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Part 4. Examining Process

Chapter 72. Employee Plans Technical Guidelines

Section 4. Employee Stock Ownership Plans (ESOPs)

4.72.4  Employee Stock Ownership Plans (ESOPs)

4.72.4.1  (04-01-2006)
Overview

  1. Guidance is provided for examiners on how to examine an IRC 4975(e) leveraged ESOP.

  2. This guideline considers changes enacted under the Small Business Job Protection Act of 1996 (SBJPA) P. L. 104–188 (see 4.4.2), the Taxpayer Relief Act of 1997 (TRA ’97) P. L. 105–34 (see 4.2.7), the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) P.L. 107-16 , and the American Job Creation Act of 2004 (AJCA) P.L. 108-173 (see 4.2.4).

4.72.4.1.1  (04-01-2006)
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.

  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% of plan assets. See ERISA 406(a)(1)(E), 406(a)(2) and 407(a)(2).

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

  4. An ESOP can debt-finance its acquisition of employer securities.

4.72.4.1.1.1  (04-01-2006)
How an ESOP Operates

  1. Following is a scenario of how an ESOP operates within the provisions of the law.

    1. An ESOP gets a loan from an outside lender, such as a bank. The ESOP signs a promissory note for the money. (In a back-to-back loan, the employer receives the loan and loans the proceeds to the ESOP to acquire employer securities for the ESOP.)

    2. The employer gives a written guarantee to the bank promising that the ESOP will repay the loan, and each year the employer will pay the ESOP enough money to permit the ESOP to make its annual loan repayment.

    3. The ESOP uses the money from the loan to buy stock from the employer (or a shareholder). Thus, the employer has received new capital. The loan is be secured by the pledge of the stock acquired by the ESOP.

    4. The stock is held in an ESOP suspense account, and is released for allocation to participant accounts as the loan is repaid with funds contributed to the ESOP by the employer, and/or by the use of dividends on employer securities in the ESOP.

    5. Each year, the employer makes a tax-deductible payment to the ESOP sufficient to enable the ESOP to make its annual debt repayment to the bank. As the debt is repaid, employer securities in the ESOP suspense account are released to the participants’ accounts. The employer can repay the acquisition indebtedness of the ESOP out of the earnings from its new capital.

    6. Since the employer’s contributions to the ESOP used to repay the loan are deductible within the IRC 404(a)(9) limits, a leveraged ESOP allows the company to repay the entire loan on a tax-favored basis.

4.72.4.1.2  (04-01-2006)
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 the loan is:

    1. Primarily for the benefit of plan participants, and

    2. 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 above 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 Reg. 54.4975–7(b)(1)(ii).

4.72.4.1.3  (04-01-2006)
Tax Credit ESOPs

  1. Prior to 1987, there were two other forms of ESOPs: Tax Reduction Act stock ownership plan (TRASOP) and Payroll stock ownership plan (PAYSOP).

    1. The Tax Reduction Act of 1975 allowed employers an additional 1% tax credit for a contribution of employer securities to a TRASOP equal to 1% of the employer’s qualified investment in property for the year. See IRC 48(n) (repealed).

    2. An additional 1/2% tax credit was allowed by later legislation for a contribution of employer securities to a TRASOP equal to employee contributions of up to 1/2% of the employer’s qualified investment in property for the year (the matching employee plan percentage).

    3. The Economic Recovery Tax Act of 1981 (ERTA) replaced the TRASOP with the PAYSOP, which provided a tax credit of 1/2% based on the compensation of participants in the PAYSOP paid after 12/31/82. See IRC 41 (repealed). The PAYSOP was repealed by the Tax Reform Act of 1986 (TRA ’86) for compensation paid or accrued after 12/31/86.

4.72.4.1.3.1  (04-01-2006)
Unused Credits Carryforward

  1. The TRASOP and PAYSOP rules are repealed. However, IRC 39 provides for the carryforward of unused business credits. The TRASOP credit may be carried forward for a 15 year period. But the PAYSOP credit had to be elected and funded in the year the compensation was paid.

  2. Prior to its repeal by TRA ’86, IRC 404(i) provided for the deductibility of the unused portion of the employee stock ownership credit. Under IRC 404(i), any part of the credit under IRC 41 that was not allowed for a taxable year due to IRC 38, was allowed as a deduction for the last taxable year to which it could have been allowed as a credit. This provision is still effective for the portion of the IRC 41 credit attributable to compensation paid or accrued before 1987.

    1. Thus, an otherwise allowable TRASOP credit attributable to a qualifying investment made prior to 1983 may be carried forward for 15 years.

    2. If it has not been exhausted due to the tax liability limitations, that portion may be deducted in the last year (at the latest, the 15th year) without regard to the usual limits on deductions for contributions to qualified plans. See IRC 404(i) (repealed).

4.72.4.1.3.2  (04-01-2006)
Failure to Comply Penalty

  1. Prior to its repeal by TRA ’86, IRC 6699 imposed a penalty on a taxpayer who had claimed the TRASOP or PAYSOP credit for any taxable year and then failed to satisfy all of the IRC 409 requirements or failed to make any required contributions within the specified time.

    1. The penalty is equal to the amount involved in the failure.

    2. The "amount involved" is an amount determined by the Secretary of the Treasury, but not greater than the amount of the credit claimed for the taxable year in which the failure occurred and not less than the product of 1/2 of 1% of the maximum amount, multiplied by the number of months, or parts thereof, during which such failure continued.

  2. No penalty is imposed if the failure is corrected within 90 days after the employer is notified by the Secretary of such failure.

    1. A separate failure to comply occurs each year in which a failure remains uncorrected.

    2. IRC 6699 continues to apply to TRASOPs and PAYSOPs that remain in existence.

4.72.4.1.4  (04-01-2006)
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 whether code "A" (ESOP) or code " B" (leveraged ESOP) is filled in.

4.72.4.2  (04-01-2006)
Qualification Requirements

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

4.72.4.2.1  (04-01-2006)
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).

4.72.4.2.1.1  (04-01-2006)
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.

4.72.4.2.2  (04-01-2006)
Floor Offset Arrangements

  1. Generally, under the prohibited transaction rules of ERISA, a plan may not invest more than 10% 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 12/17/87. After that effective date, a floor-offset arrangement is treated as a single plan for purposes of the 10% limit.

    3. Where the 10% 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.

4.72.4.2.2.1  (04-01-2006)
Examination Steps

  1. Determine whether the employer maintains any defined benefit plans. If yes,

    1. Determine whether the benefits provided by the defined benefit plan are reduced by benefits under the ESOP in an arrangement established after 12/17/87.

    2. Determine whether the value of the employer securities exceeds 10% of the combined assets of the ESOP and the defined benefit plan.

    3. Impose the prohibited transaction tax on the fair market value of the employer securities that exceeds 10% of the assets of the combined plans, if there is a transaction with a disqualified person.

4.72.4.2.3  (04-01-2006)
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 also Reg. 1.401(a)–20, Q&A 3(c).

4.72.4.2.3.1  (04-01-2006)
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.

4.72.4.2.4  (04-01-2006)
Participation, Coverage and Nondiscrimination Requirements

  1. The participation (IRC 401(a)(26) for years beginning before January 1, 1997), coverage (IRC 410(b)), and nondiscrimination (IRC 401(a)(4)) requirements 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 participation, coverage or nondiscrimination requirements. See Regs. 54.4975–11(e)(1), 1.401(a)(26)–2(d)(1)(i), 1.410(b)–7(c)(2) and 1.401(a)(4)–(c)(4). IRC 401(a)(26) is inapplicable to defined contribution plans for years beginning after December 31, 1996.

  2. An ESOP cannot be aggregated with another plan.

    • For 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 Reg. 1.401(k)–1(b)(3)(ii)(B), IRC 401(k)(3) and the Technical Guidance on CODAs in IRM 4.72.2. Note the new 401(k) regulations.

  3. An ESOP cannot satisfy the IRC 401(a)(4) nondiscrimination requirements through the use of the nondesign-based safe harbor at Reg. 1.401(a)(4)–(b)(3), or by cross-testing under Reg. 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 9/29/04, 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 section 414(l) plan for purposes of ADP and ACP testing and allowed an employer to permissively aggregate two section 414(l) plans, one that is an ESOP and one that is not.

4.72.4.2.4.1  (04-01-2006)
Examination Steps

  1. Check that the ESOP satisfies the participation, coverage and nondiscrimination requirements without 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 the Technical Guidance on Matching Contributions in IRM 4.72.3.

4.72.4.2.5  (04-01-2006)
Vesting

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

4.72.4.2.5.1  (04-01-2006)
Examination Step

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

4.72.4.2.6  (04-01-2006)
Deduction Limits

  1. An employer’s deduction for contributions to a stock bonus or profit-sharing plan is limited to 25% of the participants’ compensation. (See IRC 404(a)(3) as amended by EGTRRA for years beginning after 12/31/01. Otherwise, the 404(a)(3) limit is 15%.)

  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 (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% of the ESOP participants’ compensation.

    1. There is no limit on the employer’s deduction for contributions to an ESOP used to repay interest on a loan. See IRC 404(a)(9)(B). 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 1997 plan year, Company M makes a contribution of 30% of the participants’ compensation to repay principal and interest on the ESOP loan: 25% of compensation was used to repay the principal on the loan and 5% of compensation was used to repay the interest on the loan. The entire 1997 contribution is deductible under IRC 404(a)(9).

4.72.4.2.6.1  (04-01-2006)
IRC 404(k) Deduction

  1. In addition to the deduction permitted under IRC 404(a)(3) and 404(a)(9), under IRC 404(k) an employer may deduct dividends (called applicable dividends) paid on employer securities held by an ESOP if such dividends are—

    1. Paid in cash to the participants,

    2. Paid to the plan and distributed in cash to the participants within 90 days after the end of the plan year in which the dividends are paid to the plan, or

    3. Used to repay an ESOP loan. Dividends on unallocated and allocated stock may be used. If dividends on allocated stock are being used, the account to which the dividends would have been allocated must have employer securities with a fair market value not less than those dividends allocated to it.

  2. IRC 404(k) as amended by EGTRRA, in addition, provides for a deduction for dividends reinvested in employer securities in taxable years for a C corporation beginning on or after 1/1/02. For the C Corporation to receive this deduction, the ESOP participant must be given an election under the terms of the plan between:

    1. (i) the payment of dividends to participants or

      (ii) the payment to the ESOP and distribution in cash to participants not later than 90 days after the close of the plan year in which paid, and,

    2. the payment of dividends to the ESOP and reinvestment in employer securities. (See, Notice 2002-2 2002-1 C.B. 285.)

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

  4. If the employer securities paying the dividends were acquired after 8/4/89, such dividends are deductible under IRC 404(k) only if they are used to repay a loan the proceeds of which were used to acquire the employer securities which are paying the dividends.

    Example:

    Company M maintains an ESOP that acquired employer securities in an exempt loan in 1994. Also in 1994, Employer M terminated a profit-sharing plan and permitted participants to have a direct transfer of their profit-sharing plan accounts to the ESOP. The cash transferred from the profit-sharing plan to the ESOP is reinvested in employer securities. The exempt loan obtained by the ESOP is repaid with contributions made by Company M and with cash dividends paid on the employer securities held by the ESOP which were purchased with the exempt loan proceeds. Company M can claim a dividend deduction under IRC 404(k) for the dividends paid on the securities acquired in the exempt loan which are used to repay the loan. Company M can not claim a dividend deduction under IRC 404(k) to the extent the exempt loan was repaid with cash dividends paid on employer securities purchased with the funds transferred from the terminated profit-sharing plan. This is because these employer securities were acquired by the ESOP after 8/4/89, but not with the proceeds of the exempt loan.

  5. Dividends on employer securities that were not acquired in an exempt loan, but were acquired by an ESOP before 8/5/89, can be used to repay a loan the proceeds of which were used to acquire employer securities and deducted under IRC 404(k).

  6. 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.

  7. A dividend that is unusual in amount or a probable attempt to evade taxes 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). You ascertain the dividend rate is 70%, and that this is an extraordinary dividend that is greatly in excess of the dividend 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).

  8. 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, 2001–6 I.R.B. 491.

  9. Even though S corporation distributions are not eligible for deductions under IRC 404(k), such distributions in regards to both allocated and unallocated S corporation stock may still be used to pay off an exempt loan the proceeds of which were used to purchase such stock. If S corporation distributions on allocated stock are used, employer securities with a fair market value of not less than the amount of such distribution must be allocated to such account. (See IRC 4975(f)(7) as enacted by the American Job Creation Act of 2004 and effective for distributions made with respect to S corporation stock after 12/31/97.)

4.72.4.2.6.2  (04-01-2006)
Examination Steps

  1. Cancelled checks, payroll records, trust receipts and disbursement records, and participant’s accounts should be examined to determine that the IRC 404 limits have not been violated. Problems could also arise if the number of participants decreased so as to lower the deductible limits.

  2. Look at the applicable question on Schedule E, ESOP Annual Information, of Form 5500, to find out whether the employer repaid the exempt loan using dividends on employer securities.

  3. Look at the question on Schedule E with regard to whether any dividends used to repay an exempt loan were not generated by employer securities acquired in that exempt loan. If the answer is yes, find out if the employer securities paying those dividends were acquired after 8/4/89. If yes, disallow the deduction.

  4. Determine whether the amount of dividends paid exceed the employer’s current or accumulated earnings or profits under IRC 316. Review the question on Schedule E of Form 5500 for this information. If yes, disallow the deduction.

  5. Check whether the dividends paid on employer securities held by the ESOP are reasonable. A reasonable dividend does not include an unusually large dividend used to repay ESOP debt which is greatly in excess of the dividend the ESOP sponsor can reasonably be expected to pay on a recurring basis.

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

4.72.4.2.7  (04-01-2006)
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 4.72.4.2.8, Put Options. 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 an 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 5th 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 12/31/86.

    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 5 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 5 years plus one additional year (up to 5 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 I.R.B. 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 nonvoting or preferred stock if the loan proceeds were also used to acquire voting common stock. See Reg. 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 4.3.6) and allocated to a participant’s account can be forfeited only after other assets have been forfeited. See Reg. 54.4975-11(d)(4).

4.72.4.2.7.1  (04-01-2006)
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 an 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.

4.72.4.2.8  (04-01-2006)
Put Option

  1. IRC 409(h) and Reg. 54.4975–7(b)(10) require an employer security to be subject to a put option if it is not readily tradeable on an established market when distributed or if it is subject to a trading limitation when distributed.

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

    1. listed on a national securities exchange registered under section 6 of the Securities Exchange Act of 1934, or

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

  3. The National Association of Securities Dealers (NASD) is a national securities association registered under section 15A(b). It runs the National Association of Securities Dealers Automatic Quotation System (NASDAQ). Therefore, over-the-counter stocks traded on NASDAQ are publicly traded.

    Note:

    Stocks listed on the "pink sheets" are not publicly traded because the "pink sheets" are not a system sponsored by the NASD.

  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 5 years. The employer must provide adequate security and pay reasonable interest on the unpaid amounts of the total distribution. See IRC 409(h)(5).

  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 not readily tradeable. No put option is required if participants have the right to receive distributions in cash.

4.72.4.2.8.1  (04-01-2006)
Examination Steps

  1. Check that employer securities not readily tradeable on an established market can be put to the employer.

  2. Make sure the put is exercisable for two 60 day periods: 60 days following the date the employer securities were distributed and 60 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.

    • For 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. Nor are employer securities adequate security.

4.72.4.2.9  (04-01-2006)
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 nonmonetary units, rather than by dollar amounts. See Regs. 54.4975–11(d)(1) and (2).

4.72.4.2.9.1  (04-01-2006)
Examination Step

  1. Check the participants’ accounts to verify the trustee is following the allocation formula in the plan.

4.72.4.2.10  (04-01-2006)
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 (1/24/83) there may be instances where the investment of more than 50% 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 tradeable 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 tradeable common stock, closely held common stock of the employer which has a combination of voting power and dividend rights equal to or in excess of 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 meets the requirements of a. or b. above, and if the conversion price is reasonable as of 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 1563(a)(4) and without regard to the exception to the attribution from trusts rule at IRC 1563(e)(3)(C).

    1. IRC 409(l)(4) provides special circumstances in which a first tier subsidiary may be considered to be includable in a controlled group of corporations for purposes of IRC 409, even where the parent owns less than 80% 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% of the voting power in all classes of stock and at least 50% 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% 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) provides special circumstances in which a second-tier subsidiary may be considered to be 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% of the voting power of all classes of stock and at least 50% 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% 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.

4.72.4.2.10.1  (04-01-2006)
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 tradeable common stock. This information may have to be requested from the employer. If there is readily tradeable 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. Also look at the answer to the question concerning the conversion formula on Schedule E, ESOP Annual Information. 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 20% to 30% range.

4.72.4.2.11  (04-01-2006)
Permitted Disparity

  1. An ESOP established after 11/1/77, cannot be integrated with Social Security benefits. .

  2. ESOPs established and integrated on or before 11/1/77, can remain integrated. Such plans can continue in operation to 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 Reg. 54.4975–11(a)(7)(ii).

    2. The permitted disparity rules of IRC 401(l) do not apply to ESOPs, except for ESOPs which were in existence on 11/1/77, which were integrated. See Reg. 1.401(l)–1(a)(4)

4.72.4.2.11.1  (04-01-2006)
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 11/1/77, and the integration level or percentage has not been increased by plan amendment(s).

  2. Verify that no ESOP established after 11/1/77, is integrated.

4.72.4.2.12  (04-01-2006)
Valuation

  1. Since ESOPs are designed to invest primarily in employer securities, the examination of this type of plan necessitates that you be able to determine the fair market value of qualified employer securities. See IRM 4.72.8, Employee Plans Technical Guidance on Valuation of Assets.

4.72.4.2.12.1  (04-01-2006)
Examination Steps

  1. The balance sheet on Form 5500 provides information such as whether investments are in employer securities, acquisition indebtedness and/or other liabilities (indicates leverage), and party-in-interest transactions. In smaller plans determine whether a valuation was made by adding the assets at the beginning of the year to the contributions and receipts less the disbursements during the year and comparing the total to the assets at the end of the year. If the total equals the assets at the end of the year, a valuation probably has not been made because the total only reflects the receipts and disbursements.

  2. When reviewing the income statement, note any noncash contributions as these may also indicate the acquisition of employer securities.

  3. Where stock is publicly traded, examine stock confirmation slips, trust receipt and disbursement accounts, and market records to verify the fair market value of security transactions.

  4. Where stock is not publicly traded, 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 comparable to the value of comparable non-publicly traded companies. See Reg. 54.4975–11(d)(5).

  5. Where stock is not publicly traded and the transaction involves a disqualified person, the fair market value must be determined as of the transaction date. Secure the appraisal report, if any, 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. In addition, 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, 1959-1 C.B. 237. The independent appraisal will not in itself be a good faith determination. Also, examine the capital stock accounts of the employer to substantiate transactions of similar stock. If there is a problem with the stock valuation, use Form 5202, "Request for Engineering Service" to request assistance from the Examination engineer.

4.72.4.2.12.2  (04-01-2006)
Independent Appraiser

  1. TRA ’86 enacted IRC 401(a)(28)(C) which provides that employer securities acquired by an ESOP (whether by contribution or purchase) after 12/31/86 that are not readily tradeable 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 tradeable on an established securities market. See IRM 4.72.8, Technical Guidance on Valuation Assets for a detailed discussion of the independent appraiser rules for nonpublicly traded shares held by an ESOP.

4.72.4.2.12.2.1  (04-01-2006)
Examination Step

  1. Review the applicable question on the Form 5500 series return concerning independent appraisers to determine whether employer securities held in an ESOP that are not readily tradeable on an established securities market were valued by an independent appraiser.

4.72.4.2.12.3  (04-01-2006)
Employer Securities and Prohibited Transactions

  1. The fiduciary is responsible for determining that employer securities are properly valued. It is not enough for a fiduciary to rely in good faith on a third party valuation to establish that adequate consideration was paid. A fiduciary must make his/her own prudent investigation of value and determine that the underlying assumptions on which the valuation was made have not changed 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 too much for employer securities. This may occur due to an improper valuation of employer stock that is closely-held.

    2. There is a prohibited transaction if there is a sale of any property between a plan and a disqualified person (e.g., an employer) unless the prohibited transaction exception below applies. See IRC 4975(e)(2)(C) and IRC 4975(c)(1)(A).

    3. There is a prohibited transaction exception where the sale is for "adequate consideration" . See IRC 4975(d)(13) and ERISA 408(e). 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).

4.72.4.2.12.3.1  (04-01-2006)
Examination Steps

  1. Determine whether fair market value was paid for the stock. Look at the valuation report on the company’s shares. See if the company that makes products has share prices that rise and fall with its earnings. If the company’s earnings have fallen but the report says the price per share has risen, it may indicate an incorrect valuation. Also check the correlation between earnings and stock price 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 report was written. If they have, it is likely the shares’ value should also have fallen. The plan fiduciary can no longer rely on the price per share from the valuation report because the facts on which it was based have changed.

  3. Ask to see documentation of the fiduciary’s prudent investigation to ensure the underlying assumptions have not changed since the last valuation.

4.72.4.2.12.4  (04-01-2006)
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, 1969–2 C.B. 88, 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. (All requirements of Rev. Rul. 69–494 do not 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.

4.72.4.2.12.4.1  (04-01-2006)
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. Although technically an exclusive benefit violation, a violation of the exclusive benefit rule generally should not be pursued where it appears employer securities were acquired at an inflated price but the stock subsequently increased in value with the result that a benefit to plan participants has occurred.

  4. If such stock was acquired from a disqualified person, imposing the excise tax under IRC 4975 would still be appropriate.

  5. A violation of the exclusive benefit rule does not occur merely because employer securities acquired at fair market value later decline in value.

4.72.4.2.13  (04-01-2006)
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, 1995–35 I.R.B. 5.

4.72.4.2.13.1  (04-01-2006)
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.


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