publicly traded.

b. The right of first refusal can be in favor of the employer, the ESOP or both.

5. Diversification of Account Balances From Employer Securities.

a. Participants in an ESOP who are at least 55 and have participated in the ESOP for at least 10 years must be given an opportunity to diversify their ESOP holdings during a six-year "qualified election period" that begins with the first plan year in which the participant meets the eligibility requirements.

b. The amount eligible for diversification is 25% of the participant’s ESOP account balance, except that during the last year of the qualified election period the percentage increases to 50%. Participants are entitled to one diversification election during each year of the qualified election period, with the percentages applied on a cumulative basis to all elections made during the entire qualified election period.

c. The diversification requirements can be satisfied in one of two ways:

i. The ESOP may distribute cash or employer securities (subject to the put option) of the portion of the ESOP account with respect to which the diversification election is made; or

ii. In lieu of a distribution of assets, the ESOP may offer to the participants in the ESOP eligible for diversification three or more investment options other than employer securities with respect to the portion of their ESOP account eligible for diversification.

E. Appraisal of Employer Securities.

1. If employer securities are not readily tradable on an established securities market, appraisals of the fair market value of the stock must be done by a qualified independent appraiser.

2. Valuations are needed on at least an annual basis as of the last day of the plan year for purposes of determining values of account balances and the purchase price for any employer securities acquired pursuant to a put option. However, any transactions between the ESOP and a "party in interest" or "disqualified person" must be based upon the appraised fair market value of the stock as of the date of the transaction.

II. Leveraged ESOP Transactions.

A. General Description.

1. The ESOP borrows money from someone (either a bank or the employer) and uses the proceeds to acquire qualifying employer securities.

a. Generally, the ESOP will be unable to obtain a loan on its own credit – it must obtain financing assistance from the employer.

b. That financing assistance will come in the from the funds provided by the employer (either through the employer’s general funds or as a result of the employer borrowing money and then loaning all or a portion of the loan proceeds to the ESOP – this latter approach is often referred to as a "back to back" loan) or through a loan to the ESOP which is guaranteed by the employer.

2. The ESOP repays the loan through a combination of deductible contributions (to the ESOP) by the employer and dividends paid on employer stock held by the ESOP.

3. If the ESOP borrows money and purchases stock from the employer, the employer ends up with loan proceeds it can use for general business purposes and then repays the loan with deductible contributions to the ESOP.

B. Additional Qualification Requirements/Considerations.

1. Any transaction between a qualified plan and an employer or a significant shareholder of the employer is a "prohibited transaction" subject to sanction under ERISA and the Internal Revenue Code. A loan to an ESOP is exempt from these prohibited transaction rules (an "exempt loan") if the requirements identified below are satisfied.

2. Primary Benefit Requirement.

a. The ESOP loan must be primarily for the benefit of ESOP participants and their beneficiaries.

b. The determination of whether the loan is for such primary benefit is made on the basis of all facts and circumstances. In all events, however, the proceeds of the loan must be used within a reasonable period of time to acquire employer securities or to refinance a prior loan incurred to acquire employer securities.

3. The loan must be at a reasonable rate of interest.

4. Special Requirements Applicable to Security/Liability for the Loan.

a. The loan must be without recourse against the ESOP, and the only collateral that can be given by the ESOP as security for the loan is qualifying employer securities, contributions to the ESOP and earnings attributable to the securities and employer contributions.

b. Upon a default of the loan, plan assets transferred to the lender cannot exceed the amount of the default. Furthermore, if the lender is a disqualified person such as the employer or a shareholder, plan assets transferred upon a default cannot exceed the amount of the default – acceleration of the entire unpaid loan balance is not permitted.

5. Release of Employer Securities and Allocation to Participants’ Accounts.

a. Employer securities acquired with the proceeds of an exempt loan are initially placed in a suspense account while they are pledged as security for the loan. While they are in the suspense account, the securities are not allocated to any participant’s account and passthrough voting is not required.

b. As payments are made on the loan, employer securities must be released from the suspense account and allocated to participants’ accounts in the ESOP.

i. The number of securities which must be released each year from the suspense account is generally determined by multiplying the number of the securities in the suspense account by a fraction, the numerator of which is the total principal and interest payments for the year, and the denominator of which is the sum of the numerator plus the interest and principal to be paid for all future years.

ii. A special rule permits securities to be released solely by reference to principal payments if and only if the loan provides for principal and interest payments no less rapid than level annual payments of such amounts for 10 years. The special rule is unavailable from the time that, by reason of extension, renewal or refinancing, the sum of the expired term of the loan and the remaining term of the extended, renewed or refinanced loan is more than 10 years – you can’t extend the loan beyond 10 years and continue to amortize on the basis of principal payments only.

6. Higher Limits on Deductible Contributions and Annual Additions to Participant Accounts.

a. Section 404 of the Internal Revenue Code generally limits the amount of deductible contributions which can be made to a defined contribution plan such as an ESOP to 15% of the compensation of eligible plan participants.

i. The percentage is increased to 25%, however, for contributions applied to repay principal on an exempt loan that was incurred to acquire employer securities.

ii. There is no percentage limitation applicable to contributions applied to pay interest on an exempt loan that was incurred to acquire employer securities.

iii. No more than $170,000 (for 2000, adjusted annually for inflation) of compensation of any participant may be taken into consideration.

iv. These special rules are inapplicable to S corporations.

b. Section 415 of the Code limits the amount of "annual additions" (generally employer contributions and forfeitures) that can be made to the account of any participant in a defined contribution plan to the lesser of $30,000 (adjusted for inflation) or 25% of the participant’s compensation:

i. Where employer contributions are used to make payments on an exempt loan and employer securities are thereby released from the suspense account and allocated to participants’ accounts, the ESOP can have annual additions determined by reference to either the amount of employer contributions or the fair market value of employer securities allocated to the participants’ accounts. If provided in the plan document, it might even be permitted to use one method for some period of time and then switch to the other.

ii. If no more than 1/3 of employer contributions to an ESOP in any year are allocated to the accounts of "highly compensated employees," the limits on annual additions do not apply to:

A. forfeitures of employer securities acquired with the proceeds of the exempt loan; and

B. employer contributions applied to pay interest on an exempt loan that was incurred to acquire employer securities.

III. Special Tax Benefits Associated with ESOPs.

Section 1042 Rollover Transactions.

1. A seller of employer securities to an ESOP can defer recognition of gain on the sale if the requirements of Section 1042 of the Internal Revenue Code are satisfied.

2. The selling shareholder must have owned the employer securities sold to the ESOP for at least three years and the securities cannot be readily tradable on an established securities market.

3. After the sale, the ESOP must own at least 30% of the employer’s outstanding stock. The requirement can be satisfied even if the ESOP does not acquire all of its 30% ownership through that particular sale.

4. The selling shareholder must acquire "qualified replacement securities" ("Replacement Securities") within a specific 15-month period.

a. The Replacement Securities must be acquired during a 15-month period which begins three months before the Section 1042 sale and ends 12 months after the Section 1042 sale. For example, if stock were sold to the ESOP on April 1, 2000, the Replacement Securities could be acquired anytime during the period from January 1, 2000 until March 31, 2001.

b. Gain will be recognized to the extent that less than the amount realized from the sale of the stock is invested in Replacement Securities. For these purposes, the amount realized from the sale is net of any transaction costs incurred in connection with the sale.

c. Replacement Securities defined

i. The Replacement Securities must be stock, bonds or other debt instruments, or rights to acquire any of the foregoing, of an "eligible U.S. operating corporation." There is no requirement that the securities be of only one company. Any number of Replacement Securities in different companies can be acquired. Furthermore, as long as the requirements described below concerning the companies are satisfied, the companies can be publicly-traded or privately-held.

ii. An "eligible U.S. operating corporation" is a U.S. corporation which (A) does not derive more than 25% of its gross receipts from "passive" types of income such as dividends, interest, rents, annuities, royalties, or sales of stock and bonds, and (B) uses more than 50% of its assets in the conduct of a trade or business. The first requirement eliminates investments in, among other things, mutual funds, real estate companies, and real estate investment trusts (REITs). Though they might otherwise be prohibited from being an eligible corporation under the foregoing rules, certain insurance companies and financial institutions can be eligible operating corporations. In no event, however, can the Replacement Securities be securities of the employer.

5. Taxpayers/Transactions Ineligible for Section 1042 Rollover Treatment.

a. C corporations are not eligible to receive nonrecognition of gain in a Section 1042 transaction.

b. The stock of an S corporation cannot be sold in a Section 1042 transaction.

6. Certain Employees are Ineligible to Receive Allocations by an ESOP of the stock acquired in a Section 1042 transaction.

a. The stock acquired by the ESOP in a Section 1042 sale cannot be allocated under the ESOP to certain employees of the employer who might otherwise be entitled to be allocated some of the stock under normal ESOP allocation rules. The substance of these rather complex provisions is that neither the selling shareholder, his/her brothers, sisters, spouse, ancestors and descendants nor any other shareholder owning more than 25% of the employer’s stock can be allocated any portion of the employer’s stock sold to the ESOP, even though they continue to be employees of the employer.

b. Notwithstanding the foregoing, descendants of the selling shareholder may participate in the ESOP’s allocation of the purchased shares if they are allocated not more than 5% (in the aggregate) of such purchased shares.

c. If these requirements are violated, the person receiving the prohibited allocation is taxed currently on the allocation and the employer is subject to an excise tax equal to 50% of the amount involved.

7. Excise Tax on Early Dispositions of Section 1042 Stock by an ESOP.

a. If the ESOP sells stock purchased in a Section 1042 sale during the 3-year period immediately following the sale to the ESOP, an excise tax equal to 10% of the amount realized from the transfer will be imposed on the employer. (The IRS wants to insure that the ESOP acquires the shares for purposes of providing benefits to employees and not as a means of deferring taxable gain that would otherwise be realized by a selling shareholder selling the shares to a third party purchaser.)

b. The excise tax does not apply to normal distributions of stock by the ESOP following death, retirement, disability or other termination of employment of an ESOP participant. The excise tax will also not apply if the ESOP transfers the stock acquired through the Section 1042 sale in a nontaxable "reorganization," such as if the employer, within the three year period, merges into a public company and the majority of the consideration is stock of the public company.

8. Subsequent Gain Recognition By the Selling Shareholder.

a. Upon a subsequent disposition of Replacement Securities, the amount of gain that went unrecognized pursuant to the taxpayer’s Section 1042 transaction is recognized. The gain is recognized even if the disposition is effected through a transaction whereby gain would otherwise not be recognized.

b. Gain will also be recognized if the corporation issuing the Replacement Securities disposes of a substantial portion of its assets (other than in the ordinary course of business) and the selling shareholder is in control of the corporation.

c. Certain dispositions are excepted from gain recognition:

i. A corporate reorganization which qualifies under Section 368 of the Internal Revenue Code so long as the other corporations in the reorganization are not owned by the selling shareholder.

ii. A transfer at death – note that in this situation there is also a step-up in basis at death to fair market value so the gain deferred under Section 1042 will never be recognized for income tax purposes.

iii. A transfer by gift – private rulings from the IRS have confirmed that the "gift" exception includes charitable contributions of Replacement Securities.

9. Elections and Written Statements Required.

a. By the Selling Shareholder. Section 1042 treatment must be elected by the selling shareholder by filing an election with his/her income tax return for the year in which the sale occurs. The content of the election must satisfy certain specific requirements imposed by the Internal Revenue Code and the Regulations thereunder.

b. By the Employer. The electing taxpayer must file a consent of the employer to be subject to the excise taxes described in A.6.C. and A.7. above. The consent must be filed at the same time as the taxpayer’s election.

B. Deduction of Dividends Paid with Respect to Employer Securities Held by the ESOP.

1. The employer can be entitled to a deduction for dividends paid with respect to employer stock held by the ESOP. S corporations that sponsor ESOPs, however, are ineligible for this special deduction.

2. The deduction is available only if the dividend is:

a. paid in cash to ESOP participants and their beneficiaries;

b. paid to the ESOP and distributed by the ESOP to ESOP participants and their beneficiaries within 90 days after the close of the plan year in which paid; or

c. used by the ESOP to make payments with respect to an ESOP loan whose proceeds were used to acquire employer securities. The deduction will only be available in this situation if the ESOP also allocates to each participant employer securities which have a fair market value at least equal to the amount of the dividend paid with respect to the employer securities allocated to the participant’s account.

3. The deduction is not available if the IRS determines that the dividend "constitutes, in substance, an evasion of taxation." To the extent a dividend is not "reasonable" the deduction will be denied under this rule. The dividend should not exceed a dividend that the employer can reasonably be expected to pay on a recurring basis.

4. Caveats.

a. The deduction for the dividend is available for the taxable year of the employer in which the dividend is paid or distributed to participants, or in which the dividend is used to make payments on the loan.

b. To be treated as a dividend and eligible for the deduction, the distribution must be made while the employer has earnings and profits.

c. The deduction is not available for purposes of the corporate alternative minimum tax.

d. Payments or distributions of dividends to ESOP participants constitute ordinary income but are not subject to the 10% excise tax on early distributions from qualified plans or the income tax withholding rules that otherwise applies to distributions from qualified plans.

C. ESOPs Sponsored By S Corporations.

1. An ESOP can be sponsored by an S corporation, and the ESOP does not have to pay income taxes on its allocable share of the S corporation’s income – the income is not treated as so-called "unrelated business taxable income" subject to the special tax that is imposed upon otherwise tax-exempt organizations such as qualified plans. This can give an S corporation a lower current income tax cost.

2. Remember, however, that if the S corporation has other shareholders they will be subject to income tax on their allocable share of the income and, therefore, will require that dividends be distributed annually in an amount at least equal to their income taxes associated with that income. Because of the single class of stock requirement that applies to S corporations, this will also require a distribution to the ESOP, which amount must be allocated to participants’ accounts (or used to make payments on an exempt loan). Conversion to S corporation status generally will be a benefit only if the ESOP will own more than 50% of the corporation. Conversion to an S corporation is dangerous, however, for a C Corporation that uses the LIFO method for inventory – the "LIFO recapture" tax.

3. S corporation ESOPs are not eligible for the increased deductions granted to leveraged ESOPs, cannot engage in Section 1042 deductions, and cannot make deductible dividend distributions.

IV. Special Tax/Planning Considerations Associated with an ESOP.

A. Liquidity for the Employer’s Repurchase Obligation

If employer securities are not publicly traded, the employer/ESOP will have to come up with cash to make distributions or purchase employer securities acquired pursuant to the put option. The cash costs associated with a "mature" ESOP can be significant and should be planned for.

B. Amortization of ESOP Debt

Remember the limits of Sections 404 and 415 on the amount of contributions that can be made to an ESOP. Be sure that any payments required by a third-party lender (i.e. the amortization schedule of the leveraged ESOP loan to the ESOP) can be made in compliance with those requirements, and make sure that the debt can be amortized within those requirements within a reasonable period of time. If you cut it too close, allocations of forfeitures and/or contributions to other qualified plans (e.g. 401(k) plans) can prevent the employer from making contributions to an ESOP that are required to amortize ESOP debt.

 

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