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IRS Scrutinizes Sales of Suspense Account Stock to Prepay ESOP Loans

David Johanson

March 1995

The Internal Revenue Service (IRS) issued a number of private letter rulings during 1994 (9416043, 9417032, 9417033, and 9426048) concerning the use of proceeds from the sale of stock held in an ESOP suspense account to prepay the outstanding principal balance on an ESOP loan. In those private letter rulings, the IRS approved the use of such proceeds to prepay the ESOP loan in situations involving mergers, takeovers, and other types of corporate reorganizations that resulted in the termination of the ESOPs. The IRS National Office Employee Plans Division is now looking closely at situations where the cash proceeds received from the sale of ESOP suspense account stock are used to prepay an ESOP loan and the ESOP will not be terminated. The IRS will consider whether it is appropriate to use the sale proceeds to prepay the ESOP loan or whether future employer contributions will be required for that purpose.

The ESOP loan regulations under the Employee Retirement Income Security Act of 1974, as amended (ERISA), and the Internal Revenue Code of 1986, as amended (Code), require that any use of proceeds from the sale of suspense account stock to prepay an ESOP loan must be "primarily" for the benefit of ESOP participants. The IRS determines compliance with this primary benefit requirement on a facts-and-circumstances basis. Among the factors the IRS considers are whether the transaction promotes employee ownership, whether contributions to the ESOP have been substantial and recurring, and the extent to which the method of loan prepayment results in benefits for ESOP participants.

The IRS also has taken the position in the prior private letter rulings that the allocation of excess sale proceeds (attributable to ESOP suspense account stock) to ESOP participants results in "annual additions" for purposes of the allocation limitations under section 415(c) of the Code. In the summer of 1994, the ESOP Association protested to the IRS that such treatment was not supported under the Code, inasmuch as the amount so allocated to ESOP participants' accounts represents investment earnings, not employer contributions. The ESOP Association received a response that the "issue is receiving careful attention by the appropriate offices within the Service" and that it would be contacted "if it appears that further discussion with [the ESOP Association] would be productive." The ESOP Association recently sent another communication to the IRS regarding this very important issue. I will update readers of the ESOP Forum if the IRS responds to the ESOP Association's inquiries regarding the section 415 issue. I also will update readers if the IRS issues any formal guidance on the use of sale proceeds to prepay an ESOP loan in a situation in which the ESOP is not terminated.

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