distributions from an esop - the menke group · 2011. 5. 17. · distributions from an esop in the...

Distributions from an ESOP in the Form of Employer Stock: An Unfortunate Trap for the Unwary John D. Menke

Distributions in the form of employer securities can enable the plan sponsor to shrink the percentage of company stock that is held by the ESOP and, in the case of lump-sum distributions, can result in significant tax savings for employees. In the author's opinion, however, such distributions pose a trap for the unwary in that, contrary to the generally accepted interpretation, even in those cases where the employer is an S corporation or has a bylaw provision that restricts ownership of substantially all employer securities to employees, the language of Section 409(h)(1)(B) of the Code does not give the employer a call option on these securities. The author recommends that Section 409(h) should be amended to effectuate the Congressional intent that a call option be permissible in these circumstances.

There is a widely held misconception among employers and plan administrators that employers can have the best of both worlds when it comes to making distributions from an ESOP in shares of employer stock. The generally held belief is: If the em-ployer has a bylaw 01' charter provision that restricts ownership to employees and the ESOP, then (1) the plan will be able to make dis-tributions in the form of employer securities, and (2) the employer will be able to immediately repurchase the stock. This distribution procedure will generally resuit in the best of both worlds in that (1) in the case of a lump-sum distribution of employer securities, the em-ployee will be taxed at the favorable long-term capital gains tax rate on the net unrealized appreciation; (2) the employer will be able to shrink the number of shares held by the ESOP; and (3) the employee will have no option to keep the stock.

John D. Menke is the founder and president of Menke & Associates, Inc., a San Francisco-based firm that has specialized in the installation and admin-istration of ESOPs for over 30 years. Mr. Menke is a graduate of Yale Law School and is the author of Menke ESOP Plan Distribution Forms Manual (Menke and Associates, 200S).

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28 The Journal of Employee Ownership Law and Finance, Vol. 17/3

With S corporations, the generally held belief is: If the employer is a S corpomtion, then (1) the plan will be able to make distributions in the form of employer securities, and (2) even without a bylaw or charter provision that restricts ownership to employees and to the ESOP, the employer will be able to immediately repurchase the stock for cash, and the employee will have no option to keep the stock.

Unfortunately, the fly in the ointment is that in no instance will the employer have the equivalent of a "call" option on the stock. The employee will in fact have an option to keep the stock, and the employee cannot be forced to sell the stock back to the company or to the plan. The result creates a trap for the unwary. This trap can be extremely dangerous in the case of S corporations because an S corporation will lose its S corporation election if a shareholder trans-fers his or her shares to an ineligible shareholder. Thus, if a partici-pant in an S corporation ESOP receives a distribution in the form of employer securities, elects to retain his or her shares, and subse-quently transfers his or her shares to an ineligible shareholder, such participant can force a termination of the S corporation election.

Situations where the employer does not have a call option, con-trary to commonly accepted wisdom, are (1) all distributions, in-cluding retirement and termination distributions, that are made in the form of employer securities fTom an ESOP maintained by an S corporation; (2) all distributions, including retirement and termi-nation distributions, that are made in the form of employer securi-ties from an ESOP maintained by a C corporation, even if the com-pany has a bylaw or charter provision that restricts ownership of stock to active employees; (3) diversification distributions that are made in the form of employer securities; (4) in-service distributions that are made in the form of employer securities; (5) required mini-mum distributions that are made in the form of employer securi-ties; and (6) plan termination distributions that are made in the form of employer securities to participants that are still employed by the company.

Tax: Advantages of lump-Sum Distributions of Company Stock Distributions from an ESOP in the form of shares of company stock have many advantages. One of the compelling reasons for making

Distributions from an ESOP in the Form of Employer Stock 29

distributions in the form of company stock, for example, is that lump-sum distributions in the form of company stock enable participants to have a portion of their distribution taxed at long-term capital gains tax rates rather than having the entire distribution taxed at ordi-nary income tax rates. However, diversification distributions, in-service distributions, and required minimum distributions do not qualify for this tax benefit because such distributions do not qualify as lump-sum distributions.

The tax benefit associated with a lump-sum distribution of com-pany stock derives from Section 402(e)(4)(B) of the Internal Rev-enue Code (the "Code"), which provides that in the case of a lump-sum distribution of employer securities, the employee will not be taxed at the time of distribution on the net unrealized appreciation (NUA). The result is that the employee pays an ordinary income tax on the cumulative cost basis of the employer securities at the time of distribution and pays a capital gains tax on the NUA at the time that the stock is sold back to the plan or to the company, as the case maybe.

Thus, in the case of plans that have relatively large account balances, it is often desirable to have all lump-sum distributions made in the form of employer stock so that participants can take advantage of the capital gains tax rate applicable to the apprecia-tion of the stock.

Corporate Reason for Making Plan Distributions in Company Stock

Another frequent reason for making distributions in the form of company stock is to enable the company to shrink the percentage of company stock that is held by the ESOP. Generally, reducing the ESOP's ownership percentage can be accomplished in either of two ways. One approach is to have the company repurchase a block of company stock directly from the ESOP. However, this approach can result in a "prohibited transaction" because it necessarily involves a purchase and sale of stock between the plan and a "party-in-inter-est." Thus, if the transaction does not meet the conditions for the exemption under Section 408( e) of the Employee Retirement Income Security Act of 1974 (ERISA), the fiduciaries can be held liable for breach of fiduciary duties.


This potential liability can be entirely avoided by having the shares first distributed to participants and then repurchased by the company (or by the plan). Under this approach, there is no transac-tion between the plan and a party-in-interest. Thus, there is no possibility of having engaged in a prohibited transaction.

There can be any number of good reasons for wanting to shrink the percentage of company stock that is held by an ESOP. One rea-son might be to reduce the company's future repurchase liability. Another reason might be that continued repurchases of company stock by the plan using existing trust funds would result in existing employees owning all or most of the stock, whereas repurchase of the stock by the company and recontribution of this stock to the ESOP in a subsequent year would result in new employees receiv-ing a greater allocation of this stock.

Employer Concerns

Many closely held companies have been hesitant to make distribu-tions in the form of shares of company stock out of fear that a dis-gruntled employee may decide to keep the stock and thereafter be-come a nuisance by attending shareholder meetings, blocking shareholder actions, and demanding to see copies of the company's financial statements.

For the most part, except in the case of S corporations, these fears are unfounded. Assuming that the former employee would, at most, hold a 1 % or 2% interest in the company, there is very little that such an employee could do to block actions taken at a shareholders' meet-ing. On the other hand, a 1% shareholder could make it impossible to take action by unanimous written consent of shareholders, which would then necessitate having an actual shareholders' meeting.

It should also be remembered that under the provisions of Sec-tion 409(h)( 4) of the Code, if a participant elects to receive shares of company stock, the participant must be given a "put" option, but the participant can exercise the put option only during two "win-dow" periods. The first window is the 50-day period following the date of distribution, and the second window is any 50-day period during the following plan year. The purpose of giving the partici-pant two put option window periods is to enable the participant to hold the stock until the following plan year when the updated ap-praisal may result in a higher stock price.


If, for example, the distribution is made in a year when the valu-ation happens to be down, the participant is not necessarily penal-ized if he or she has the ability to sell the stock in the following year when the stock may have recovered some or all of its value. Simi-larly, if the distribution is made during a given plan year and it is obvious that the stock will have a significantly higher value at the end of that year, the second put option window enables the partici-pant to capture that additional appreciation.

On the other hand, if a participant does not exercise the put option during either the first window period or the second window period, the put option lapses, and the participant thereafter has no assurance that the company or the plan will repurchase his or her shares. In addition, once the put option lapses, the value of the stock may drop 25% to 35% in value due to the discount for lack of mar-ketability that would then apply.

The net effect of the put option provisions of Section 409(h)( 4) of the Code is to give the participant some additional upside potential rather than forcing the participant to cash out his or her shares at the time of distribution. The provisions of Section 409(h)( 4) also serve to exert pressure on the participant to exercise his or her put option before the expiration date. Nevertheless, nothing in Section 409(h)( 4) prevents a truly disgruntled employee from electing to keep his or her shares, despite the expiration of the put options, and despite tlle existence of the right of first refusal restriction, which only restricts the participant from selling his or her shares to a third party without first offering to sell the shares back to the company or to the ESOP.

Also, now that ESOPs are permitted to own part or all of the stock of an S corporation, it is even more important that the com-pany andlor the plan have some type of call option on the stock upon distribution from the plan lest the number of shareholders exceed 100, thereby causing an automatic termination of the S election. It should be noted that the ESOP counts as only one shareholder. Thus, this problem arises only if stock distributions cause the total num-ber of shareholders to exceed 100 at any given moment in time. On the other hand, as noted earlier, the larger problem is that a dis-tributee of stock from an S corporation ESOP may decide to trans-fer his or her shares to an ineligible shareholder, thereby causing a termination of the S corporation election.

Thus, from the perspective of most closely held companies, the ideal scenario is for the plan to have the ability to make distribu-


tions in the form of shares of company stock, and for the company or the plan to have the ability to immediately "call" the stock in exchange for cash (or in exchange for a promissory note payable in five equal annual installments).

A false Assumption May Create a Trap for the Unwary

As mentioned at the outset, many employers and plan administra-tors have assumed, incorrectly, that if the employer is an S corpora-tion or has a bylaw or charter restriction that limits ownership to employees and to the ESOP, the ideal scenario already exists in that the plan has the ability to make distributions in the form of shares of company stock, and the company has the ability to call the stock in exchange for cash (or in exchange for a promissory note).

One reason why this assumption is incorrect in the case of an employer that has a bylaw or charter restriction is that the typical bylaw or charter restriction only restricts ownership to employees and to the ESOP. The typical bylaw or charter restriction against ownership, by definition, does not apply to an employee who re-ceives a distribution of employer securities but remains as an ac-tive employee of the employer. Thus, in cases where the employee has received a distribution on account of a diversification distribu-tion, an in-service distribution, a required minimum distribution on or after attainment of age 70Y., or a distribution on account of a plan termination, the bylaw or charter restriction does not apply because the person receiving the distribution is still an active em-ployee.

There is a way around this dilemma in one specific situation: If a company becomes 100% owned by its ESOP, it can then amend its bylaws or charter to simply restrict ownership only to the ESOP. In that case, then the ESOP will be the only permitted shareholder, and all participants will have to sell their shares back to the plan or to the company, regardless of whether they are terminated employ-ees or continuing employees. However, the ESOP is the 100% owner in only about 20% of the cases, so this solution will not work in the great majority of cases.

A second reason why the existing assumption is incorrect is that a careful reading of Code Section 409(h)(2)(B(i), together with a


review of the legislative history of that section of the Code, reveals that regardless of whether the company is an S corporation or is a C corporation with a bylaw or charter provision that restricts owner-ship to active employees, Section 409(h)(2)(B)(i) permits only a put option, not a call option, where the distribution is made in the form of shares of employer securities.

The author has had informal discussions with the Office of Associate Chief Counsel of the Employee Benefits & Exempt Orga-nizations division of the Internal Revenue Service (IRS) regarding this matter, and the Office of Associate Chief Counsel has indicated that it agrees with the above interpretation of Section 409(h)(2)(B)(i).

If the IRS definitively rules that Section 409(h)(2)(B)(i) permits only a put option, not a call option, the consequences to a plan spon-sor that has incorrectly interpreted the provisions of Section 409(h)(2)(B)(i) could be quite severe.

For an ESOP to be a qualified plan, it must comply with all of the qualification requirements of Section 409 of the Code and with the regulations promulgated thereunder. Under Treasury Regula-tion Section 54.4975-7(b)( 4), no securities acquired with the pro-ceeds of an exempt loan may be subject to a put, call, or other op-tion, or a buy-sell or similar arrangement while held by and when distributed from the plan, other than the put option and the right of first refusal described in paragraphs (b)(9) and (b)(10) of that Trea-sury regulation.

Thus, unless the provisions of Section 409(h)(2)(B)(i) supercede the provisions of the Treasury regulation by expressly authorizing the use of a call option, a plan sponsor who distributes employer securities subject to the requirement that such securities must be immediately resold to the plan or to the company runs the risk that it has violated the qualification requirements for an ESOP. If the plan is disqualified, then the plan sponsor will lose all of the tax benefits attributable to a qualified plan. In addition, if the plan is disqualified, any transaction between the plan and a party-in-inter-est will be a prohibited transaction and will be subject to excise taxes.

As a practical matter, it is doubtful that the IRS will challenge existing plans to the extent that such existing plans have an IRS determination letter and have express language in the plan to the effect that all distributions of employer securities are subject to the requirement that such securities must be resold to the plan or to the company. If, however, the plan does not have this express lan-


guage, then it will clearly be subject to disqualification in the event of an IRS audit.

For the time being, plan sponsors can also rely upon the express language of Rev. Proc. 2003-23 and 2004-14. In Rev. Proc. 2003-23, the IRS ruled that an S corporation's S election would not be termi-nated as a result of an ESOP's distribution of S corporation stock where the participant directs that such stock be distributed to an IRA in a direct rollover, provided that the terms of the ESOP require that the S corporation repurchase its stock immediately upon the ESOP's distribution of the stock to the IRA. Rev. Proc. 2004-14 provided the same ruling where the terms of the plan required that the plan itself repurchase the stock immediately upon distribution. Both of these revenue procedures were based on the following explicit assump-tion regaJ:ding the provisions of Section 409(h)(2)(B) of the Code:

Under § 409(h)(2)(B), an ESOP that provides for distributions in the form of securities of an employer that is an S corporation is permitted to pro-vide that the S corporation stock included in the distribution is subject to a repurchase requirement. Thus, an ESOP is permitted to provide that any stock in an S corporation that is distributed is subject to immediate repurchase by the S corporation on a direct rollover of the stock from the ESOP to an IRA.

Although this language clearly gives a favorable interpretation of Section 409(h)(2)(B), the authors of these two revenue procedures have advised this author that the above stated assumption was prob-ably mistaken and that the IRS may need to reissue these revenue procedures. In the event that these revenue procedures are reissued, the IRS will apparently reach the same conclusions, but the reason-ing will be based upon policy considerations rather than on the lan-guage of Section 409(h)(2)(B)(i).

Since revenue procedures can be revoked by the IRS at any time and frequently are revoked from time to time, it is the opinion of this author that the ESOP industry should seek a legislative fix to this problem rather than rely upon the provisions of any given rev-enue procedure.

Current Provisions of Section 409(h)

Paragraph (h)(l)(A) of Section 409 states the "general rule" that a participant must have the right to demand that his benefit be dis-


tributed in the form of employer securities. Paragraph (h)(l)(B) adds the additional requirement that if the stock is not readily tradable, the employee must "have a right to require that the employer repur· chase employer securities under a fair valuation formula."

Paragraph (h)(2)(A) then adds much·needed flexibility by pro· viding that the benefit "may be distributed in cash or in the form of employer securities."

Paragraph (h)(2)(B) then creates an "exception" to the foregoing rules for S corporations and for companies that have a bylaw or charter restriction on ownership. Under the exception provided in paragraph (h)(2)(B), S corporations and companies that have a by· law or charter restriction can make distributions under one of two alternative forms of distribution.

Under the first alternative, such companies can eliminate the right that the participant would otherwise have to demand distribution in the form of employer securities under paragraph (h)(l)(A), and can simply make the distribution in cash. Under this alternative, the plan has the effect of a call option because the shares are cashed out within the plan and the participant has no option to receive shares of em· ployer securities. The downside of this alternative is that the partici· pant does not have the opportunity to receive capital gains treatment on NUA, and the company is not able to shrink the ESOP.

Under the second alternative provided in the exception con· tained in paragraph (h)(2)(B), an ESOP that is maintained by an S corporation or by a company that has a bylaw or charter restriction "may distribute employer securities subject to a requirement that such securities may be resold to the employer under terms which meet the requirements of paragraph (l)(B)."

As noted above, paragraph (l)(B) provides that the employee then has a "right to require" that the employer repurchase his or her employer securities under a fair valuation formula.

The advantage of using the second alternative is that the par· ticipant will now have the opportunity to receive capital gains treat· ment on NUA (if the distribution is a lump·sum distribution), and the employer will have the opportunity to shrink the ESOP. The quintessential question is, does this alternative also enable the com· pany to require that all stock be sold back to the company (or to the plan)? Simply put, how should paragraph (h)(l)(B) be interpreted? Does paragraph (h)(l)(B) give employers a call option, or does para· graph (h)(l)(B) instead give the employee a put option?


The backhanded way that paragraph (h)(2)(B) is phrased, i.e., "the plan may distribute stock subject to a requirement that such securities may be resold to the employer under terms which meet the requirement of paragraph (l)(B)," has led some practitioners to conclude that if the distribution is made in the form of employer securities, paragraph (h)(2)(B) creates a "requirement" that such securities be resold to the employer.

Unfortunately, a review of the legislative history of this provi-sion reveals, in the opinion of this author, that this is not a correct interpretation of paragraph (h)(2)(B). What paragraph (h)(2)(B) ac-tually says is that ifthe distribution is made in the form of employer securities, then the plan must offer the participant the put option that is otherwise required in paragraph (h)(l)(B). Thus, if a plan's distribution policies and/or distribution forms are audited by the IRS or by the DOL, there is a significant risk that the IRS and/or the DOL may seek to disqualify the plan and/or hold the fiduciaries li-able for not having offered the required put option rights to the plan participants.

The net effect of the two alternative forms of distribution pro-vided under the exception set forth in paragraph (h)(2)(B) is that S corporations and companies that have a bylaw or charter restric-tion are on the horns of a dilemma. If the company wants to give its employees the benefit of capital gains treatment on NUA or wants to shrink its ESOP, it can do so, but it does so at the risk that dis-gruntled employees have the right to retain their shares of company stock. The only alternative is to make all distributions in cash, which then deprives the employer of the ability to shrink the ESOP and deprives the distributees of the benefit of capital gains treatment on NUA. Although the risk that a disgruntled employee will hold on to his or her shares is relatively low, most employers are highly risk-adverse when it comes to having stock owned by a disgruntled employee. To avoid this risk, most employers will simply opt to make all distributions in cash rather than in stock.

Practice Pointer

The foregoing analysis highlights one important practice pointer with respect to S corporation ESOPs. As mentioned above, many S corporations have assumed that they could have their ESOP make distributions in the form of shares of employer securities and then


require that all such shares be sold back to the employer. As we have seen above, this assumption is incorrect. Rather, all employ-ees who receive distributions of employer securities from an S cor-poration ESOP, whether due to termination of employment or due to distributable events prior to termination of employment, have the right to retain those shares for as long as they please. This cre-ates the possibility that a distributee of such stock may subsequently decide to transfer his or her shares to an ineligible shareholder, thereby causing a termination of the S corporation election.

One remedy to this problem is to adopt a charter or bylaw re-striction that prohibits all shareholders from transferring their shares to any person or entity that would not be an eligible shareholder of an S corporation. In the case of most regular S corporations, such a restriction will be contained in a shareholders' buy-sell agreement. In the case of an ESOP, however, Treasury Regulation Section 59.4975-7(b)( 4) prohibits an ESOP from being a party to a "buy-sell or similar arrangement." The simple solution to this problem is to incorporate the transfer restriction in the company's articles or by-laws, where it will apply to all shareholders.

Companies that have long operated as C corporations often have buy-sell agreements, but these buy-sell agreements do not have any restrictions against selling or transferring shares to a shareholder that would not be an eligible shareholder of an S corporation. Once a C corporation becomes substantially owned by its ESOP and elects to be taxed as an S corporation, the company typically files the Form 2553 election form and assumes that nothing more needs to be done. As a result, participants who receive distributions in the form of company stock are potentially free to transfer their shares to share-holders who are not eligible S corporation shareholders. Again, the simple solution to this problem is to incorporate a restriction in the company's articles or bylaws that prohibits all shareholders from transferring their shares to any person or entity that would not be an eligible shareholder of an S corporation.

Did Congress Mean What It Said?

The question remains, does Section 409(h)(1)(B) truly provide for a put option rather than a call option? Is it possible that Congress actually intended to allow a call option in the case of S corpora-tions and companies having a bylaw or charter restriction but that

38 The Journal of Employee Ownership Law and Finance. Vol. 17/3

it inadvertently drafted the restriction to provide for a put option instead?

The answers to these questions are important for one reason. If Congress inadvertently drafted the restriction to provide for a put option rather than a call option, then it should be relatively easy to ask Congress for a "technical correction" to correct this drafting miscue. If, on the other hand, based upon policy considerations previously considered and debated, Congress clearly intended to allow employees the option of retaining share ownership in all situ-ations where a bylaw or charter restriction did not otherwise apply, then there would be no point in asking Congress to reconsider an issue it has previously considered and resolved.

To answer these questions, it will be necessary to review the long and torturous legislative history of the enactment and evolu-tion of Section 409(h) of the Code.

Early Definitions of an ESOP The ESOP was first defined 30 years ago in ERISA, which amended the Code to add only three provisions relating to ESOPs. The first provision (Section 4975(e)(7)) defined the term "employee stock ownership plan" to mean a defined contribution plan that is a stock bonus plan that is qualified, or a stock bonus and a money purchase plan both of which are qualified under Section 401(a), and which are designed to invest primarily in qualifying employer securities. The second provision (Section 4975(e)(8)) defined "qualifying em-ployer security" to mean an employer security that is stock or oth-erwise an equity security. The third provision (Section 4975(d)(3)) provided an exemption from the prohibited transaction rules of Section 4975(c) of the Code for any loan to an ESOP if such loan is primarily for the benefit of participants and beneficiaries of the plan, if such loan is at a reasonable rate of interest, and if any collateral given to a disqualified person by the plan consists only of qualify-ing employer securities. Subsection (B) of Section 4975(e)(7) then left it up to the Secretary of the Treasury to further define the rights and restrictions applicable to ESOPs.

Tax Reduction Act ESOPs The Tax Reduction Act of 1975 added a new type of ESOP to the tax code called the Tax Reduction Act ESOP (a "TRASOP"). The


Tax Reduction Act of 1975, among other things, amended Section 46 of the Code to increase the investment tax credit from 7% to 10% and further amended Section 46 of the Code to provide for an addi-tional 1 % investment tax credit, provided that the company would contribute shares of company stock to the TRASOP having a value equal to 1 % of the amount of investment tax credit property pur-chased by the company.

Section 301(d)(3) of the Act for the first time spelled out the requirement that allocations in a TRASOP must be in direct pro-portion to relative employee compensation; Section 301( d)( 4) of the Act provided that no stock could be distributed before the end of the investment tax credit holding period (84 months), except in the case of separation from service, death, or disability; and Section 302( d)(9) of the Act provided that "employer securities" meant com-mon stock having voting power and dividend rights no less favor-able than the voting power and dividend rights of other common stock issued by the employer.

The 1975 Act was entirely silent as to whether distributions fTom a TRASOP could be made in cash rather than in the form of em-ployer securities. Nevertheless, it was clear that distributions could be made only in the form of employer securities because ERISA defined the ESOP as a type of stock bonus plan, and Treasury Regu-lation Section 1.401-1(a)(2)(iii) required that a stock bonus plan must distribute benefits in the form of employer securities in order to remain as a qualified plan.

What is particularly interesting, however, is the fact that the 1975 Act contained no requirement that the employer provide a put op-tion with respect to employer securities that were not readily trad-able. Apparently, few if any closely held companies at that time sponsored stock bonus plans, so it was assumed that the stock was publicly tradable and could be readily sold in the market.

Technical Information Release 1413

On November 4, 1976, the IRS published temporary regulations regarding ESOPs and TRASOPs. These temporary regulations were published in Technical Information Release (T.LR.) 1413 and were in the form of questions and answers. T.LR. 1413 contained only two questions relating to rights and restrictions on employer secu-rities distributed from an ESOP.

40 The Journal of Employee Ownership Law and Finance, Vol. 17(3

The first question was whether the employer could have a right of refusal, and the answer was yes:

Q: Mayan employee who receives employer stock from an ESOP trust be required to offer to sell the stock to the employer before offering to sell it to a third party?

A: Yes. However, the agreement providing for this arrangement must also provide that the selling price of the stock (to be paid to the em-ployee) shall not be less than its fair market value. Furthermore, in no event may the employer offer a price less than that offered to the em-ployee by another potential buyer making a bona fide offer.

The second question was whether the employer could have a call option on employer securities distributed from an ESOP, and the answer was no:

Q: Mayan ESOP of the stock bonus type provide that upon receipt of employer securities distributed by the ESOP trust, the employee is re-quired to sell such securities to the employer within a specified period?

A: No. Section 1.401(b)(1)(iii) of the Income Tax Regulations requires a stock bonus plan to distribute benefits in stock of the employer com-pany. If the distribution is conditioned upon the sale of such stock to the employer within a specified period, the effect is to distribute cash, rather than employer stock, to the employee, contrary to the requirements of Section 1.401(b)(1)(iii).

Here again, however, it is interesting to note that T.I.R. 1413 did not contain any requirement that the employer provide a put option with respect to employer securities that were not readily tradable.

On July 30, 1976, the IRS issued proposed regulations that would have superseded the temporary regulation. However, the proposed regulations contained many provisions that were regarded by tax practitioners as being overly restrictive, including a requirement that would have required that all voting rights be passed through to participants. The proposed regulations were, in effect, nullified by the provisions of Section 803(h) of the Tax Reform Act that was passed later that year.

ESOP Final Regulations After holding extensive public hearings, the IRS then issued so-called "final regulations" on ESOPs on November 17,1978. These


are the regulations set forth in Section 54.4975-7, Section 54.4975-11, and Section 54.4975-12 of the Treasury Regulations. These regulations set forth very detailed rules and regulations regard-ing "ESOP requirements" that, for the most part, still apply to this day.

The final regulations contained four specific provisions that created a "bright line" with respect to permitted rights and options on shares of employer securities.

First, the regulations provided that qualifying employer securi-ties could, but need not, be subject to a right of first refusal, unless such securities were publicly traded at the time the right could be exercised (Section 59.4975-7(b)(9)). Second, the regulations pro-vided that qualifying employer securities must be subject to a put option if such securities were not publicly traded at the time of dis-tribution (Section 59.4975-7(10)). Third, the regulations provided that employer securities acquired by an ESOP could not be subject to a "put, call, or other option, or buy-sell or similar arrangement, while held by the plan or when distributed from the plan," other than the put option and the right offirst refusal provisions described above (Section 59.4975-7(b)(4)). Fourth, the final regulations pro-vided that benefits distributable from an ESOP (other than cash dividends) were distributable only in stock of the employer (Sec-tion 54.4975-11(f)(1)).

The preamble to the final ESOP regulations contains much use-ful information as to the background and rationale for many of the provisions contained in the final regulations, but it contains no dis-cussion whatsoever as to why the authors of these regulations chose to prohibit any type of call option on ESOP shares. One can sur-mise, however, that the prohibition on any type of call option was again based upon the argument that a call option would, in effect, result in a cash distribution, which would be inconsistent with the basic definition of a stock bonus plan.

Revenue Act of 1978

The Revenue Act of 1978 was signed by the President on November 7, 1978. Many of the provisions of the final ESOP regulations and the final TRASOP regulations were, in effect, superceded by the provisions of the Revenue Act of 1978 even before the final regula-tions were published on November 17, 1978.


The reason for the changes that were made by the Revenue Act of 1978 are described in the report ofthe Senate Finance Commit-tee, filed October 1, 1978, as follows:

The ESOP provisions and the TRASOP provisions have now been part of the tax laws for several years. Experience in the operation of these provi-sions has indicated that several changes are appropriate. In addition, based on experience since the Tax Reduction Act of 1975, the committee has determined that the TRASOP provisions should be made permanent and should be made a part of the Code.

Section 141 of the Revenue Act of 1978 rewrote the ESOP final regulations and the final TRASOP regulations and made them part of the Code for the first time by amending the tax code to add new Section 409A to the Code. New Section 409A replaced the term "TRASOP" with the term "tax credit ESOP," and defined an ESOP in subsection (a) as a defined contribution plan which (1) meets the requirement of Section 401(a); (2) is designed to invest primarily in employer securities; and (3) meets the requirements of subsections (bl, (c), (d), (e), (f), (g), and (h) of that section.

New subsection 409A(h) (later redesignated as 409(h) in the Tax Reform Act of 1984, as noted below) spelled out the new distribu-tion requirements for ESOPs. Subsection 409A(h)(1) provided that:

(1) In General - A plan meets the requirement of this subsection if a participant who is entitled to a distribution from the plan:

(A) has a right to demand that his benefits be distributed in the form of employer securities; and

(E) if the employer securities are not readily tradable on an established market, has a right to require that the employer repurchase employer securities under a fair valuation formula.

New subsection 409A(h)(2) then went on to provide that a plan would not fail to meet the requirements of Section 401(a) merely because under the plan the benefits might be distributed in cash or in the form of employer securities.

Thus, for the first time, ESOPs were permitted to make distri-butions in cash. If, however, the distributions were made in the form of employer securities, then the employer was required to offer the participant a put option, as was the case under the ESOP final regu-lations.


The report of the Senate Finance Committee explained the rea-son for now allowing distributions to be made in cash as follows:

The committee believes that any participant (or beneficiary) who receives a benefits distribution from an ESOP or a TRASOP (attributable to an ESOP loan or an additional investment tax credit) should be able to con-vert that stock interest in the employer to its cash equivalent. In fact, the committee recognizes that in the usual situation this conversion occurs almost simultaneously with the actual distribution. The committee be-lieves that the administrative paper-work and expense which is required for the ESOP or TRASOP to make a distribution in stock and then imme-diately repurchase the stock for cash is unwarranted in most situations. Accordingly, the committee believes that this process should be simpli-fied when the participant desires to receive this ESOP or TRASOP ben-efit in cash. However, if a participant wishes to actually receive this ESOP or TRASOP benefit in stock of the employer, and retain ownership of this stock, he should be able to do so, and he should have the future right to convert that stock interest to its cash equivalent through a "put option" to the employer or to the trust under the ESOP or the TRASOP. The committee believes that the terms of this put option should not cre-ate a hardship for the participant, the ESOP or TRASOr, the employer or its shareholders.

Technical Corrections Act of 1979

Despite the clarity of the Senate Finance Committee explanation, it was not clear that new Section 409A(h) applied to leveraged ESOPs as well as tax credit ESOPs. Accordingly, the Technical Corrections Act of 1979 amended Section 409A(h) to make it clear that the pro-visions of Section 409A(h)(1) (b) and Section 409A(h)(2) also applied to leveraged ESOPs.

Economic:: Recovery Act of 1981

The Economic Recovery Act of 1981 replaced the ESOP 1 % invest-ment tax credit with an ESOP payroll-based tax credit equal of .5% of eligible payroll. The 1981 Act also amended Section 409A(h)(2) of the Code, relating to the right to demand employer securities, by adding the following new sentence:

In the case of any employer whose charter of bylaws restrict the owner-ship of substantially all outstanding employer securities to employees or to a trust described in Section 401(a), a plan which otherwise meets the


requirement of this subsection or Section 4975(e)(7) shall not be consid-ered to have failed to meet the requirements of Section 401(a) merely because it does not permit a participant to exercise the right described in paragraph (l)(A) if such plan provides that participants entitled to a dis-tribution from the plan shall have a right to receive such distribution in cash.

The Conference Committee Report to the 1981 Act explained the reason for this change as follows:

The Senate amendment also changes the cash distribution and put-option rules to reflect certain State laws and corporate charter restric-tions which prevent compliance with present law rules.

Under the 1981 Act, the plan was limited to two distribution op-tions. Under the first option, the plan could make distributions either in cash or in employer stock. If the distribution was made in employer stock, the employer was required to offer a put option to sell the stock back to the employer. If the distribution was made in cash, the employee still had the right to demand distribution in the form of employer stock un-der Section 409A(h)(1), and the employer would then be required to of-fer a put option to sell the stock back to the employer under Section 409A(h)(1)(B).

Under the second option, if the company had a bylaw or charter restriction restricting the ownership of substantially all outstanding employer securities to employees or to a plan qualified under Section 401(a), then distribution could be made entirely in cash and the em-ployee would have no right to demand distribution in the form of em-ployer securities under Section 409A(h)(1)(a).

The net effect of the 1981 Act was to create a call option for those employers who had a bylaw or charter restriction restricting ownership of substantially all outstanding employer securities to employees or to a qualified plan, provided that the distribution was made in cash rather than in stock.

The provisions of the 1981 Act, however, had two negative con-sequences, one for employers and one for employees. The negative consequence for the employer was that the employer could only eliminate the right to demand stock under Section 409A(h)(1)(A) by making the distribution in cash. This would necessitate cashing out the participant's employer securities within the plan prior to making the distribution in the form of cash. Thus, under this ap-proach, the employer did not have the ability to shrink the amount of employer securities owned by the ESOP.


The negative consequence to the employee was that distribu-tion in the form of cash eliminated any possibility that the employee could have a portion of his distribution taxed at capital gains tax rates rather than having the entire distribution taxed as ordinary income.

Tax Reform Ad of 1984

The Tax Reform Act of 1984 brought forth major new tax advan-tages for ESOPs by adding the Section 1042 provisions (providing for the nonrecognition of gain in the case of certain sales to an ESOP), the Section 404(k) provisions (providing for the deduction of cer-tain dividends paid to an ESOP) and the Section 133 provisions (providing for the exclusion from taxation of 50% of the interest earned on certain ESOP loans) to the Code, and by freezing the ESOP payroll tax credit at .5% through 1987. Despite these sweeping changes, however, the 1984 Act made no changes to ESOP distri-bution provisions in Section 409A(h) of the Code, other than to change the designation of Section 409A(h) to Section 409(h).

Tax Reform Ad of 1986

The Tax Reform Act of 1986 further amended Section 409(h)(2) to eliminate the two negative consequences described above by adding the following clause at the end of the first sentence of subsection (2):

, except that such plan may distribute employer securities subject to a requirement that such securities may be resold to the employer under the terms which meet the requirements of Section 409(0).

The explanation for this change was set forth by the staff of the Joint Committee on Taxation in the Explanation of Technical Cor-rections Provisions of the Tax Reform Act of 1986 as follows:

Effective as of the date of enactment, the Act permits a plan sponsored by a corporation whose by-laws or charter restrict the ownership of sub-stantially all outstanding employer securities to employees or a trust described in Section 401(a) to distribute employer securities in certain cases. If such a plan does distribute employer securities, the distribution requirements and put option requirements generally applicable to ESOPs (except for the requirement that the employee has a right to demand that


the distribution be paid in employer securities) will apply to the distri-bution.

The net effect of the 1986 amendment was to create a third dis-tribution option in addition to the two distribution options described above. First, as before, if the employer did not have a bylaw or char-ter restriction, it could make distributions either in cash or in em-ployer securities, subject to the requirement that the participant be given a right to demand employer securities and a right to put the securities back to the employer.

Second, as before, if the employer did have a bylaw or charter restriction, it could simply make distributions in cash, in which case the employees would have no right to demand distribution in the form of employer securities.

Third, under the 1986 amendment, if the employer did have a bylaw or charter restriction, it could also make distributions in the form of employer securities (thereby enabling the employee in cer-tain cases to receive capital gains treatment on the NUA, and the employer to shrink the amount of employer securities held by the ESOP), but the employer would then be required to provide a put option pursuant to the terms of Section 409(0) of the Code.

Unfortunately, this was not the solution employers were look-ing for. Under the 1986 amendment, an employer who had a prop-erly crafted bylaw or charter restriction could make distributions in shares of employer stock and thereby provide its employees (in certain cases) with the capital gains treatment on the NUA (while also shrinking the ESOP), but it did so at the peril of having dis-gruntled employees decide to keep their shares rather than put the shares back to the employer.

Worse yet, the 1986 amendment to Section 409(h)(2) was tech-nically incorrect. As noted above, the 1986 amendment stated that the securities could be resold to the employer "under terms which meet the requirements of Section 409(0)." The intent of the amend-ment was to say that either the securities must be sold to the em-ployer under a fair valuation formula, or that the securities could be resold to the employer subject to the put option provisions of Section 409(h)( 4), Section 409(h)(5), and Section 409(h)(6).

Instead, the amendment incorrectly referred to Section 409(0), which was the section that described when distributions under an ESOP must commence. Moreover, the 1986 amendment should have


been added to the second sentence of Section 409(h)(2), not the first simtence of Section 409(h)(2), since it is the second sentence that refers to companies that have a bylaw or charter restriction.

The ideal solution would have been to amend Section 409(h)(2) to instead add the following clause at the end of the second sen-tence of subsection (2):

, except that such plan may distribute employer securities subject to a requirement that such securities must be immediately resold to the em-ployer or to the plan under a fail' valuation formula.

This language would in fact have provided a true call option. It would have given the employee the benefit of capital gains taxation in the case of lump-sum distribution on account of plan termina-tions, and it would have given the employer the protections that it would otherwise have had under the cash distribution option pro-vided by the second sentence in Section 409(h)(2).

Technical and Miscellaneous Revenue Act of 1988

The technical glitches under the 1986 Act were corrected by the Technical and Miscellaneous Revenue Act of 1988. The 1988 amend-ment revised the first sentence of Section 409(h)(2) to say, as it had said prior to the 1986 amendment, that ESOP benefits could be dis-tributed in cash or in the form of employer securities, and revised the second sentence of Section 409(h)(2) to say that an employer having a bylaw or charter restriction could distribute employer se-curities "subject to a requirement that such securities may be re-sold to the employer under terms which meet the requirements of paragraph (1)(E)."

This amendment corrected the technical glitches, but still left employers with an imperfect fix, since it referred back to the re-qull.'ement of paragraph (1)(E), which in turn refers to the put op-tion provisions of subparagraphs (4), (5), and (6) of Section 409(h).

Taxpayer Relief Act of 1997

The most recent changes to Section 409(h) are the amendments that were made by the Taxpayer Relief Act of 1997. The 1997 Act made


two changes to Section 409(h)(2). First, it split the two sentences of prior subsection (2) into two separate subparagraphs. The first sen-tence of prior subsection (2) is now denominated as subparagraph (A), and the second sentence of prior subsection (2) is now denomi-nated as subparagraph (B). In addition, new clause (E) now provides that subparagraph (B) shall apply to any ESOP that is maintained by UrI) an employer whose charter or bylaws restrict ... ownership," or U(II) an S corporation."

The Joint Committee of Taxation's "General Explanation" of the 1997 Act explains the reason for this amendment as follows:

It is possible that an S corporation may lose its status as such if the ESOP is required to give stock to plan participants, rather than cash equal to the value of the stock. ... The Act provides that ESOPs of S corporations may distribute cash to plan participants. Such a plan may distribute employer securities, as long as the employee has a right to require the employer to purchase the securities (as under the rules applicable to ESOPs generally).

Once again, this was not the solution S corporation ESOP spon-sors were looking for. Under the foregoing provisions, if an S corpo-ration wants to make ESOP distributions in cash, it can do so, and the employee will then have no right to demand distribution in shares of employer securities. However, if the S corporation employer wants to make distributions in the form of employer securities so that em-ployees can receive capital gains treatment on NUA in the case of a plan termination, or so that the employer can shrink the ESOP, it can do so (even without having a bylaw or charter restriction), but it does so at the peril of having disgruntled employees decide to keep their shares rather than put the shares back to the employer.

Again, the ideal solution would have been to amend the last clause of Section 409(h)(2)(B)(i) to say that distributions can be made entirely in cash, uexcept that such plan may distribute employer securities subject to a requirement that such securities must be immediately resold to the employer or the plan under a fair valua-tion formula."

Analysis of legislative History A number of observations and conclusions can be drawn from the forgoing review of the legislative history of Section 409(h). First, it


is obvious that up until 1981, the IRS clearly intended to prohibit any form of call option on shares of employer securities distributed from an ESOP. In response to the specific question of whether em-ployees could be required to sell their shares back to the employer within a specified period, the IRS in T.I.R. 1413 (November 4, 1976) specifically said no.

It should be noted, however, that the rationale for this answer was based upon the technical argument that the effect of a call op-tion would be to distribute cash, which would have been contrary to the definition of a stock bonus plan in Reg. Section 1.401 (b)( 1 )(iii).

It was the Revenue Act of 1978 that first permitted ESOPs to make distributions either in cash or in the form of employer securi-ties. The rationale that the Senate Finance Committee gave for making this change was to simplify the administrative paperwork that was otherwise required when stock was distributed and then immediately repurchased. However, the 1978 Act made no change in the provision that gave the employee the right to demand distri-bution in the form of employer securities, and the Senate Finance Committee's discussion of this "right" was in terms of something that the employee "should be able to do" rather than in terms of something that was required by Reg. Section 1.401(b)(1)(iii).

Apparently, however, Congress had a complete change of heart in the 1981 Act when it amended Section 409A(h)(2) to provide that if the employer had a bylaw or charter restriction, the plan would be permitted to make the distribution in cash, and the employee would be foreclosed from exercising the right that he or she would otherwise have had under Section 409A(h)(2) to demand distribu-tion in the form of employer securities.

Thus, under the 1981 Act, if the employer had a bylaw or char-ter restriction, it no longer mattered that the cash distribution had the effect of a call option, and it no longer mattered that the em-ployee "should" be able to demand distribution in the form of em-ployer securities. Simply stated, if the employer had a bylaw or charter restriction and the distribution was made in cash, the em-ployee would have no right to demand distribution in the form of employer securities.

Subsequently, Congress realized that the simple cash-out distri-bution option provided under the 1981 Act had the drawbacks of depriving the employee of the ability to get capital gains treatment on NUA and depriving the employer of the ability to shrink the ESOP.


Accordingly, the 1986 Act attempted to liberalize this cash-out procedure by allowing an employer that had a bylaw or charter re-striction to make the distribution in the form of shares of employer securities, subject to the requirement that such securities "may" be resold to the employer.

Apparently, the intent of this amendment was simply to liber-alize the 1981 provision by allowing the employer to have a man-datory cash-out, but structured in such a way that would enable the employee to receive capital gains treatment on NUA and the employer to shrink the ESOP. Also, there is nothing in the commit-tee reports that would suggest that Congress intended to cut back on the general principle established in the 1981 Act that an employer having a bylaw or charter restriction could eliminate the employee's right to retain shares of company stock.

Rather, it would appear that when Congress attempted to liber-alize the 1981 provisions in the 1986 Act, it botched the attempt through a number of technical drafting errors. First, as noted ear-lier, the 1986 amendment, which added the clause that employer securities could be resold to the employer under the requirements of Section 409(0), incorrectly referred to the wrong Code section. Section 409(0) was a paragraph that described when distributions under an ESOP must commence, not a section that described either a put option or a call option. In addition, this clause was added to the wTong sentence of Section 409(h)(2).

Based on these drafting errors, one can surmise that Congress meant to describe the provisions of a call option in the 1986 amend-ment but inadvertently wound up describing the provisions of a put option instead.

Subsequently, in the 1988 Act, Congress corrected the purely technical glitches, but it left the erroneous description of the call option in place.

The net result of the current language is that if the company is an S corporation or has a bylaw or charter restriction, the plan can have the equivalent of a call option by simply making all distribu-tions in cash. However, if it makes distributions in the form of employer securities, the participant will have a put option, but the company cannot have a call option.


Conclusion Based upon the foregoing, I conclude that the last sentence of Sec-tion 409(h)(2)(B)(i) was the result of an inadvertent drafting error rather than the result of a clear and definite policy decision. Based upon the legislative history, it appears that Congress intended to permit the employer and the plan to have the equivalent of a call option in the case of S corporations and corporations that have a charter or bylaw provision that restricts ownership to active em-ployees and to the plan. Accordingly, I recommend that the ESOP community should make a concerted effort to obtain a technical correction of this language at the earliest possible date.

In addition to this technical correction, I recommend that the ESOP community lobby for an additional provision that would per-mit the equivalent of a call option in all cases (regardless of whether the company is an S corporation or a C corporation, and regardless of whether the company has a charter or bylaw restriction) where the distribution is triggered by liquidity events other than normal distri-butions made upon death, retirement, or termination of employment.

Whenever an employee receives a diversification distribution, an in-service distribution, or a required minimum distribution, for example, the whole purpose of the distribution is to give the par-ticipant liquidity. The only reason for making the distribution in the form of employer securities in these situations is so that the employer can fund the liquidity need with company funds rather than plan funds, or so that the company can shrink the ESOP by having the shares repurchased by the company rather than remain in the plan. In these situations, no purpose is served by giving the participant the right to retain his or her shares, since the whole purpose of the distribution is to enable the participant to liquidate a portion of his or her shares.

By the same token, if it is contemplated that all the shares will be distributed and then repurchased by the employer in order to effectuate a plan termination, the only reason for making the distri-bution in the form of employer securities is so that (1) the employer can terminate the ESOP by having the shares repurchased by the company; and (2) the employees can receive the benefit of paying taxes on the NUA at capital gains tax rates. Here again, since the whole purpose of the distribution is to liquidate all of the shares


held by the ESOP, no purpose is served by giving the participant fhe right to retain his or her shares.

In my opinion, the changes suggested above would be a win-win situation for all concerned. First, these changes would enable employees to get capital gains treatment in many situations where they cannot do so under current provisions. Second, these changes would enable the employer to fund certain liquidity events (diver-sification distributions, in-service distribution, required minimum distributions, and plan termination distributions) with company money rather than with plan money. Finally, by permitting the company or the plan to have a call option in these situations, the administration of many ESOPs would be greatly simplified.

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