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4.72.4 Employee Stock Ownership Plans (ESOPs)

Manual Transmittal

May 23, 2017

Purpose

(1) This transmits revised IRM 4.72.4, Employee Plans Technical Guidance, Employee Stock Ownership Plans (ESOPs).

Background

This IRM provides guidance for examiners on how to examine an Employee Stock Ownership Plan.

Material Changes

(1) IRM 4.72.4.1, Program, Scope and Objectives, and the subsections thereunder, were added to meet the new internal controls requirements.

(2) Minor editorial changes have been made throughout the document.

Effect on Other Documents

This supersedes IRM 4.72.4 dated August 18, 2016.

Audience

Tax Exempt and Government Entities
Employee Plans

Effective Date

(05-23-2017)

Lisa J. Beard
Acting Director, Employee Plans
Tax Exempt and Government Entities

Program Scope and Objectives

  1. Purpose: IRM 4.72.4, Employee Plans Technical Guidance, Employee Stock Ownership Plans (ESOPs), provides technical guidance as well as examination steps to be taken by an Employee Plans (EP) agent when auditing a IRC 4975(e) leveraged ESOPs. This section will also aid group managers in their review of the agent’s case file and to provide assistance to the agent as needed.

  2. Audience: This IRM provides procedures for agents, their group managers and support staff in EP Exam.

  3. Policy Owner: Director, EP Examination.

  4. Program Owner: EP Examination.

  5. Program Authority: EP’s Examination’s authority to resolve issues is derived from its authority to make determinations of tax liability under IRC 6201.

  6. Program Goals: The information contained in this IRM is designed to promote quality ESOP examinations. To achieve this objective, the format of this IRM is laid out by each area of qualification and taxation. For each area, the applicable law is discussed and followed by the examination steps the agent should take to verify compliance with the law. This section will also aid group managers in their review ESOP cases, in providing technical assistance to their agent and in resolving ESOP issue with the taxpayer.

Background

  1. EP Examination is the division designated to determine whether an ESOP is in compliance with current law. As part of EP Examination’s responsibilities, a determination of tax liability must be made for non-complaint ESOPs. EP Examination should seek to resolve the tax liability discovered during examination under the authority provided under IRC IRC 6201.

Authority

  1. The authority for conducting ESOP examinations is primarily provided by IRC 401, IRC 409, IRC 4975, IRC 4978, IRC 4979A, IRC 4980 and IRC 6201, the underlying regulations, and the following laws:

    • Employee Retirement Income Security Act of 1974 (ERISA)

    • Small Business Job Protection Act of 1996 (SBJPA)

    • Taxpayer Relief Act of 1997 (TRA ’97)

    Note:

    Other Code sections such as 318, 404, 410, 411, 415, 416, 512 1042, 1361 and 1563 also come into play when examining an ESOP as well as other laws.

Program Controls

  1. Tax Exempt Quality Measurement System (TEQMS) is the quality control system used to oversee the entire examination program. For more information on TEQMS, see IRM 4.71.15.1.3, Program Controls and Program Reports - TEQMS.

  2. All examinations will be done in accordance with the Taxpayer Bill of Rights as listed in IRC 7803(a)(3).

    Note:

    Additional information may be found on the irs.gov website at www.irs.gov/taxpayer-bill-of-rights.

Acronyms and Forms

  1. This manual uses the following acronyms and references the following forms.

    Acronyms

    Acronym Definition
    CODA Cash or Deferred Arrangement
    DOL The Department of Labor
    ERISA Employee Retirement Income Security Act of 1974
    ESOP Employee Stock Ownership Plans
    FMV Fair Market Value
    FTSE Financial Times Stock Exchange
    IRC Internal Revenue Code
    KSOP ESOP with a 401(k)
    NASD National Association of Securities Dealers
    NASDAQ National Association of Securities Dealers Automatic Quotation System
    QJSA Qualified Joint and Survivor Annuity
    QPSA Qualified Preretirement Survivor Annuity
    SBJPA Small Business Job Protection Act of 1996
    SEC Securities and Exchange Commission
    TEQMS Tax Exempt Quality Measurement System
    TRA ’97 Taxpayer Relief Act of 1997
    UBIT Unrelated Business Income Tax


    Forms and Schedules

    Form Name
    Form 5309 Application for Determination of Employee Stock Ownership Plan.
    Form 5500 Annual Return/Report of Employee Benefit Plan
    Form 5500, Schedule R Retirement Plan Information.
    Form 5500, Schedule H Financial Information
    Form 5500, Schedule I Financial Information - Small Plans


General ESOP Requirements

  1. ESOPs are qualified retirement plans designed to invest primarily in employer securities.

  2. ESOPs are also used as a technique of corporate finance. ESOPs can be used to meet the general financing requirements of a corporation, as well as transfer ownership of corporate stock to employees.

    Note:

    A leverage ESOP is an ESOP that acquires employer securities through a debt-financing arrangement.

  3. Generally, qualified plans are not permitted to acquire or hold employer securities or employer real property with a fair market value in excess of 10 percent of plan assets. See Employee Retirement Income Security Act (ERISA) sections 406(a)(1)(E), 406(a)(2) and 407(a)(2).

    Exception:

    Eligible individual account plans are specifically exempted from the 10 percent limitation and the investment diversification rules. See ERISA 407(b)(1), 404(a)(1)(C), and 404(a)(2). Since ESOPs are eligible individual account plans under ERISA 407(d)(3), they can invest in employer securities without regard to the 10 percent limitation if the plan document so provides

Establishment and Operation of an ESOP

  1. The steps to create a leveraged ESOP are:

    1. The employer and ESOP simultaneously execute loan documents with an outside lender. For purposes of this section, a bank will be considered the outside lender.

      Note:

      The loan made by the bank to the employer is referred to as a "back-to-back" loan.

    2. The ESOP will execute loan documents including a promissory note and a collateral stock agreement with the bank.

    3. The employer will execute a guarantee with the bank promising that the ESOP will repay the loan. The employer commits to pay the ESOP enough money each year to enable the ESOP to satisfy its annual loan obligation.

    4. The loan proceeds are distributed to the employer.

    5. The employer loans the money to the ESOP.

    6. The ESOP uses the money to acquire employer securities from the employer (or shareholder).

    7. The stock (employer securities) is placed in a suspense account.

      Reminder:

      The collateral used to obtain the bank loan is the stock (employer securities).

    8. Each year the employer makes contributions to the ESOP at least equal to the amount required to be repaid by the ESOP to the bank. The employer may also pay dividends to the ESOP attributable to the employer stock held in the ESOP suspense account.

    9. As the ESOP repays the outside lender, the stock held in the ESOP suspense account is released for allocation to participant accounts.

  2. Benefits received by the employer through establishing a leveraged ESOP include:

    1. New capital is made available to operate the business.

    2. The employer can repay the acquisition indebtedness of the ESOP out of the earnings from the new capital.

    3. Employer contributions to the ESOP used to repay the loan are deductible. Thus, a leveraged ESOP allows the company to repay the entire loan on a tax-favored basis.

      Note:

      The annual employer contributions made to the ESOP to make its annual debt repayment to the bank are tax-deductible within the IRC 404(a)(9) limits.

Prohibited Transaction Exemption

  1. There is a prohibited transaction exemption for loans to a leveraged ESOP. See IRC 4975(d)(3) and IRC 4975(e)(7). The loan to the ESOP is not a prohibited transaction if:

    1. The loan is primarily for the benefit of plan participants.

    2. The loan is at a reasonable interest rate and any collateral given to a disqualified person by the plan consists only of qualifying employer securities.

  2. The leveraging transaction described in IRM 4.72.4.2.1, Establishment and Operation of an ESOP, would be a prohibited transaction if the plan was not an ESOP. The lending of money or other extension of credit between a plan and a disqualified person, such as the employer, is a prohibited transaction under IRC 4975(c)(1)(B). The employer’s guarantee to the lender that the ESOP will repay the loan is an extension of credit to the plan. See 26 CFR 54.4975–7(b)(1)(ii).

Examination Steps

  1. As part of the pre-examination planning, determine whether Form 5309, Application for Determination of Employee Stock Ownership Plan, has been filed.

    1. If Form 5309 was not filed, indications are the plan never intended to be an IRC 4975(e)(7) ESOP and/or it has never been updated for changes in the regulations.

    2. If Form 5309 was filed, verify that a determination letter was requested and received specifically with respect to whether the plan is an ESOP under IRC 4975(e)(7).

  2. A question on the Form 5500 series asks for information about the plan features.

    Note:

    Code 2P is completed for leveraged ESOPs.
    Code 2O is filled in for non-leveraged ESOPs.
    Code 2Q is filled in for Sub S corporations.

Qualification Requirements

  1. When the ESOP is established as a portion of the plan, the ESOP portion must meet IRC 4975(e)(7) and certain portions of IRC 409. The plan as a whole must meet IRC 401(a).

ESOP Defined

  1. An ESOP is a defined contribution plan which is a stock bonus plan, or a stock bonus plan and money purchase plan. See IRC 4975(e)(7).

    1. When the trust books are kept separately for each type of plan, the applicable rules are applied to the ESOP accounts. When the accounts are kept as a whole, break down the accounts by plan to ensure the necessary requirements are being followed.

    2. If a plan fails to be an ESOP under IRC 4975(e)(7) and IRC 409, it can still be a qualified plan (such as a stock bonus plan) under IRC 401(a).

Examination Steps
  1. Check whether the ESOP is a portion of the plan.

  2. If yes, make sure the ESOP requirements apply to the portion of the trust assets that make up the ESOP.

Floor Offset Arrangements

  1. Generally, under the prohibited transaction rules of ERISA, a plan may not invest more than 10 percent of its assets in qualifying employer securities. This limitation does not apply to an eligible individual account plan. See ERISA 407(a) and (b).

    1. An ESOP is an eligible individual account plan, unless its benefits are taken into account in determining the benefits payable to a participant under any defined benefit plan. See ERISA 407(d)(3)(C).

    2. This means an ESOP cannot be used to offset the benefits under a defined benefit plan in a floor-offset arrangement, effective with respect to arrangements established after December 17, 1987. After that effective date, a floor-offset arrangement is treated as a single plan for purposes of the 10 percent limit.

    3. Where the 10 percent limit is exceeded, a prohibited transaction has taken place under IRC 4975(c)(1)(A) due to the sale or exchange of employer securities between a plan and a disqualified person which is not exempt under IRC 4975(d)(13), if there is a transaction with a disqualified person.

Examination Steps
  1. If Then
    The employer maintains a defined benefit plan established after 12-17-1987 Determine if a floor-offset arraignment exists.
    A floor-offset arraignment exists Determine if more than 10% of assets are invested in employer securities
    The employer securities comprise more than 10% of combined plan assets Assess IRC 4975 on the FMV of employer securities in excess of 10%.

Joint and Survivor Annuity Rules

  1. IRC 401(a)(11)(C) provides an exception to the qualified joint and survivor annuity (QJSA) and qualified preretirement survivor annuity (QPSA) requirements for the portion of a participant’s accrued benefit in an ESOP to which the IRC 409(h) rules apply.

  2. The exception is applicable where the plan provides that the ESOP participant’s vested benefits are payable to the spouse on death, where the participant does not elect a life annuity, and where the ESOP is not a transferee plan of assets from a defined benefit plan or a defined contribution plan subject to IRC 412 minimum funding standards. See 26 CFR 1.401(a)–20, Q&A 3(c).

Examination Steps
  1. Verify that the ESOP contains QJSA and QPSA language.

  2. If not, insure the ESOP contains language that satisfies the exception to the QJSA and QPSA requirements.

Participation, Coverage and Nondiscrimination Requirements

  1. The coverage requirements of IRC 410(b) and the nondiscrimination requirements of IRC 401(a)(4) are applicable to an ESOP. These requirements must be satisfied separately by an ESOP. An ESOP may not be considered together with another plan in order to meet the coverage or nondiscrimination requirements. See 26 CFR 54.4975–11(e)(1), 26 CFR 1.410(b)–7(c)(2) and 26 CFR 1.401(a)(4)–1(c)(4).

  2. An ESOP cannot be aggregated with another plan.

    Example:

    The use of matching employer contributions to an ESOP to satisfy nondiscrimination requirements relating to qualified cash or deferred arrangements (CODAs) (including a cash or deferred arrangement which forms a portion of the ESOP) is not permitted. See 26 CFR 1.401(k)–1(b)(3)(ii)(B), IRC 401(k)(3) and IRM 4.72.2, Employee Plans Technical Guidance, Cash or Deferred Arrangements (CODAs).

  3. An ESOP cannot satisfy the IRC 401(a)(4) nondiscrimination requirements through the use of the nondesign-based safe harbor rules under 26 CFR 1.401(a)(4)–2(b)(3), or by cross-testing under 26 CFR 1.401(a)(4)–8(b).

  4. Note that on December 29, 2004, new IRC 401(k) and (m) regulations were published. These regulations are effective for plan years beginning after 2005. However, employers are permitted to apply these regulations to any plan year ending after September 9, 2004, provided the employer applies all the rules in the regulations for that year and for all subsequent years. The new regulations eliminate the disaggregation of the ESOP and non-ESOP portions of a single IRC 414(l) plan for purposes of Actual Deferral Percentage and Actual Contribution Percentage testing and allowed an employer to permissively aggregate two IRC 414(l) plans; one that is an ESOP and one that is not.

Examination Steps
  1. Check that the ESOP satisfies the participation, coverage and nondiscrimination requirements while being aggregated with any other plan, or with the non-ESOP portion of the plan of which it is a part.

  2. In the case of an ESOP which is part of a CODA, check the terms of the ESOP to ensure that if the employer matches the employees’ elective deferrals under the CODA by making contributions to the ESOP, the matching contributions to the ESOP are not taken into account for purposes of meeting the nondiscrimination rules of IRC 401(k). Also, check the CODA’s terms. Insure also that the ESOP matching contributions satisfy IRC 401(m). See IRM 4.72.3, Employee Plans Technical Guidance, Employee Contributions and Matching Contributions.

Vesting

  1. For ESOPs, the vesting requirements of IRC 411 and the top-heavy requirements of IRC 416, apply.

Examination Step
  1. Check that ESOP participants vest in their accounts in accordance with the vesting rules in IRC 411 and IRC 416.

Deduction Limits

  1. An employer’s deduction for contributions to a stock bonus or profit-sharing plan is limited to 25 percent of the participants’ compensation.

  2. There are special deduction rules for contributions by a C corporation to an ESOP used to repay principal and interest on a loan to an ESOP. See IRC 404(a)(9).

  3. IRC 404(a)(9)(A) states that, for C corporations, notwithstanding the provisions of IRC 404(a)(3) and IRC 404(a)(7), an employer’s deduction for contributions paid to an ESOP to repay the principal on a loan used to acquire qualifying employer securities can be as high as 25 percent of the ESOP participants’ compensation.

  4. There is no IRC 404 limit on a C corporation's deduction for contributions to an ESOP used to repay interest on a loan. See IRC 404(a)(9)(B). However, the IRC 415 limits apply to allocations resulting from these contributions, unless the plan meets the requirements of IRC 415(c)(6). The ESOP must actually use the employer contributions to repay the loan by the due date of the employer’s return (including extensions) to take advantage of the increased limits.

    Example:

    Company M, a C corporation, maintains a leveraged ESOP. For the 2013 plan year, Company M makes a contribution of 30 percent of the participants’ compensation to repay principal and interest on the ESOP loan: 25 percent of compensation was used to repay the principal on the loan and five percent of compensation was used to repay the interest on the loan. The entire 2013 contribution is deductible under IRC 404(a)(9).

IRC 404(k) Deduction
  1. In addition to the deduction permitted under IRC 404(a)(3) and IRC 404(a)(9), IRC 404(k)(a), provides that a C corporation may deduct dividends paid on employer securities held by an ESOP, "applicable dividends" . In order to take advantage of the dividend deduction, the terms of the plan must provide that the dividends are paid in one of the following ways:

    1. In cash to participants, or

    2. To the ESOP and, within 90 days after the close of the plan year in which the payment was received, distributed in cash to the participants.

    3. At the election of the participant under one of the following methods:

      1. As provided in (a) or (b) above, or

      2. Paid to the plan and reinvested in qualifying employer securities

      Note:

      An ESOP can offer participants a choice among the options described in bullets (1) and (2) above. See Notice 2002-2.

    4. As payments on the exempt loan that acquired the shares that generated the dividend.

    Note:

    If dividends on allocated stock are used to repay a loan, the fair market value of employer securities released from suspense and allocated to participants’ accounts must equal or exceed the amount of such dividends. This allocation due to the use of dividends is in addition to the allocation due to the loan repayment.

  2. IRC 404(k) also provides that any payment or distribution described therein will not cause a plan to violate IRC 401, IRC 409, or IRC 4975 or engage in a prohibited transaction under IRC 4975(d)(3).

  3. A dividend that is unusually large could be an attempt to evade taxes and should be challenged. See IRC 404(k)(5)(A) which provides for the disallowance of an IRC 404(k) dividend deduction if the dividend constitutes, in substance, an evasion of taxation. Note that applicable dividends must also meet the requirements of IRC 316.

    Example 1: Amounts paid that exceed accumulated and current earnings and profits may not constitute a dividend. Amounts that constitute the payment of unreasonable compensation, or are not reasonable dividends, are an evasion of taxation and cannot be deducted as dividends under IRC 404(k). An example of a reasonable dividend is one that is at a rate normally paid by the employer in the ordinary course of business.

    Example 2: Company M repays an exempt loan with dividends on employer securities acquired with exempt loan proceeds. Company M claims a dividend deduction under IRC 404(k). The dividend rate is 70 percent which is determined to be excessive since it goes far beyond the amount of dividends Company M can reasonably be expected to pay on a recurring basis. These dividends are not reasonable and are not deductible under IRC 404(k).

  4. Corporate payments in redemption of stock held by an ESOP that are used to make distributions to terminating ESOP participants do not constitute "applicable dividends" under IRC 404(k) and are not deductible. See Rev. Rul. 2001–6, 26 CFR 1.162(k)-1 and 26 CFR 1.404(k)-3. This is an issue being litigated by Chief Counsel. Chief Counsel should be notified if this type of deduction is found.

  5. IRC 404(k) dividend deductions are not applicable to Sub S corporation ESOPs. However, Sub S corporation distributions (as described in IRC 1368(a)) on allocated or unallocated stock in an ESOP may be used to pay down an ESOP loan. See IRC 4975(f)(7).

Examination Steps
  1. In order to determine compliance with the IRC 404 limits, examine cancelled checks, payroll records, trust receipts along with disbursement records, and participant’s accounts. Problems could also arise if the number of participants decreased so as to lower the deductible limits.

  2. Look at the Form 5500 Schedule H, Question (2)b(2) to determine whether dividend income was received.

  3. Check whether dividends on employer securities (allocated or unallocated) were used to pay down the exempt loan or were distributed to participants. If dividends on allocated stock were used, check to see that the affected participants' accounts were reimbursed by shares with the same fair market value as the dividends.

  4. Check whether the dividends paid on employer securities held by the ESOP are reasonable. A reasonable dividend will not exceed the dividend the ESOP sponsor can reasonably be expected to pay on a recurring basis.

  5. Determine whether any corporate redemptions of ESOP stock were deducted under IRC 404(k). If yes, disallow the deduction.

Distributions

  1. Distributions from an ESOP may be made in cash subject to the participant’s right to demand distribution in the form of employer securities. An employee also has the right to require the employer to repurchase certain employer securities which the employee receives in a distribution. See IRM 4.72.4.3.8, Put Option. If the employer’s corporate charter (or by-laws) restricts the ownership of substantially all outstanding employer securities to employees or to a trust under a qualified plan, the participant may be precluded from demanding a distribution in the form of employer securities. Also, TRA ’97 provides that an ESOP which is maintained by a Sub S corporation can preclude the distribution of employer securities to a participant. See IRC 409(h).

  2. IRC 409(o) provides that an ESOP participant who is entitled to receive a distribution can elect to commence distributions sooner than the period described under IRC 401(a)(14) and IRC 401(a)(9). A participant can elect, with the consent of his/her spouse (as required by IRC 401(a)(11) and IRC 417), to commence the distribution of his/her account balance not later than one year after the close of the plan year— (i) in which the participant separates from service by reason of normal retirement age, disability, or death, or (ii) the fifth plan year following the plan year in which the participant otherwise separates from service, as long as the participant is not reemployed by the employer before this distribution is required to begin. IRC 409(o) applies to stock acquired after December 31, 1986.

    1. The election for accelerated distribution does not apply to any employer securities acquired with the proceeds of an ESOP loan until the close of the plan year in which the loan is repaid in full.

    2. Unless the participant elects otherwise, the account balance must be distributed in substantially equal periodic payments (at least annually) over a period not to exceed five years. Equal periodic payments may be measured in dollars or shares.

    3. If the participant’s account balance exceeds $800,000 (adjusted for cost-of-living increases), the distribution period is increased, unless the participant elects otherwise, to five years plus one additional year (up to five additional years) for each $160,000 (adjusted for cost-of-living increases), or fraction thereof, by which the balance exceeds $800,000 (as adjusted). See Notice 95–55, 1995–45 IRB 11.

  3. If an ESOP acquires more than one class of employer securities available for distribution with the proceeds of the loan, the distributee must receive substantially the same proportion of each class. Thus, a distributee may not receive only non-voting or preferred stock if the loan proceeds were also used to acquire voting common stock. See 26 CFR 54.4975–11(f)(2).

    1. The above distribution is based on shares allocated to a participant’s account and such allocation is proportionate (as to separate classes of stock) with respect to shares acquired with each loan.

    2. This rule does not apply when separate loans at separate times are used to buy different classes of stock.

  4. Assets released from a suspense account (described in IRM 4.72.4.4.6, Release from Suspense Account, and allocated to a participant’s account can be forfeited only after other assets have been forfeited. See 26 CFR 54.4975-11(d)(4).

Examination Steps
  1. Make sure the plan gives employees the right to get a distribution in the form of employer securities, unless the corporate charter or by-laws restricts stock ownership to employees or to a qualified plan, or unless the ESOP is maintained by a Sub S corporation that precludes the distribution of employer securities to participants.

  2. Check the plan to make sure a participant can elect an accelerated distribution under IRC 409(o).

  3. Look at the assets allocated to a participant from the suspense account. If securities available for distribution consist of more than one class, check that the participant received substantially the same proportion of each class as reflected in the suspense account assets available for distribution.

  4. Check that the released suspense account assets allocated to a participant’s account were forfeited after other assets were forfeited. If more than one class of qualifying employer securities has been allocated to a participant’s account, make sure the participant forfeits the same proportion of each class.

Put Option

  1. IRC 409(h) and 26 CFR 54.4975–7(b)(10) require an employer security to be subject to a put option if, when distributed, are either:

    1. Non-readily tradable on an established market, or

    2. Subject to a trading limitation

  2. Employer securities are "readily tradable on an established securities market" if they are "readily tradable" as defined at 26 CFR 54.4975–7(b)(1)(iv). "Publicly traded" includes securities that are:

    1. Listed on a national securities exchange registered under section six of the Securities Exchange Act of 1934.

    2. Quoted on a system sponsored by a national securities association registered under section 15A(b) of the Securities Exchange Act of 1934.

  3. The National Association of Securities Dealers (NASD) is a national securities association registered under section 15A(b) of the Securities Exchange Act of 1934. It runs the National Association of Securities Dealers Automatic Quotation System (NASDAQ). Therefore, stocks traded on NASDAQ are readily tradable.

    Note:

    Stocks listed on the "pink sheets" are non-readily tradable because the "pink sheets" are not a system sponsored by the NASD.

    Note:

    Notice 2011-19, 2011-1 CB 550, provides that, generally effective for plan years beginning after January 1, 2012, the term "readily tradable" as defined in 26 CFR 1.401(a)(35)-1(f) will apply for purposes of IRC 409(h) ("put options" ) as well as for all other ESOP purposes, such as for IRC 401(a)(28)(C), IRC 401(a)(35) and IRC 409(l). This definition includes securities described in 26 CFR 54.4975-7(b)(10), but also adds securities traded on a foreign national securities exchange that is officially recognized, sanctioned or supervised by a governmental authority and where the security is deemed by the Securities and Exchange Commission (SEC) as having a ready market under its rules. Under the current SEC rules, a security that is included on the FTSE Group All-World Index is deemed to have a ready market.

  4. The put option must permit a participant to "put" the security to the employer. However, if the employer will violate federal or state law by honoring such put option, the put option must permit the security to be put, in a manner consistent with such law, to a third party (other than the ESOP) that has substantial net worth at the time the loan is made and whose net worth is reasonably expected to remain substantial. An ESOP cannot be required to honor a put option, but it can have the right to assume the obligations of the put option.

  5. The put option must be exercisable for at least 60 days following the date of the distribution and for at least an additional 60 day period in the following plan year. See IRC 409(h)(4).

    1. If the participant receives a total distribution which is required to be repurchased by the employer, the employer must make payments in substantially equal periodic payments (at least annually) over a period beginning not later than 30 days after exercise of the put option and not exceeding five years. The employer must provide adequate security and pay reasonable interest on the unpaid amounts of the total distribution. See IRC 409(h)(5).For more on what constitutes adequate security, see the example in IRM 4.72.4.3.8.1, Examination Steps.

  6. If the participant receives installment distributions which are required to be repurchased by the employer, the employer must pay for the securities no later than 30 days after the put option is exercised. See IRC 409(h)(6).

  7. In the case of an ESOP established and maintained by a bank or similar financial institution which is prohibited by law from redeeming or purchasing its own securities, an exception to the general rule provides that put options be given on securities that are non-readily tradable. No put option is required if participants have the right to receive distributions in cash.

Examination Steps
  1. Check that employer securities non-readily tradable on an established market are allowed to be put to the employer.

  2. Make sure the put is exercisable for two 60 day periods:

    1. Sixty days following the date the employer securities were distributed and

    2. Sixty days in the following plan year.

  3. If the employee puts shares to the employer received in a total distribution, make sure the employer provides adequate security and pays reasonable interest on the unpaid portion. A put option is not adequately secured if it is not secured by any tangible assets.

    Example:

    Adequate security may be an irrevocable letter of credit, a surety bond issued by a third party insurance company rated "A" or better by a recognized insurance rating agency, or by a first priority perfected security interest against company assets capable of being sold, foreclosed upon or otherwise disposed of in case of default. Promissory notes secured by a company’s full faith and credit are not adequate security. In addition employer securities do not constitute adequate security.

Allocations

  1. Assets released from the suspense account under an IRC 4975 ESOP due to repayment of an exempt loan must be allocated to the participants’ accounts at the end of the plan year. This allocation must be based on shares of stock or other non-monetary units, rather than by dollar amounts. See 26 CFR 54.4975–11(d)(1) and (2).

Examination Step
  1. Check the participants’ accounts to verify the trustee is following the plan’s allocation formula.

Qualifying Employer Securities

  1. An ESOP must invest primarily in qualifying employer securities. See IRC 4975(e)(7). There is no specific percentage that defines the term "primarily." It is a flexible term that takes into account facts and circumstances such as the investment performance of the qualifying employer securities.

  2. An ESOP can sell qualifying employer securities or refrain from purchasing additional securities based on the investment performance of the securities. This would be consistent with the fiduciary duties under Title I of ERISA. The Department of Labor (DOL) stated in Advisory Opinion 83–6A (January 24, 1983) there may be instances where the investment of more than 50 percent of plan assets in qualifying employer securities would not satisfy the fiduciary responsibility requirements of Title I. The DOL Advisory Opinion concluded the "primarily" requirement must be satisfied over the life of the ESOP.

  3. IRC 4975(e)(8) defines a "qualifying employer security" as an employer security within the meaning of IRC 409(l). IRC 409(l) provides that employer securities consist of the following:

    1. Common stock issued by the employer, or by a corporation within the same controlled group, which is readily tradable on an established securities market. This requires that sales of the stock take place regularly and consistently based on the facts and circumstances.

    2. If there is no readily tradable common stock, closely held common stock of the employer which has a combination of voting power and dividend rights equal to or greater than the class of common stock of the employer having the greatest dividend rights.

    3. Noncallable preferred stock if the stock is convertible into stock which satisfies the requirements of a) or b) above, and the conversion price is reasonable on the date the ESOP acquired the preferred stock.

  4. For purposes of IRC 409(l), a "controlled group of corporations" is defined at IRC 1563(a), but without regard to the insurance company rule at IRC 563(a)(4) and the exemption from the attribution rules for plan trusts provided at IRC 1563(e)(3)(C).

    1. IRC 409(l)(4)(B) addresses situations when a first tier subsidiary would be considered includable in a controlled group of corporations for purposes of IRC 409, even when the parent owns less than 80 percent of the first tier subsidiary. The effect of this provision is to permit the acquisition of the controlling corporation’s stock by an ESOP maintained by the first tier subsidiary. If a corporation owns directly stock possessing 50 percent of the voting power in all classes of stock and at least 50 percent of each class of non-voting stock in the first tier subsidiary, then the first tier subsidiary (and all other corporations below it in the chain which would meet the 80 percent test of IRC 1563(a) if the first tier subsidiary were the parent) is considered to be an "includable corporation" for IRC 409 purposes.

    2. IRC 409(l)(4)(C) addresses situations when a second-tier subsidiary would be considered includable in a controlled group of corporations for purposes of IRC 409. The effect of this provision is to permit the acquisition of the controlling corporation’s stock by an ESOP maintained by the second-tier subsidiary. If a corporation owns directly stock possessing all of the voting power in all classes of stock and all of the non-voting stock of a first-tier subsidiary, and if the first-tier subsidiary owns stock possessing at least 50 percent of the voting power of all classes of stock and at least 50 percent of each class of non-voting stock of the second-tier subsidiary (and all other corporations below it in the chain which would meet the 80 percent test of IRC 1563(a) if the second-tier subsidiary were the common parent) is considered to be an "includable corporation" for purposes of IRC 409.

Examination Steps
  1. Examine the ESOP’s investment accounts to verify it is investing primarily in employer securities.

  2. If the ESOP holds closely held common stock of the employer, check that the employer has no readily tradable common stock. This information may have to be requested from the employer. If there is readily tradable common stock, then the ESOP cannot hold the closely held stock.

  3. If the ESOP holds preferred stock, determine whether the conversion price is reasonable. Look at the conversion formula in the corporate charter documents. If the conversion formula does not allow participants to share in any appreciation in the value of the common stock, the conversion price is not reasonable.

    Note:

    A conversion price that is based on the common stock’s fair market value as of the date the ESOP acquired the preferred stock is reasonable because it permits participants to share in all of the appreciation in the value of the common stock. A formula that includes a conversion premium is permitted if the conversion premium is reasonable. The reasonableness of a conversion premium is determined on its facts and circumstances. Generally, a reasonable conversion premium will be in the 20to 30 percent range. A conversion price which is neither a stated dollar amount nor a fixed ratio between the preferred and common stock should be examined closely. For example, a variable conversion price based on the reduction in the ESOP debt may call into question the valuation of the preferred stock.

Permitted Disparity

  1. ESOPs established after November 1, 1977, cannot be integrated with Social Security benefits.

  2. ESOPs established and integrated on or before November 1, 1977, can remain integrated. Such plans can continue to operationally increase the integration level if the increase is determined by reference to criteria existing outside of the plan.

    1. Plans can not be amended to increase the integration percentage or level. See 26 CFR 54.4975–11(a)(7)(ii).

    2. The permitted disparity rules of IRC 401(l) do not apply to ESOPs established after November 1, 1977. ESOPs that were establish and integrated on or before November 1, 1977, can continue to use permitted disparity. See 26 CFR 1.401(l)–1(a)(4).

Examination Steps
  1. During an examination you may encounter integrated ESOPs. Examine corporate minutes, the plan itself, amendments subsequent to adoption, and relevant dates to verify the plan was established on or prior to November 1, 1977, and the integration level or percentage has not been increased by plan amendment(s).

  2. Verify that no ESOP established after November 1, 1977, is integrated.

Valuation

  1. Since ESOPs are designed to invest primarily in employer securities, you must be able to determine the fair market value of qualified employer securities. See IRM 4.72.8, Employee Plans Technical Guidance, Valuation of Assets in Defined Contribution Plans.

Examination Steps
  1. In order to gain an understanding of the financial situation of the plan, review the Schedule H or I, which ever is applicable. Pay particular attention to the information reported about investments in employer securities, party-in-interest transactions, acquisition indebtedness, noncash contributions (may indicate the acquisition of employer securities) and other liabilities (which may indicate the plan is leveraged.

    Note:

    For small plans holding only employer securities, add beginning of the year assets to contributions (and other plan receipts, if applicable) and subtract distributions (and other plan expenses/disbursements, if applicable). If the total equals year end assets, it is likely that a valuation was not preformed. This basic computation reflects that assets increased or decreased due to receipts and disbursements and not due to a change in the value of employer stock held by the plan.

    Note:

    If a plan has 100 or more participants at the beginning of the year, Schedule H is filed with Form 5500. If the number of participants at the beginning of the year is less than 100, a Schedule I is filled.

  2. When the stock is readily tradable, examine stock confirmation slips, trust receipt and disbursement accounts, and market records to verify the fair market value of security transactions.

  3. Where stock is non-readily tradable, and the transaction does not involve a disqualified person, the fair market value must be determined as of the plan’s most recent valuation date. Examine the records used to value the stock at the last valuation date in order to determine whether the assigned value is in line with the value of comparable non-readily tradable companies. See 26 CFR 54.4975–11(d)(5).

  4. Where stock is non-readily tradable and the transaction involves a disqualified person, the fair market value must be determined as of the transaction date. Secure the appraisal report, if one was prepared and use it as a basis for verifying the adequate consideration rules. If possible, request both the prior and subsequent appraisals for comparison purposes. If the appraisal method is not consistently applied, inquire as to the reason for the change. Additionally, determine whether any projections used were reasonable estimates of what has actually occurred.

    Note:

    Particular attention should be given to subsequent events that could have been foreseen and have an impact on value. See Rev. Rul. 59-60. The independent appraisal will not, in and of its itself, be a good faith determination of value if all relevant factors are not considered in the report. Also, examine the capital stock accounts of the employer to substantiate transactions of similar stock. If there is a problem with the stock valuation, make a referral to engineering services using the web-based Specialist Referral System.

Independent Appraiser
  1. IRC 401(a)(28)(C) provides that employer securities acquired by an ESOP (whether by contribution or purchase) after December 31, 1986 that are non-readily tradable on an established securities market must be valued by an independent appraiser (within the meaning of IRC 170(a)(1)). Valuation by an independent appraiser is not required in the case of employer securities which are readily tradable on an established securities market. See IRM 4.72.8.7.1, Independent Appraiser Rules for a detailed discussion of the independent appraiser rules for non-readily tradable shares held by an ESOP.

Examination Step
  1. Review question 12 on Form 5500, Annual Return/Report of Employee Benefit Plan, Schedule R, Retirement Plan Information, to determine whether employer securities held in an ESOP are non-readily tradable on an established securities market. Also, review corporate documents to determine if these securities were valued by an independent appraiser.

Employer Securities and Prohibited Transactions
  1. The fiduciary is responsible for determining that employer securities are properly valued. It is not considered good faith for a fiduciary to simply rely on a third party valuation to establish that adequate consideration was paid. A fiduciary must make his/her own prudent investigation of value. This would include a review of the assumptions used in the valuation and a verification that the assumptions were still valid at the time the ESOP purchases the shares. See Donovan v. Cunningham, 716 F.2d 1455 (5th Cir. 1983) and Rev. Rul. 59–60.

    1. There is a prohibited transaction if an ESOP pays a disqualified person more than the fair market value for the employer securities. This would occur when a valuation of closely-held employer stock overstated the stock’s value.

    2. Generally, a prohibited transaction occurs when there is a sale of any property between a plan and a disqualified person. Without the exception provided by IRC 4975(d)(13) and ERISA 408(e), the acquisition of employer securities by the ESOP would be a prohibited transaction. See IRC 4975(e)(2)(C) which provides that the employer is a disqualified person and IRC 4975(c)(1)(A) which provides that the sale is prohibited.

      Note:

      Adequate consideration must be provided in order for the IRC 4975(d)(13)/ ERISA 408(e) exceptions to apply.

      Note:

      Adequate consideration is defined as the fair market value of the security as determined in good faith by the plan trustee or named fiduciary. See ERISA 3(18)

      .

Examination Steps
  1. Determine whether fair market value was paid for the stock by reviewing the valuation report conducted for purposes of determining the value of employer stock. There should be a correlation between earnings and share price. If the company’s earnings have fallen, but the report reflects a share price increase, further scrutiny is warranted since this may indicate the valuation report is incorrect. An analysis of the relationship between earnings and stock price should be conducted even if there is no valuation report.

  2. Check the employer’s audit report to see if the company’s earnings have fallen after the valuation date specified in the report. If earnings have fallen, share value should have a corresponding decrease. Clearly, the plan fiduciary can not rely on the share value specified in the valuation report because the facts on which the report was based have changed.

  3. The fiduciary is required to conduct a prudent investigation to ensure the underlying assumptions have not changed since the last valuation. Supporting documentation would have been generated by the fiduciary during his/her investigation. These documents should be requested for review and analysis.

Exclusive Benefit Rule
  1. An exclusive benefit violation may occur if an ESOP acquires stock for more than its fair market value, (e.g., the stock is acquired from a shareholder).

    1. Rev. Rul. 69–494, provides guidelines for determining whether a plan investment is consistent with the exclusive benefit rule. These guidelines, as applied to ESOPs, require a determination of whether the amount paid for the stock exceeds its fair market value at the time of acquisition. (Not all of the requirements contained in Rev. Rul. 69–494 apply to stock bonus plans and ESOPs.)

    2. An exclusive benefit violation should be considered only where there is a significant depletion of plan assets.

      Caution:

      A Technical Advice request may be required when an exclusive benefit violation is pursued. See IRM 4.71.13.4.1Mandatory Technical Advice for further information.

Examination Steps
  1. Determine whether fair market value was paid for the stock.

  2. Evaluate stock purchases for exclusive benefit violations by applying the fair market value rules of Rev. Rul. 69–494 at the time of the initial purchase and again at the time of any subsequent purchase. Even if the initial purchase did not violate the exclusive benefit rule, a subsequent purchase may have resulted in a violation.

  3. If employer securities are acquired by the ESOP at an inflated price, an exclusive benefit violation occurred. However, if the stock value subsequently increases to the point where the value results in a benefit to plan participants, the issue should not be pursued.

    Reminder:

    Prohibited transaction excise tax under IRC 4975 would be applicable if the stock was acquired from a disqualified person (e.g. the employer or a substantial shareholder of the employer)

  4. An exclusive benefit violation doesn’t automatic occur when employer securities acquired at fair market value subsequently decline in value. Additional investigative steps must be taken to determine the accuracy of the lower share price.

Voting Rights

  1. Employer securities held by an ESOP must meet the IRC 409(e) requirements pertaining to voting rights.

    1. If the employer has a "registration-type class of securities," each participant must be entitled to direct the plan as to the manner in which employer securities, allocated to the account of such participant, are to be voted. A registration-type class of securities means a class of securities required to be registered under section 12 of the Securities Exchange Act of 1934.

    2. If the employer does not have a registration-type class of securities, each participant must be entitled to direct the plan as to the manner in which voting rights under employer securities, allocated to the account of such participant, are to be exercised with respect to any corporate matter which involves the voting of such shares with respect to the approval or disapproval of a corporate merger or consolidation, recapitalization, reclassification, liquidation, dissolution or sale of substantially all assets of a trade or business. The right to direct the plan as to the voting of allocated securities in the above instances exists only if the applicable state law also provides for shareholder voting in those instances.

    3. If a plan trustee does not receive voting instructions on employer securities allocated to a participant’s account, the plan can provide that the trustee will vote those shares. See Rev. Rul. 95–57.

Examination Steps
  1. Check the plan terms to make sure participants are entitled to vote employer securities allocated to their accounts.

  2. Check the summary plan description to make sure participants are aware of their right to vote allocated employer securities in accordance with IRC 409(e).

  3. Check the corporate minutes to determine whether any events occurred that entitle participants to pass-through voting.

Diversification Election - IRC 401(a)(28)(B)

  1. For employer securities acquired after December 31, 1986, IRC 401(a)(28)(B) provides that each "qualified participant" in a plan may elect, within 90 days after the close of each plan year in the "qualified election period" , to direct the plan with regard to the investment of at least 25 percent of the participant’s plan account. The account balance subject to the diversification election increases to 50 percent in the final year of the election period.

    A qualified participant is an employee that satisfies the two requirement below:
    1. Reached age 55, and

    2. Completed at least 10 years of participation

    Note:

    Years the employee participated in a predecessor plan must be included in determining years of participation in the plan.


    The qualified election period is the sixth plan year period beginning with the later of:
    1. The first plan year in which the individual first became a qualified participant

    2. The first plan year beginning after December 31,1986.

  2. In general, for plan years beginning after December 31, 1986, an ESOP which is described in IRC 401(a)(35) (i.e., an ESOP which has readily tradable employer securities and which is a portion of another plan or has assets attributable to IRC 401(k) or (m)) is not subject to IRC 401(a)(28)(B). Q&A–9 of Notice 88–56, provides that the portion of a qualified participant’s account subject to the diversification election in all years of the qualified election period (other than the final year) is equal to:

    1. Twenty-five percent of the number of shares of employer securities acquired by the plan after December 31, 1986, that have ever been allocated to a qualified participant’s account, less

    2. The number of shares of employer securities previously diversified pursuant to a diversification election made after December 31, 1986.

    Note:

    All ESOPs not subject to IRC 401(a)(35) remain subject to the diversification requirements of IRC 401(a)(28)(B)

Diversification Requirement
  1. There are three methods by which a plan can satisfy the diversification requirement. The first two (subparagraph a) and b) below) are contained in IRC 401(a)(28)(B)(ii). The third method (subparagraph c) below) is authorized by Notice 88–56, Q&A–13. The plan can:

    1. Provide that the portion of the participant’s account subject to the diversification election is distributed within 90 days after the period in which the election can be made.

    2. Offer at least three investment options to each participant making the diversification election, and within 90 days after the election period ends, the plan invests the portion of the amount in accordance with the diversification election.

    3. Offer a participant the option to direct the plan to transfer the portion of the account subject to the diversification election to another qualified defined contribution plan of the employer that offers at least three investment options. This transfer must be made no later than 90 days after the end of the election period.

Examination Step
  1. Check that the plan provides a diversification election for employer securities acquired after December 31, 1986.

Diversification Requirement - IRC 401(a)(35)
  1. The IRC 401(a)(35) diversification rules apply to all defined contribution plans (ESOP or non-ESOP) which hold any readily tradable employer securities (applicable defined contribution plans). IRC 401(a)(35) is generally effective for all plan years starting after December 31, 2006.

  2. All ESOPs which are stand-alone (i.e., not a portion of another plan and don’t have any assets attributable to elective deferrals or matches) are exempted from these requirements. Thus, IRC 401(a)(35) is applicable to the following plans:

    1. A stock bonus plan with readily tradable employer securities,

    2. An ESOP with such securities that is a portion of any other plan (plans that combine an ESOP with a 401(k), (KSOPs))

    3. A stand-alone ESOP with such securities and has assets attributable to elective deferrals or employer matches.

      Note:

      A plan is not considered to hold amounts subject to IRC 401(k) or (m) if there are rollover accounts containing separate accounts that were previously subject to those sections.

  3. A plan holding non-readily tradable employer securities is treated as being subject to the IRC 401(a)(35) diversification requirements if any member of a control group that includes the employer maintaining the plan has issued readily tradable stock.

  4. These diversification rules apply to employer securities attributable to a participant’s elective deferrals and after tax contributions without regard to the participant’s years of service. However, with regard to employer securities attributable to employer non-elective contributions, these rules apply only to participants who have completed three years of service.

  5. Diversification requirements:

    1. The plan must offer at least three investment options, other than employer securities and allow the participant the opportunity to switch out of employer securities no less frequently than quarterly. However, if the non-employer security investment account within the plan provide for an investment change more frequently than quarterly, the plan must allow for employer stock divestment at least as frequently as that investment right; for example, if the plan contains a non-employer security investment account (allowing for a trade a month), the plan must also allow the participant the right to switch out of employer securities at least once a month. An exception to this rule allows plans to limit short term trading in employer securities to seven days even if the plan contains a day trading investment option in other securities. See 26 CFR 1.401(a)(35)-1(e)(3)(iii).

      Example:

      If the plan contains a non-employer security investment account (allowing for a trade a month), the plan must also allow the participant the right to switch out of employer securities at least once a month.

      Exception:

      An exception to this rule allows plans to limit short term trading in employer securities to seven days even if the plan contains a day trading investment option in other securities. See 26 CFR 1.401(a)(35)-1(e)(3)(iii).

    2. A plan may not place a direct or indirect restriction on a participant’s right to divest employer securities that is not placed on other plan investment options.

      Example:

      An indirect restriction would be when the plan provides that upon the participant’s divestment of employer securities the participant is not allowed to reinvest in employer securities for a period of time. See 26 CFR 1.401(a)(35)-1(e)(ii)(B).

    3. Additionally, the plan can not provide a benefit that is conditioned on investment in employer securities.

      Example:

      A benefit conditioned on investment in employer securities would be a provision that provides for added employer matches for amounts invested in employer securities.

    Exception:

    A plan may also impose a percentage limit on the amount participants may invest in employer securities. See 26 CFR 1.401(a)(35)-1(e)(2)(ii) and (iii)

    Exception:

    Trading restrictions provided by securities law, as well as those which operate during the first 90 days after the plan becomes subject to IRC 401(a)(35).

Nonterminable ESOP Provisions and IRC 411(d)(6)

  1. After an ESOP ceases to be an ESOP (such as where the plan is amended and converted into a non-ESOP plan), the employee’s right to put non-readily tradable employer securities to the employer continues to exist. It is a nonterminable right described at 26 CFR 54.4975–11(a)(3)(ii).

  2. IRC 411(d)(6) and the Treas. Regs. thereunder provide that a plan will not satisfy the requirements of IRC 411 if the accrued benefit, early retirement benefit, retirement-type subsidy or optional forms of benefits of participants are eliminated or reduced by a plan amendment. IRC 411(d)(6)(C) provides an exception to the IRC 411(d)(6) prohibitions for ESOPs.

  3. 26 CFR 1.411(d)–4, A–2(d) provides guidance on the elimination, with respect to all participants, of IRC 411(d)(6) protected optional forms of benefits applicable to ESOPs.

    1. Optional forms of distributions (e.g. single sum, installment) can be eliminated.

    2. If the employer becomes substantially employee-owned, or the employer is a Sub S corporations (for taxable years of the employer beginning after December 31, 1997), the right to demand a distribution in employer stock can be eliminated and substituted with cash instead.

    3. Cash may be substituted for a distribution of employer securities when:

      • Employer securities become readily tradable (thereby eliminating the put option)

      • Employer securities cease to be readily tradable

      • Substantially all of the employer stock or assets of the employer’s business are sold and the employer securities continue to be readily tradable.

  4. Although the Commissioner of the Internal Revenue can provide additional rules and exceptions in revenue rulings, notices and other documents of general applicability, this has not been done at this time.

    Exception:

    Notice 2013-17, 2013-1 CB 1082, which provides relief from the anti-cutback requirements of IRC 411(d)(6) for ESOPs that were subject to IRC 401(a)(28)(B) and provided for in-service distributions of diversification amounts (an option provided for in that section), but have since become subject to the diversification requirements of IRC 401(a)(35).

    Reminder:

    IRC 401(a)(35) does not provide for in-service plan distributions. The Notice provides that these ESOPs may be amended to eliminate that option in order to conform with IRC 401(a)(35) without failing IRC 411(d)(6). General, applies to amendments that are both adopted and put into effect under an ESOP by the last day of the first plan year beginning on or after January 1, 2013, or by the time the plan must be amended to satisfy IRC IRC 401(a)(35)

    .

Examination Steps
  1. Make sure the right to put non-readily tradable employer securities to the employer is not eliminated when an ESOP is amended to become a non-ESOP.

  2. If an optional form of distribution is eliminated verify with the exceptions provided for ESOPs at 26 CFR 1.411(d)–4, A–2(d).

Loan Requirements

  1. The failure of a plan to follow the exempt loan rules results in the loan being non-exempt and subject to the prohibited transaction tax; it does not cause the plan to be disqualified or lose its status as an ESOP.

    1. An exempt loan is a loan that meets the requirements of 26 CFR 54.4975–7(b).

    2. A non-exempt loan is a loan that fails to satisfy the requirements of 26 CFR 54–4975–7(b).

  2. An exempt loan is a loan made to an ESOP by a disqualified person or a loan to an ESOP from a third party which is guaranteed by a disqualified person. See 26 CFR 54.4975–7(b)(1)(ii). Generally, these kinds of loans are prohibited transactions under IRC 4975(c)(1)(B) because they constitute the lending of money or other extension of credit between a plan and a disqualified person. IRC 4975(d)(3) provides that if the requirements for that section are met, such loans to an ESOP are exempt from the prohibited transaction rules.

Examination Step

  1. During the examination of an ESOP with loan provisions, if you determine the loan is non-exempt, refer to IRM 4.72.11, Prohibited Transactions.

Primary Benefit Requirement

  1. An exempt loan must be primarily for the benefit of the ESOP participants. Thus, the stated interest rate on the loan must be reasonable. When a loan is made to an ESOP, the interest rate of the loan and the price of the employer securities acquired with the loan proceeds must not result in a draining off of plan assets. See IRC 4975(d)(3) and 26 CFR 54.4975–7(b)(3).

Examination Steps
  1. Determine whether the loan’s interest rate and the price paid for the securities did not result in assets being draining from the plan. The prime interest rate, rates for a similar transaction, rates charged by banks, and rates charged by other financial institutions should be used as a measuring device to determine an acceptable interest rate.

  2. Scrutinize the loan against prior loans of the same nature and loans to other entities to determine whether arms-length dealing existed. Items to be compared are interest, cost of assets purchased, collateral, pre-payment penalties, and any other provisions or restriction in the terms of the loan. See IRM 4.72.4.3.12, Valuation, for methods used to determine fair market value.

  3. Any other facts and circumstances relating to the loan can be used to substantiate compliance with or violation of the primary benefit requirement.

Loan Proceeds

  1. Exempt loan proceeds must be used by an ESOP within a reasonable amount of time after their acquisition by the ESOP to either:

    1. Acquire qualifying employer securities.

    2. Repay the loan.

    3. Repay a prior exempt loan.

  2. Other than the right of first refusal and put option exceptions as provided in 26 CFR 54.4975–7(b)(9), securities acquired with exempt loan proceeds may not be subject to a put, call, option, or a buy-sell agreement or similar arrangement while held by the ESOP or when distributed from the ESOP. See IRM 4.72.4.4.8, Right of First Refusal, IRM 4.72.4.3.8, Put Option, and 26 CFR 54.4975-7(b)(4).

Examination Steps
  1. Examine the buy and sell slips, receipt records, and loan contracts to determine the exempt loan proceeds were used to:

    1. Purchase qualifying employer securities.

    2. Repay such loans.

    3. Repay a prior exempt loan.

  2. Examine the acquired employer securities to ensure there is no call, put, other option, buy-sell agreement or similar arrangement or any other restriction on the securities other than the exception for the right of first refusal and put options while held in the trust or when distributed.

Liability of ESOP for Loan

  1. A lender can seek repayment of an ESOP loan only out of the following plan assets:

    1. The employer securities acquired with exempt loan proceeds that are collateral for the loan.

    2. Collateral used in a prior exempt loan repaid with exempt loan proceeds.

    3. Contributions made to the ESOP to meet plan exempt loan obligations.

    4. Earnings on collateral or the contributions noted in c) above.

  2. The contributions and earnings must be accounted for separately on the books of the ESOP. See 26 CFR 54.4975–7(b)(5).

Examination Step
  1. Examine the ESOP, the assets, and the exempt loan contract to ensure that any recourse by the lender does not exceed or extend beyond the assets stated above.

Default

  1. If the lender is an unrelated third party (not a disqualified person) and the loan is secured by the employer securities held in the suspense account, suspense account assets can be transferred to the lender to the extent of the remaining loan amount.

  2. If the lender is a disqualified person (e.g., the employer), then the amount that can be transferred on default is limited to the amount of the missed payment. This prevents an employer from manipulating the default mechanism in order to use plan assets to repay an exempt loan. A default can cause a loan to be a non-exempt loan. See 26 CFR 54.4975–7(b)(6).

Examination Steps
  1. Determine whether there has been a default in repaying the loan.

  2. If there has been a default, check whether the shares in the suspense account are collateral for the loan.

  3. If the suspense account is collateral for the loan and the employer is the lender, make sure the employer does not use suspense account assets in an amount greater than the value of the missed payment(s).

  4. Determine whether the default has caused the loan to become non-exempt.

Release from Suspense Account

  1. Employer securities acquired with exempt loan proceeds are placed in a suspense account to be allocated to participants accounts as the loan is paid off by employer contributions.

  2. The loan is repaid and securities are released from a suspense account based on principal and interest payments.

    1. Securities can also be released from a suspense account based solely on principal payments if certain conditions are met. See 26 CFR 54.4975–7(b)(8).

      Note:

      This method will result in fewer shares being released and allocated in the earlier years of the loan. As with all loans, in the early years of the loan the portion of the loan payment attributable to principle is small and the portion attributable to interest is high.

    2. Sometimes employers will renew loans in which securities are released based only on principal payments in order to keep allocations low.

Examination Steps
  1. Check the plan and associated documents, such as administrative committee minutes or financial statements to determine the method used to release shares from the suspense account.

  2. If the shares were released based upon the principal only method, then determine whether the loan period, and any renewal extension, or refinancing period exceeds 10 years. The release of employer securities from a suspense account must revert to the principal and interest method when the loan period (including extensions) exceeds 10 years.

  3. Verify that as the loan is repaid, stock is released from the suspense account and allocated to participant accounts in accordance with the repayment provisions of the loan contract and plan document. If a situation is encountered where contributions have been missed or where large repayments are made to the lender, additional analysis should be conducted to determine if the effect of the missed payment(s)/large payment(s) is a violation of the anti-discrimination provisions of the Code.

Repaying Exempt Loan

  1. Employer securities acquired with exempt loan proceeds are placed in a suspense account to be allocated to participants’ accounts as the loan is paid off by employer contributions. If unallocated employer securities are used to repay the loan, they will not be available for allocation to participants’ accounts.

  2. IRC 4975(d)(3) and 26 CFR 54.4975–7(b)(3) provide that an exempt loan must be primarily for the benefit of the ESOP participants. Thus, a plan should not provide that the loan may be repaid using proceeds derived from the sale of unallocated employer securities held in the suspense account. However, if upon examination it is found that the ESOP engaged in this type of transaction, a determination of whether the primary benefit requirement was violated will be based on all the surrounding facts and circumstances. Factors to consider include:

    1. Whether the transaction promotes employee ownership of employer stock.

    2. Whether contributions to an ESOP that is part of a stock bonus plan are recurring and substantial.

    3. The extent to which the method of repayment of the exempt loan benefits the employees.

    4. All aspects of the loan transaction, including the method of repayment.

Examination Steps
  1. Make sure the plan provision covering repayment of the third party loan to the ESOP does not state that the loan can be repaid using proceeds derived from the sale of unallocated employer securities held in the suspense account.

  2. If in operation the plan uses the proceeds from the sale of suspense account assets to repay a loan, determine whether the facts and circumstances support a finding that the primary benefit requirement has not been violated.

Right of First Refusal

  1. The right of first refusal is an optional provision that can be used on qualifying employer securities acquired with exempt loan proceeds. This option is favorable for the employer and the ESOP since it enables an employer to keep shares of closely-held stock which have been distributed to a participant in friendly hands and out of the hands of third parties.

    1. When a participant receives an offer by a third party to buy non-readily tradable securities, the participant must notify the employer or ESOP (whichever holds the right of first refusal) of the written offer by the third party to purchase the securities.

    2. The employer, or ESOP, has 14 days to match the offer by the third party or to pay, if greater, the fair market value of the securities. See IRM 4.72.4.3.8, Put Option, and 26 CFR 54–4975–7(b)(9).

Examination Steps
  1. Examine the receipt and disbursement records of the ESOP securities and the employer securities accounts to determine if either the trust or the employer has purchased securities which had previously been distributed to a participant and then reacquired from the participant under a right of first refusal provided in the plan. If the securities in question were purchased originally with the proceeds of an exempt loan, then scrutinize the transaction to ensure:

    1. The stock is non-readily tradable at the time the right is exercised.

    2. The right only applies to the employer and/or the trust (ESOP).

    3. The right was only enforceable within 14 days from the date written notice was given to the holder of the right of an offer by a third party.

    4. The selling price and other terms are the greater of— (i) the fair market value per 26 CFR 54.4975–11(d)(5), or the price and terms offered by a buyer, excluding the employer and the trust (ESOP), making a good faith offer to purchase the security.

  2. Secure copies of the good faith offer and, if necessary, contact third parties and the former participants to verify the above requirements. Care should be taken to comply with disclosure requirements.

IRC 415 Limits

  1. An ESOP may be funded through an exempt loan (a leveraged ESOP) or may be funded directly by employer contributions (non-leveraged ESOP). Employer securities held by a leveraged ESOP are released from the suspense account and allocated to participants’ accounts by reason of employer contributions to the ESOP to repay the loan and by reason of the use of dividends on employer securities in the ESOP to repay the loan.

  2. If stock has been acquired in an exempt loan, annual additions under IRC 415(c) can be calculated under either of two methods:

    1. The amount of the employer contributions used to repay a loan.

    2. If provided for in the plan, the lesser of the amount in (a) or the value of the employer securities allocated with respect to such contributions.

  3. If an ESOP is not funded by an exempt loan, the fair market value of the employer securities on the date they were purchased by, or contributed to, the ESOP is treated as an annual addition.

  4. IRC 415(c)(6) provides that if not more than one-third of the employer contributions to an ESOP for a plan year are allocated to the accounts of participants who are highly compensated employees, within the meaning of IRC 414(q), then all forfeitures of leveraged stock and all employer contributions to pay interest on a leveraged loan which are charged against the participant’s account are eliminated from the computation of the annual addition. This is called a broad-based ESOP.

Examination Steps
  1. Determine whether the ESOP is funded by an exempt loan or by direct employer contributions.

  2. If the ESOP is not funded by an exempt loan, make sure the fair market value of stock on the date it was purchased by, or contributed to, the ESOP is treated as an annual addition.

  3. If the ESOP is funded by an exempt loan, determine whether annual additions are calculated based on employer contributions made to repay the loan, or based on the value of the employer securities allocated to participant accounts.

  4. If annual additions are calculated based on employer contributions to repay an exempt loan, a separate computation will be necessary to arrive at each participant’s share of the contribution used by the ESOP to repay the loan.

    1. Analyze the encumbered stock account and the liability accounts of the trust to determine the number of shares released from encumbrance and the employer contribution made, so that a contribution per share released figure can be determined.

      Note:

      TOTAL CONTRIBUTION TO PAY LOAN ÷ TOTAL NUMBER OF RELEASED SHARES = COST PER RELEASED SHARE

    2. Multiply the number of released encumbered shares allocated to a participant’s account by the cost per released share in order to arrive at an amount to be used to verify compliance with IRC 415.

    3. Do not include shares released due to the payment of dividends. Also, if you are examining a broad-based ESOP, do not include shares released due to the payment of loan interest.

  5. Determine if more than 1/1 of employer contributions to a leveraged ESOP were allocated to the accounts of highly compensated employees. If so, check that annual additions include forfeitures of employer securities and employer contributions used by the ESOP to pay interest on loans to acquire employer securities.

  6. Check the plan document to see if it permits the plan to use the special ESOP rules at IRC 415(c)(6).

Special ESOP Transactions

  1. Other issues involving ESOPs include:

    1. The exception to the reversion tax for a transfer to an ESOP.

    2. Nonrecognition sales of securities to an ESOP.

IRC 4980 Exception

  1. There is an exception to the tax on the amount of any employer reversion from a qualified plan to the extent any of the reversion is transferred to an ESOP. See IRC 4980(c)(3).

  2. The amount transferred to the ESOP, and the income therein, must be invested in employer securities or used to repay an ESOP loan that was used to purchase employer securities within 90 days.

    Note:

    An extension of the 90 day period may be granted by the Secretary.

    1. The amount allocated to participant accounts in the year of the transfer cannot be less than the lesser of:

      • The maximum allowable under IRC 415, or

      • 1/1 of the amount attributable to the securities acquired

    2. Any portion of the transferred amount which is not allocated to participant accounts in the year of the transfer must be credited to a suspense account (IRC 4980 suspense account) and allocated from that account to the accounts of participants ratably over a period not greater than seven years. Additional employer contributions to an ESOP cannot be made until the amount in the suspense account is fully allocated. When amounts are allocated to participant accounts from the IRC 4980 suspense account, they are treated as employer contributions for IRC 415 purposes, except the annual addition will not exceed the value of the securities when they were placed in the IRC 4980 suspense account.

    3. At least half of the participants in the qualified plan from which the reversion is being transferred must be ESOP participants as of the close of the first plan year in which the allocation is required.

Examination Steps
  1. Check whether the ESOP contains an IRC 4980 suspense account. If yes, go on to the other examination steps in this section.

  2. Check that the transferred assets were used within 90 days (or longer, if an extension was granted) to purchase employer securities or to repay a loan.

  3. Make sure amounts in the IRC 4980 suspense account are allocated over a period not greater than seven years.

  4. If the requirements of paragraphs (2) or (3) are not met, impose the 20 percent excise tax under IRC 4980(a) on the amount transferred to the ESOP.

Stock Sales

  1. Under IRC 1042, if a taxpayer or executor elects to sell qualified securities to an ESOP, and the taxpayer purchases qualified replacement property within the replacement period, then any long-term capital gain will be recognized only to the extent the amount realized on the sale exceeds the cost to the taxpayer of the qualified replacement property.

  2. After the sale, the ESOP must own at least 30 percent of either:

    1. Each class of outstanding stock of the corporation which issued the qualified securities.

    2. The total value of all outstanding stock of the corporation.

  3. The person or entity selling securities to the ESOP must have held the qualified securities for at least three years as of the time of the sale. The replacement period is the period which begins three months before and ends 12 months after the date of the sale of the qualified securities.

  4. "Qualified replacement property" is any security issued by a domestic operating corporation which:

    1. Did not, for the taxable year preceding the taxable year in which such security was purchased, have passive investment income in excess of 25 percent of the gross receipts of the corporation.

    2. Is not the corporation which issued the qualified securities.

  5. "Qualified securities" are employer securities, defined in IRC 409(l), issued by a domestic corporation that has no stock readily tradable on an established securities market, and was not received by the taxpayer from a qualified plan or pursuant to the exercise of a stock option.

  6. The taxpayer’s basis in the qualified replacement property is reduced by the amount of the gain not recognized by reason of the purchase. When the taxpayer disposes of any qualified replacement property, any gain is to be recognized to the extent of the gain which was not recognized due to the purchase of the qualified replacement property. But see the exception at IRC 1042(e)(3).

Prohibited Allocations for Purposes of IRC 409(n)

  1. IRC 409(n) states a plan must provide that the assets of an ESOP attributable to employer securities acquired by the ESOP in a sale to which IRC 1042 applies (IRC 1042 securities) cannot accrue for the benefit of the persons specified in IRC 409(n). Also, the IRC 1042 securities acquired by the ESOP cannot be allocated to the accounts of the persons specified in IRC 409(n) directly or indirectly under any qualified plan of the employer. Any stock acquired in a sale to an ESOP will be subject to the restrictions of IRC 409(n) if any of the sellers elect IRC 1042 treatment with respect to their sale of employer securities.

  2. Allocations of IRC 1042 securities cannot be made during the nonallocation period to any taxpayer who makes an IRC 1042 election, or to anyone who is related to the taxpayer within the meaning of IRC 267(b), unless the lineal descendant exception of IRC 409(n)(3)(A) applies.

    1. This exception provides that an allocation of IRC 1042 shares to a relative of the taxpayer who made the IRC 1042 election is not prohibited if he/she is a lineal descendant of the taxpayer, and the amount allocated to all such lineal descendants during the nonallocation period does not exceed five percent of the employer securities held by the plan attributable to a sale under IRC 1042 by a person related to such descendants (within the meaning of IRC 267(c)(4)).

    2. The lineal descendant exception does not apply to persons prohibited from allocations because they are treated as 25 percent shareholders, described below.

  3. The nonallocation period is the period beginning when the securities are sold to the plan pursuant to IRC 1042, and ends on the later of:

    1. Ten years after the date of the sale.

    2. The date this indebtedness is repaid, if the plan borrowed money to purchase the IRC 1042 securities.

  4. Allocations of IRC 1042 securities also cannot be made, at any time, to a person who owns, after the application of IRC 318(a), more than 25 percent of (i) any class of outstanding stock of the corporation which issued the employer securities or of any corporation which is a member of the same controlled group, or (ii) the total value of any class of outstanding stock of such a corporation.

    1. IRC 318(a) is applied to the "25 percent ownership of any class of stock" test without regard to the employee trust exception in IRC 318(a)(2)(B)(i). Therefore, stock owned by a qualified plan is attributed to a participant or beneficiary for purposes of (i) above.

    2. A person is treated as a 25 percent shareholder if he/she has the requisite ownership interest at any time in the one-year period ending on the date of the sale to the plan, or the date the securities are allocated to participants in the plan.

IRC 4979A Excise Tax for Purposes of IRC 409(n)

  1. If there is a prohibited allocation in violation of IRC 409(n) of qualified securities acquired in an IRC 1042 sale, the securities are treated as though they have been distributed to the participant. See IRC 409(n)(2).

  2. An excise tax under IRC 4979A is imposed if there is a prohibited allocation of qualified securities acquired in an IRC 1042 sale. The tax is equal to 50 percent of the amount involved and is to be paid by the employer sponsoring the plan.

IRC 4978 Excise Tax

  1. An excise tax under IRC 4978 can be imposed if, during the three year period after the date on which an ESOP acquired any qualified securities in a nonrecognition sale under IRC 1042, the plan disposes any of the securities and either of the following apply:

    1. The total number of shares held by the plan after the disposition is less than the total number of employer securities held immediately after the sale.

    2. Except to the extent provided in regulations, the value of qualified securities held by the plan after the disposition is less than 30 percent of the total value of all employer securities as of the disposition.

  2. The excise tax will be 10 percent of the amount realized on the disposition if either a. or b. above apply. However, the amount realized for this purpose will not exceed that portion allocable to qualified securities acquired in the sale to which the nonrecognition of gain provisions applied, determined as if such securities were disposed of from:

    1. IRC 1042 securities acquired during the three year period ending on the date of disposition.

    2. Any other employer securities.

  3. The three year holding period and excise tax do not apply to any distribution of qualified securities (or sale of such securities) which is made by reason of a participant’s:

    1. Death or disability.

    2. Separation from service for any period which results in a one-year break in service.

    3. Retirement after attaining 591/1 years of age.

  4. The following are exchanges or dispositions on which the excise tax is not imposed:

    1. An exchange of qualified securities in an IRC 368(a)(1) reorganization for stock of another corporation.

    2. An exchange of qualified securities in an IRC 332 liquidation into an eligible worker-owned cooperative.

    3. The disposition of shares pursuant to a diversification election under IRC 401(a)(28).

Examination Steps

  1. Check the applicable question on Form 5309 to determine whether the plan is designed to permit the purchase of employer securities under IRC 1042.

  2. Determine whether after the acquisition of the employer securities, the ESOP owned at least 30 percent of either:

    1. Each class of outstanding stock of the employer corporation.

    2. The total value of all outstanding stock of the corporation.

  3. Check that the employer securities sold to the ESOP were held for at least three years by the taxpayer prior to the sale. Refer to the taxpayer’s individual or corporate return, if necessary.

  4. Determine whether "qualified replacement property" was purchased within the replacement period by the taxpayer. Refer to the taxpayer’s individual tax return, if necessary.

  5. Determine whether any IRC 1042 securities are allocated to the persons specified in IRC 409(n) and whether the allocations occurred during the nonallocation period.

  6. Check whether any IRC 1042 securities were disposed of within three years after the plan acquired them.

Subchapter S Corporation ESOPs

  1. Effective for tax years after December 31, 1997, the Small Business Job Protection Act of 1996 (SBJPA) and the Taxpayer Relief Act of 1997 (TRA ’97) made amendments that permitted Subchapter S (Sub S) corporations to adopt and sponsor ESOPS. See IRC 1361(c)(6). The ESOP is treated as a single shareholder for purposes of the 100-shareholder rule. In conjunction with this law change, certain special rules apply to Sub S ESOPS.

    1. Normally, the flow-through of a Sub S corporation’s income to the ESOP would have constituted unrelated business income (UBI) and would be subject to unrelated business income tax (UBIT). TRA ‘97 eliminated the UBI provision, with the effect that Sub S corporate income, to the extent owned by the ESOP, is not currently taxable, nor is the income subject to UBIT.

    2. An ESOP is required to adjust its basis in Sub S corporation stock under IRC 1367(a) for the ESOP’s pro rata share of the corporation’s item. Upon the distribution of the Sub S corporation stock by an ESOP to a participant, the stock’s net unrealized appreciation under IRC 402(e)(4) is determined using the ESOP’s adjusted basis in the stock. See Rev. Rul. 2003-27.

    3. Due to the statutory limits on the number of shareholders permitted for a Sub S corporation, IRC 409(h) was modified to allow cash distributions in lieu of the right to demand distribution from the ESOP in the form of qualifying employer securities. See IRC 409(h)(2)(B)(ii). An ESOP maintained by a Sub S corporation may permit distributions of employer securities, but is not required to do so.

  2. A number of IRC sections that provide advantages to C corporation ESOPs are not available to Sub S corporation ESOPs.

    1. A Sub S corporation ESOP has lower deduction limits than an C corporation ESOP. The 25 percent deduction limit under IRC 404(a)(9)(A) for contributions paid to an ESOP to repay the principal on a loan used to acquire qualifying employer securities is unavailable to a Sub S corporation. Also, the unlimited deduction under IRC 404(a)(9)(B) for contributions to an ESOP used to repay interest on a loan is unavailable to a Sub S corporation ESOP. See IRC 404(a)(9)(C). An employer’s deduction for contributions to a Sub S corporation ESOP is subject to the same limits as any profit-sharing or stock bonus plan, i.e., 25 percent of the participants’ compensation. See IRC 404(a)(3).

    2. The deduction on applicable dividends paid on employer securities under IRC 404(k) does not apply to Sub S corporation ESOPs. However, as stated in paragraph (6) of IRM 4.72.4.3.6.1, IRC 404(k) Deduction, a Sub S corporation can use Sub S corporation distributions on both allocated and unallocated shares to repay an exempt loan as long as the requirements of IRC 4975(f)(7) are met.

    3. The exclusion under IRC 415(c)(6) from annual additions for allocations attributable to employer contributions to repay interest on an exempt loan and forfeitures of employer securities does not apply to Sub S corporation ESOPs.

    4. The tax deferral on gains received by a shareholder on the sale of qualified securities to an ESOP is not available to Sub S corporation shareholders. See IRC 1042(c)(1)(A).

Examination Steps

  1. Determine the type of entity that has adopted the ESOP under examination. If adopted by an electing Sub S corporation, apply the statutory requirements relevant to Sub S corporation ESOPs. In addition, confirm whether a valid existing ESOP was adopted and effective on or before March 14, 2001. Refer to the next section if the Sub S corporation makes an "S" election after March 14, 2001 or if the ESOP is started after March 14, 2001, in which event the new anti-abuse provisions of EGTRRA will go into effect.

  2. Review the allocations made and perform an analysis of the IRC 415(c) limits. Verify that the Sub S corporation ESOP did not attempt to utilize the IRC 415(c)(6) exception, relating to the disregard of certain forfeitures and interest payments as annual additions.

  3. Verify that the additional IRC 404(a)(9) deduction limit on contributions to pay down an exempt loan of 25 percent is not utilized by the Sub S corporation. A Sub S corporation ESOP is limited to the deduction limit under IRC 404(a)(3).

  4. If Sub S corporation distributions (as described in IRC 1368) on allocated shares are used to pay down an exempt loan, make sure that the affected accounts are reimbursed by shares equal to the fair market value of the Sub S corporation distributions.

  5. Verify that no IRC 1042 transfers have been made to the Sub S ESOP.

  6. Carefully scrutinize any Sub S corporation ESOP, where all, or substantially all outstanding stock of the Sub S, is owned by the ESOP. Please conduct detailed interviews with the taxpayer and/or representative. The operation of the business, customers and related corporations for which they perform services should be discussed. If it is determined that this Sub S corporation is an organization whose principal business is performing, on a regular and continuing basis, management functions for another organization (or for one organization and other related organizations), additional development may be needed. It is possible that an affiliated service group may exist under IRC 414(m)(5).

IRC 409(p)

  1. EGTRRA of 2001 enacted IRC 409(p) effective for plan years after December 31, 2004. The law was immediately effective for Sub S corporation ESOPs established on or after March 14, 2001. The law’s intent is to restrict the tax benefits provided by a Sub S corporation ESOP to years or situations where employee coverage under the ESOP is broad-based; where the ESOP benefits rank-and-file employees as well as highly compensated employees and historical owners. IRC 409(p) provides that upon the occurrence of a "nonallocation year," "prohibited allocations" to "disqualified persons" are deemed to be distributed and includable in income tax. In addition, IRC 4979(A) imposes on the Sub S corporation a 50 percent excise tax on the "prohibited allocations." That section also imposes a 50 percent excise tax on the value of the "synthetic equity" owned by "disqualified persons" during a nonallocation year, whether a prohibited allocation has occurred or not. An ESOP that violates IRC 409(p) by having a prohibited allocation during a nonallocation year would fail to satisfy the requirements of IRC 4975(e)(7) and lose it’s prohibited transaction exemption under IRC 4975(d)(3). An additional result is the exception under IRC 512(e)(3) would cease to apply to the plan, so that the plan would owe income tax as a result of unrelated business taxable income under IRC 512.

    1. The general effective date for IRC 409(p) is for ESOP years that begin after December 31, 2004.

    2. The special effective date is for ESOP years ending after March 14, 2001. The special effective date applies to corporations that converted to Sub S status or established ESOPs after March 14, 2001. In these situations, the provisions apply to plan years ending after March 14, 2001. Therefore if a Sub S corporation makes an election after March 14, 2001 or the ESOP is started after March 14, 2001, the ESOP will always be subject to the new anti-abuse legislation.

      Note:

      See Rev. Rul. 2003-6 for guidance with respect to certain arrangements involving the establishment of ESOPS holding securities in Sub S corporations that the Service determined will not be considered timely established on or before March 14, 2001.

      Note:

      This ruling provides that the delayed effective date for IRC 409(p) does not apply in certain circumstances. The facts of this revenue ruling pertain to a promoter, who arranges for the establishment of a number of Sub S corporations that have no substantial assets or business and the formation of ESOPs for each of these corporations on or before March 14, 2001. Employees of the promoter are initially covered by these ESOPs. The Sub S corporations are then marketed to other taxpayers, along with the associated ESOPs, after March 14, 2001. The ruling states that for purposes of IRC 409(p), these ESOPs are not considered established on or before March 14, 2001 and therefore, are not entitled to the delayed 2005 effective date.

Examination Steps
  1. Determine the type of entity that sponsored the ESOP under examination. If adopted by an electing Sub S corporation, ascertain whether a valid existing ESOP was adopted and effective on or before March 14, 2001. In addition, confirm that a valid "Sub S " election was made on or before March 14, 2001.

  2. Before accepting the validity of a timely March 14, 2001 adoption, the agent should consider the potential that the scenario contained in Rev. Rul. 2003-6 applies. If based on interview(s) and/or other case development, it appears that abusive step transactions such as those covered by Rev. Rul. 2003-6 apply, then the agent should pursue the earlier effective date of plan years ending after March 14, 2001, with respect to IRC 409(p) and IRC 4979A.

  3. If the Sub S ESOP was timely adopted and effective on or before March 14, 2001, the general effective date of plan years beginning after December 31, 2004 will apply with respect to IRC 409(p) and IRC 4979A.

  4. If not timely adopted by March 14, 2001, the agent should apply IRC 409(p) and IRC 4979A, effective for plan years ending after March 14, 2001.

Nonallocation Year

  1. Under IRC 409(p), a nonallocation year means a plan year during which on any date disqualified persons own 50 percent or more of the stock in the Sub S corporation taking into account all outstanding shares in the Sub S corporation (including shares held by the ESOP) and by also taking into account "synthetic equity."

  2. A disqualified person is one who is either a member of a "deemed 20 percent shareholder group" or "deemed 10 percent shareholder" taking into account synthetic equity owned by the individual if such addition causes the individual to become disqualified.

  3. A person is a member of a "deemed 20 percent shareholder group" if the number of "deemed-owned shares" of the person and the person's family is at least 20 percent of the total Sub S corporation shares held by the ESOP.

  4. The term "deemed-owned shares" is the sum of:

    1. Stock allocated to an account of an individual by the ESOP

    2. An individual's share of unallocated stock held by the ESOP

      Reminder:

      IRC 409(p)(4)(C)(ii) provides that a person’s share of unallocated Sub S corporation stock held by such plan is the amount of the unallocated stock which would be allocated to such person if the unallocated stock were allocated to all participants in the same proportions as the most recent stock allocation under the plan.

  5. A person is a "deemed 10 percent shareholder" if the person is not a member of a "deemed 20 percent shareholder group" and the number of the person's "deemed-owned shares" is at least 10 percent of the total Sub S corporation shares held by the ESOP.

  6. For purposes of determining ownership, the attribution rules of IRC 318 apply, modified with the exception that the members of an individual’s family shall include members of the family described in IRC 409(p)(4)(D). See IRC 409(p)(3)(B). Family members will include:

    1. Individual’s spouse

    2. Ancestors or lineal descendant of the individual or the individual’s spouse

    3. Brother or sister of the individual or the individual’s spouse and any lineal descendant of the brother or sister

    4. The spouse of any individual described in b) or c)

  7. The definition of a "nonallocation year" is any ESOP plan year where, at any time during the year, "disqualified persons" own directly or through attribution, 50 percent of the number of outstanding shares of the Sub S corporation. The attribution rules of I IRC 318 apply in this computation except there are some modifications that will not be addressed here. See IRC 409(p)(3)(B) for the attribution rules.

  8. IRC 409(p)(5) provides that in the case of a person who owns synthetic equity, the shares of stock on which such synthetic equity is based on is treated as outstanding stock of the Sub S corporation and deemed owned shares of that individual.

  9. IRC 409(p)(6)(C) defines synthetic equity as any stock option, warrant, restricted stock or similar right that gives the holder the right to acquire or receive stock of the Sub S corporation. It also includes a stock appreciation right, phantom stock unit, or similar right to a future cash payment based on the value of such stock or appreciation in such value.

  10. The definition of synthetic equity includes non-qualified deferred compensation. This includes any remuneration for services rendered to the Sub S corporation to which IRC 404(a)(5) applies.

  11. The number of synthetic equity shares attributed to a stock option is based on the number of shares that are subject to that option. For example, an option to purchase 10 shares of Sub S Corporation stock becomes 10 shares of synthetic equity without regard to the option price. The number of synthetic equity shares based on shares of stock but for which payment is made in cash or other property (e.g., phantom stock units), the number of synthetic equity shares is equal to the number of shares having a fair market value equal to the cash or other property paid.

  12. In the case of synthetic equity that is not determined by reference to shares (i.e., nonqualified deferred compensation), the person entitled to the synthetic equity is treated as owning the number of shares equal to the present value of the synthetic equity divided by the fair market value of a share of the Sub S Corporation’s stock as of the same date.

  13. The number of synthetic equity shares based on nonqualified deferred compensation may be determined on the first day of the ESOP’s plan year or any other reasonable determination date.

  14. An ESOP may provide that the number of synthetic equity shares treated as owned on a determination date may remain constant from that date until the date immediately preceding the third anniversary of the determination date.

  15. The number of shares otherwise determined is ratably reduced to the extent that Sub S corporation shares are owned outside the ESOP.

  16. Determination of a "disqualified person" and the occurrence of a nonallocation year.

    1. A person is considered a disqualified person if their synthetic equity shares and deemed-owed shares is 10 percent or more of the total amount of synthetic equity shares and deemed shares of the corporation.

    2. A nonallocation year occurs when all shares of stock held by all disqualified persons is divided by all the outstanding stock and synthetic equity of the disqualified persons and the result is 50 percent or more.

Prohibited Allocations

  1. IRC 409(p)(1) provides that a "prohibited allocation" is one that violates the requirement that, during a "nonallocation year" , no portion of the assets of the ESOP may be accrued (or be allocated directly or indirectly under any qualified plan of the Sub S corporation) for the benefit of any "disqualified person."

  2. "Prohibited allocations" consists of Sub S corporation stock owned by the ESOP and any assets attributable to such stock held under the ESOP for the benefit of a disqualified person during a nonallocation year. In addition prohibited allocations include any allocation for a disqualified person under any IRC 401(a) qualified plan of the employer to the extent that a contribution or other annual addition is made that for the nonallocation year, would otherwise been added to the account of the disqualified person under the ESOP and invested in Sub S corporation stock but for an ESOP plan provision to comply with IRC 409(p).

  3. In addition to the excise tax imposed on a Sub S corporation under IRC 4979(A), see IRM 4.72.4.7.6, IRC 4979(A) for Purposes of IRC 409(p), a prohibited allocation in a nonallocation year is treated as distributed to the disqualified person at the time of the prohibited allocation. This would also cause the plan to fail to satisfy the requirements of IRC 4975(e)(7). As a result, the plan would lose the prohibited transaction exemption for loans under IRC 4975(d)(3) and also become subject to the unrelated business tax under IRC 512.

Avoidance or Evasion

  1. IRC 409(p)(7)(B) states that the Secretary may, by regulation or other guidance, provide that a nonallocation year occurs in any case in which the principal purpose of the ownership structure constitutes an avoidance or evasion of the prohibited allocation rules.

  2. 26 CFR 1.409(p)-1(g)(2) states that in situations involving synthetic equity, a determination as to whether the principle purpose of the structure constitutes an avoidance or an evasion is made by taking into account all the surrounding facts and circumstances to determine whether, to the extent of the ESOP’s stock ownership, the ESOP receives the economic benefits of ownership in the Sub S corporation.

IRC 4979A for Purposes of IRC 409(p)

  1. IRC 4979A(a) provides for an excise tax on the Sub S corporation equal to 50 percent of the "amount involved." The "amount involved" includes:

    1. The amount allocated to the account of any person in violation of IRC 409(p)(1) (i.e., a prohibited allocation has occurred). IRC 4979(A)(e)(2) provides that for these purposes the amount involved for the first nonallocation year is determined by taking into account the total value of all the deemed-owned shares of all disqualified persons with respect to such plan.

    2. If synthetic equity is owned by a disqualified person in a nonallocation year, use the value of the shares on which such synthetic equity is based.