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Part 4. Examining Process

Chapter 72. Employee Plans Technical Guidelines

Section 4. Employee Stock Ownership Plans (ESOPs) (Cont. 1)

4.72.4  Employee Stock Ownership Plans (ESOPs) (Cont. 1)

4.72.4.2 
Qualification Requirements

4.72.4.2.14  (04-01-2006)
Diversification Election

  1. For employer securities acquired after 12/31/86, 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% of the participant’s plan account. The account balance subject to the diversification election increases to 50% in the final year of the election period.

  2. Q&A–9 of Notice 88–56, 1988–1 C.B. 540, 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. 25% of the number of shares of employer securities acquired by the plan after 12/31/86, 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 12/31/86.

  3. A "qualified participant" is any employee who has completed at least 10 years of participation in the plan and has attained age 55. In determining years of participation in the plan, include years the employee participated in a predecessor plan. The "qualified election period" is the 6 plan year period beginning with the later of the first plan year—

    1. in which the individual first becomes a qualified participant, or

    2. beginning after 12/31/86.

4.72.4.2.14.1  (04-01-2006)
Diversification Requirement

  1. There are three methods by which a plan can satisfy the diversification requirement. The first two are statutory and appear in IRC 401(a)(28)(B)(ii). 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; or

    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. See Notice 88–56, Q&A–13.

4.72.4.2.14.2  (04-01-2006)
Examination Step

  1. Check that the plan provides a diversification election for employer securities acquired after 12/31/86.

4.72.4.2.15  (04-01-2006)
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), and employee’s right to put nonreadily tradeable employer securities to the employer continues to exist. It is a nonterminable right described at Reg. 54.4975–11(a)(3)(ii). However, a plan that is no longer an ESOP is not required to be primarily invested in employer securities because the right to a particular form of investment is not an IRC 411(d)(6) protected benefit.

    1. IRC 411(d)(6) and the regulations 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.

  2. Reg. 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. A single sum or installment optional form of distribution can be eliminated.

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

    3. Where employer securities become readily tradeable, a distribution in the form of employer securities can be substituted for cash, thereby eliminating the put option.

    4. Where employer securities cease to be readily tradeable, a distribution in the form of employer securities can be eliminated and cash can be substituted instead.

    5. If the employer securities continue to be readily tradeable, but substantially all of the employer stock or assets of the employer’s business are sold, a distribution in the form of employer securities can be eliminated and cash can be substituted instead.

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

4.72.4.2.15.1  (04-01-2006)
Examination Steps

  1. In an ESOP amended to become a non-ESOP, make sure the right to put nonreadily tradeable employer securities to the employer is not eliminated.

  2. Determine whether optional forms of benefits that have been eliminated comply with the exceptions for ESOPs at Reg. 1.411(d)–4, A–2(d).

4.72.4.3  (04-01-2006)
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. Failure to follow the rules 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 Reg. 54.4975–7(b).

    2. A non-exempt loan is a loan that fails to satisfy the requirements of Reg. 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 Reg. 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.

4.72.4.3.1  (04-01-2006)
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.

4.72.4.3.2  (04-01-2006)
Primary Benefit Requirement

  1. An exempt loan must be primarily for the benefit of the ESOP participants. 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 cause plan assets to be drained off. The interest rate on the loan must also be reasonable. See IRC 4975(d)(3) and Reg. 54.4975–7(b)(3).

4.72.4.3.2.1  (04-01-2006)
Examination Steps

  1. Determine whether the interest rate for the loan and the price for the securities are devices for draining off plan assets. 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 4.72.4.2.12 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.

4.72.4.3.3  (04-01-2006)
Loan Proceeds

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

    1. to acquire qualifying employer securities;

    2. to repay the loan; or

    3. to repay a prior exempt loan.

  2. Securities acquired with exempt loan proceeds may not be subject to a put, call, or other option, or buy-sell or similar arrangement while held by the ESOP or when distributed from the ESOP, other than the right of first refusal (see 4.72.4.3.8) and put option (see 4.72.4.2.8). See Reg. 54.4975–7(b)(4).

4.72.4.3.3.1  (04-01-2006)
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; or

    3. repay a prior exempt loan.

  2. Examine the securities to ensure there is no call, put, other option, buy-sell arrangement or any other restriction on the securities while in the trust or upon distribution, other than those provided in Regs. 54.4975–7(b)(9) and (10).

4.72.4.3.4  (04-01-2006)
Liability of ESOP for Loan

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

    1. Assets 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. Also, the contributions and earnings must be accounted for separately on the books of the ESOP. See Reg. 54.4975–7(b)(5).

4.72.4.3.4.1  (04-01-2006)
Examination Step

  1. Examine the ESOP, the assets and the exempt loan contract to ensure that any recourse by the lender does not exceed the assets of the ESOP as stated above.

4.72.4.3.5  (04-01-2006)
Default

  1. If the loan is secured by the employer securities held in the suspense account and there is a default on the loan, a lender who is a third party and not a disqualified person can have suspense account assets transferred 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 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 Reg. 54.4975–7(b)(6).

4.72.4.3.5.1  (04-01-2006)
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 greater in value than the missed payment to repay the loan.

  4. Determine whether the default has caused the loan to become nonexempt.

4.72.4.3.6  (04-01-2006)
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 Reg. 54.4975–7(b)(8). This results in low allocations of securities in the early years of the loan, when mainly interest is being paid off.

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

4.72.4.3.6.1  (04-01-2006)
Examination Steps

  1. Refer to the question on Schedule E, ESOP Annual Information, which determines the method the employer uses to repay the loan.

  2. Analyze the loan contract and its repayment provisions to verify that as the loan is repaid, stock is released from the suspense account and allocated to participant accounts

  3. Analyze the loan contract, the encumbrance account, the allocation schedule, and the receipts and disbursements accounts to substantiate compliance with the regulations. Also, if you encounter a situation where contributions have been missed for a period of years, or where there are large repayments to the lender, additional analysis should be undertaken to determine if the effect of such non-payment or large payments proves to be a violation of the exclusive benefit requirement or the anti-discrimination provisions of the Code.

  4. Determine whether the loan is structured so that securities are being released from the suspense account based on principal payments only. Ensure the plan document permits the release of shares from the suspense account based on the principal only method. If so, 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.

4.72.4.3.7  (04-01-2006)
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 Reg. 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.

  3. Whether an ESOP in operation violates the primary benefit requirement by repaying an exempt loan with the proceeds from the sale of unallocated securities will be determined based on all the surrounding facts and circumstances.

    1. Among the facts relevant to the primary benefit requirement are whether the transaction promotes employee ownership of employer stock, whether contributions to an ESOP that is part of a stock bonus plan are recurring and substantial, and the extent to which the method of repayment of the exempt loan benefits the employees.

    2. All aspects of the loan transaction, including the method of repayment, will be scrutinized to see whether the primary benefit requirement is satisfied.

4.72.4.3.7.1  (04-01-2006)
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 a plan in operation does use 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.

4.72.4.3.8  (04-01-2006)
Right of First Refusal

  1. Qualifying employer securities acquired with exempt loan proceeds may be, but need not be, subject to a right of first refusal. This is a right in favor of the employer or ESOP, or both, that 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-publicly traded 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 4.72.4.2.8 and Reg. 54–4975–7(b)(9).

4.72.4.3.8.1  (04-01-2006)
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 not publicly traded at the time the right is exercised;

    2. The right only applies to the employer or the trust (ESOP) or both;

    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; and

    4. The selling price and other terms are the greater of— (i) the fair market value per Reg. 54.4975–11(d)(5), or

      (ii) 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.

4.72.4.3.9  (04-01-2006)
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 to the ESOP used to repay a loan, or

    2. The value of the employer securities allocated to participants. If the annual additions are calculated with respect to employer contributions, appreciation in the stock’s value from the time it entered the suspense account will not be counted for IRC 415 purposes. See Regs. 54.4975–11(a)(8)(ii) and 54.4975–7(b)(8)(iii).

  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. See Reg. 1.415–6(b)(4).

  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.

4.72.4.3.9.1  (04-01-2006)
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 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, so that a contribution per released share can be determined.

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

  6. Determine whether more than 1/3 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

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

4.72.4.4  (04-01-2006)
Special ESOP Transactions

  1. Other issues involving ESOPs include—

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

    2. The partial interest exclusion on loans to an ESOP, and

    3. Nonrecognition sales of securities to an ESOP.

4.72.4.4.1  (04-01-2006)
IRC 4980 Exception

  1. There was 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. IRC 4980(c)(3). This exception applied to any amount transferred—

    1. after 3/31/85, and before 1/1/89, or

    2. after 12/31/88, pursuant to a termination which occurs after 3/31/85, and before 1/1/89.

  2. Within 90 days after the transfer (or longer period as the Secretary may prescribe), the amount transferred, and the income therein, must be invested in employer securities or used to repay an ESOP loan that was used to purchase employer securities.

    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 1/8 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 allocation of such amount. 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.

4.72.4.4.1.1  (04-01-2006)
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. Make sure the transfer of assets to the IRC 4980 suspense account took place:

    1. After 3/31/85, and before 1/1/89; or

    2. After 12/31/88, due to a plan termination after 3/31/85 and before 1/1/89. There is no exception to the reversion tax for amounts transferred to an ESOP after these dates.

  3. 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.

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

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

4.72.4.4.2  (04-01-2006)
Partial Interest Exclusion

  1. A bank, insurance company, corporation actively engaged in the business of lending money, or a regulated investment company may exclude 50% of the interest received from a securities acquisition loan. See IRC 133(a). A securities acquisition loan may result in a lower interest rate on a loan to an ESOP.

    Note:

    IRC 133 has been repealed by the SBJPA effective with respect to loans made after 10/13/95, (other than loans made pursuant to a written binding contract in effect on such date).

  2. A "securities acquisition loan" is:

    1. A loan to a corporation (back to back loan) or ESOP (direct loan) to the extent the proceeds are used to acquire employer securities for the ESOP (see IRC 133(b)(1)(A)), or

    2. A loan to a corporation to the extent that, within 30 days, employer securities are transferred to the plan in an amount equal to the loan proceeds, provided the securities are allocable to participant accounts within one year of the loan (an immediate allocation loan). See IRC 133(b)(1)(B).

  3. A loan to a corporation which is lent to an ESOP is treated as a securities acquisition loan if:

    1. The repayment terms are substantially similar to the loans terms to the corporation from the lender (a mirror loan), or

    2. The loan from the corporation to the ESOP requires a more rapid repayment of interest or principal (a rapid payment loan), and allocations under the ESOP attributable to this repayment do not discriminate in favor of highly compensated employees (within the meaning of IRC 414(q)). See IRC 133(b)(3).

  4. The term of a securities acquisition loan made after 7/10/89, cannot be greater than 15 years.

    1. If a securities acquisition loan is made after 7/10/89, a plan must hold more than 50% of each class of outstanding stock of the employer corporation, or more than 50% of the value of all outstanding stock of the corporation. See IRC 133(b)(6).

    2. If a loan is made after 7/10/89, ESOP participants must be able to direct the voting of all allocated securities in the ESOP acquired through a securities acquisition loan in accordance with IRC 409(e)(2). The full pass-through of voting rights applies even if the securities are not a registration-type class of securities (i.e., are closely held). See IRC 133(b)(7).

  5. The excludable period during which the partial interest exclusion is available is, in general, the 7 year period beginning on the date of the loan for any original securities acquisition loan (i.e., the direct loan or back to back loan described at IRC 133(b)(1)(A) or immediate allocation loan described at IRC 133(b)(1)(B)).

    1. If the term of an original acquisition loan described at IRC 133(b)(1)(A) is greater than 7 years, the excludable period is the term of the loan (which cannot be greater than 15 years).

    2. The excludable period for a rapid payment loan described at IRC 133(b)(3)(B) or an immediate allocation loan described at IRC 133(b)(1)(B) cannot be greater than 7 years.

4.72.4.4.3  (04-01-2006)
IRC 133 Excise Tax

  1. An excise tax is imposed if a taxable event occurs with respect to securities acquired by an ESOP in an IRC 133 transaction. See IRC 4978B. A taxable event subject to the excise tax occurs where there is any disposition of employer securities acquired in a IRC 133 transaction within 3 years of their acquisition if: a. the total number of employer securities held by the plan after the disposition is less than the total number of employer securities held after the acquisition, or b. except to the extent provided in regulations, the value of the employer securities held by the plan after the disposition is 50% or less of the total value of all employer securities at the time of the disposition.

  2. A taxable event subject to the excise tax also occurs if there is a disposition of employer securities acquired in an IRC 133 transaction to which a. and b. above do not apply if the disposition occurs before the securities are allocated to participant accounts, and the proceeds of the disposition are not allocated.

  3. The excise tax is equal to 10% of the amount realized on the disposition to the extent allocable to IRC 133 securities, determined as if such securities were disposed of from:

    1. IRC 133 securities acquired during the 3-year period ending with disposition, beginning with the securities first so acquired;

    2. IRC 133 securities acquired prior to the 3-year period, unless such securities (or proceeds from their disposition) have been allocated to participant accounts;

    3. IRC 1042 securities acquired during the 3 year period ending on the date of the disposition, beginning with the securities first so acquired;

    4. Any other employer securities.

  4. The excise tax does not apply to a distribution of IRC 133 securities which is made due to a participant’s:

    1. death or disability,

    2. separation from service for a period which results in a one-year break in service, or

    3. retirement after attaining 591/2 years of age.

  5. The excise tax does not apply to an exchange of IRC 133 securities—

    1. In a corporate liquidation that has acquired those securities into an eligible worker-owned cooperative.

    2. Pursuant to a diversification election under IRC 401(a)(28).

    3. For employer securities of another corporation pursuant to an IRC 368(a)(1) reorganization.

    4. A forced disposition of IRC 133 securities due to operation of a State law will not be treated as a disposition if the securities were regularly traded on an established securities market at the time they were acquired by the plan.

4.72.4.4.4  (04-01-2006)
Examination Steps

  1. Look at the applicable questions on Schedule E of Form 5500, ESOP Annual Information, to determine whether the plan has engaged in a securities acquisition loan under IRC 133. If yes, complete the remaining examination steps in this section.

  2. Determine whether the loan is from a qualified lender.

  3. Check that the loan qualifies as a securities acquisition loan.

  4. For post 7/10/89 loans, determine whether the ESOP held 50% of the stock, or 50% of the value of the stock, after the securities acquisition loan.

  5. For post 7/10/89 loans, make sure full pass-through voting rights apply to IRC 133 securities that have been allocated.

  6. Determine whether the partial interest rate exclusion of the lender is available for a period not in excess of the excludable period. This is an item for referral to a corporate tax examiner.

  7. Determine whether any IRC 133 securities were disposed of in a taxable event. If yes, find out whether any of the exceptions to the excise tax apply.

4.72.4.5  (04-01-2006)
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% of:

    1. each class of outstanding stock of the corporation which issued the qualified securities, or

    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 3 years as of the time of the sale. The replacement period is the period which begins 3 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% of the gross receipts of the corporation, and

    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 tradeable on an established securities market, and 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).

4.72.4.5.1  (04-01-2006)
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 5% 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% 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. 10 years after the date of the sale, or

    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% 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% 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% 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.

4.72.4.5.2  (04-01-2006)
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% of the amount involved and is to be paid by the employer sponsoring the plan.

4.72.4.5.3  (04-01-2006)
IRC 4978 Excise Tax

  1. An excise tax under IRC 4978 can be imposed if, during the 3-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:

    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, or

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

  2. The excise tax will be 10% 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 133 securities acquired during the 3-year period ending on the date of such disposition;

    2. IRC 133 securities acquired before such 3-year period unless such securities have been allocated to accounts of participants;

    3. IRC 1042 securities acquired during the 3-year period ending on the date of disposition;

    4. Any other employer securities.

  3. The 3-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, or

    3. retirement after attaining 591/2 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).

4.72.4.5.4  (04-01-2006)
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% of—

    1. each class of outstanding stock of the employer corporation, or

    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 3 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 3 years after the plan acquired them.

4.72.4.6  (04-01-2006)
Subchapter S Corporation ESOPs

  1. Effective for tax years after 12/31/97, the Small Business Job Protection Act of 1996 (SBJPA) and the Taxpayer Relief Act of 1997 (TRA ’97) made amendments that permitted Sub S Corporations to adopt and sponsor ESOPS. See IRC section 1361(c)(6). The ESOP is treated as a single shareholder for purposes of the 75-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 tax income (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 section 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 section 402(e)(4) is determined using the ESOP’s adjusted basis in the stock. See, Revenue Ruling 2003-27, 2003-11 I.R.B. (March 17, 2003).

    3. Due to the statutory limits on the number of shareholders permitted for a Sub S Corporation, IRC section 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 section 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 S corporation ESOPs.

    1. An S corporation ESOP has lower deduction limits than an C corporation ESOP. The 25% 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 an 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 an S corporation ESOP. See IRC 404(a)(9)(C). An employer’s deduction for contributions to an S corporation ESOP is subject to the same limits as any profit-sharing or stock bonus plan, i.e. 25% 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 S corporation ESOPs. However, as stated in 4.6.1(6) an S corporation can use S corporation distributions on both allocated and unallocated shares to repay an exempt loan as long as the requirements of section 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 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 S corporation shareholders. See IRC 1042(c)(1)(A).

4.72.4.6.1  (04-01-2006)
Examination Steps

  1. Determine the type of entity that has adopted the ESOP under examination. If adopted by an electing S Corporation, apply the statutory requirements relevant to 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 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. If dividends were declared and issued for the year under audit, confirm that no deduction was taken under IRC 404(k).

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

  4. Verify that the expanded IRC 404(a)(9) deduction limit of 25% is not utilized by the S Corporation. A stock bonus ESOP should be limited to the 15% limit, for years prior to January 1, 2002.

  5. If an exempt loan is utilized, verify that the expanded deduction of contributions applied toward interest payments per IRC 404(a)(9) is not utilized.

  6. If an exempt loan is utilized, confirm that dividends paid on allocated shares is not used to service the exempt loan debt.

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

  8. Carefully scrutinize any 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, business customers and related corporations for which they perform services should be discussed. If it is determined that this Subchapter S entity is a organization whose principal business is performing, on a regular and continuing basis, management functions for another organization (or for 1 organization and other related organizations), additional development may be needed. It is possible that an affiliated service group may exist under IRC section 414(m)(5).

4.72.4.6.2  (04-01-2006)
IRC 409(p)

  1. EGTRRA of 2001 enacted IRC section 409(p) effective for plan years after 12/31/04, but immediately effective for S corporation ESOPs established on or before 3/14/01. The intent of this law is to limit the tax deferrals provided by an S corporation ESOP to those situations where there is broad-based employee coverage under the ESOP and the ESOP benefits rank-and-file employees as well as highly compensated employees and historical owners. Section 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 S corporation a 50% excise tax on the " prohibited allocations" . That section also imposes a 50% 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). As an additional result, 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 12-31-04.

    2. The special effective date is for ESOP years ending after 3-14-01. The special effective date applies to corporations that converted to S status or established ESOPs after 3-14-01. In these situations, the provisions apply to plan years ending after 3-14-01. Therefore if an S corporation makes an election after 3-14-01 or the ESOP is started after 3-14-01, the ESOP will always be subject to the new anti-abuse legislation.

      i. Revenue Ruling 2003-6, 2003-3 I.R.B. 286, January 21, 2003, guidance with respect to certain arrangements involving the establishment of ESOPS holding securities in S Corporations that the Service determined will not be considered timely established on or before March 14, 2001.

      ii. This ruling provides that the delayed effective date for IRC section 409(p) does not apply in certain circumstances. The facts of this revenue ruling pertain a promoter, who arranges for the establishment of a number of 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 section 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.

4.72.4.6.2.1  (04-01-2006)
Examination Steps

  1. Determine the type of entity that sponsored the ESOP under examination. If adopted by an electing S Corporation, ascertain whether a valid existing ESOP was adopted and effective on or before March 14, 2001. In addition, confirm that a valid "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 Revenue Ruling 2003-6 applies. If based on interview(s) and/or other case development, it appears that abusive step transactions such as those covered by Revenue Ruling 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 sections 409(p) and 4979A.

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

4.72.4.6.3  (04-01-2006)
Nonallocation Year

  1. Under IRC 409(p), a nonallocation year means a plan year during which on any date disqualified persons own 50% or more of the stock in the S corporation taking into account all outstanding shares in the 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% shareholder group" or "deemed 10% shareholder " taking into account synthetic equity owned by the individual if such addition causes the individual to become disqualified.

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

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

    (i). stock allocated to an account of an individual by the ESOP and

    (ii). an individual's share of unallocated stock held by the ESOP. IRC section 409(p)(4)(C)(ii) provides that a person’s share of unallocated 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.

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

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

      Family members will include the

    (i). individual’s spouse,

    (ii). ancestors or lineal descendant of the individual or the individual’s spouse,

    (iii). brother or sister of the individual or the individual’s spouse and any lineal descendant of the brother or sister, and

    (iv). the spouse of any individual described in (ii) or (iii). The definition of a "non-allocation year" is any ESOP plan year where, at any time during the year, "disqualified persons" own directly or through attribution, 50% of the number of outstanding shares of the S corporation. The attribution rules of §318 apply in this computation except there are some modifications that will not be addressed here. See IRC section 409(p)(3)(B) for the attribution rules.

  3. 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 S corporation and deemed owned shares of that individual.

    1. 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 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.

      (i). Section 1.409(p)-1T(f)(2)(iv) of the Regulations (published in 2003) (the "2003 Regulations" ) expanded the definition of synthetic equity to include non-qualified deferred compensation. This includes any remuneration for services rendered to the S corporation to which IRC 404(a)(5) applies.

      (ii). 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 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.

      (iii). 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 so shares equal to the present value of the synthetic equity divided by the fair market value of a share of the S Corporation’s stock as of the same date. Section 1.409(p)-1T of the regulations, published in 2004 ("the 2004 Regulations" ) and superseding the 2003 regulations, but generally effective 1/1/05, provided the following special rules in regards to synthetic equity:

      • 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.

      • 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.

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

  4. Determination of a "disqualified person" and the occurrence of a nonallocation year. (Person-by-person rule)

    Under the 2003 Regulations, a person’s synthetic equity shares are added to his deemed-owned ESOP shares to determine whether he is a disqualified person. This total number of shares is then compared with the total number of deemed-owned shares and outstanding synthetic equity shares. If the result is 10% or higher the individual is a disqualified person.

    To determine whether a nonallocation year has occurred under the 2003 Regulations, all the shares of stock of all the disqualified persons are compared with all the outstanding stock and synthetic equity of the S corporation. If the result is 50% or higher, a nonallocation year has occurred.

    1. Since the above type of determination allowed other shareholders to dilute the interests of the person being tested and prevent them from being treated as a disqualified person, the 2004 regulations changed the testing methods, generally effective 1/1/05. (See the transitional rules in section 1.409(p)-1T(i)(2). Under the person-by-person rule, the individuals total shares (deemed-owned and synthetic equity shares) are compared with the total number of deemed owned shares and the individual’s synthetic equity shares. Similarly, the determination of a nonallocation year is made by comparing all the shares of the disqualified persons with all the outstanding shares of the S corporation and all the synthetic equity shares of the disqualified persons.

4.72.4.6.4  (04-01-2006)
Prohibit 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 S corporation) for the benefit or any "disqualified person" .

    Under the 2004 regulations "prohibited allocations" consists of 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 ("impermissible accruals" ). In addition prohibited allocations include any allocation for a disqualified person under any IRC401(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 S corporation stock but for an ESOP plan provision to comply with IRC 409(p).

    1. Section 1.409(p)-1T(i)(2)(iii)(A) of the 2004 Regulations provides a special transitional rule for purposes of IRC 409(p) but not for purposes of the imposition of the excise tax under IRC 4979(A), which provides that ESOP shares held for a disqualified person after 1/1/05 will not be treated as a prohibited allocation in 2005 if the shares are disposed of before 7/1/05.

    2. In addition to the excise tax imposed on an S corporation under IRC 4979(A) (See 4.72.4.6.6 below) 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 section IRC 4975(d)(3) and also become subject to the unrelated business tax under IRC 512.

4.72.4.6.5  (04-01-2006)
Avoidance or Evasion

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

    1. Section 1.409(p)-1T(g)(2) of the 2004 Regulations 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 S corporation.

4.72.4.6.6  (04-01-2006)
IRC 4979(a) for Purposes of IRC 409(p)

  1. IRC 4979(a) provides for an excise tax on the S corporation equal to 50% 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. upon the ownership of synthetic equity by a disqualified person in a nonallocation year, the value of the shares on which such synthetic equity is based. Note that this excise tax is imposed independent of whether a prohibited allocation has occurred or whether any of the disqualified persons participated in the plan.


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