Employer Stock Issues In Qualified Plans

Published in The Practical Tax Lawyer

AN EMPLOYEE STOCK OWNERSHIP PLAN (ESOP) is a qualified defined contribution retirement plan, much like a profit-sharing or 401(k) plan. An ESOP, however, is designed to invest primarily in employer securities. The Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code of 1986 (Code), provide substantial tax incentives and planning opportunities for employers that sponsor ESOPs. Besides providing retirement benefits, ESOPs can address corporate finance and other business objectives, including resolving ownership succession issues; diversifying investments; planning their estates and charitable donations; borrowing funds to finance transactions or refinance debt; reducing or eliminating federal income tax; and increasing employee benefits and productivity incentives. ESOPs are attractive to employers for many reasons, but they have special characteristics and requirements that distinguish them from other defined contribution plans.

ESOP AS DEFINED CONTRIBUTION PLAN - The Code divides all qualified deferred compensation plans into two categories — defined contribution plans (Code §414(i); ERISA §3(34)) and defined benefit plans (Code §414(j); Treas. Reg. §1.401‑1(b)). A defined contribution plan provides benefits equal to a participant's account balance, which may include employer contributions, participant contributions, forfeitures, and a participant's pro rata share of the income, loss, and expenses applicable to the trust. A defined benefit plan provides annuity benefits on a formula, typically based on service and compensation.

An ESOP is another type of defined contribution retirement plan, which contains a stock bonus plan element. A stock bonus plan is a plan established and maintained to provide benefits similar to those provided by profit‑sharing plans, but distributable in employer stock. Treas. Reg. §1.401‑1(a)(2) (iii) and (b)(1)(iii). ESOPs are subject to the same general qualification requirements as profit-sharing and other defined contribution plans, but there are several special rules that distinguish them.

SPECIAL ESOP QUALIFICATION REQUIREMENTS - An ESOP must be identified in the plan document as an employee stock ownership plan Treas. Reg. §54.4975-11(a)(2), and designed to invest primarily in employer securities, Treas. Reg. §54.4975-11(b). The Internal Revenue Service (IRS) has not interpreted the phrase "designed to invest primarily in employer securities," but the phrase implies that an ESOP must be intended to permit the plan trustees to invest or hold most of the plan assets in employer securities without specific duration or percentage requirements. Similarly, Department of Labor (DOL) guidance does not establish a specific standard for the "primarily invested" requirement, but instead looks to facts and circumstances. DOL Advisory Opinion 83‑6A (Jan. 24, 1983). In Advisory Opinion 83-6A, DOL stated that neither ERISA nor the regulations impose a maximum or minimum percentage on the amount of plan assets that must be invested in employer securities under ERISA §407(d)(6). Code section 409(l) defines "employer securities" as common stock issued by an employer that is readily tradable on an established securities market. If an employer's common stock is not publicly traded, the term means common stock issued by the employer that has a combination of voting powers and dividend rights equal to or greater than the powers and rights of the class of common stock of the employer that has the greatest voting powers and the class of common stock that has the greatest dividend rights. "Employer securities" also include non-callable preferred stock if such stock is convertible into the qualified common stock described above at a reasonable conversion price (as of the date of acquisition by the ESOP). Code §409(l)(3). For a discussion of employer security design, see Kim Schultz Abello and Gregory K. Brown, ESOPs and Security Design: Common Stock, Super Common or Convertible Preferred? 23 J. Pens. Plan. & Compliance 99 (Summer 1997). The term "employer securities" also includes, for a non-publicly traded company, securities issued by any member of the employer's controlled group of corporations. Under Code section 409(l)(4), the phrase "controlled group of corporations" has the meaning set forth in Code section1563(a) (disregarding subsections (a)(4) and (e)(3)(C)), except that the parent company must own only 50 percent (rather than 80 percent) of the stock of a subsidiary for that subsidiary and those below it to be members of the controlled group.

Code §415 Limitations for ESOPs

Code §415(c)(1) generally provides that the contributions that may be credited as "annual additions" to a participant's defined contribution plan accounts in a limitation year may not exceed the lesser of (i) $49,000 (for 2011), or (ii) 100 percent of the participant's compensation. "Annual additions" are employer contributions, employee contributions, and forfeitures for the year to all defined contribution plans sponsored by an employer. Code §415(c)(6) contains a special limitation rule for leveraged ESOPs sponsored by C corporations. Under this special rule, if no more than one‑third of the employer ESOP contributions are allocated to highly compensated employees (as defined in Code §414(q)), the employer contributions to the ESOP that are used to pay interest on the ESOP loan and reallocated forfeitures of employer securities that were acquired with the proceeds of the loan are excluded from the annual addition limitation calculation.

The IRS final regulations issued in April 2007 provide that annual additions under an ESOP for purposes of the Code §415 limits may be calculated based on employer contributions used to repay an exempt loan or based on the fair market value of the employer securities allocated to participant accounts. See 72 Fed. Reg. 16,878 (Apr. .If the annual additions are calculated based on employer contributions, appreciation in the value of the employer securities from the time they were purchased and placed in the suspense account is not counted for Code §415 purposes. Treas. Reg. §54.4975-11(a)(8) (ii).Dividends paid on employer securities held by an ESOP generally are treated as plan earnings and do not count against the Code §415 annual addition limits. See, e.g., Treas. Reg. §1.415(c)-1(b)(1)(iv).

Dividends

Unlike other defined contribution plans, ESOPs may make tax-advantaged distributions of dividends paid on employer securities. A C corporation may deduct dividends paid on employer securities held by a leveraged ESOP maintained by the corporation or a controlled group member, provided that the dividends are paid in cash directly or through the ESOP to ESOP participants or their beneficiaries; reinvested in employer securities, if participants have been given the election to receive the dividends in cash or to reinvest them in employer securities; or used to repay an ESOP loan. Code §404(k). The IRS has published proposed regulations that would deny a deduction to a U.S. subsidiary of a foreign parent for dividend payments made by the parent. Prop. Treas. Reg. §1.404(k)-2. In addition, the IRS has the authority to disallow a dividend deduction that constitutes an avoidance or evasion of taxation. Code §404(k)(5)(A). The special dividend distribution rules are not available to S corporations. Any S corporation distributions that are passed through an ESOP in a manner similar to C corporation dividends will be treated as distributions from the plan. The 10 percent penalty tax on early distributions will apply, withholding will be required, participants whose account balances exceed $5,000 must consent in writing to receive the distribution, and the distribution will be eligible for rollover to an IRA or a qualified plan. Corporate law "dividends" in an S corporation may not be treated as "dividends" for tax purposes because a "dividend" for tax purposes must be paid from current or accumulated earnings and profits, which an S corporation does not have (unless it carries over accumulated earnings and profits from a prior status as a C corporation). Code §§316 and 1371(c).

Dividends Paid To Participants

Dividends paid to ESOP participants or their beneficiaries are deductible if they are paid in cash directly or paid to the ESOP with a subsequent distribution to participants or beneficiaries within 90 days after the end of the plan year in which the dividends are paid. Code §404(k)(2)(A)(i) and (ii). The corporation paying the dividends is entitled to take a deduction in the year in which the ESOP participants or beneficiaries have a corresponding income inclusion. Code §404(k)(4)(A). Code section 404(k) dividends paid in cash to ESOP participants and beneficiaries constitute ordinary income to the participants and beneficiaries, and they are exempt from the 10 percent penalty tax on early distributions from qualified plans. Code §72(t)(2) (A)(vi).They are not eligible for the 15 percent tax rate on qualified dividends. Jobs and Growth Tax Relief Reconciliation Act of 2003, Pub. L. No. 108-27, Code §1(h)(11)(B)(ii)(III).Tax withholding is not required with respect to such dividend payments Code §3405(e)(1)(B)(iv) and the payments are exempt from the $5,000 mandatory distribution restrictions. Code §411(a)(11)(C). However, they are not eligible for tax-free rollover to an IRA or another qualified plan. Treas. Reg. §1.402(c)-2, Q&A- 4(e).

Dividends Reinvested In Employer Securities

Under Code §404(k)(2)(A), an ESOP sponsor may allow participants and their beneficiaries to elect to reinvest applicable ESOP dividends in qualified employer securities through their accounts in the ESOP without causing the employer to lose the dividend deduction. An ESOP sponsor that offers such an election must allow participants to elect:

Either (i) payment of dividends in cash or (ii) payment to the ESOP and...