An employee stock ownership plan (ESOP) is a type of tax-qualified retirement plan. ESOPs are designed to invest primarily in qualifying employer securities, as defined in applicable tax rules. ESOPs differ from stock options, employee stock purchase plans, and other types of equity-based compensation, and they are subject to ESOP-specific requirements under the Internal Revenue Code (the IRC) and the Employee Retirement Income Security Act (ERISA).
This alert describes how IRC requirements determine whether a business can offer an ESOP to its employees. It also identifies which corporate structure is associated with a potential business owner tax benefit.
Definition of Employer Securities. A central aspect of ESOP compliance is whether the class and type of equity interests held by the ESOP constitute “employer securities” within the meaning of IRC section 409(l). The IRC defines this type of equity interest as common stock issued by the employer (or by a corporation that is a member of the same controlled group) that is readily tradable on an established securities market. Where there is no readily tradable common stock, the term “employer securities” means common stock issued by the employer (or by a corporation that is a member of the same controlled group) having a combination of voting power and dividend rights equal to or in excess of (A) that class of common stock of the employer (or of any other such corporation) having the greatest voting power, and (B) that class of common stock of the employer (or of any other such corporation) having the greatest dividend rights.
Key aspects of the foregoing definition affect ESOP planning for entities organized as limited liability companies under state law, entities with a non-voting class of equity, and multi-company controlled groups.
Limited Liability Company Units. A state law limited liability company (LLC) may, for various reasons, elect to be taxed as an S Corporation or, less commonly, as a C Corporation. In such cases, the question for ESOP purposes is whether LLC units may be treated as common stock under applicable ESOP rules. IRC section 7701 and guidance in a 2015 private letter ruling indicate that the answer is yes, LLC units may be treated as common stock. The specifics of any LLC structure would need to be confirmed to ensure that the attributes of common stock attendant to the applicable units are present.
In Private Letter Ruling 201538021 (Sept. 18, 2015), the Internal Revenue Service (the IRS) analyzed a parent-subsidiary structure involving a parent LLC that had elected to be taxable as a corporation, and a subsidiary with respect to which the parent elected qualified subchapter S subsidiary (Q sub) treatment. The analysis of the parent operating agreement focused on provisions stating that all LLC units conferred identical rights to distributions, dividends, and liquidation proceeds. Further, the parent represented that its operating agreement would be amended to provide that all LLC units would have the same voting rights and otherwise meet the requirements of IRC section 409(l)(2). The IRS concluded that the LLC units were employer securities as described in IRC section 409(l)(2) for purposes of IRC section 4975(e)(7), another ESOP-related tax provision.
Thus, based on this letter ruling, one can conclude that a business organized as an LLC may have the flexibility to offer an ESOP. Key to moving forward when considering an ESOP would be understanding the business’s tax election(s), reviewing the operating agreement, and determining whether any operating agreement amendments are needed – all in the context of the owners’ business and tax objectives. As private letter rulings can be relied on only by the taxpayer to whom the ruling is directed, individual analysis by a prospective ESOP sponsor’s counsel is important.
Subsidiary Structure. ESOPs may be offered to employees of the entity whose equity is held by the ESOP, as well as to employees of certain affiliated organizations. In addition to general tax-qualified plan rules about which entities in an affiliated group must be considered for satisfying various qualification tests, an ESOP’s equity interests must be qualifying employer securities with respect to employees of each participating employer. Further, various ESOP-specific rules and exceptions must be applied properly as to each participating employer’s employees. Private Letter Ruling 201828007 (April 17, 2018) addressed participation of employees of a wholly-owned C Corporation subsidiary in an ESOP established by a parent S Corporation. Because the ESOP sponsor in the ruling (the parent S Corporation) owned 100% of the stock of its subsidiary, the subsidiary easily met the applicable affiliated entity standard, permitting the employees of the subsidiary to participate in the ESOP.
A particular ESOP rule and an exception were at issue in this ruling, however. If the exception to the “right to demand stock” requirement described below were unavailable as to the C Corporation subsidiary’s employees due to the organizational structure, the subsidiary’s employees would not have been able to participate in the ESOP unless the ESOP’s payment provisions were amended. Unless an exception applies, ESOPs must permit a participant to receive his or her ESOP benefit in-kind – i.e., in the form of the ESOP sponsor’s stock. Significantly, (i) S Corporations and (ii) C Corporations with specific by-law restrictions may choose to distribute benefits solely in cash. The question in the ruling was whether this ESOP sponsor could preclude its subsidiary’s employees from receiving benefits in-kind, even though those participants were employed by a C Corporation – based on the fact that the ESOP was established and maintained by an S Corporation. The private letter ruling concluded that the ability to pay benefits solely in cash extended to all participants, even the subsidiary’s employees.
The IRS also weighed in on whether the ESOP would continue to be subject to limits on allocations to certain “disqualified persons,” which limits only affect ESOPs holding S Corporation stock. The answer to this question was that the ESOP would continue to be subject to limits on allocations to certain “disqualified persons.” The definition of disqualified persons for a particular ESOP sponsor includes certain owners and should be analyzed with the ESOP’s legal counsel. It is important to note that both employees of the parent and the C Corporation subsidiary in the ruling could have been subject to the allocation rules, depending on parent stock ownership and other factors.
Owner ESOP Benefits and Corporate Structure. Special tax rules offer the potential for tax deferral of gain from the sale of stock to an ESOP under IRC section 1042. IRC section 1042 is a consideration for founders or other significant owners of a business who are evaluating establishment of an ESOP, often in the context of business succession planning. IRC section 1042 permits deferral of gain recognition on a sale of stock to an ESOP if various requirements are satisfied. Business owners should consult with ESOP counsel in identifying and complying with those requirements. However, a threshold factor is that such deferral is available only for sales of shares of a C Corporation with no publicly traded stock. If an S Corporation election is or was in place – or is planned either before or after establishment of an ESOP – a tax analysis should be part of the planning process. This analysis would involve the timing of any election or revocation, the timing for any planned sale, and any post-sale period in which C Corporation status must be maintained. The analysis is typically conducted by ESOP and tax counsel working together.
 The affiliated entity standard is found in IRC section 1563 (with certain modifications under IRC section 409(l)) and, very generally, reaches certain parent-subsidiary groups of entities, brother-sister groups of entities controlled by the same five or fewer persons, or groups that combine the foregoing control structures. Specifics of an employer’s affiliated group should be evaluated in the context of these rules when designing an ESOP to confirm that applicable stock ownership thresholds are satisfied.