3820 / What special qualification requirements apply to employee stock ownership plans (“ESOPs”)?

Stock bonus plans and employee stock ownership plans (“ESOPs”) must meet the requirements set forth in Q 3819; S corporation ESOPs must meet the special requirements described in Q 3825.ESOPs also must meet the requirements discussed below.

Qualified Sales

Provisions of the plan must ensure that, in the case of certain “qualified sales” of employer securities by a participant or executor to the ESOP, no portion of the assets of the plan (or any other qualified plan of the employer) attributable to the securities purchased by the plan may accrue or be allocated for the benefit of any of the following persons:

(1)  a taxpayer who has elected to have the gain on the sale and replacement of employer securities deferred under the qualified sales rules of IRC Section 1042
( Q 3731);

(2)  any individual who is a member of the family (brothers, sisters, spouse, ancestors, lineal descendants) or is related under the other rules of IRC Section 267(b) to the taxpayer described in (1);

(3)  any person not described in (1) or (2) who owns, or is considered as owning under the attribution rules of IRC Section 318(a), more than 25 percent (by number or value) of any class of outstanding stock of the employer or of any corporation which is a member of the same controlled group of corporations as is the employer ( Q 3933).¹ For purposes of determining whether this limitation applies, an individual is treated as owning any securities he owned during the one-year period ending on the date of the sale to the plan, or as of the date the securities are allocated to participants in the plan.²

No employer securities acquired by the plan in any transaction to which IRC Section 1042 applied can be allocated to such persons. Thus, an employee who sold his employer securities to an ESOP and elected nonrecognition under IRC Section 1042 could not receive allocations based on other employer securities acquired by the plan in a different IRC Section 1042 transaction.³

Nonallocation Period

After the later of the date that is 10 years after the date of the sale of securities or the date of the plan allocation attributable to the final payment on indebtedness incurred in connection with the sale, a plan may permit accruals or allocations for individuals described in (1) or (2), above, but not individuals described in (3). This 10 year period is referred to as the “nonallocation period.”⁴ This time period should not be confused with the “nonallocation year”
( Q 3825).

A special rule provides that the prohibition under (2) does not apply to a lineal descendant of the taxpayer if the aggregate amount allocated for the benefit of all lineal descendants of the taxpayer during the nonallocation period is not more than 5 percent of the employer securities (or amounts allocated in lieu thereof) held by the plan which are attributable to a qualified sale by a member of any of the descendants’ families (brothers, sisters, spouse, ancestors, lineal descendants).⁵

If a plan fails to meet these requirements, not only is the plan likely to be disqualified, but a penalty tax equal to 50 percent of the amount of any prohibited accrual or allocation will generally be levied against the plan. Also, the amount of any prohibited accrual or allocation will be treated as if distributed to the individual involved and taxed as such.⁶

Regulations

An ESOP must meet requirements set forth in applicable regulations.⁷ The regulations require that an exempt loan be primarily for the benefit of participants and their beneficiaries. The proceeds of an exempt loan may not be used to buy life insurance; otherwise, the general rules applicable to the purchase of life insurance by qualified plans apply ( Q 3830). The plan or employer may have a right of first refusal if the stock is not publicly traded.

Stock that is acquired after September 30, 1976, with the proceeds of an exempt loan and that is not publicly traded or that is subject to a trading restriction must be subject to a put option exercisable only by a plan participant or by the participant’s donees or successors. The option must permit a participant to “put” the security to the employer but must not bind the plan. Nonetheless, the plan may have the right to assume the employer’s obligation when the put option is exercised. An ESOP may not otherwise obligate itself to a put option or to acquire securities from a particular security holder on the happening of an event such as the death of the holder (e.g., a buy-sell agreement). Regulations provide rules for the current distribution of income. ESOPs generally may not be integrated with Social Security.⁸