McLane
McLane, Graf, Raulerson & Middleton, Professional Association
Employee Stock
Ownership Plans and Trusts:
Benefits for Closely Held Businesses
and Business Owners
Presented By:
Steven M. Burke
McLane, Graf, Raulerson & Middleton, Professional Association
TAX AND LEGAL ISSUES
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Legal Definitions of an ESOP (Plan and Trust)
f ESOP is a qualified retirement plan which is designed
to invest primarily in the employer’s securities
f ESOP may also borrow money and enter into other
transactions
f Specific provisions ERISA and the Code create very
distinct tax incentives for employers to adopt ESOPs
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TAX AND LEGAL ISSUES
f ESOP is basically a Stock Bonus Plan which is a
qualified retirement plan under Section 401(a) of the
Code
f A Stock Bonus Plan is similar to a Profit Sharing
Plan except that the benefits in a Stock Bonus Plan
are distributable in employer stock
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TAX AND LEGAL ISSUES
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the investments of a Stock Bonus Plan are usually made
primarily in employer securities
a Stock Bonus Plan is exempt from any "fair return"
requirement with respect to investment employer stock
benefits from a Stock Bonus Plan must be distributable in
stock of the employer
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TAX AND LEGAL ISSUES
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General Requirements of ESOPs
f IRC Section 401(a) Requirements
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An ESOP generally must meet all of the qualified plan
requirements under Section 401(a) of the Code
f Designed to Invest in Employer Securities
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While there is no specific definition for "design to invest
primarily in employer's securities," it is generally believed
that an ESOP must permit the plan trustees to invest or
hold the major portion of the plan's assets into the
employer's securities
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TAX AND LEGAL ISSUES
f Voting Rights
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participant has the right to direct the vote of employer's
stock allocated to his or her account in the plan
then the ESOP must permit each participant to direct the
voting of the securities of the employer allocated to his or
her account
then the ESOP must permit each participant to direct the
voting of the securities of the employer allocated to his or
her account
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TAX AND LEGAL ISSUES
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If the ESOP does not have registration-type class of
securities, the only voting rights required to be given to
participants is that the participants must be allowed to
direct the vote of stock allocated to the account with
respect to any corporate matter involving the voting of
shares for or against corporate mergers, consolidations, sale
of all or substantially all the corporation's assets,
recapitalization, reclassifications, liquidations, dissolutions,
or such similar transactions
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TAX AND LEGAL ISSUES
f Whether or not stock has been allocated to a
participant's account, not whether the participant is
vested in their account, that determines whether and
the extent to which a participant may vote employer
stock
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TAX AND LEGAL ISSUES
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PUT Option
f A participant must be given the right to receive a
distribution from the plan in the form of Employer's
securities
f Unless employer stock is traded on an established
securities market, the participants must be given the
right to require the employer to repurchase the
shares at fair market value
f It is important to note that the ESOP itself is not
required to purchase the shares
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TAX AND LEGAL ISSUES
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Right of First Refusal
f An employer adopting an ESOP which holds non-
publicly traded stock, may provide that the employer
has a right of first refusal on stock held by the ESOP
or distributed from the ESOP to participants
f The selling price and other terms under a right of
first refusal must not be less favorable to the seller
than fair market value of the stock or purchase price
and other terms offered by a buyer making a good
faith offer
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TAX AND LEGAL ISSUES
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Distribution Requirements
f An ESOP must contain provisions that allow
distributions to a participant of the vested interest in
their account to begin not later than one year after
the end of the plan year during which the participant
terminates employment because of retirement on or
after the plan's normal retirement age, disability or
death
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TAX AND LEGAL ISSUES
f Further, if a participant is terminated (either
voluntarily or involuntarily) distributions must be
made not later than one year after the end of the fifth
plan year following the plan year during which the
termination occurs
f If a participant's account balance exceeds
$500,000.00 discretions may be over a longer period
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TAX AND LEGAL ISSUES
f The distribution requirements discussed above do
not apply to a participant's account balance which
consist of employer's securities acquired with the
proceeds from an ESOP securities acquisition loan
until the end of the plan year in which the entire loan
is repaid
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TAX AND LEGAL ISSUES
f A closely held company which has adopted an
ESOP must consider the liquidity requirements that
these provisions will impose on the employer at the
time a participant either retires or terminates
employment with an account in the ESOP with a
significant amount of employer's securities. The
employer must plan carefully at the time the ESOP
is established
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TAX AND LEGAL ISSUES
f employer establish some type of sinking fund or
designated account to meet these repurchase
requirements
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TAX AND LEGAL ISSUES
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Independent Appraiser
f An ESOP that holds employer's securities which are
not readily tradeable on a securities market must
have all valuations of those securities made by an
independent appraiser
f the independent appraiser should be a person who
does not perform any other services for a party
whose interest may be adverse to the ESOP and who
would be impartial
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TAX AND LEGAL ISSUES
f the value assigned to employer stock contributed to
the ESOP is critical
f If the ESOP trustees cause the plan to purchase
stock at a price greater than it's true value, the
purchase will be a violation of the trustee's fiduciary
duty, possibly rendering the trustees personally
liable to participants for the amount of the
overpayment
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TAX AND LEGAL ISSUES
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Diversification
f Qualified employees must be allowed to have a
portion of their account invested in assets other than
employer's securities
f "Qualified employees" are those employees who are
at least 55 years of age and who have at least 10
years of participation in the plan
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TAX AND LEGAL ISSUES
f ESOPs must permit qualified participants to
diversify their investment of at least 25% of their
ESOP account during the six year period
commencing with or after the plan year in which the
participant reaches age 55 (or if later, the plan year
in which the participant completes ten years of
participation)
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TAX AND LEGAL ISSUES
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Requirements that Plan be Designated as an
ESOP
f The ESOP plan document must specifically provide
that a plan is an ESOP.
f The plan document must also provide that
participants have certain protections with respect to
assets acquired with the proceeds of an exempt loan.
f No security acquired with the proceeds of an exempt
loan may be subject to a put, call or other option
while held by the plan.
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TAX AND LEGAL ISSUES
f An exception to this rule is for the put options that
ESOPs must grant to participants and for the right of
first refusal that an ESOP may grant in favor of the
employer or the ESOP
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TAX AND LEGAL ISSUES
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Loan Requirements
f The prohibited transaction provisions of the Code
generally prohibit any qualified retirement plan from
receiving a loan from a disqualified person or from
receiving a loan which is guaranteed by a
disqualified person
f An exception to this rule is granted for leveraged
ESOPs
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TAX AND LEGAL ISSUES
f In order to qualify for this exemption
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The loan proceeds must be used within a reasonable time
after their receipt to acquire qualified employer securities
or to repay the loan of a prior exempt loan
The loan must be without recourse against the ESOP,
except to the extent of employer securities acquired with
loan proceeds
The loan must be a term loan, not a demand loan
The loan's terms must be at least as favorable to the ESOP
as the terms of a comparable loan resulting from armslength negotiations between independent parties and it
must bear a reasonable rate of interest
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TAX AND LEGAL ISSUES
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Tax Benefits Accrue to
f An employer that establishes an ESOP
f Participants of an ESOP
f Shareholders selling stock to an ESOP
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TAX AND LEGAL ISSUES
f The benefits include
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Deductibility (in effect) of principal and interest payments
on ESOP loans
The deferred recognition of gain on the sale of a closely
held company to an ESOP
The deductibility of certain dividends on stock held by an
ESOP
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TAX AND LEGAL ISSUES
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Leveraged ESOP Buy outs
f There may be a limited market for stock in a closely
held corporation
f A leveraged ESOP essentially is a special type of
ESOP that finances the acquisition of the employer
stock with borrowed money
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TAX AND LEGAL ISSUES
f A successful ESOP buy out provides at least the
following benefits:
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It permits the transfer of the shareholders ownership
interest without recognition of taxable income
Provides employees with both retirement benefits and
added incentive in holding an ownership interest of
business
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TAX AND LEGAL ISSUES
f A leveraged ESOP buy out generally includes the
following steps
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The employer establishes an ESOP
The majority shareholder enters into an agreement with
ESOP to sell its shares to the ESOP at an agreed upon price
The ESOP borrows money from a financial institution
The leveraged ESOP uses the loan proceeds to pay the
selling shareholder for the shares it has purchased
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TAX AND LEGAL ISSUES
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Over time, the employer makes contributions and/or
dividend payments to the leveraged ESOP in the amount
needed to repay principal and interest in the loan. The
employer receives, in effect, a deduction of principal and
interest on the loan since the contribution to the ESOP is
deductible
The shares purchased by the ESOP are held in a "suspense
account" and allocated to participant accounts in the plan
as the loan is repaid by the ESOP
To be eligible for benefits plan must meet Section 401
requirements
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TAX AND LEGAL ISSUES
f Deduction of Employer Contributions
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Limited imposed by Section 404 of the Code
Apply to contributions made to an ESOP
ESOP, and may deduct up to 15% of the compensation of
all participants for that plan year (25% for plan years
beginning after 12/31/01)
In addition, employer contributions to an ESOP that are
used to repay interest on a loan used by the ESOP to
acquire employer securities are fully deductible and
employer contributions used to repay the loan are
deductible up to 25% of total compensation
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TAX AND LEGAL ISSUES
f Deduction of Employer Dividend Payments
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Corporations are generally not permitted to deduct
dividends to shareholders
Dividends paid on shares held by an ESOP
Used to repay the loan incurred to purchase employer
securities
f Allocation of Contributions
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The plan document must provide a definite formula for
allocation of employer contributions and forfeitures
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TAX AND LEGAL ISSUES
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May not discriminate in favor of highly compensated
employees
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TAX AND LEGAL ISSUES
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Tax Deferred Rollover Treatment
f A shareholder realizes gain from the sale of stock to
an ESOP may elect to defer recognition of the gain
if the requirements set forth below are satisfied
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Stockholder sells “qualified securities” to an ESOP
Makes the appropriate election
Gain is generally not recognized if the following conditions
are met:
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TAX AND LEGAL ISSUES
f
f
f
f
The ESOP must own at least 30% of either (a) each class of
outstanding stock or (b) the total value of all the corporation's
outstanding stock
The sale must otherwise qualify for long term capital gain
treatment
The shareholder held the securities for at least three years
prior to the sales of the ESOP
Within the 15-month period beginning three months before
the sale date, the seller purchases "qualified replacement
property" and files a certain written statement with the IRS
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TAX AND LEGAL ISSUES
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Making the Election
f A § 1042 to election is made by a shareholder on a
timely filed return (including extensions) filed for
the year of sale
f The taxpayer must also file a written statement in
which the employer whose employees are covered
by the ESOP consents to the application of § § 4978
and 4979A
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TAX AND LEGAL ISSUES
f A notarized statement of purchase must be timely
filed by a taxpayer when a qualified replacement
property is acquired
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30% Ownership
f The 30% threshold (discussed above) may be met by
several shareholders as a part of a single transaction
under a prearranged agreement among the
shareholders
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TAX AND LEGAL ISSUES
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Gain and Holding
f Section 1042(a) provides that any long term capital
gain realized in a sale of stock to ESOP is
recognized only to the extent that the proceeds
exceed the cost of the qualified securities purchased
with the proceeds of the sale
f If more than one item of replacement property is
acquired, basis is allocated among the items
purchased
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TAX AND LEGAL ISSUES
f The holding period of the employer securities sold to
the ESOP will be tacked to the holding period of the
replacement property
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Statute of Limitations
f A special 3-year statute of limitations applies if tax
free roll over treatment under § 1042 is elected
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TAX AND LEGAL ISSUES
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Qualified Securities
f Section 1042 requires that the stock to the ESOP the
"qualified securities.“
f "qualified securities" the stock must meet the
following important criteria:
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It must be common stock with voting and dividend rights at
least equal to the classes of common stock having the
greatest dividend and voting rights of the employer
to the stock must be issued by domestic corporation with
no stock which is readily tradeable on an established
securities market
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TAX AND LEGAL ISSUES
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Qualified Replacement Property
f Generally is any security issued by certain domestic
operating corporations
f "Security" includes corporate stock, rights to
subscribe to stock or bonds, debentures, notes,
certificates or other evidence of indebtedness issued
by a corporation
f Qualified replacement property may be comprised of
more than one piece of property
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TAX AND LEGAL ISSUES
f The Code provides that the corporation issuing the
qualified replacement securities must not have had
passive investment income exceeding 25% of its
gross receipts in the tax year preceding the year of
the replacement property was purchased
f Additionally, more than 50% of the corporation's
assets must be used in the active conduct of a trade
or business
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TAX AND LEGAL ISSUES
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Premature Disposition of Securities
f If within 3 years after acquiring a qualified security
under § 1042 transaction, the ESOP disposes of
them, the employer is liable for a 10% excise tax on
the amount realized if either of the following occur:
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The total number of shares held by the ESOP after the
disposition is less than before the disposition
If the value of the employers securities held by the ESOP
falls below 30% of the value of all employers securities as
of the date of disposition
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TAX AND LEGAL ISSUES
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Prohibited Allocation Rule
f An ESOP acquiring securities in a § 1042
transaction is prohibited from allocating plan assets
attributable to the securities to:
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An electing seller
The electing seller's family
Any more than 25% shareholder
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TAX AND LEGAL ISSUES
f Lineal decedents of the seller may be eligible for
such allocations, provided the total amount allocated
to all such lineal decedents of all sellers is no more
than 5% of the § 1042 securities attribution to such
sellers
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S CORPORATIONS AND ESOPS
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Subchapter S Corporations and ESOPs
f Prior to 1997, ESOPs could not hold stock in
Subchapter S corporations
f Small Business Job Protection Act of 1996 amended
the Code to allow qualified retirement plans,
including ESOPs, to hold stock in Subchapter S
corporations
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S CORPORATIONS AND ESOPS
f However, not all tax benefits available to ESOPs
holding stock in Subchapter C corporations are
available to ESOPs holding Subchapter S
corporation stock
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S CORPORATIONS AND ESOPS
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Benefits of S Corporation ESOPs
f Subchapter S status allows a corporation to avoid
paying federal income tax at the corporate level
f All earnings of the company allocated to Subchapter
S corporation shares held by an ESOP would go
untaxed since the ESOP is a tax-exempt entity
f Elimination of the federal tax liability clearly
enhances the cash flow of an S corporation owned
by an ESOP
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S CORPORATIONS AND ESOPS
f Note of caution
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In 2001, the Code was amended to provide that for plan years
beginning after December 31, 2004, an ESOP established by an S
corporation must provide that no portion of the ESOPs assets
attributable to employer securities can accrue for the benefit of a
"disqualified person."
In the case of an ESOP established after March 14, 2001, or an
ESOP established on or before that date that was not an S
corporation on the date, the effective date of the Act with respect
to plan years ending after March 14, 2001.
Congress intended these rules to limit the establishment of ESOPs
by S corporations to those that provided broad-based employee
coverage and benefits rank and file employee.
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S CORPORATIONS AND ESOPS
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C Corp ESOPs Still May Be the Way to Go
f Benefits of C Corporation ESOPs include
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Sellers of employer's securities continue to qualify for
Section 1042 rollover
C Corporations are allowed to deduct dividends paid on
ESOP shares
The company may convert from Subchapter C corporation
to Subchapter S corporation – election must be made
within two and one-half months of the end of the
corporation's fiscal year to be effective as of the first day of
the plan fiscal year
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S CORPORATIONS AND ESOPS
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The company may change from an S corporation to an
ESOP to allow for Section 1042 rollover eligibility
Shareholders of Subchapter S corporation cannot utilize the
Section 1042 provisions
Sellers of shares to ESOP must determine whether to
convert to S corporation or C corporation prior to the
transaction – tax implications to sellers, remaining owners,
corporations and participants must all be considered
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ERISA
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Fiduciary Rules
f Exclusive Purpose and Prudence
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Plan fiduciaries discharge their duties with respect to the
plan
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ERISA
f
f
f
Solely in the interest of the participants and beneficiaries
For the exclusive purpose of providing benefits to participants
and beneficiaries of the ESOP and defining reasonable
expenses of administering the plan
The care, skill, prudence and diligence under the
circumstances then prevailing that a prudent person acting in
a like capacity and familiar with such matters would use in
the conduct of an enterprise of like character and with like
aim
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ERISA
f Fiduciaries with respect to an ESOP are generally
those individuals that exercise any discretionary
authority or control with respect to the management
of the ESOP or the disposition of assets
f A fiduciary may be personally liable and removed as
a fiduciary for breaches of the responsibilities and
obligations imposed under ERISA
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ERISA
f A co-fiduciary may be held liable for the breach of
another fiduciary if he or she knowingly participates
or conceals a breach by the co-fiduciary, and does
not make reasonable efforts to remedy the breach
f Therefore a co-fiduciary must take reasonable steps
to remedy a breach by a fiduciary
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ERISA
f Fiduciaries may not be able to resign to avoid co-
fiduciary liability because such resignation could
itself be a fiduciary breach
f A fiduciary may not be relieved of their fiduciary
obligations under ERISA by the terms of an
agreement
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ERISA
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Prohibited Transaction Rules
f ESOPs are prohibited from entering into transactions
with parties in interest with respect to the plan under
ERISA
f These transactions include the sale of property and
the lending of money or other extension of credit
between the ESOP and a party in interest
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ERISA
f Generally prohibit an ESOP from purchasing
employer securities from the employer corporation,
or an employee, officer or director or 10%
stockholder of the corporation or obtaining a loan
from, or guaranteed by, such parties in interest
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ERISA
f Major exemptions from these rules
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First exception - the acquisition or sale of employer
securities by a leveraged ESOP is exempt from the
prohibited transaction rules if the acquisition or sale is for
adequate consideration and no commission is charged
In the case of a security that's not freely tradeable on an
established market, fair market value is determined in good
faith by the trustee of the ESOP or the named fiduciary
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ERISA
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Fair market value
f
f
f
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The price of a willing buyer and willing seller in an arms
length transaction
Determine as of the applicable date of the sale
Reflected in a written document meeting Department of Labor
regulations.
The second exemption relates to an ESOP exempt loan
f
An exempt loan must be made without recourse against the
ESOP and the collateral for the loan must consist only of
employer securities acquired with the proceeds of the loan or
that or used as collateral on a prior exempt loan
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ERISA
f Independent Counsel and Advisors
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ERISA requires that plan fiduciaries discharge their duties
with respect to the plan solely in the interest of participants
and beneficiaries of the ESOP and for the exclusive
purpose of providing benefits to the participants and
beneficiaries of the ESOP
Interests may conflict with those interests of the
participants
This issue is readily apparent where an ESOP is deciding
whether to sell employer securities
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ERISA
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There are no specific statutory requirements under the
ERISA fiduciary rules that there be independent trustees or
investment advisors for the ESOP
Courts have held that where the interests of fiduciaries
irreconcilably conflict with the interests of plan participants
and beneficiaries, the fiduciaries should obtain the benefit
of independent, legal, financial and investment counsel
Other courts have suggested that it may be desirable for the
fiduciaries with conflicts to resign and be replaced by
independent fiduciaries
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