Chapter 8 Examining Employee Stock Ownership Plans …

1 Chapter 8 Examining ESOPS, INCLUDING NEW DEVELOPMENTS Page 8-1 Chapter 8 Examining Employee Stock Ownership Plans (ESOPS), including new developments By Steven James (Gulf Coast) And Jerry Livingston (Special Review), and Steve Linder, (R&A) Reviewers INTERNAL REVENUE SERVICE TAX EXEMPT AND GOVERNMENT ENTITIES Table of Contents TABLE OF CONTENTS ..1 OVERVIEW ..7 OBJECTIVES ..7 ESOP REQUIREMENTS-DEFINITION OF AN ESOP ..8 DEFINITION OF ESOP ..8 PROHIBITED TRANSACTION 4975(D)(13)..10 ERISA 408(E) AND 408(B)(12) ..10 OPERATIONAL ASPECTS AND ADVANTAGES OF INTRODUCTION-ESOP DISTINGUISHED WITH OTHER ESOP USED AS A FINANCING ESOPS USES EXEMPT LOANS AND SUSPENSE ESOPS CAN INVEST IN EMPLOYER SPECIAL TAX RULES FOR EXAMPLE OF AN EXEMPT EXAMINATION QUALIFYING EMPLOYER SECURITIES.

2 15 DEFINITION OF QUALIFYING EMPLOYER SECURITY UNDER SECTION 4975(E)(8) ..15 QUALIFYING SECURITY DEFINITION FOR AN ESOP IS DIFFERENT THAN FOR SPECIAL DEFINITION OF CONTROLLED GROUP FOR SPECIAL CIRCUMSTANCES FOR A FIRST TIER SUBSIDIARY UNDER SECTION 409(L) ..16 SPECIAL CIRCUMSTANCES FOR A SECOND TIER Continued on next page Chapter 8 Examining ESOPS, INCLUDING NEW DEVELOPMENTS Page 8-2 Table of Contents, Continued EXAMINATION STEPS ..18 EXAMINE ESOP INVESTMENT FOR ESOPS WITH CLOSELY HELD FOR ESOPS WITH PREFERRED SPECIAL RULE UNDER SECTION 409(L)(4) ..18 DETERMINE WHETHER THE Stock IS READILY COMMON VERIFY TYPES OF SHARES HELD BY ESOP ..19 IF PLAN FAILS TO SATISFY ESOP PARTICIPATION, COVERAGE AND NONDISCRIMINATION ..20 ESOP MAY NOT BE AGGREGATED WITH ANOTHER ESOP CANNOT SATISFY 401(A)(4) WITH A NONDESIGN BASED SAFE ESOP CANNOT BE AGGREGATED UNLESS A SPECIAL RULE IS EXAMPLE-PLAN WITH ESOP AND NON-ESOP EXAMPLE-ESOP FAILS EXAMINATION PERMITTED DISPARITY AND RIGHT TO DEMAND QUALIFIED EMPLOYER SECURITIES.

3 24 PERMITTED DISTRIBUTIONS RIGHT TO DEMAND QES ..24 EXCEPTIONS TO RIGHT TO DEMAND DISTRIBUTIONS, TIMING AND PAYMENT SECTION 409(O)..26 WHEN SECTION 409(O) FORM OF IF ESOPS ACQUIRES MORE THAN ONE CLASS OF EMPLOYER ASSETS RELEASED FROM A SUSPENSE EXAMINATION PUT OPTION ..29 PUBLICLY TRADED IF EMPLOYER VIOLATES FEDERAL LAW BY HONORING PUT WHEN PUT OPTION IS OTHER EXAMINATION STEPS PUT JOINT AND SURVIVOR RULES ..32 INTRODUCTION-CERTAIN ESOP BENEFITS NOT SUBJECT TO RATIONALE FOR THIS WHEN EXCEPTION IS EXAMINATION FLOOR OFFSET ARRANGEMENTS ..34 ESOP CANNOT BE USED TO OFFSET BENEFITS UNDER A DB EXAMINATION STEPS-FLOOR Continued on next page Chapter 8 Examining ESOPS, INCLUDING NEW DEVELOPMENTS Page 8-3 Table of Contents, Continued VALUATION AND INDEPENDENT VALUATION AND INDEPENDENT VALUATION MUST BE MADE IN GOOD EXAMINATION EFFECT OF IMPROPER VALUATION.

4 39 FIDUCIARY IS RESPONSIBLE FOR PROPER A PT OCCURS IF AN ESOP PAYS A DISQUALIFIED PERSON TOO IF Stock IS UNLESS EXCEPTION APPLIES, PT OCCURS FOR TRANSACTION BETWEEN A PLAN AND A DP ..40 EXCEPTION-ADEQUATE POTENTIAL EXCLUSIVE BENEFIT VIOLATION-RR 69-494 ..41 EXAMINATION DETERMINE WHETHER FAIR MARKET VALUE WAS REVIEW VALUATION CHECK EMPLOYER S AUDIT REPORT AND DETERMINE WHETHER Stock APPRAISAL REFLECTS CERTAIN EVALUATE Stock PURCHASES FOR EXCLUSIVE BENEFIT IF Stock PURCHASED AT FMV, BUT LATER DECLINES IN ASK FOR ENGINEERING VOTING RIGHTS ..44 IF EMPLOYER HAS REGISTRATION TYPE CLASS OF IF EMPLOYER DOES NOT HAVE REGISTRATION TYPE CLASS RIGHT TO DIRECT PLAN AS TO VOTING DEPENDS ON APPLICABLE STATE VOTING RIGHTS AND UNALLOCATED IF PLAN TRUSTEE DOES NOT RECEIVE VOTING EXAMINATION DETERMINING THE NUMBER OF SHARES SUBJECT TO DEFINING QUALIFIED PARTICIPANT, YEARS OF PARTICIPATION AND QUALIFIED ELECTION THREE METHODS TO SATISFY EXAMINATION NON-TERMINABLE ESOP PROVISIONS AND 411(D)(6).

5 49 SECTION 411(D)(6) ..49 RIGHT TO EMPLOYER Stock CAN BE ELIMINATED IN CERTAIN EXAMINATION Continued on next page Chapter 8 Examining ESOPS, INCLUDING NEW DEVELOPMENTS Page 8-4 Table of Contents, Continued SECTION 415 LIMITS ..51 Stock ACQUIRED IN AN EXEMPT LOAN HOW ANNUAL ADDITIONS ARE IF ESOP NOT FUNDED BY AN EXEMPT SPECIAL RULE FOR DETERMINING ANNUAL ADDITIONS 415(C)(6) ..52 EXAMINATION TAX CREDIT TAX CREDIT DEDUCTION LIMITS ..54 DEDUCTION LIMITS LEVERAGED ESOP EXCEPTION TO USE TO PAY BACK ESOP DEDUCTION LIMITS IRC SECTION 404(K) (DIVIDEND DEDUCTION) PRE-EGTRRA (PRIOR TO 2002) ..55 IF DIVIDENDS USED TO REPAY IF EMPLOYER SECURITIES PAYING DIVIDENDS WERE ACQUIRED AFTER 8/4 DISALLOWING A REDEMPTIONS OF Stock ARE NOT EXAMINATION DEDUCTION LIMITS EGTRRA (POST 2001).

6 60 CHANGE BY APPLICABLE DIVIDENDS MUST BE FULLY VESTED, 404(K)(7) IF ELECTION TO PAY DIVIDENDS TO ESOP ..61 TIMING OF SECRETARY MAY DISALLOW DEDUCTION IF DIVIDEND CONSTITUTES AN AVOIDANCE OF TAXATION ETC..62 EXEMPT LOANS ..63 DEFINITION OF EXEMPT EXAMINATION PRIMARY BENEFIT EXAMINATION USE OF LOAN EXAMINATION COLLATERAL FOR EXEMPT LIABILITY OF ESOP FOR EXEMPT EXAMINATION EXAMINATION RELEASE OF Stock FROM SUSPENSE METHODS BY WHICH EXEMPT LOANS ARE REQUIREMENTS TO USE THE PRINCIPAL ONLY Stock RELEASED FROM A SUSPENSE Continued on next page Chapter 8 Examining ESOPS, INCLUDING NEW DEVELOPMENTS Page 8-5 Table of Contents, Continued EXAMINATION STEPS-EXEMPT LOANS ..70 REFER TO SCHEDULE E, ESOP ANNUAL ANALYZE LOAN CONTRACT AND OTHER DETERMINE METHOD OF REPAYMENT-PRINCIPAL AND INTEREST, OR PRINCIPAL REPAYING AN EXEMPT LOAN FROM THE PROCEEDS OF THE SALE OF UNALLOCATED EMPLOYER SECURITIES.

7 72 EXEMPT LOAN MUST BE PRIMARILY FOR THE BENEFIT OF ESOP WHETHER THE PRIMARY BENEFIT IS VIOLATED DEPENDS ON FACTS AND ANALYSIS OF PUBLISHED GUIDANCE ESOP DID NOT FAIL AS A RESULT OF USING PROCEEDS TO REPAY UNALLOCATED EMPLOYER SECURITIES USED TO REPAY LOAN--POSSIBLE 415(C) EXAMINATION WHEN QUALIFYING SECURITIES CAN BE FORFEITURE EXAMINATION RIGHT OF FIRST REFUSAL ..79 RIGHT OF FIRST EXAMINATION SPECIAL ESOP TRANSACTIONS ..81 SECTION 1042 TAXPAYER S BASIS IN QUALIFIED REPLACEMENT MANNER OF STATEMENT OF STATEMENT OF ELECTION MUST BE VERIFIED BY CONSENT OF IRC SECTION 1042 PROHIBITED EXCISE TAX ON PROHIBITED ALLOCATIONS OF IRC SECTION 1042 EMPLOYER EARLY DISPOSITION OF IRC SECTION 1042 EMPLOYER DETERMINING THE AMOUNT OF THE EXCISE EXAMINATION SPECIAL ESOP TRANSACTIONS, PARTIAL INTEREST EXCLUSION.

8 91 PARTIAL INTEREST DEFINING A SECURITY ACQUISITION LOAN MAY BE TREATED AS A SECURITY ACQUISITION IF SECURITY ACQUISITION LOAN IS MADE AFTER 7/10/89 ..92 SPECIAL ESOP TRANSACTION, SECTION 133 EXCISE TAX ..93 IRC SECTION 133 EXCISE DETERMINING THE EXCISE SECTION 133 EXCISE TAX DOES NOT APPLY TO THE EXAMINATION Continued on next page Chapter 8 Examining ESOPS, INCLUDING NEW DEVELOPMENTS Page 8-6 Table of Contents, Continued SPECIAL ESOP TRANSACTION-SECTION 4980 EXCEPTION ..96 IRC SECTION 4980 EXAMINATION SPECIAL ESOP TRANSACTIONS-SECTION 664(G) TRANSFERS ..98 IRC SECTION 664(G) QUALIFIED GRATUITOUS SUBCHAPTER S CORPORATION ESOPS ..99 SUB S ESOP IRA CANNOT BE A SUB S SHAREHOLDER, BUT AN EXCEPTION APPLIES IF CERTAIN REQUIREMENTS ARE SECTION 4975(F) ..100 SEVERAL ESOP PERKS NOT AVAILABLE FOR SUB S EXAMINATION PROHIBITED ALLOCATIONS IN SUB S ESOPS.

9 104 DEFINING A DISQUALIFIED PERSON AND DEEMED SHAREHOLDER DEFINING DEEMED OWNED SHARES ..105 DEFINING A DEEMED 10% 318 ATTRIBUTION RULES DEFINING NONALLOCATION DEEMED OWNED SHARES IN ESOP IS TREATED AS HELD BY PROHIBITED ALLOCATION OTHER NON-ALLOCATION SITUATIONS INCLUDING SYNTHETIC EFFECTIVE DATES FOR ESOPS HOLDING Stock IN S CORPORATIONS ..109 EFFECTIVE DATES OF IRC SECTIONS 409(P) & SPECIAL RULING FOR S CORPORATIONS ESTABLISHED AFTER REV. RUL. 2003-6 ..110 EXAMINATION STEPS-SUB S CORPORATION ..112 EXAMINATION Chapter 8 Examining ESOPS, INCLUDING NEW DEVELOPMENTS Page 8-7 Overview Introduction This lesson provides guidance pertaining to the examination of both leveraged and non-leveraged Employee Stock Ownership Plans . This Chapter describes the qualification requirements under IRC sections 401(a) and 409, as well as the additional requirements for ESOPs under IRC section 4975(e)(7) and the applicable regulations, related to both leveraged and non-leveraged ESOPS.

10 This Chapter also covers other issues pertinent to ESOPS, such as the IRC section 404(k) deduction rules, IRC section 1042 transfers, the partial interest exclusion and special rules pertaining to Sub S ESOPS. Finally, this Chapter discusses recent changes made by EGTRRA. Objectives At the end of this lesson, you will be able to: 1. Determine whether the ESOP is operated in a qualified manner. 2. Determine that the ESOP is properly invested in qualifying employer securities (QES), as defined by IRC section 409(l). 3. Determine that distribution requirements are properly satisfied (timeliness and form). 4. Determine that the applicable put options are properly applied. 5. Determine that the QES is properly valued. 6. Determine whether the employer s contributions, including dividends, are deductible.