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Using Proceeds from the Sale of ESOP Suspense Account Stock to Repay an ESOP Loan

David Johanson

January 1995

During 1994, the Internal Revenue Service (the IRS) issued a number of private letter rulings (PLRs) concerning the use of proceeds from the sale of stock held in an employee stock ownership plan (ESOP) suspense account to repay the outstanding principal balance on an ESOP loan. In recent examinations of ESOP plan documents during the determination letter application process, the IRS also has more carefully reviewed plan document language that permits the sale of ESOP suspense account stock and the use of the proceeds from such sale to repay ESOP indebtedness. Although some ESOP professionals have characterized the position taken by the IRS in the PLRs as "ludicrous," it is important that we understand the issues raised by the PLRs. This ESOP Forum attempts to provide an understanding of the issues.

The PLRs are more significant for the IRS' statement concerning the application of the Internal Revenue Code of 1986 as amended (the "Code") section 415 limitations than they are for the ruling concerning the use of the sale proceeds to repay an outstanding ESOP loan. Nevertheless, the next ESOP Forum will focus on the fiduciary issues raised by the use of the proceeds to pay off the ESOP indebtedness. These issues also were discussed by the Department of Labor in a December 1993 advisory opinion.

In the IRS' view as expressed in the PLRs, the portion of the sales proceeds that is allocated to the ESOP participants' accounts following the repayment of the ESOP loan is an "annual addition" for the purpose of calculating the Code section 415 limitations.

The facts of one of the PLRs are as follows. In 1978, a publicly traded company (the Sponsor) established an ESOP. In 1987, the employee stock ownership trust (the ESOT) established pursuant to the ESOP borrowed several million dollars to purchase shares of the Sponsor's common stock. The stock was not pledged as security for the loan.

In 1989, a third party made an unsolicited offer to purchase all of the outstanding shares of the Sponsor, including the shares held by the ESOT. The offer price for the stock was substantially greater than the price listed on the New York Stock Exchange, as well as the initial cost of the stock. The ESOT trustees tendered all of the shares held by the ESOT to the third-party purchaser.

The ESOT trustees proposed to use the proceeds from the sale of the shares held in the ESOP suspense account to repay the ESOP loan and to allocate the remaining proceeds to the ESOP participants' accounts in accordance with the terms of the plan. (It is unclear whether the allocation was based on the participants' account balances, their compensation or some other formula.) The Sponsor requested a ruling that the use of the sale proceeds to repay the ESOP loan would not jeopardize the exempt status of the ESOP loan under Code section 4975(d)(3)(A).

The IRS stated that the ESOP loan would not fail to be exempt from the prohibited transaction rules merely because the trustee sold the unallocated employer securities and used the proceeds to repay the loan; provided, however, that the sale was primarily for the benefit of the ESOP participants and beneficiaries. Based on the facts of this case, the IRS ruled that the use of the sale proceeds to repay the outstanding principal balance on the ESOP loan would not cause the loan to fail to be exempt under Code section 4975(d)(3)(A). We will address this issue more thoroughly in the next ESOP Forum.

The IRS then addressed the application of the Code section 415 limitations. It stated that the "amounts allocated to participant accounts as a result of the loan repayment [e.g. the excess remaining after the repayment] constitute an annual addition for purposes of section 415 of the Code equal to the cost (basis) of the stock at the time it was contributed to the plan or otherwise acquired with the exempt loan proceeds." According to the PLR, the amount that was to be included in the "annual addition" was equal to the product of the dollar amount allocated to each participant's account multiplied by a fraction in which the stock's basis is the numerator and the sales price is the denominator.

The IRS provided no analysis for its conclusion that the allocation of the sale proceeds constitutes a part of the "annual addition" for the purpose of the Code section 415 limitation. It is difficult to understand how it reached this conclusion. As indicated above, some ESOP professionals have characterized the IRS' conclusion as "ludicrous" and have ignored it from a planning perspective.

Assuming that the only amount that was to be allocated to the participants' ESOP accounts was the proceeds that remained in the suspense account after the repayment of the ESOT debt, such amount would normally be characterized as the profit (or earnings) on the sale of the shares. The allocation of earnings is not included in the "annual addition" for Code section 415 purposes.

Under Code section 415(c)(2), the only amounts that are included in the "annual addition" are "employer contributions, the employee contributions, and forfeitures." The allocation of excess proceeds (the earnings) cannot be even remotely characterized as any of the three forms of allocation that constitute part of the "annual addition.

Although the IRS did not cite it in support of its conclusion, Treasury Regulation section 1.415-6(b)(2) permits the Commissioner, "in an appropriate case," to treat a "transaction between the plan and the employer or certain allocations to participants' accounts as giving rise to annual additions." The allocation of earnings on the sale of stock held by an ESOT does not, however, seem to be the type of allocation that is "appropriate" for increasing the "annual addition."

The PLRs are not precedent that must be followed by other ESOP sponsors and fiduciaries. However, they are an expression of the IRS' position, which should be considered before the excess proceeds from the sale of ESOP stock are allocated to ESOP participants' accounts.

Biography and list of other "ESOP Forum" installments

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