Employee Ownership Q&A: January 2024

Q: Our company was sold two years ago to our ESOP, and the owner deferred taxes on his capital gains by reinvesting in qualified replacement property (a “Section 1042” sale) on the sale. Now we have been approached by a buyer who would pay cash and give us more than two times the current fair market value. I have heard, though, that in a 1042 transaction if the stock held by the ESOP drops below 30% of the total shares within three years of the sale to the ESOP, the company must pay a 10% excise tax on the sale. Does this apply even if the company is sold?

A: The tax would apply. The tax is equal to 10% of the value of the shares to which 1042 applied. The company must pay this tax. There are some exceptions to this rule. If the sale is in a Section 368 stock-for-stock exchange, the tax does not apply. It also does not apply if the trust ownership drops below 30% because shares are distributed to former employees.

Trustees, of course, must act in the best interests of plan participants in deciding on the sale. The buyer might assume the tax but reduce the purchase price by that amount. The trustee might try to negotiate for a higher sale price to accommodate that, but it is also possible that the economics of the deal will now make the buyer decide not to pursue the offer. The trustee might also ask the seller to assume the tax because it is the seller who benefited. If the seller is being paid a note, the company is in a stronger position to make this argument because the sale would result in the note being paid off. The seller is under no compulsion to agree to anything, however, unless the seller agreed at an earlier point to do so as part of the sale terms.

Q: We want to revise our bonus system and have heard some companies talk about a tiered system that pays key employees last but gives them an opportunity to get a higher percentage of the available bonus pool if the company does really well. How would this work?

A: The core idea behind tiered bonuses of profit sharing is that if a profit target is met, amounts above the target will be paid out up to a certain amount either to all employees or just to non-key employees first. For instance, a company might say that the first $100,000 in profit will be divided among all non-key employees equally or on relative pay. Amounts over that amount up to $200,000 will be shared with everyone on the same basis. Amounts over $200,000, however, will primarily benefit key employees.

There are endless variations on this idea, of course, but the basic concept is to make sure everyone gets a bonus before any special incentives for key employees are paid.

Q: I am a former employee of a successful ESOP company. I left two years ago. The company has moved my stock into a money market fund and said that I cannot access the money for another three years. After that, I’ll begin receiving it in installments. Can they do that? I would really have preferred to keep the account in their stock because it has done well. At a minimum, I would prefer better investment opportunities than money market funds. Is the company permitted to take these actions, and do I have any right to change them?

A: We get this question a lot. Many companies need to do a better job of explaining what is happening. It is common for companies to move stock into other investments after people terminate but not pay them out for some time. The theory is that this helps discourage people from leaving just to get their account balances. Once the stock has been sold, the proceeds need to be reinvested prudently. Views on what is prudent differ. Is the most prudent thing the most conservative investment, or should it be more diversified? Most advisors now urge companies to take the latter approach, albeit still with a fairly conservative mix of assets. As a plan participant, however, you do not have the ability to direct the investments unless the plan allows that, which most do not.

Q: SECURE 2.0 provided that required minimum distributions (RMDs) do not have to start until age 73 in 2023, increasing to 75 by 2033. Do we need to amend our plan to reflect this for retired employees still in the plan?

A: The issue here is the latest date distributions must start. Your plan can require they start early for people who are at or older than the plan’s retirement age. If that is not the case, then you should work with your attorney and plan administrator to change the plan language to reflect the new law. Note that distributions can be rolled over into an IRA (and then be subject to RMD rules) but RMDs cannot. But it still may be advisable to reflect the change in your plan to avoid confusion.

Q: We have an account segregation policy. We are concerned that we will not have the cash to do this in the next few years. Can we change it?

A: You can change it if your plan allows that. Otherwise, you need to amend the plan. This can only apply to terminations going forward and should not have the effect of discriminating in favor of more highly paid people, so consult your attorney. (See also article from this month's newsletter.)

Have a question about ESOPs? We welcome you to contact us by phone or email. We also maintain the online ESOP Q&A, an important member benefit containing answers to over 700 common—and not so common—questions about all aspects of ESOPs. You can browse by category or search for a topic.