January 2, 2020

IRS Rules That Typical ESOP Floor Price Protection Plans Are Taxable

In General Legal Advice Memo 2019-03, the IRS ruled that payments from a company to a former employee under an ESOP price protection plan are immediately taxable if made directly to the employee, but not if the employer makes a special "qualified non-elective contribution" to the plan that is allocated to the former employee’s account and then distributed as part of the ultimate account distribution. Once those funds are distributed, they would be taxed under normal distribution rules.

Floor price protection plans are used by some non-100% ESOPs as part of a leveraged transaction to buy more shares. The new debt puts downward pressure on the stock price until the loan is repaid. Employees nearing retirement age can be adversely affected, so price protection plans allow companies to make up some or all the difference the added leverage creates. The vast majority of the plans do this by making an additional cash payment to employees covered by the plan (often those 55 or older) equal to this difference. There are different ways of computing this, but the goal is to assess what the stock price would have been absent the leverage and provide the employee with a total payout not less than that.

While the ruling provides clarity on this issue, it is already the standard practice of ESOP companies to treat the direct payments to employees as taxable income.