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The Employee Ownership Update

Corey Rosen

July 23, 1996

(Corey Rosen)

Tax Bill Contains Important Employee Ownership Provisions

Aside from the Subchapter S and section 133 provisions of H.R. 3448 described in the last update, the small business tax relief bill working its way through Congress contains other important provisions affecting employee ownership as well.

As part of efforts to simplify rules, five-year averaging for lump-sum distributions would be repealed, the limits on company contributions to both a defined contribution plan (such as an ESOP) and defined benefit pension plan would be phased out, and "highly compensated employee" would be redefined as a 5% owner or an $80,000 per year employee (an amount to be indexed for inflation). Current rules defining highly compensated employees are very complicated.

More important are changes in 401(k) plan nondiscrimination testing rules. New alternative tests would allow plans to qualify, for instance, if all eligible participants got at least a 3% of pay corporate contribution, even if they made no salary deferrals to the 401(k). Alternatively, a plan would pass if 100% of elective contributions for all employees were matched up to 3%, or a 50% match was provided on deferrals of 3% to 5%, and highly compensated employees received a percentage match no higher than non-highly compensated employees. The changes could encourage ESOP/401(k) plans, with companies using the ESOP to provide the minimum match.

These provisions are likely to survive a House-Senate conference and become law if the minimum wage bill becomes law.

IRS Issues a Spate of New ESOP Rulings

The IRS issued a number of new rulings in the last few months, a few of which were significant.

In Revenue Ruling 96-30, the IRS ruled that a corporate spin-off of a subsidiary for the purpose of allowing the employees of that subsidiary to become owners of the subsidiary's stock under an ESOP was a valid business purpose, thus qualifying the transaction as a tax-free corporate transaction.

In a more significant ruling (PLR 9612034), the IRS allowed a company to break its ESOP into two pieces to facilitate a sale of a subsidiary. The company operated a leveraged ESOP for all its employees. It sold a subsidiary by breaking the ESOP into two ESOPs, one for the company and one for the subsidiary to be sold. Then it allocated a pro-rate share of the stock and remaining loan to the subsidiary, which repaid its piece of the remaining loan through the sale of the unallocated shares. The excess was allocated to employee accounts. The IRS approved this approach, but said the excess amounts would count as contributions under section 415 allocation limits, leaving unclear what would happen if these amounts exceeded the section 415 limits.

In a peculiar ruling (TAM 9624002), the IRS allowed an employer to terminate an ESOP and pay off the loan through the sale or unallocated shares. What was odd was the conclusion that two sons of the seller, who were allocated 10% of the stock, were deemed not to violate the prohibited allocation rules of section 409(n) even though the seller took advantage of the section 1042 rollover. Normally, such an allocation would be prohibited because of their relationship to the seller.

Finally, in perhaps the most important ruling, in PLR 9625045 the IRS allowed a company to use the current market value of shares in a leveraged ESOP as the basis for calculating its contribution value under section 415. The company's stock value had declined sharply since the ESOP. ESOP contributions had been used to match employee 401(k) contributions, but if the contributions were calculated as equal to the cost of repaying principal on the loan, the company would not have been able to provide as high a match as it had promised.

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