ESOP Operational Issues
Allocation Restrictions Triggered by a Section 1042 Sale to an ESOP (Part 2)
May 18, 2010In my last column, 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:
For this purpose, the definition of family does not include aunts and uncles, nieces and nephews, in-laws, stepchildren, or stepparents.
- Lineal descendants
- Estate and trust beneficiaries
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.
In future columns, 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.
Author biography and other columns in this series