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Home > ESOPs > Articles Online > ESOP Forum >
Although the ESOP Forum started to focus on S corporation ESOPs in its last release, a recently discovered internal memorandum issued by the Internal Revenue Service (IRS) on June 13, 1996, which characterizes "casual" sales of unallocated company stock as prohibited transactions, and the IRS' use of such memorandum in reviewing ESOP determination letter applications, has temporarily shifted the ESOP Forum's focus to this subject.
The recently released memorandum interprets General Counsel Memorandum (GCM) 39747 and Private Letter Ruling (PLR) 8828009 to conclude that an ESOP does not qualify if it contains provisions that permit the proceeds from the "casual" sale of unallocated company stock held in an ESOP suspense account to be used to repay an ESOP loan. Furthermore, the memorandum concludes that such "casual" sales are not for the exclusive benefit of ESOP participants but rather are for the benefit of the ESOP sponsor, and, therefore, constitute prohibited transactions under section 4975 of the Internal Revenue Code of 1986, as amended (the Code), for which an exemption is not available.
The IRS' rationale is that an ESOP loan that is used to finance the purchase of company stock must generally be repaid by employer contributions and earnings and dividends on such employer contributions, according to the ESOP loan regulations under Code section 4975. Because such loans are typically guaranteed by the ESOP sponsor or are made by the ESOP sponsor to the ESOP, they are liabilities of the ESOP sponsor and not of the ESOP plan participants. As such, the IRS concluded that it would improperly benefit the ESOP sponsor to the detriment of the ESOP plan participants if the ESOP fiduciaries could sell unallocated company stock held in the ESOP and use the proceeds to repay the ESOP loan because this would relieve the ESOP sponsor of its obligation to make contributions to the ESOP to allow the ESOP to repay the debt.
The IRS does recognize in the memorandum that neither the above-mentioned GCM or PLR prohibit the sale of unallocated company stock on plan termination, corporate merger, a complete asset sale, or other similar events that would not violate Code section 4975(e)(7) and the regulations thereunder.
With this memorandum as support, many employee plan specialists at the IRS' key district offices have started to question language in ESOP plan documents that permits the sale of company stock and the use of proceeds from such sales to repay the debt incurred to purchase such stock when reviewing determination letter applications. One harsh result from such questioning has been the issuance of a caveat in the determination letter to the effect that it may not be relied upon as granting a prohibited transaction exemption under Code section 4975(c)(2).
An effective response to the IRS' inquiry regarding "casual" sale language is to modify the language that permits sales of unallocated company stock to provide that such sales cannot occur unless they are in the best interests of ESOP plan participants. This has worked in a number of IRS key districts to obtain a determination letter that does not contain the section 4975(c)(2) caveat.
Another focus of such IRS inquiries and the IRS memorandum has been on the debiting of ESOP participants' accounts to reflect the repayment of an ESOP loan. The IRS' memorandum does not clearly explain why this is problematic but links this provision to its concern about "casual" sales of unallocated company stock. Although the inquiries have not focused on changing such language, ESOP companies that are seeking determination letters for their plans should be reluctant to modify ESOP plan document language that provides for such debiting because it is a necessary element of proper ESOP recordkeeping.
This ESOP forum will continue to apprise readers of developments like this and practical solutions for effectively dealing with such developments. It will return once again to an S corporation ESOP focus in the next release of this forum. In the meantime, please feel free to raise other issues that this forum should focus on by sending email to the author at drj@esop-law.com.
Copyright © 2002 by The National Center for Employee Ownership (NCEO) (phone 510/208-1300; email nceo@nceo.org; WWW http://www.nceo.org/). All rights reserved.
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