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The Employee Ownership Update

Corey Rosen

August 1, 2003

(Corey Rosen)

IRS Cracks Down on ESOP S Corporation Deferred Compensation Scams

In temporary and proposed regulations (Reg. 129709-03, T.D. 9081; the proposed regulations are the same text), the IRS has cracked down on S corporation ESOP scams using non-qualified deferred compensation and/or management company arrangements that are designed to avoid or evade the anti-abuse provisions of IRC Sec 409(p). The temporary and proposed regulations are the same, and are effective July 21, 2003, and are applicable for plan years ending after October 20, 3003.except for legitimate S corporation ESOPs that were established on or before March 14, 2001, and eligible for the delayed effective date of January 1, 2005.

The new regulations provide that non-qualified deferred compensation, even if not payable in stock, will be considered to be synthetic equity and subject to a present value calculation.. The synthetic equity attributable to non-qualified deferred compensation arrangements will then be added to other equity interests held by disqualified persons in determining the amount of deemed-owned shares to see if the ESOP has a non-allocation year. If it does, severe tax penalties apply. Companies can avoid having non-qualified deferred compensation benefits treated as synthetic equity by paying out non-qualified deferred compensation on or before July 21, 2004. It is important to note that rights to acquire stock or other similar interests in a related entity that is the only significant asset of the S corporation and of which the S corporation is the only significant owner are also treated as synthetic equity (other ownership arrangements will be looked at next). However, a right of first refusal as part of a buy-sell arrangement is not per se such a right. The IRS said it may issue additional rules for situations where the entity is not the only asset of the S corporation and is not primarily or entirely owned by it.

The rules are intended to prevent scams in which an ESOP management company is (typically) set up as an ESOP S corporation. It sets up or spins off an operating company and contributes all or most of its stock to it. The operating company also has an ESOP. The operating company then pays the management company most of its profits as a fee, and management may receive substantial non-qualified deferred compensation benefits. Alternatively, there may be no management company, but management is paid large amounts of non-qualified deferred compensation. In either case, ESOP shares end up with little value because equity value is diverted away from shareholders. The IRS said these arrangements are clearly not intended to benefit employees and the IRS intends to continue to this regulatory project to assure that S ESOPs are set up to benefit employees broadly, not just save taxes and benefit a limited number of executives.

IRS Simplifies ESOP Section 1042 Filings

In temporary regulations issued July 9 (EE-96-85), the IRS has made it easier to comply with filing requirements under Section 1042 of the Code. That section allows certain sellers to qualified ESOPs to defer capital gains taxes on the sale by reinvesting in qualified replacement property (QRP). Under prior rules, sellers had to have statement of purchase notarized for the QRP within 30 days of purchase. Now they can have the statement notarized any time up to the filing of their tax return for the return following a qualifying purchase.

FAS 150 and ESOPs: Still Up in the Air

There is still no firm consensus on just what the Financial Accounting Standards Board (FASB) really means by its new FAS 150, an accounting protocol effective December 15, 2003 for closely held companies and June 15, 2003 for public companies. FAS 150 requires companies to record a liability on their balance sheets for mandatorily redeemable obligations, including "puttable stock." On the one hand, shares held by ESOP participants and put to the company certainly seem to fall within this definition. However, "puttable stock" has a more narrow definition here, including that the put option be transferable (it is not in an ESOP). "Mandatorily redeemable" requires that the employee has no choice but to sell the shares back. More important, the statement explicitly exempts ESOPs following current AICPA standards for ESOP accounting. Unfortunately, this only applies to the stock when it is in the plan, not once it has been issued to participants. The rules thus suggest that plans in which the shares are redeemed prior to an employee leaving (as would be the case in S corporations and companies in which the bylaws state that "all or substantially all" of the stock be owned by employees) and plans in which the employee only owns the shares on a temporary basis (the IRS, in rulings on S corporations, has said that such transient ownership does not constitute ownership for S corporation purposes, for instance) would not be covered. It might also not apply to plans in which the company buys back shares and recontributes them to the ESOP. However, it might apply to plans in which the employee, after termination or distribution, can sell the shares back to the company. In that case, the fair market value of shares outstanding subject to these rights might have to be booked as a balance sheet liability and changes in value marked as an adjustment to income.

Whatever the outcome of this issue, it appears FASB will revisit ESOP repurchase obligation specifically in its second round of rulings pursuant to FAS 150 sometime time next year.

Options Expensing Bill's Prospects Dim

Efforts to pass H.R. 1372 and S. 979 ("The Broad Based Stock Option Plan Transparency Act") appear to be faltering. Although the House bill now has over 50 bipartisan sponsors, and the Senate bill has some of the most notable members supporting it, the chairs of the committees where the bills now reside have not indicated any eagerness to move the bills. Many members of Congress would be reluctant to take sides on the issue. Supporting expensing would antagonize some industry constituents, but opposing it could seem to be taking a stand against corporate reform.

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