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David Johanson's ESOP Forum
IRS Rules on Using Proceeds from the Sale of Unallocated Shares to Repay an ESOP Loan
David Johanson
June 2000
As a result of the consolidation of many business industries and the substantial amount of financial resources available to fund the roll-up of multiple businesses in the same industries into a single enterprise (and thereafter enter into an initial public offering for such enterprise's capital stock), many ESOPs have received offers to purchase their company stock in recent years. In those cases where the ESOP has yet to repay in full its acquisition indebtedness, the ESOP's fiduciaries are normally faced with some significant decisions regarding whether to sell, whether to market the company stock to another purchaser or whether to sell such company stock. If a sale is appropriate and possibly necessary, such ESOP fiduciaries also must decide how to use the proceeds of such sale and still satisfy their fiduciary responsibilities under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), as well as the requirements of the Internal Revenue Code of 1986, as amended (the "Code"). The Internal Revenue Service (the "IRS") has recently provided some useful advice on this subject.In Private Letter Ruling ("PLR") 200018058 (issued May 5, 2000), the IRS ruled that the termination of an ESOP and the sale of shares of company stock to the plan sponsor in connection with a merger of the plan sponsor with another company did not violate (1) the primary benefit requirement under Section 4975(d)(3)(A) of the Internal Revenue Code of 1986, as amended (the "Code"), (2) the provisions of Treas. Reg. Section 54.4975-7(b)(8) relating to release of company stock from encumbrance or (3) the requirement of the exempt loan regulations relating to its specific term as provided under Treas. Reg. Section 54.4975-7(b)(13). The IRS also ruled that the proceeds that the ESOP received on the sale of unallocated shares of company stock was a permissible source of repayment of the exempt loan under Treas. Reg. Section 54.4975-7(b)(5).
After purchasing 63% of the issued and outstanding shares of company stock in 1991, the ESOP sponsor made recurring, substantial and timely payments to the ESOP over a seven-year period, resulting in the allocation to ESOP participants' accounts of approximately 50% of the purchased shares. When the company established the ESOP, it fully intended to continue to make payments on the exempt loan until maturity and all of the company stock was allocated. In 1998, however, the company received an unsolicited offer to merge with an unrelated entity and entered into a letter of intent that provided for the termination of the ESOP as a prerequisite for the merger.
The IRS once again concluded in this PLR that the relevant facts and circumstances to be considered in determining whether an exempt loan is primarily for the benefit of the ESOP's plan participants and beneficiaries are as follows: (1) whether the transaction promotes employee ownership of company stock; (2) whether contributions to the ESOP are recurring and substantial; and (3) the extent to which the repayment of the exempt loan benefits the employees. Based upon the facts briefly summarized above, the IRS concluded that the transactions contemplated by the ESOP sponsor would not cause the exempt loan to fail to satisfy the requirements for exemption from the prohibited transaction rules under Section 4975 of the Code, including the primary benefit requirement.
With respect to repayment of an exempt loan, Treas. Reg. Section 54.4975-7(b)(5) indicates that the employer has the primary responsibility for repayment through contributions to the ESOP. This section also provides that the only assets of an ESOP that may be given as collateral on an exempt loan are qualifying securities of two classes: (1) those acquired with the proceeds of the exempt loan, and (2) those that were used as collateral on a prior exempt loan repaid with the proceeds of the current exempt loan. No person entitled to payment under the exempt loan shall have any right to assets of the ESOP other than: (1) collateral given for the loan, (2) contributions that are made under an ESOP to meet its obligations under the loan, and (3) earnings attributable to such collateral and the investment of such contributions.
Therefore, Section 54.4975-7(b)(5) of the Treasury Regulations does not establish a per se prohibition against exempt loan prepayment by an ESOP. As noted above, if an ESOP contemplates prepaying an exempt loan, the funds used to prepay the loan must be limited as described in this regulation. According to this PLR, "proceeds received on sale of unallocated shares are a permissible source of repayment of the exempt loan."
Rachele Hoag, a summer associate at Mr. Johanson's firm, assisted with the drafting of this article.
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