EMPLOYEE STOCK OWNERSHIP PLANS JANE ARMSTRONG PHELPS DUNBAR LLP

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1 EMPLOYEE STOCK OWNERSHIP PLANS JANE ARMSTRONG PHELPS DUNBAR LLP Jane Armstrong, Esq., Partner, Phelps Dunbar, LLP Jane Armstrong is a partner at Phelps Dunbar LLP, a regional law firm that is headquartered in New Orleans. She has practiced exclusively in the areas of employee benefits and executive compensation for over 30 years. Jane has been listed in all editions of the Best Lawyers in America and Louisiana Super Lawyers, and is listed in the Chambers U.S.A. as a leading practitioner in the employee benefits field. She is a frequent speaker and author on retirement plan issues. Jane graduated from Vanderbilt University School of Law, where she was elected to the Order of the Coif. 1

2 Types of Plans Holding Employer Securities Defined contribution plan invested in employer securities Stock bonus plan ESOP, including profit sharing plan for purposes of dividends paid deduction Leveraged ESOP ELIGIBLE ESOP SPONSORS C Corp S Corp Type of Entity Eligible Sponsor Ineligible Sponsor LLC taxed as C Corp MAYBE (PLR (9/18/2015)) LLC taxed as Partnership Partnership 2

3 ESOP TRANSACTIONS Leveraging Code Sec. 4975(d)(3) Exempt loan made to finance purchase of employer securities Re-financings DOL FAB (9/26/2002) Renegotiation of exempt loan to extend term, reduce interest rate or to increase principal ESOP TRANSACTIONS 1042 Exchange Sale of stock to ESOP by substantial shareholders Gain on sale deferred, provided replacement securities acquired with sales proceeds and held for required period Sub S ESOPs Code Sec ESOP may be Sub S corp shareholder Beginning 1/1/1998, Sub S distributions made to ESOP not considered UBIT 3

4 BASIC ESOP REQUIREMENTS Code Sec. 4975(e)(7) BASICS Must be a defined contribution plan, designated as stock bonus plan or stock bonus and MPP (Code Section 4975(e)(7) Designed to invest primarily in qualified employer securities Definition - Code Sec. 409(l) Primarily = at least majority (DOL Ad. Op. 83-6A) 4

5 BASICS Qualified Employer Securities Common stock issued by sponsor with combination of voting power/voting rights equal to the class having greatest rights Convertible preferred stock may be OK May be issued by controlled group member May be authorized and unissued or treasury shares or shares purchased from shareholders Prohibited transaction exemption ERISA Sec. 408(e) BASICS - Voting Voting pass-through requirements Code Sec. 409(l) Allocated securities, whether or not vested Public corporations All votes Closely-held entities Specified matters Merger, consolidation, liquidation, asset sale, dissolution No instructions administrator may vote or mirror vote (plan provision) (DOL Interp. Bull ) 5

6 BASICS - Distributions Participant may elect to receive stock, unless sponsor s articles prohibit No post-distribution limitations on distributed shares permitted, except: Right of first refusal in favor of company Put in favor of participant BASICS - Distributions Must permit distribution no later than: Code Sec. 409(o)(1)(A) Last day of plan year following plan year in which separation for retirement, death, disability occurs 5 years following other separation events Further delay permitted if exempt loan outstanding (until loan repayment or NRA) 6

7 BASICS Distributions For stock acquired after 12/31/86: Code Sec. 409(o)(1)(C) Pay in not more than 5 annual installments, absent participant election Account balance over $1,070,000 May add 1 year for each $210,000 over limit Dollar limits adjusted annually BASICS - Put Code Section 409(h) Applies to employers who are not publicly traded Use fair market value Applies: During 60 days following distribution and for 60 days in the next play year 7

8 BASICS - Put Cash payment Installments require interest and security TAM Applies to sponsor, who may assign to plan or to a shareholder, but who remains primarily liable OTHER GENERALLY APPLICABLE REQUIREMENTS 8

9 Independent Appraiser Code Section 401(a)(28)(C) Closely-held stock IRS Ann (examination guidelines independence) Applies to all transactions made in employer securities Distributions/Puts Purchases/Sales Allocations Appraisal Issues Required under ERISA Sec. 408(e) (PT exemption for purchase of employer securities from disqualified person for adequate consideration ) When is an appraisal stale? Difference between appraisal and fairness opinion 9

10 Appraisal/Distribution Example Plan year ends 12/31/2015 Valuation completed 6/1/2016 Distribution event occurs 5/1/2016 Plan provisions: Use valuation date immediately preceding distribution Use valuation date immediately following Treatment of dividends Diversification Code Section 401(a)(28)(B); IRS Notice Applies to qualified participants Age years participation in ESOP Distribution or transfer right If distribute, put applies 10

11 Diversification Operation During qualified election period 5 years beginning with or after plan year in which attain age 55 Applies to 25% of total number of shares, reduced by number previously diversified Final year of election period, applies to up to 50% of number of shares, reduced by prior diversifications Replacement Rule Cash allocated to accounts may generally be applied for plan purposes (intra-plan) if replaced by securities with not less than same fair value Loan repayment, distributions Plan document requirement Replacement similar to an earnings allocation; should not be annual addition. Treas. Reg (c)-1(b)(iv) 11

12 NUA Net unrealized appreciation (NUA) Treas. Reg (a)-1(b)(2) At distribution: Trustee s basis taxed as ordinary income, subject to 10% penalty tax Appreciation (over trustee s basis) excluded from income and taxed as long-term capital gain at subsequent sale NUA Tracking Basis Generally, Average Cost Method Average cost to the trustee of all securities of the same type distributed Calculated at time of distribution or within 12 months Exchanged securities basis carried over (PLR ) 90-day reinvestment period if securities are sold 12

13 LEVERAGING ISSUES Repaying Loan Sources of loan repayment: Employer contributions Dividends/distributions on suspense account shares Proceeds of refinanced loan For C Corps - dividends paid on previously allocated securities - if replaced with securities released of equal value (replacement rule) 13

14 Repaying Loan For S Corps - after 12/31/1997, distributions on previously allocated securities - if replaced with securities released of equal value (replacement rule) Sale of suspense account shares (PLR (prepayment in connection with plan termination); PLR (same)) Timing Conversion ESOP established in 2014 Employer makes cash contribution for 2014 (delivered in 2015) Allocated as of 12/31/2014 ESOP enters into leveraging transaction early in 2015 First payment due 7/1/2015 Can 2014 contribution be applied to repay loan? 14

15 Contributions Code Sec. 404(a)(9) Increased contributions permitted C CORPS Code Sec. 404(a)(9) 25% contribution limit for loan principal No limit on deduction for interest payments Contributions Code Sec. 404(a)(9) Cautions: Timing - Loan must be incurred during plan year for contribution made before tax filing date Dividends/distributions must be commercially reasonable Under Code Section 404(j) cannot deduct contributions in excess of 415 limits 15

16 Annual Additions Code Sec. 415 Treas. Reg (c)-1(f) Allocate using amount ($) of employer contributions made to repay principal and interest (when securities have appreciated) Example: P & I payment = $250, allocation = pro rata portion of $250,000, using 415 compensation Annual Additions Code Sec. 415 Alternative (for depreciated securities) Allocate using fair market value of shares at time of release Plan document requirement Example: P & I payment = $250,000 Fair market value of released shares = $130,000 Allocate using $130,000 and 415 compensation 16

17 Annual Additions Code Sec. 415 Treas. Reg (c)-1(f)(3) Available to C corps only No more than 1/3 of contribution allocated to HCEs Exclude from annual additions forfeitures of securities acquired with loan proceeds Exclude from annual additions amounts applied to repay interest Plan Termination Leveraged ESOP Exempt loan outstanding at termination date Loan repaid using securities allocated to suspense account Remaining securities treated as an investment gain and allocated by account balance PLR ; Example: At time of stock sale: Loan balance (p&i) = $570,000 Deal value of suspense securities = $780,000 Amount treated as investment gain and allocated to accounts = $210,000 17

18 ADDITIONAL SUBCHAPTER S RULES S Corp Rules Participants NEED NOT have right to demand distribution in form of employer securities Distribute cash Distribute shares with mandatory repurchase requirement Cannot rollover S corp employer securities to IRA (Code Sec. 1361(IRA may not be S corp shareholder) 18

19 Prohibited Allocations Code Section 409(p) During a non-allocation year, no portion of the plan attributable to employer securities may accrue to disqualified persons Prohibited Allocations Code Section 409(p) Penalties: Prohibited allocation treated as distribution to disqualified person on first day of plan year 50% excise tax imposed on Sub S Code Sec Loss of PT exemption under Code Sec. 4975(d)(3) Loss of UBIT relief under Code Sec. 512(e)(3) 19

20 Definition Non-Allocation Year A plan year if AT ANY TIME during year: Disqualified persons own at least 50% of S corp shares (including deemed-owned shares) Disqualified persons own at least 50% of sum of S corp shares (including deemed-owned shares) and synthetic equity Definition Non-Allocation Year Deemed-Owned Shares allocated under ESOP and to be allocated from suspense account Synthetic Equity Options, warrants, restricted stock, stock subscription agreements, similar contracts, and deferred compensation 20

21 Disqualified Person Person owning at least 10% of all deemedowned shares Person and family members owning at least 20% of all deemed-owned shares Person owning at least 10% of deemed-owned shares, taking into account synthetic equity owned by the person Person and family members owning at least 20% of deemed-owned shares, taking into account synthetic equity Family Member Spouse Lineal ascendants and descendants Lineal ascendants and descendants of spouse Siblings, including lineal descendants of siblings Siblings of spouse, including lineal descendants of spouse s siblings 21

22 Definition Prohibited Allocation Impermissible accrual S Corp shares that are employer securities in ESOP ESOP assets attributable to shares (dividends, sales proceeds, earnings) Applies whether attributable to current or prior year (accumulated account balance) Assets held in account as of last day of 2004 plan year MAY be disregarded in certain circumstances Impermissible allocation Contribution or annual addition in ESOP Correction and Monitoring No correction under EPCRS Plan and ownership of synthetic equity must be monitored daily to avoid occurrence of non-allocation year Remedy: transfer employer securities, including attributable amounts to non-esop portion of plan BEFORE FIRST DAY OF PLAN YEAR 22

23 Correction and Monitoring Intra-plan transfers: Plan document must designate non-esop portion (separate account for each disqualified person, including family members) Determine sufficient amount taking into account possible allocations and changes in synthetic equity Transfer must be made from ESOP account to non-esop before the first day of any non-allocation year UBIT rules apply to non-esop account IRS Employee Plan News 7/1/2008 (model plan language for transfer) NUA BASIS S CORP Rev. Rul Basis adjustments required under Code Sec Increased for items of income under Code Section 1366 and certain other enumerated items Decreased for Distributions not includable in income Items of loss and deduction under Code Sec. 1366(a) Certain other enumerated adjustments 23

24 NUA BASIS S CORP Example 1,000 shares Purchase price: $1 million Basis = $1,000 per share 2015 allocations $50,000 income $20,000 tax distribution Basis = $1,030 per share ($50,000 income - $20,000 distribution)/1,000 shares JANE ARMSTRONG Phelps Dunbar LLP armstroj@phelps.com 24