ARTICLE
March 2010

Allocation Restrictions Triggered by a Section 1042 Sale to an ESOP

Part 1

There is much speculation that the capital gains tax rate may increase at some point in the future. If so, we may see an increasing number of tax-deferred sales to an ESOP (i.e., Section 1042 sales).

A 1042 sale does trigger some unique operational issues that will be summarized here. As with other ESOP operational issues, there are areas of uncertainty, so consultation with your own ESOP advisor on your situation is recommended.

Code Section 409(n) provides that certain employees are prohibited from receiving:

  1. an allocation of the shares acquired in a 1042 transaction
  2. an allocation in lieu of such 1042 share allocations
  3. earnings on the 1042 shares

The employees who are subject to these prohibitions (the "prohibited group") include:

  1. the selling shareholder
  2. an individual who is related to the selling shareholder (although there is an exception for limited allocations to lineal descendants)
  3. any more-than-25% shareholder of the company

The nonallocation period for the selling shareholder and family members begins on the date of the 1042 sale to the ESOP and ends on the later of the date that is 10 years after such sale or the date on which the last 1042 shares are released from the unallocated suspense account and allocated among participant accounts. The prohibition on allocations of 1042 shares to a more-than-25% shareholder generally extends indefinitely.

A practical consequence of these rules is that any 1042 shares must be tracked separately in the plan administration process. This separate tracking is needed to ensure that not only are the 1042 shares allocated correctly when first purchased or released from the unallocated suspense account but also that the shares are allocated correctly when reallocated either as forfeited shares or recycled shares. There may also be separate tracking of the cash or other investment accounts within the ESOP to ensure that allocations of items such as dividends or other earnings on the 1042 shares are not allocated to the accounts of the prohibited group.

The above general summary leads into many questions, including:

  1. Do 1042 shares ever lose their taint as 1042 shares?
  2. What is the definition of family for purposes of these provisions?
  3. What happens when you have multiple sellers?
  4. How does the exception for allocations to lineal descendants work?
  5. When and how does one determine whether an individual is a more-than-25% shareholder?
  6. What is an allocation in lieu of 1042 shares?
  7. How does a subsequent S election by the plan sponsor affect these rules?
  8. What are the consequences of making a prohibited allocation?

With respect to the first question, as long as the shares remain in the ESOP trust, the 1042 taint also remains with those shares. Thus, as alluded to above, the shares of terminated participants may be re-allocated to active participants as either forfeited or recycled shares, but they will continue to be treated as 1042 shares and as such cannot be allocated to the prohibited group. Alternatively, if the shares are distributed to the former participants and the ESOP subsequently repurchases such shares, then those shares would no longer be considered 1042 shares. Note that this does require that the shares actually leave the trust, even if for only a moment.

Part 2

In Part 1 I started a discussion on the provisions of Code Section 409(n) that prohibit the allocation of shares sold to an ESOP in a Section 1042 tax deferred sale to certain employees ("the prohibited group.") Included in the prohibited group are the selling shareholder, certain of his or her family members, and any more-than-25% shareholders of the company. So which family members are precluded from receiving allocations of the 1042 shares? For this purpose, the definition of family includes:

  • Spouse
  • Ancestors
  • Lineal descendants
  • Siblings
  • Estate and trust beneficiaries

For this purpose, the definition of family does not include aunts and uncles, nieces and nephews, in-laws, stepchildren, or stepparents.

There is an exception that may allow for limited allocations to lineal descendants. Specifically, lineal descendants of a selling shareholder can receive allocations of 1042 stock sold by their lineal ascendant during the non-allocation period up to a cumulative maximum of 5% of the 1042 shares sold by such lineal ascendant. Note however, the lineal descendant exception is not available to the extent that such lineal descendant is a direct or indirect shareholder of more than 25% of the company. (I will discuss the indirect ownership concept more in my next column.)

Where there are two or more lineal descendants, the 5% limit applies in the aggregate to all such lineal descendants. Also, while not entirely clear, the 5% limit appears to be a cumulative limit rather than a year-by-year limit. For example, assume the selling shareholder sells 1,000 shares to the ESOP, and the loan incurred to acquire such shares is amortized over 10 years. The maximum number of these 1042 shares that could be allocated to such selling shareholder's lineal descendants over the 10-year share release period would be 50 shares.

Where there are multiple sellers to the ESOP, the determination of the prohibited group and the application of the lineal descendant exception become more complicated. Assume that three shareholders sell to an ESOP in one integrated transaction with one loan funding the purchase, and all three make the Section 1042 election. Are each of these three individuals prohibited from receiving allocations of the shares sold by the other two shareholders in addition to their own shares? Yes, the language in Code Section 409(n) prohibits the allocation to any taxpayer who makes a Section 1042 election. This would be true even if the sales were not part of one integrated transaction.

What if there is one integrated transaction and one of the selling shareholders did not elect Section 1042 treatment? The IRS had indicated several years ago, on an informal basis, that because the sales were part of one integrated transaction, the shares sold by the shareholder who did not elect 1042 treatment would still be subject to the 1042 taint and could not be allocated to the prohibited group and that the prohibited group may include the shareholder who did not make the 1042 election. The IRS had also indicated informally that a lineal descendant of one shareholder who was eligible for the 5% allocations could only receive such allocations of the shares sold by his or her lineal ascendant and not an unrelated seller. Many practitioners may take different positions on these issues. If you have multiple sellers, you will want to consult with your own ESOP advisors on all of the Section 409(n) implications. The proper structuring of the transaction(s), including separate purchase agreements, loan documents, etc., may be the key to achieving the result that is desired.

Next I will discuss the determination of a more-than-25% shareholder for purposes of these provisions as well as the consequences of violating the Code Section 409(n) non-allocation requirements.

Part 3

Let us continue the discussion of the non-allocation restrictions of Code Section 409(n) by defining a more-than-25% shareholder for this purpose. A person will be considered a more-than-25% shareholder if he or she owns more than 25% (in terms of either number of shares or value) of:

  • Any class of stock of the company issuing the shares sold to the ESOP, or
  • Any class of stock of any corporation in a controlled group of corporations with the corporation issuing the shares sold to the ESOP.

Indirect ownership is considered as well as direct ownership. An individual is considered to indirectly own the shares that are owned by the following related individuals or entities:

  • Spouse
  • Parents
  • Children and grandchildren
  • Partnerships and S corporations
  • Estates and trusts, including the ESOP trust

An individual will be considered a more-than-25% shareholder if he or she owns, directly or indirectly, more than the 25% at any time during the one-year period ending on the date of a particular Section 1042 sale. If a person meets this criterion, he or she is prohibited from ever receiving an allocation of the Section 1042 shares acquired in that transaction.

A person may become a more-than-25% shareholder in the future as the shares acquired in a leveraged Section 1042 transaction are still being allocated among ESOP participants. This is important because any participant who is a more-than-25% shareholder on the date of any allocation of the Section 1042 shares cannot receive an allocation of those shares. Note that the shares in a participant's ESOP account are considered to be owned by such person for purposes of this test. Hence, it is possible that the ESOP allocations will cause a person to become a more-than-25% shareholder and become ineligible for further allocations of 1042 shares. Although this is not entirely clear, an ESOP participant should be able to receive an allocation of shares that causes him or her to exceed the 25% limit with future allocations ceasing at such point (unless and until the ownership drops below 25% at some point in the future).

There are a few miscellaneous questions I would like to address:

  • Since Code Section 1042 is available only with respect to a sale of C corporation stock to an ESOP, does Section 409(n) apply to an S corporation ESOP? Yes, to the extent that there was a Section 1042 sale to the ESOP before the company made the S election.
  • What is an "allocation in lieu of"? The concept here is that not only is the affected person prohibited from receiving an allocation of the 1042 shares but he or she also is prohibited from receiving a "make-up allocation." In other words, it is not possible to make a cash contribution to the ESOP or another qualified plan on behalf of such individual in an amount that he or she would have received as a stock allocation absent these rules. Note however, some companies do attempt to make these individuals whole through allocations in a nonqualified arrangement.
  • What are the consequences of violating Code Section 409(n)?
    • One likely consequence is the failure to follow the terms of your ESOP document as most documents include provisions that incorporate the rules of Code Section 409(n). Failure to follow the terms of the plan document could lead to the disqualification of the ESOP.
    • The individual receiving the prohibited allocation will be deemed to have a taxable distribution equal to the amount of the prohibited allocation.
    • The employer sponsoring the ESOP must pay a 50% excise tax on the amount of the prohibited allocation.

If a violation of Code Section 409(n) has occurred, you should consult with your ESOP advisors on possible correction alternatives.