Investment in Employee Stock Ownership Plans Clarified Through Recent Developments

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1 INVESTMENT IN EMPLOYEE STOCK OWNERSHIP PLANS 1 Investment in Employee Stock Ownership Plans Clarified Through Recent Developments Gregory K. Brown and Jeffrey M. Johns * An employee stock ownership plan ( ESOP ) is a defined contribution retirement plan designed to invest primarily in stock of the sponsoring employer (or an affiliated employer) that finances the purchase of such stock through a loan from, or guaranteed by, the sponsoring employer. In accordance with applicable regulations (the Exempt Loan rules), a leveraged ESOP holds the employer securities acquired with an ESOP loan in a suspense account. As the ESOP repays the loan over time, shares are released from the suspense account and allocated to participant accounts according to a specified formula. The operation of an ESOP involves a variety of fiduciary and tax issues and situations, such as whether or when to sell employer stock and what to do about outstanding debt when employer stock is sold, and how the S Corporation rules integrate with the operation of an ESOP. The following explores some recent developments with respect to the clarification of such issues and situations. IRS Rulings Clarify Issues for S-Corporation ESOPs Recent guidance from the Internal Revenue Service has clarified several issues related to ESOPs sponsored by S corporations including how and when an ESOP may direct a rollover of S corporation stock to a participant s individual retirement account, when an ESOP must adjust its basis in S corporation stock and the corresponding effect on net unrealized appreciation for ESOP distributions, and certain issues relating to the distribution of the earnings of an S corporation used to repay an ESOP loan: Rollover of S Corporation Stock to IRA Will Not Terminate S Election In Rev. Rul , 1 the IRS said that a corporation s S election will not be adversely affected by the direct rollover of the corporation s stock from * Gregory K. Brown is a Principal of Gardner Carton & Douglas, LLC in Chicago, Illinois. Jeffrey M. Johns is an associate at Shook Hardy & Bacon in Kansas City, Missouri IRB 511 (February 20, 2003). 1

2 2 JOURNAL OF TAXATION OF INVESTMENTS an ESOP to an IRA provided certain conditions are met. Specifically, where a participant directs that his ESOP distribution be made in the form of a direct rollover to his IRA, the ESOP sponsor s S election will not be treated as terminated, provided that: The terms of the ESOP require that the S corporation repurchase its stock immediately upon distribution to the IRA; The S corporation actually repurchases the stock effective the same day as the distribution; and No income (including tax-exempt income), loss, deduction, or credit attributable to the distributed stock under Code Section 1366 is allocated to the participant s IRA. Generally, ESOPs are required to provide for distributions in the form of employer securities. S corporation ESOPs are permitted to provide for distributions of cash or of employer securities subject to a repurchase requirement. Under the qualified retirement plan rules, an ESOP must permit the distributee of any eligible rollover distribution to have such distribution paid in a direct rollover to an eligible retirement plan. The definition of eligible retirement plan includes the IRA of the distributee. Therefore, an ESOP that holds S corporation stock and permits distribution in the form of employer securities is required to permit participants to elect to have an eligible distribution of S corporation stock paid in a direct rollover to an IRA. In 1996, Congress amended the Internal Revenue Code to make ESOPs (along with other qualified retirement plans) eligible S corporation shareholders. However, this eligibility does not extend to an IRA trustee or custodian. As a result, ESOP sponsors and practitioners have been concerned about the effect that an even momentary holding of S corporation stock by an IRA, in connection with an ESOP rollover distribution would have on the S election of the corporation. The holding of Rev. Rul puts these concerns to rest. ESOP Must Adjust Basis of S Corporation Stock for Pro Rata Share of Income Under Code Section 1367(a), the basis of each shareholder s stock in an S corporation must be adjusted over time for certain income and expenses of the corporation, including the items of income, loss and deduction described in Code Section 1366(a)(1). Section 1366(a)(1) provides that in determining the tax of an S corporation shareholder for the shareholder s taxable year in which the taxable year of the S corporation ends, there is

3 INVESTMENT IN EMPLOYEE STOCK OWNERSHIP PLANS 3 taken into account the shareholder s pro rata share of the corporation s undistributed income. In Rev. Rul , 2 the IRS said that, although an ESOP is a taxexempt entity under Section 501(a), the stock of an S corporation held by an ESOP is subject to the same basis adjustments as stock held by any other S corporation shareholder. Accordingly, with respect to the specific facts of the revenue ruling, the ESOP s pro rata share of an S corporation s undistributed income for a taxable year increases the basis of each share of S corporation stock held by the ESOP. With respect to ESOP distributions, any amount distributed from a qualified retirement plan is generally taxable to the distributee in the year in which distributed. However, in the case of any lump-sum distribution that includes employer securities, the net unrealized appreciation (NUA) attributable to the employer securities is excluded from the distributee s gross income. Under the Income Tax Regulations, the amount of NUA in such employer securities is equal to the excess of the market value of such securities at distribution over the ESOP s cost or other basis in the securities. Accordingly, Rev. Rul confirms that the amount of NUA in S corporation stock distributed by an ESOP shall be determined using the ESOP s adjusted basis in the stock, including any adjustments under Code Section 1367(a). Thus, a taxable distribution of S corporation stock from an ESOP will result in ordinary income to the distributee equal to the ESOP s adjusted basis in the S corporation stock. Any sale proceeds for an amount over such adjusted basis will normally be a long term capital gain. Using S Corporation Earnings to Repay an ESOP Loan In PLR , 3 the IRS ruled that an ESOP s use of a special onetime distribution of the S corporation earnings of its sponsor to make principal and interest payments on an ESOP loan to the sponsor would not violate the Exempt Loan rules. Further, such payments are considered annual additions for purposes of the qualified retirement plan limits under Code Section 415. Company A, an S corporation, maintained a typical leveraged ESOP under which shares of employer securities held in the ESOP s suspense account were allocated to participants as the ESOP repaid the ESOP loan. As an S corporation, Company A maintained an accumulated adjustment account ( AAA ) in accordance with Code Section In addition to normal annual distributions of S corporation earnings to shareholders, in 2002, Company A intended to make a one-time additional S corporation IRB 597 (February 20, 2003). 3 August 1, 2002.

4 4 JOURNAL OF TAXATION OF INVESTMENTS earnings distribution from the AAA in order to allow shareholders to receive a portion of Company A s accumulated and distributed profits. Under the ESOP Exempt Loan rules, persons entitled to payment under an ESOP loan are generally entitled only to the assets of an ESOP to the extent such assets are (i) loan collateral, (ii) contributions made to allow the ESOP to repay the loan, and (iii) earnings attributable to such collateral and the investment of such collateral. In this case, since the unallocated shares of Company A stock were held in the suspense account as collateral for the ESOP loan, the earnings attributable to such shares (i.e., the one-time additional distributions) may be used to repay the ESOP loan to the extent such earnings are from the AAA of Company A. However, S corporation earnings attributable to allocated shares may not be used to repay the loan. Under Code Section 415, annual additions to a qualified retirement plan are generally defined as the sum of employer contributions, employee contributions and forfeitures for the year. With respect to ESOPs, the amount of employer contributions that are considered annual additions is calculated with respect to employer contributions used to repay principal of an ESOP loan. In this case, notwithstanding the fact that the amount of the one-time earnings distribution is used to repay the ESOP loan, because such distribution is not an employer contribution, employee contribution or forfeiture, the amount of the earnings distribution does not constitute annual additions under the qualified retirement plan rules. ESOP Loan Refinancing Decisions Implicate Fiduciary Duties Refinancing the loan under a leveraged ESOP is a strategy that employers that sponsor an ESOP may implement to realign the level of employee benefits provided under the ESOP in accordance with projections developed during the ESOP s implementation. A well-designed ESOP normally creates a loan repayment schedule that provides for a release of shares consistent with a certain projected level of benefits or employer contributions. To create this repayment schedule, ESOP sponsors may consider projections as to share price appreciation, number of participants, participant turnover, deduction limits and participant compensation over the expected term of the ESOP loan. In the event that actual experience significantly deviates from the projections such as a greater-than-expected increase in share value or unforeseen decrease in the number of participants the number of shares released under the original formula may provide a level of benefits to participants greater than originally expected.

5 INVESTMENT IN EMPLOYEE STOCK OWNERSHIP PLANS 5 To realign the future release of shares with the original projections, an ESOP sponsor may seek to refinance the ESOP loan. Typically, the ESOP will enter into a new loan with a revised repayment schedule and use the proceeds of the new loan to pay off the balance of the existing ESOP loan. As shares are released under the new repayment schedule, the release period, as compared to the period of the original loan, is actually extended. As a result, fewer shares are released from the suspense account during the period of the original ESOP loan. Because an ESOP loan refinancing may effectively slow down the release of shares to current ESOP participants, which may not be in their best interests, refinancing decisions often raise issues under ERISA s fiduciary standards and the prohibited transaction rules of ERISA and the Code. ERISA requires fiduciaries to act prudently, solely in the interest of plan participants and for the exclusive purpose of providing benefits to participants. In the case of an ESOP loan refinancing where a refinancing decision may benefit future participants at the expense of current participants, careful consideration must be given to ensure that the transaction satisfies ERISA s fiduciary standards. In late 2002, the Department of Labor ( DOL ) released new guidance addressing the fiduciary considerations involved with the decision to refinance an ESOP loan. Field Assistance Bulletin was the DOL s first Field Assistance Bulletin ( FAB ), a new vehicle designed to publicize technical guidance to DOL field enforcement staff and provide the regulated community with information regarding the DOL s views on technical applications of ERISA. FAB explains that, at a minimum, in making an ESOP refinancing decision, an ESOP fiduciary must make a careful assessment of the costs and benefits conferred upon the ESOP and the likely consequences of a failure to refinance and ensure that the transaction is arranged primarily in the interest of participants and beneficiaries in accordance with regulations under Section 408(b)(3) of ERISA. Consistent with the obligation under the regulations to consider all the surrounding circumstances of a refinancing that results in an extended period for the allocation of shares, an ESOP fiduciary must assess the extent to which the refinancing is consistent with: (a) the documents and instruments governing the plan, including loan and related agreements; and (b) the reasonable expectations of plan participants and beneficiaries, as might be determined by 4 Posted on the Department s website at (September 26,2002).

6 6 JOURNAL OF TAXATION OF INVESTMENTS reference to the ESOP s summary plan description or other participant communications describing benefits under the plan. Although an ESOP refinancing may also benefit the employer, the fiduciary duty to act with undivided loyalty to participants and to satisfy the primary benefit test of Section 408(b)(3) requires the fiduciary to focus on the benefits of the refinancing transaction to the plan s participants and beneficiaries. Accordingly, a refinancing would satisfy the primary benefit test if the fiduciary reasonably concludes that the transaction is advantageous to the plan s participants and beneficiaries after a careful assessment of the costs and benefits of the transaction, and if the terms related to the refinancing are at least as favorable as the terms that would have resulted from an arm s-length negotiation between independent parties, the FAB said. Taking this analysis a step further, the FAB recognizes that a fiduciary has a duty of impartiality to all plan participants and thus may appropriately balance the interests of different classes of participants, but points out that a refinancing may adversely affect the interests of current participants; therefore, a fiduciary cannot reasonably assess the costs and benefits conferred upon an ESOP without giving due consideration to the interest of current participants. The Department agrees that a refinancing would satisfy the primary benefit test if the fiduciary reasonably concludes that the transaction is advantageous to the plan s participants and beneficiaries after a careful assessment of the costs and benefits of the transaction, and if the terms related to the refinancing are at least as favorable as the terms that would have resulted from an arm s-length negotiation between independent parties. The bulletin acknowledges that employers often offer certain inducements for the plan to engage in the refinancing which could support the fiduciary s conclusion that the transaction satisfies the primary benefit test. Such inducements may include: a commitment that shares held in the suspense account will not be applied to repayment of the outstanding portion of the refinanced loan if the ESOP is terminated (often referred to as event protection ); additional diversification rights for participants; an increase in the amount of the employer s matching contribution; or the payment of a dividend make whole to compensate participants and beneficiaries for the increased use of dividends for loan repayment. However, as may be expected, the FAB indicates that a decision whether some or all of such inducements are sufficient to satisfy the primary benefit test is highly dependent on the particular facts and circumstances surrounding the transaction. The FAB identifies one circumstance of particular importance where the ESOP sponsor has made an enforceable commitment to make all of the contributions necessary to repay the loan. If the ESOP has such an un-

7 INVESTMENT IN EMPLOYEE STOCK OWNERSHIP PLANS 7 qualified right to receive contributions and release shares in accordance with the original repayment schedule, the downside to the ESOP of rejecting the proposed refinancing may be minimal while the economic value transferred to the ESOP sponsor in the transaction may be substantial, unless the ESOP receives substantial additional consideration for entering into the transaction. Repayment of ESOP Loan to Acquiring Employer Does Not Breach Fiduciary Duties to Plan Participants Saint-Gobain v. Key Trust According to the U.S. Court of Appeals for the Sixth Circuit in Benefits Committee of Saint-Gobain Corp. v. Key Trust Co. of Ohio N.A., 5 an ESOP trustee would not breach its ERISA fiduciary duties to plan participants by following instructions to repay the outstanding balance of an ESOP loan after the ESOP sponsor was acquired by a successor company. Reversing the decision of the lower court and rejecting the Department of Labor s amicus curiae position, the court held that the Trustee s transfer of the loan repayment to the acquiring company would not violate the Trustee s duty to administer the ESOP for the exclusive benefit of participants because the participants had no right to those assets. The court reasoned that reneging on the loan repayment would be a windfall to the ESOP participants. In 1990, Furon Corp. established the Furon ESOP. Key Trust was the successor Trustee to the Furon ESOP. Between 1990 and 1997, the Trustee entered into a series of unsecured ESOP loans with Furon in order to purchase Furon stock for future allocation to ESOP participants (the ESOP Loans ). The Trustee pledged no security in the acquired Furon stock for the ESOP Loans; however, the Furon stock acquired with the loan proceeds was placed in a Suspense Subfund under the ESOP. As the Trustee repaid the ESOP Loans out of ESOP contributions made by Furon, shares of stock were released from the Subfund and allocated to participant accounts according to a formula specified in the ESOP documents. In 1997, Saint-Gobain Corp. acquired 95% of Furon s stock, including all of the Furon stock held by the Furon ESOP. At that time, the outstanding principal amount of the ESOP Loans owed to Furon was approximately $2.3 million. As the successor ESOP sponsor, Saint-Gobain terminated the Furon ESOP and appointed the Saint-Gobain Benefits Committee to administer the ESOP s termination and distribution of assets. The Benefits Committee instructed the Trustee to use the cash proceeds of the sale of Furon stock in the Subfund to repay the outstanding ESOP Loan to Saint-Gobain F.3d 919 (6th Cir. 2002).

8 8 JOURNAL OF TAXATION OF INVESTMENTS When the Trustee refused, the Benefits Committee filed suit to compel the Trustee to repay the ESOP Loans alleging that a failure to do so constituted a breach of the terms of the ESOP and a breach of the Trustee s fiduciary duties. The Trustee counterclaimed that: (1) ERISA precluded the repayment of the ESOP Loans with the assets in the Subfund; (2) the ESOP Trust Agreement required the allocation of the sale proceeds to participant accounts; and (3) the Benefits Committee s instructions constituted a breach of its fiduciary duties. The U.S. District Court for the Northern District of Ohio ruled in favor of the Trustee, holding that if the Trustee were to repay the ESOP Loans with the proceeds of the stock sale, the Trustee would violate its ERISA fiduciary duties to the ESOP participants. Noting that there was no relevant case law directly on point, the appeals court focused on the conflicting positions of the DOL and IRS on this issue as well as the actual terms of the ESOP documents to analyze whether the Trustee s repayment of the ESOP Loans would violate the Trustee s fiduciary duties. The DOL, in its amicus curiae position and in previously issued opinion letters, explained that plan fiduciaries, in deciding to repay ESOP loans, should consider whether the lender has a security interest in the employer securities in the suspense account (or the proceeds from the sale thereof) i.e., whether the securities served as collateral for the loan. In the absence of a security interest, the DOL reasoned the repayment of the outstanding loan balance would appear to violate ERISA because the lender would have no legal right to the employer securities or sale proceeds and the plan would have no legal obligation to use the sale proceeds to repay the loan. Therefore, because the Furon ESOP Loans were not secured by the Furon stock in the Suspense Subfund, the Trustee s repayment of the loans with the sale proceeds would violate ERISA. Conversely, in addressing this issue in previously issued private letter rulings, the IRS reached the opposite conclusion that the parallel Code provisions to the ERISA provisions cited by the DOL did not establish a per se prohibition against the use of ESOP stock sale proceeds to repay an ESOP loan. Interestingly, the court relied on the fact that the IRS had also issued a favorable determination to the Saint-Gobain Benefits Committee finding that the proposed repayment did not endanger the exempt status of the ESOP Loans. The IRS expressly states in its determination letters that only the form, and not the operation of the plan, is being approved and thus, reading an IRS determination letter as approving the loan requirement in these circumstances is not appropriate. Recognizing that the ESOP required this repayment, the Trust Agreement allowed this repayment, the Benefits Committee directed this repayment and the IRS had approved this repayment, the court focused on what

9 INVESTMENT IN EMPLOYEE STOCK OWNERSHIP PLANS 9 ERISA requires in this case with the touchstone of its fiduciary analysis being the effect of the proposed repayment on the ESOP participants. Finding that repayment of the ESOP Loans would not harm the participants interests, the court noted that the ESOP, in entering into the loan, did not provide a complete or immediate interest in the stock in the Subfund to participants; instead, providing an incremental interest that grew as the loan was repaid and as stock was allocated to and vested in individual participant accounts. Effectively, participants were entitled only to amounts in the Subfund after repayment of the loan. The court went on to explain that allowing the Trustee to stiff the employer for the loan would be a windfall to participants and that the purpose of the relevant ERISA safeguards was not to obtain windfalls for participants but to ensure that the rights promised by the employer were fulfilled. In this case, the court stated, those rights as well as a large surplus on top of that have inured to the participants. Failure to Divest Employer Stock Does Not Breach Fiduciary Duties With the recent stock market decline, several cases have addressed the issue of what an ESOP or other defined contribution plan fiduciary should do when confronted with employer stock which is declining in value. These recent cases have held that an ESOP fiduciary is entitled to a presumption in favor of purchasing and holding employer stock even as the share values decline, but the presumption may be rebutted with a showing of abuse of discretion. The relevant cases are: Landgraff v. Columbia/HCA Healthcare Corp., 6 Wright v. Oremet Metallurgical Corp., 7 and Steinman v. Hicks. 8 Several cases have addressed employer stock held in a 401(k) plan. The district court in In re McKesson HBOC, Inc. ERISA Litigation, 9 dismissed the plaintiff s ERISA claims with leave to amend, holding that the fiduciaries were not obligated to violate the securities laws or other laws merely to protect the interests of Plan participants. In this case, McKesson Corporation merged with HBOC, a company that allegedly had engaged in improper and fraudulent accounting practices. The plaintiffs argued that the McKesson fiduciaries breached their fiduciary duties by failing to sell the company stock after the merger based on actual or imputed knowledge of HBOC s financial wrongdoing. The court rejected this argument and held that the McKesson fiduciaries did not breach their WL (M.D. Tenn. 2000) F.Supp. 2d 1224 (D. Ore. 2002) U.S. Dist. LEXIS 4429 (C.D. Ill. 2003) WL (N.D. Cal. 2002).

10 10 JOURNAL OF TAXATION OF INVESTMENTS duties by failing to divest the plan of company stock because there was no manner in which the fiduciaries could have avoided the decline in stock price without violating the federal securities laws. Other cases involving 401(k) employer stock lawsuits have had good outcomes for the defendants. In Hall v. Policy Management Systems Corp., 10 the district court dismissed plaintiff s ERISA claims outright against an investment committee, the company and its chief executive officer. The plaintiff did not allege that the fiduciaries were aware of any corporate wrongdoing and the court held that these defendants had no obligation to discover the fraudulent behavior of non-committee corporate officials, in part because obtaining and disclosing inside information would violate the federal securities laws. Another court has dismissed claims against a plan sponsor and its board of directors without prejudice based on plaintiff s failure to allege that those defendants were in a fiduciary capacity. Crowley v. Corning. 11 The court also dismissed plaintiff s claims against the plan committee because there were no allegations that the committee members had any adverse information about the target company s prospects. Note however, that in Nelson v. IPALCO Enterprises, Inc., 12 the court held that an employer s amendment to its 401(k) plan in connection with a corporate transaction was a fiduciary decision and not a settlor decision. Here, the plan sponsor amended the plan document to require the employer stock fund to hold the acquiring company s stock, which dropped significantly after the transaction. The court believed that the plan sponsor in requiring liquidation of the acquired company s stock, was arguably exercising authority and control over existing assets and had undertaken a fiduciary role. Inside ESOP Trustees Did Not Violate Fiduciary Duties by Setting Their Own Compensation Eckelkamp v. Beste Four executives of a small, privately held company who were also trustees of the company s ESOP did not breach their ERISA fiduciary duties by setting their own compensation because the compensation levels were not excessive. In Eckelkamp v. Beste, 13 the Sixth Circuit affirmed the district court s grant of summary judgment, rejecting the testimony of plaintiffs expert that claimed that the executives compensation was excessive WL (D.S.C. 2001) F.Supp. 2d 222 (W.D. N.Y. 2002) WL (S.D. Ind. 2003) WL (8th Cir. (Mo.)), December 31, 2002).

11 INVESTMENT IN EMPLOYEE STOCK OWNERSHIP PLANS 11 Melton Machine and Control Company established an ESOP in In connection with the sale of the company to the ESOP, the individual defendants became company executives and ESOP trustees. Under their guidance, the company s annual sales increased from $2 million in 1985 to $20 million in 2000 and the company s stock price increased from $14,000 per share to $109,000 per share for an average annual rate of return of 20%. The court noted that Melton s employees also shared in the company s success over this period. As of 2000, the average employee earned over $100,000 in annual compensation, which was 125% over the medium market rate for similar positions in the industry. Further, the average employee with at least one year of service had accounts under Melton s qualified retirement plans, including the ESOP, valued at nearly $350,000. As part of their management duties, the defendants were responsible for setting employee salaries, including their own. In January 2000, a Melton employee took documents detailing the levels of executive compensation from the briefcase of one of the defendants. These documents were subsequently publicized to company employees and formed the basis for the lawsuit alleging that the defendants breached their ERISA fiduciary duties by overcompensating themselves and by failing to ensure that the annual appraisals of ESOP stock were properly conducted. With respect to the issue of overcompensation, the district court clarified that the establishment of compensation levels is a business decision that does not involve the administration of an ERISA plan nor implicate fiduciary duties regarding a plan. The district court stated that: Business decisions can still be made for business reasons, notwithstanding their collateral effect on prospective, contingent employee benefits. Therefore, the defendants were not acting as ERISA fiduciaries when they set their own compensation. Further, the court of appeals affirmed the lower court s finding that the overcompensation analysis of the plaintiffs expert failed to take into account the fact that all Melton employees were paid in excess of market rates and that the analysis was based on comparisons to companies that were not comparable to Melton. The district court also found multiple flaws in the valuation expert s appraisal methodology used to show that defendants had consistently allowed the ESOP stock to be undervalued. Specifically, the district court criticized the expert s use of a control premium in the absence of a potential sale of the company and identified a double-counting of dividends for valuation purposes. Because plaintiffs presented no further evidence to show a breach of fiduciary duty in the annual ESOP valuation, the court of appeals found that the district court did not abuse its discretion in neglecting the valuation expert s testimony and granting summary judgment on this claim.

12 12 JOURNAL OF TAXATION OF INVESTMENTS However, the court s rejection of the control premium for use in redeeming the distributed shares of terminated participants is both perplexing and disturbing. It is apparent from the facts in the district court decision that the plan paid a control premium when it purchased 100 percent of Melton s stock and it seems anomalous that the plan could pay a control premium for the shares, yet the shares are valued without a control premium when distributed. This is not a good deal for the participants and appears to be just the sort of thing that the fiduciary rules of ERISA are designed to prevent. Conclusion Several S Corporation ESOP operational issues have been clarified, while many more technical issues remain outstanding. While fiduciary issues have busied many court calendars, plan sponsors and fiduciaries have been given more specific interpretations on holding of employer stock, refinancing of ESOP loans and repayment of ESOP debt with loan suspense account shares that are unpledged.