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"Control" ESOP Transactions

David Johanson

September 1997

Over the past few years, professionals in the employee ownership community have developed a business succession structure for a sale of company stock to an employee stock ownership plan and trust (ESOP) that provides significant advantages to the owner who sells such stock to the ESOP (in that he or she receives "control" value rather than a price discounted for minority interest purposes) and commits the owner to selling a controlling interest in the company within a reasonable period of time, which, in turn, provides employees certainty that the sale to the ESOP will not simply be for liquidity purposes.

Typically, in order to justify the ESOP's paying "control" value for company stock, a number of safeguards and protections are included in the transaction documents for the ESOP and its participants. For example, the owner not only sells 30% of the issued and outstanding company stock to the ESOP in the first transaction but he or she also commits to selling at least another 21% of such stock within three to seven years after the first transaction. In addition, the owner commits the company to assist the ESOP in financing the second transaction and, if the company is not financially able to do so at the time of the second transaction, the owner commits to curing any collateral deficiency to allow the ESOP to exercise its purchase rights. The owner also abstains from any involvement as a member of the ESOP's Board of Trustees in exercising the purchase rights, although he or she may continue as a member of such Board after the initial transaction is completed. If the owner attempts to sell the company after the first transaction and before the second transaction in which the ESOP purchases "control," the ESOP is given the opportunity to exercise its purchase rights first, to exercise its purchase rights and "tag along" with the owner in the sale or to permit the transaction to occur and hold onto its purchase rights. ESOP participants are normally protected further in these transactions by receiving a commitment from the company that any stock that is distributed from the ESOP for a certain period of time after the initial transaction will be repurchased by the company at a minimum or "floor" price (regardless of fair market value at the time) and, in any event, will receive "control" value for such stock.

Despite all of these protections that can be and are built into these "serial" sale ESOP transactions, the Internal Revenue Service (IRS) has recently questioned this structure for an ESOP transaction on audit of a number of ESOP companies. It is not entirely clear whether such companies included all of the above protections in their ESOP transactions. Nevertheless, the IRS' main contention on audit has been that the ESOP did not receive "control in fact" (or voting control) at the time of the initial transaction and, therefore, could not pay "control" price at that time.

The IRS' contention is suspect in at least one major respect. In summary, but not exact language, the U.S. Department of Labor's (DOL's) proposed "adequate consideration" regulations provide for the payment of "control" price if the ESOP is given a right to purchase a controlling interest pursuant to a written binding commitment that exists at the time of the initial transaction and may be exercised by the ESOP within a reasonable period of time after the initial transaction. The regulations also indicate that the ESOP may pay "control" price if it acquires "control" in the initial transaction. The DOL's proposed regulations, thus, draw a distinction between immediate "control in fact" (or voting control) and such "control" passing within a reasonable period of time. To disregard this distinction as the IRS has chosen to do in these audit situations swallows the DOL's rule of allowing "control in fact" to pass within a reasonable period of time. Apparently, the IRS is attempting to take "jurisdiction" over this issue based upon the fact that the DOL has never finalized its proposed regulations, which were originally proposed in May 1988.

There are a number of aspects of the DOL's proposed regulations that need clarification but taking the position the IRS has with respect to the "control" transaction language in the proposed regulations does not make practical or intuitive sense. If structured properly, this type of transaction ensures that the ESOP will gain "control" of the company within a reasonable period of time after the initial transaction and will not simply be a liquidity device motivated primarily by the owner's financial considerations, which, albeit are very important, but should not be the primary reason for completing an ESOP transaction.

This forum will revisit this subject in the future as more information becomes available regarding the IRS' position. 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.

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