IRC Section 1042 Tax Deferred Sale of Stock to an ESOP and Private Letter Ruling (PLR) 200827018 Involving a Predecessor LLC

PLR 200827018 is a private letter (PLR) ruling that allowed two selling shareholders of a C Corporation to include the time period that they owned a predecessor LLC that was merged into a newly created C Corporation in the 3-year holding period defined in IRC Section 1042(b)(4) - Sales of stock to employee stock ownership plans or certain cooperatives – Requirements to qualify for nonrecognition – 3-year holding period.

The PLR notes that the merger was part of a IRC Section 368(a)(1)(F) - Definitions relating to corporate reorganizations - Reorganization - In general reorganization ("a mere change in identity, form, or place of organization of one corporation, however effected").

PLR Analysis

• Precedential status - IRC Section 6110(k)(3) - Precedential status provides that a private letter ruling cannot be "used or cited as precedent."
  
  
• Nonrecognition of gain – The shareholders requested a ruling so they can elect to sell their stock to an ESOP under IRC Section 1042(a) - Sales of stock to employee stock ownership plans or certain cooperatives – Nonrecognition of gain and defer long-term capital gains taxation on the sale.
  
  

  (a) Nonrecognition of gain
  

  If—
  

  (1) the taxpayer or executor elects in such form as the Secretary may prescribe the application of this section with respect to any sale of qualified securities,
  

  (2) the taxpayer purchases qualified replacement property within the replacement period, and
  

  (3) the requirements of subsection (b) are met with respect to such sale, then the gain (if any) on such sale which would be recognized as long-term capital gain shall be recognized only to the extent that the amount realized on such sale exceeds the cost to the taxpayer of such qualified replacement property.
  
  

• IRC Section 1042 Requirements - IRC Section 1042(b) - Sales of stock to employee stock ownership plans or certain cooperative – Requirements to qualify for nonrecognition defines four requirements to qualify for Section 1042 deferred tax treatment:

(b) Requirements to qualify for nonrecognition

A sale of qualified securities meets the requirements of this subsection if—

(1) Sale to employee organizations

The qualified securities are sold to—

(A) an employee stock ownership plan (as defined in section 4975 (e)(7)), or

(B) an eligible worker-owned cooperative.

(2) Plan must hold 30 percent of stock after sale

The plan or cooperative referred to in paragraph (1) owns (after application of section 318 (a)(4)), immediately after the sale, at least 30 percent of—

(A) each class of outstanding stock of the corporation (other than stock described in section 1504 (a)(4)) which issued the qualified securities, or

(B) the total value of all outstanding stock of the corporation (other than stock described in section 1504 (a)(4)).

(3) Written statement required

(A) In general

The taxpayer files with the Secretary the written statement described in subparagraph (B).

(B) Statement

A statement is described in this subparagraph if it is a verified written statement of—

(i) the employer whose employees are covered by the plan described in paragraph (1), or

(ii) any authorized officer of the cooperative described in paragraph (l), consenting to the application of sections 4978 and 4979A with respect to such employer or cooperative.

(4) 3-year holding period

The taxpayer's holding period with respect to the qualified securities is at least 3 years (determined as of the time of the sale).

• Employer securities – IRC Section 409(l) - Qualifications for tax credit employee stock ownership plans - Employer securities defined provides a definition of employer securities:

(l) Employer securities defined

For purposes of this section—

(1) In general

The term "employer securities" means common stock issued by the employer (or by a corporation which is a member of the same controlled group) which is readily tradable on an established securities market.

(2) Special rule where there is no readily tradable common stock

If there is no common stock which meets the requirements of paragraph (1), the term "employer securities" means common stock issued by the employer (or by a corporation which is a member of the same controlled group) having a combination of voting power and dividend rights equal to or in excess of—

(A) that class of common stock of the employer (or of any other such corporation) having the greatest voting power, and

(B) that class of common stock of the employer (or of any other such corporation) having the greatest dividend rights.

(3) Preferred stock may be issued in certain cases

Noncallable preferred stock shall be treated as employer securities if such stock is convertible at any time into stock which meets the requirements of paragraph (1) or (2) (whichever is applicable) and if such conversion is at a conversion price which (as of the date of the acquisition by the tax credit employee stock ownership plan) is reasonable. For purposes of the preceding sentence, under regulations prescribed by the Secretary, preferred stock shall be treated as noncallable if after the call there will be a reasonable opportunity for a conversion which meets the requirements of the preceding sentence.

(4) Application to controlled group of corporations (see Code)

(5) Nonvoting common stock may be acquired in certain cases (see Code)

• Qualified securities – IRC Section 1042(c)(1) - Sales of stock to employee stock ownership plans or certain cooperative – Definitions; special rules – Qualified securities defines qualified securities as employer securities that are held by a closely held C corporation company that has not received its stock through certain stock arrangements:
  
  

  
  

  (1) Qualified securities
  

  The term "qualified securities" means employer securities (as defined in section 409(l)) which—
  

  (A) are issued by a domestic C corporation that has no stock outstanding that is readily tradable on an established securities market, and
  

  (B) were not received by the taxpayer in—
  

  (i) a distribution from a plan described in section 401 (a), or
  

  (ii) a transfer pursuant to an option or other right to acquire stock to which section 83, 422, or 423 applied (or to which section 422 or 424 (as in effect on the day before the date of the enactment of the Revenue Reconciliation Act of 1990) applied).

• Other provisions – IRC Section 1042 - Sales of stock to employee stock ownership plans or certain cooperatives contains additional requirements, including the IRC Section 1042(a)(2) requirement to purchase qualified replacement property (generally stocks or bonds of domestic companies) within the replacement period (three months before to twelve months after the sale):
  
  

  (c) Definitions; special rules
  

  (1) Qualified securities
  

  (2) Eligible worker-owned cooperative
  

  (3) Replacement period
  

  (4) Qualified replacement property
  

  (A) In general
  

  (B) Operating corporation
  

  (C) Controlling and controlled corporations treated as 1 corporation
  

  (D) Security defined
  

  (5) Securities sold by underwriter
  

  (6) Time for filing election
  

  (7) Section not to apply to gain of C corporation
  

  (d) Basis of qualified replacement property
  

  (e) Recapture of gain on disposition of qualified replacement property
  

  (1) In general
  

  (2) Special rule for corporations controlled by the taxpayer
  

  (3) Recapture not to apply in certain cases
  

  (f) Statute of limitations
  

  (g) Application of section to sales of stock in agricultural refiners and processors to eligible farm cooperatives
  

  (1) In general
  

  (2) Qualified refiner or processor
  

  (3) Eligible farmers' cooperative
  

  (4) Special rules
  
  

• Treasury Regulation - Sec. 1.1042-1T Questions and answers relating to the sales of stock to employee stock ownership plans or certain cooperatives (temporary) answers the following questions in a Q&A format:
  
  1. What does section 1042 provide?
  2. What is a sale of qualified securities for purposes of section 1042(b)?
  3. What is the time and manner for making the election under section 1042(a)?
  4. What is the basis of qualified replacement property?
  5. What is the statute of limitations for the assessment of a deficiency relating to the gain on the sale of qualified securities?
  6. When does section 1042 become effective?

Other Section 1042 Transaction Thoughts

• The sellers can avoid taxation upon the death of the seller, as the heirs will receive the property with a stepped-up basis.
• Two or more shareholders may combine their sales to meet the 30% requirement.
• Certain allocation restrictions apply to the selling shareholder(s) and certain relatives. In most cases, they will be unable to share in the allocation of the ESOP shares, even if they remain employees of the company.
• Using ESOP Planning to React to Changing Times notes how an increase in capital gains rates, which could happen in the near future, could create an increase in Section 1042 transactions.
• Analysis of IRC Section 401(a)(35) Proposed Regulations – Definition of Publicly Traded and the Impact on Other ESOP Provisions discusses how IRC Section 401(a)(35) Regulations - REG–136701–07 - Diversification Requirements for Certain Defined Contribution Plans could impact thinly traded companies, including the impact on Section 1042.
• REITs as Section 1042 Qualified Replacement Property discusses how an argument has been made that certain real estate investment trusts (REITs) may be eligible as qualified replacement property.
• ESOPs and Charitable Contributions discusses how an IRC Section 1042 sale can be combined with charitable giving to achieve the seller's estate planning objectives.

Study: S ESOP Companies Create Jobs and Savings for Workers and Have Higher Productivity, Profitability, Job Stability, and Job Growth

Last month we discussed how a recent Study Asserts that Broader Employee Ownership and Participation Improves Company Performance and Social Welfare. New University of Pennsylvania Study Finds S ESOPs Yield Billions in New Benefits for U.S. Workers and the Economy announces that a new study finds that S ESOPs create new jobs and savings that would not have otherwise been earned:

WASHINGTON, July 28 /PRNewswire-USNewswire/ -- In a new University of Pennsylvania study, two leading tax and economic experts found that Subchapter S companies owned by their employees through ESOPs generate some 85,000 new jobs each year and create $14 billion in new savings for workers that otherwise would not have been earned. "From a long-term societal perspective," write the study's authors, "it is perhaps the best possible gain: a forced retirement plan."

The authors reported that S ESOPs offer their workers higher job stability, which accounts for $3 billion worth of the workers' savings. Moreover, they found, S ESOPs' higher productivity, profitability, job stability and job growth collectively help ESOP companies amass $33 billion more in combined earnings than what they would earn if they were not ESOP-owned S corporations.

The authors' economic analysis of the current-law tax benefits for S ESOP companies led them to conclude that the creation of S ESOPs by Congress more than a decade ago has increased tax collections from both employees and employers. This, the authors report, is largely because the additional wealth created by S ESOPs generates additional federal and state taxes; because S ESOPs do not expand capacity among deferred-tax savings options (such as 401k's and others, which they note are under-utilized); and because workers pay taxes on their S ESOP savings accounts when they are liquidated at rates substantially higher than what are paid on other tax-deferred plans.

The study, which represents the first ever assessment of the costs and benefits of S corporation ESOP laws, was released yesterday by the University of Pennsylvania's Michael Knoll and Steven Freeman. Freeman is a Senior Lecturer and Resident Scholar in the School of Arts and Sciences and Resident Scholar in the School's Center for Organizational Dynamics. Knoll is the Theodore Warner Professor of Law and holds a secondary appointment at the Wharton School.

S corporation ESOPs have become the subject of some scrutiny, noted Knoll and Freeman, since the December 2007 announcement by Chicago financier Sam Zell that he was acquiring the iconic Tribune Company and converting it to an S-ESOP company. According to the authors, Congressional passage of laws allowing for S ESOPs more than a decade ago has led to the creation of nearly 3,700 S ESOP companies nationwide (about 40 percent of all U.S. ESOPs), and that about 3.7 million Americans work and participate in S ESOPs.

Open Book Management: Helping to Eliminate the Emotional and Subjective Conversations

Open The Books - The Minds Will Open is a blog post that discusses the benefits of open-book management:

Smart companies have recognized that using open book management helps eliminate the emotional and subjective conversations. Open book management is based on the numbers - the facts (unless the organization is so corrupt it cooks its books). Business is about numbers - sales, expenses, inventory, profits, cash, stock value and more.

The fundamental purpose of a company is to offer a service that makes money. If your employees do not understand how their every day actions contribute to the bottom line, I will venture to say that you have a lot of unresolved issues in your company that drive you nuts.

In the News: Acquiring Companies as Part of a Growth and Expansion Model

Houchens Industries (Bowling Green, KY)

Houchens completes deal for Tampico Beverages discusses how Houchens Industries, the tenth-ranked ESOP on The Employee Ownership 100, acquired Tampico Beverages Inc. as part of its growth and expansion model.

Houchens Industries Inc. on Friday completed its acquisition of Tampico Beverages Inc., part of an aggressive expansion that has included adding a brokerage firm and an optical chain to the employee-owned company..."Our strategy is to diversify our holdings so we don't have too many eggs in one basket, and to buy very profitable companies that have growth potential and have good management," Coates said in an interview.

Houchens said Tampico Beverage will retain its name, employees and management team based in Chicago. It was the latest acquisition by a company that has accelerated its buyout activity since clearing about $1.5 billion from the sale of its Commonwealth Brands cigarette subsidiary to the British company Imperial Tobacco Group PLC in a $1.9 billion deal in 2007…Already this year, Houchens has closed deals to acquire brokerage and financial services firm Hilliard Lyons and the Cohen's Fashion Optical chain. It also acquired regional grocery store chain Buehler Foods and acquired 50 percent interest in a Kentucky-based fence materials distribution company.

The article also discusses how the company is continuing to look for more companies and discusses the company's current holdings and sales:

Houchens' holdings also include convenience stores, restaurants, insurance, construction, manufacturing, recycling, tanning supply distribution and software and Website development. With its latest additions, Houchens' overall yearly sales will reach about $3 billion, Coates said.

Here are some additional related ESOP acquisition posts:

• 2007 ESOP Statistics, Estimating Techniques, 1993 Peak, and Aggressive Acquirers
• Using ESOPs as a Financing Technique
• In the News: An Aggressive Growth Strategy/Paying an ESOP Loan Too Quickly/Mirror Loans/ESOP M&A Issues
• Addressing Benefit and Compensation Issues in an M&A Transaction

10 Reasons to Sell a Company to the Employees and 2 Employee Ownership Analogies

Sharing the Reins: 10 Reasons To Sell Your Company To Your Employees contains an article by John Abrams, the former owner of South Mountain Co., that discusses 10 reasons to consider selling a company to the employees:

1. Maturity. Once the entrepreneurial leap of starting a new business has been achieved without constraints, and a viable company has been established, restructuring to employee ownership can be a natural part of the maturation process.

2. Commitment. Employee ownership encourages a sense of empowerment and promises deeper connections and greater commitment (and length of employment) among the employee owners.

3. Freedom. The potential loss of control for the founder is more than balanced by the new-found freedom that comes with shared responsibility.

4. Participation. If you keep the entry fee low enough (we keep ours to "the price of a good used car") full participation will be encouraged.

5. Equity. By using a system of internal capital accounts through which the profit is shared and equity is measured, employee owners can track their stake in the company and accumulate a nest egg that they take with them when they depart.

6. Effectiveness. Over 11,000 companies nationally, with 8.5 million employees (and $400 billion in assets held by these employees) have some form of employee ownership. Maybe these companies know something.

7. Legacy. Employee ownership is the ticket to good legacy and smooth transitions. By sharing ownership early on, the difficult question that comes when founders are ready to retire - what to do with this business - is avoided.

8. Justice. The inherent injustice of our current economic system (all wealth goes to the shareholders) can be tackled, through employee ownership, by shifting wealth to the real stakeholders, those who actually create it.

9. Productivity. A democratic workplace gives meaning to our work lives and encourages good performance. A happy workforce is a productive one.

10. Accountability. If the people who make the decisions are the people who will also bear the consequences of those decisions, better decisions are likely to result.

The article also shares two employee ownership analogies. First, he uses the popular car analogy: "In the history of mankind, nobody has ever washed a rented car." He also compared the dynamics of employee ownership to how the Roman army rationed food:

Rations were in the form of large loaves of bread, each sufficient to feed two soldiers. This presented a problem, since when the soldiers had little to do, they tended to fight among themselves, particularly over who got the bigger half of the loaf. The Romans developed a nifty solution. They passed a regulation that one soldier had to divide the loaf and the other chose which half to take. Employee ownership is a similarly self-enforcing system. Each owner's actions on behalf of the others, and the company, are actions on his or her own behalf at the same time.

We also discussed the South Mountain Co. in In the News: More Responsibility and Better Decision-Making and In the News: Employee Ownership Success Stories.

IRS Employee Plans Video Webpage

The IRS Office of Employee Plans (EP) has produced an IRS Employee Plans Video Webpage that currently contains nine videos:

These videos provide useful information to help retirement plan sponsors choose and operate their plans and to help participants ensure their retirement benefits are protected. Participants will also learn more about the value of plans as a way to save for retirement.

Here is a list of the nine videos:

1. "The Navigator" —Navigating Employer Information on Retirement Plan
2. Maintaining Your Plan
3. Self-Correcting Plan Mistakes
4. Fixing Plan Mistakes Found During an IRS Audit
5. Increasing Your Retirement Savings
6. Managing Your IRA
7. Starting a SEP or SIMPLE IRA Plan
8. Stopping Abuses in Retirement Plans
9. IRS Enforcement Priorities

Here are links to posts with related videos:

• 2008 AACE Award Winning Video: The Little ESOP That Did
• DOL Releases Introductory Retirement Plans Video (SEP, SIMPLE IRA, 401(k) Plan)
• Online Video Describes the Benefits of being an Employee Owned Company

Social Security Retirement Estimator and Planner

The U.S. Social Security Administration has an online Retirement Estimator that will estimate retirement earnings:

The Retirement Estimator produces estimates that are based on your actual Social Security earnings record. Retirement estimates are just that, estimates. They will vary slightly from the actual benefit you may receive in the future because:

• Your Social Security earnings record is constantly being updated;
  
• Our calculators use different parameters and assumptions (e.g., different stop work ages, future earnings projections, etc.); and
  

Your actual future benefit will be adjusted for inflation.

The website also discusses how the Retirement Planner provides detailed information about"Social Security retirement benefits under current law":

• Looking for information, you can:
  
  
  • Find your retirement age,
    
  • Use the benefit calculators to test out different retirement ages or future earnings amounts,
    
  • Learn about Social Security programs,
    
  • Find out what happens if you work after you retire, and
    
  • Learn how certain types of earnings and pensions can affect your benefits.
    
    
• Already near retirement age, you can:
  
  
  • Discover your retirement options,
    
  • Get information about how members of your family may qualify for benefits,
    
  • Find instructions on how to apply for benefits and what supporting documents you'll need to furnish, and
    
  • Apply for retirement benefits.
    

In the News: Embracing New Technologies and Approaches, Adopting Lean Manufacturing and Cellular Manufacturing Philosophies

Rable Machine Inc. (Mansfield, OH)

Rable Machine in Mansfield honored for employee ownership discusses how Rable Machine Inc., a 100% ESOP-owned Ohio manufacturer of precision machined parts and assemblies has been recognized for creating substantial value through a combination of company earnings and employee compensation:

Rable Machine Inc., a local manufacturer of precision machined parts and assemblies, has been named a "Top 25 in Growth" in 2008 among 95 Leading Edge Award winners in 17 northeast Ohio counties...According to Owners at Work, a Kent State University publication, "Rable has grown aggressively in the last three to four years and invested $3 million in new technology supported by the adoption of lean manufacturing and cellular manufacturing philosophies. In 2008 alone, four new high tech turning centers have been purchased, installed and currently producing precision parts. The firm is an employee stock ownership plan company that is 100 percent owned by its 72 employees."

"None of our efforts toward growth and change would have worked without the involvement of the people who work here," said CEO Scott Carter in the Owners at Work story. "As employee-owners, they understand the need to focus on our customers and on quality, along with the need to embrace new technologies and approaches. Because of their hard work, their learning and their commitment to mentor others, our business has skyrocketed. We have increased our business with existing customers and gained new customers too."

The Company has been an ESOP company since 1992.

Related Links:

• Lean – Lean is a business system designed to achieve maximum efficiency of resources
  
• Cellular Manufacturing – A workplace design that arranges the factory floor into teams or work cells

Post-Gust Required Amendments

Required Amendments (Revised 7/8/2008) is a chart with a list of required amendments and due dates for defined contribution plans since the GUST restatement:

Post-GUST Amendments

• Required Minimum Distribution Final Reg (Required)
• Deemed Section 125 Compensation (Optional)
• Economic Growth and Tax Relief Reconciliation Act (EGTRRA)(Required)
• Automatic Rollover Amendment (Required)
• Roth Amendment (Optional)
• Katrina Amendment (Optional)
• 401(k) Final Regulations Amendment (Required)
• 2007 Interim Amendment (Required)

EGTRRA Restatement

• 2007 Interim Amendment (Required)

Plan Termination Amendments

• Amendment for DC Plan Terminating in 2008 (Required)

The chart also provides the same information for defined benefit plans, and provides the following details under the 2007 Interim Amendment section:

(It includes changes in Norma Retirement Age, Code section 415 Compensation, Excess Annual Additions, and Restorative Payments; along with an election for Post-Severance Compensation.)

Updating Your ERISA Retirement Plan for Section 415 Changes discusses the IRC Section 415 Final Regulations (T.D. 9319 - 72 Fed. Reg. 16878 (April 5, 2007) - Limitations on Benefits and Contributions Under Qualified Plans), with an emphasis on the post-employment compensation provisions:

The proposed regulations generally did not allow post-employment compensation to be considered compensation under Section 415 with 2 exceptions: (i) if the payments would have been paid if employment had been continued (such as overtime or commissions); or (ii) if the payments were due to accrued bona fide leave (such as vacation or sick leave) that would have been available if employment had been continued. These exceptions would only apply if the compensation was paid out no later than 2 ½ months after termination of employment.

With regard to the post-employment compensation, the final regulations adopted the proposed regulations with one adjustment. The final regulations extend the time period for severance compensation payout. Instead of requiring payment within 2 ½ months after termination of employment, payment of post-employment compensation (as allowed by the exceptions) must be made by the later of 2 ½ months after severance or the end of the limitation year that includes the participant's termination date.

Every Company's Retirement Plan Must be Amended this Year also discusses the IRC Section 415 amendment and its deadline:

If a plan document is not amended before the deadline, it will be subject to disqualification by the IRS. Generally, the deadline is the last day for filing the corporate tax return for the plan year commencing on or after July 1, 2007. For example, if the plan year is used to measure the Code Section 415 limitation, and the plan year is the calendar year, then the deadline is the filing of the corporate tax return for the 2008 calendar year.

Despite this general rule, the deadline may be earlier in 2008 depending on how the plan is written. This means that, if your company has a qualified retirement plan, it should be amended in the near future to avoid qualification problems.

Check with your retirement plan consultant or attorney for more information about your plan documents. ESOP Planning: Plan Documents and Disclosures, an installment in our ESOP Planning series, discusses some of the items to consider during your review and discussion.

August Recess and the Congressional Company Visit

August Recess is Approaching - Time to Setup a Meeting with Your Member of Congress discusses how the August Recess provides a great opportunity to invite a member of Congress to visit your company:

Having a member of Congress visit your company is one of the most important government relations activities you can undertake. It is that the most effective activity for obtaining support for ESOPs from a member of Congress. The company visit is more effective than a visit in the member of Congress's home office and certainly more effective than visiting with a member of Congress in Washington DC.

The post also recommends The Congressional Company Visit Kit: Practical Steps for Unparalleled Results, Summer 2008:

The report we will supply will tell you what prior record, if any, the member of Congress has on ESOP issues. The report will tell you what committees in Congress the member serves on, and what relevancy, if any, those committees have to ESOP laws. The report will tell you what the public record says is that member's prime interests as a legislator, and the major, if any, legislative initiatives the member of Congress is involved with. Finally this report will share any interesting data about the member who will visit your company that is relevant to her or his service in Congress, and/or issues.

Innovative Compensation Practices and the Sovereign Bank ESOP

The July 15, 2008 Employee Ownership Update is online and discusses the following:

• Innovative Ideas in Compensation
  
• Sovereign Bank Employees Sue Over ESOP
  
• Restricted Stock Practice Guide Released
  

The Update discusses innovative compensation practices, including Choosing Between a Higher Base Salary and a Higher Potential Bonus and providing a Three-Tier Reward System.

It also discusses the Sovereign Bancorp ESOP Issues and the Certified Equity Professional Institute at Santa Clara University and the first draft of their research project, GPS: Guidance. Procedures. Systems. (Restricted Stock and Restricted Stock Units), which is now available for public comment.

Sovereign Bancorp ESOP Issues: Reasonable Interest Rates and Prudent Investments

Sovereign slide hits retirement shares discusses how a group of Sovereign Bancorp Inc. employees are suing the company:

A lawsuit seeking class-action status in federal court in Pennsylvania says Sovereign charged the ESOP too much on loans to buy bank shares.

The lawsuit, in which Wentworth is a plaintiff, also argues Sovereign's past and present leadership acted imprudently by having too much of the overall retirement plan's investments in Sovereign stock, court records show.

Reasonable Interest Rate?

We know that the interest rate of a loan "must not be in excess of a reasonable rate of interest. All relevant factors will be considered in determining a reasonable rate of interest, including the amount and duration of the loan, the security and guarantee (if any) involved, the credit standing of the ESOP and the guarantor (if any), and the interest rate prevailing for comparable loans." While at the surface a 10% interest rate appears to be higher than normal, all relevant factors must be considered to gain an understanding of whether or not the interest rate was reasonable.

Prudent Investment?

An ESOP by definition is "designed to invest primarily in qualifying employer securities".

The article documents some steps the company took to diversify the overall retirement investments:

• The ESOP and matching contributions are funded by Sovereign and not the participants.
  
• In 2004, Sovereign combined the ESOP with a 401(k) plan to provide greater diversification.
  
• Sovereign makes matching contributions in company stock. The contributions can immediately be transferred to other investments at the discretion of the participants.
  
• Sovereign froze the ESOP in early 2007.

How to Measure the Losses?

As with many other members of the banking industry, the value of the Sovereign has significantly declined since the beginning of 2007. The article demonstrates the extent of the losses by comparing the total value of company stock from year-to-year. To be fair, I don't think this is painting the most accurate picture for two reasons:

1. Sovereign sold shares throughout the year, contributing to the decrease in the total value of company stock held by the plan.
   
2. Since the plan includes a mix of ESOP shares (funded and directed by the company) and employer match shares (funded by the company and subsequently directed by the participants), we do not have enough information to determine how much of the drop of the total value of the company stock had to do with participants transferring their match shares to other investments.

The fair market value of Sovereign is likely a better measure than the total value of stock assets in the plan.

Media Coverage

Is Sovereign partially or completely at fault? Unfortunately, we do not have enough information to make an informed viewpoint at this time. However, as we have seen in the past, it is important to be skeptical of ESOP coverage in the media, and when necessary Counter Negative ESOP Coverage with the Facts.

Choosing Between a Higher Base Salary and a Higher Potential Bonus

Pay, Your Own Way: Firm Lets Workers Pick Salary discusses how an employee-owned company allows its top managers to choose between a higher base salary and a lower base salary with a higher potential bonus:

Compensation experts say the approach is rare and potentially risky, but Skyline employees say it offers flexibility and motivates them to succeed... The idea proved popular. Twelve of the 15 eligible managers this year chose lower salaries and higher potential bonuses... Skyline's plan works by adjusting managers' commission targets; those who take lower salaries get lower commission targets, allowing them to accrue bigger bonuses for exceeding their targets. Other bonus factors include nonfinancial measures such as customer satisfaction and timely project completion. No bonuses are paid if Skyline doesn't generate an operating profit.

The article highlights the risks and benefits of allowing employees to choose their mix of salary and potential bonus:

Pros:

• Employees can cater to their personal needs.

• Employees can adjust the mix to market factors.

• Motivates those who choose bigger potential bonuses; others may feel the need to "earn their keep."

Cons:

• Can lead to unequal compensation and foster resentment.

• Can leave some employees vulnerable to market downturns.

• May sap motivation of employees with high salaries and smaller potential bonuses.

The article also discusses how the company's culture focuses on open-book management and employee ownership, and how the company shares its profits through a separate long-term equity plan:

"Owners get more reward for taking risk," he says. "That's business, and that's the entrepreneurial spirit that we are seeking to capture."

Letter from Barack Obama Regarding ESOPs

The latest Employee Ownership Blog post, Presidential Candidates and ESOPs, publishes a copy of a November 2, 2005 letter from Senator Barack Obama regarding a version of The ESOP Promotion and Improvement Act of 2007 (S. 1322):

Thank you for contacting me in support of S. 1319, the Employee Stock Ownership Plans Promotion and Improvement Act of 2005. ESOPs provide stability and security to many American families, so I am glad you wrote on this issue.

I appreciate the valuable role Employee Stock Ownership Plans play in the current economy. They provide incentives for employees to improve the performance of a company, which can contribute to our country's productivity. They are also an important path to economic opportunity for many families, and may be relied upon in times of economic need.

At the same time, concern is growing about the potential downside of ESOPs. If the value of an employee's company does not increase, the ESOP may be less beneficial than other types of plans. And, in extreme cases, if the company fails, the loss to employees could be significant. We have all witnessed disturbing episodes of corporations taking employees' hard-earned retirement savings down with them into bankruptcy, and we should be careful to encourage policies that discourage this unfortunate circumstance.

On the balance, I am confident that there is a place for ESOPs in the American economy. And I believe there should be further consideration of their role in public policies that encourage ownership and protect the income of hard-working families. S. 1319 has been referred in the Senate Finance Committee. I do not serve on this Committee, but I will keep your letter in mind should this legislation come before the full Senate.

Again, thank you for contacting me. Please stay in touch on this or any issue of concern.

Sincerely,

Barack Obama
United States Senator

More information about the bill and other current ESOP legislation can be found on the right-hand sidebar of this Blog.

In the News: ESOP-Owned Banks Merge, Hiring an Employee with an ESOP Attitude

Morton Community Bank and Alpha Bank (Morton, IL)

We recently discussed the merger of two ESOP companies in In the News: Merging Multiple ESOP Companies to Form a Holding Company, Reducing Costs and Providing Diversification. Keeping the hometown feel with $1.7 billion assets discusses another merger of ESOPs. Morton Community Bank and Alpha Community Bank are merging to become part of Hometown Community Bancorp Inc., the largest privately-owned bank in Illinois with $1.7 billion in assets. The article notes how the percentage of employee ownership has grown over the years and how that affects how they hire employees:

And, over the past three decades Honegger said he has seen a large change in the ESOP (Employee Stock Ownership Program) at MCB, watching it grow from 10 percent to the high 30s. Alpha Bank has an ESOP of 44 percent.

"What hasn't changed is the basic thing a bank does, which is buy money and sell money," he said.

Honegger added, "The other thing that hasn't changed is our attitude. It's attitude, attitude attitude."

He said recently the bank was looking to hire two new employees. A number of potential employees came in from big banks. They went through 14 big bank employees before finding the right two.

"We don't hire people quickly," Honegger said.

"The people we do hire must have that ESOP attitude, and understand they are owners."

Retirement Plan Pitfalls

The IRS's Tax Talk Today program returns today at 2 pm and was discussed in IRS's July Tax Talk Today: "Retirement Plan Pitfalls":

IR-2008-86, July 3, 2008

WASHINGTON — The Internal Revenue Service's Tax Talk Today program returns on Tuesday, July 8, 2008 at 2 p.m. with a Web cast on "Retirement Plan Pitfalls."

Few issues are as important to the owner of a business and its employees as the proper administration of its retirement plans. Ensuring that the retirement plan is in good running order keeps the promise made in setting up the plan.

Attend this program to learn how to use the IRS Fix-It Guides to identify and correct frequently encountered errors the IRS sees in retirement plans. These correction programs help retirement plans operate within the law and protect participant benefits.
And they provide real incentives to identify and correct mistakes sooner rather than later. In addition, the IRS will provide tips on how these mistakes can be avoided in the future.

Moderated by Les Witmer, the show's panel of experts includes Avaneesh Bhagat, IRS, Program Coordinator, Employee Plans Voluntary Compliance; Dan Morgan, Partner Dickstein Shapiro, LLP; Thomas G. Schendt, Partner, Alston & Bird LLP; and Monika Templeman, IRS, Director, Employee Plans Examination.

Tax Talk Today is a Web cast aimed at educating tax and payroll professionals on the most current and complex tax issues. Tax professionals are encouraged to watch and submit questions.

Viewers can register online to access the Web cast at no charge. Tax professionals in need of continuing education credits are eligible to receive one CPE credit by viewing the May 13 Web cast.

Archived shows are available on the site also.

Obstacle to Sustaining an ESOP: A Successful Company

We have recently discussed ESOP Sustainability and The Legacy of an ESOP Company. Sustaining Employee Ownership for the Long Term discusses how a company's success can be one of the biggest obstacles to sustaining an ESOP or other employee ownership program in the long-term. The article identifies six solutions to meeting the obligation to provide liquidity to shareholders, noting that only the first three solutions are sustainable solutions:

1. Cash belonging to employees
   
2. Cash belonging to the company
   
3. Government subsidies (via tax deductions) made available for this purpose
   
4. New (outside) investors
   
5. Sales of company assets
   
6. Sale of the company itself

The article discusses focusing on three sources of funding:

1. The Internal Stock Market – The article cites SAIC and CH2MHill as examples of companies that have adopted an effective internal stock market that allows employees to buy and sell shares from each other. In order to implement this kind of system, there are SEC registration issues that will need to be resolved.
   
2. Tax Subsidies to Support Employee Ownership – This source refers to the powerful tax benefits of employee stock ownership plans (ESOPs) and how they can free up additional cash.
   
3. Cash Management Techniques to Smooth Cash Demands on the Company – This section discusses enabling participants to sell shares prior to retirement to smooth cash demands, paying employees in installments, using promissory notes, and using the ESOP to borrow cash to purchase the stock.

The article also provides an excellent final consideration:

As you grapple with the challenge of addressing the liquidity demands associated with internal stock ownership, it is important to keep in mind that the means by which a company's employees are able to sell their shares will also go a long way toward determining the system by which employees will acquire their shares. After all, the disposition of a share by one party is necessarily the acquisition of the share by another party. In effect, the issue of how employees should "divest" stock and the issue of how they should "acquire" stock are simply two sides of a single coin. The fact is that, to be successful and sustainable, a system of internal stock ownership must necessarily effectuate both dispositions and acquisitions of shares – and through the same mechanisms. As we work to design a system of employee ownership that assures sufficient liquidity to the employee-shareholders, then, it is essential that we not lose sight of the overriding need to create an ownership system that offers fair and appropriate provisions regarding the means by which employees will acquire shares in the first place and go on to participate in the company as inspired, committed and engaged employee-owners. Don't kill the patient in order to save it!

2008 AACE Award Winning Video: The Little ESOP That Did

The Employee Ownership Blog has posted a link to The Little ESOP That Did, the winner of the 2008 AACE Award, Category 3 - Audio Visual, by Harrell Remodeling, Inc. (Mountain View, CA):

The winning video by Harrell Remodeling, Inc. of Mountain View California, impressed judges with its practicality, fun attitude, and clear ESOP message. It showcases the company's teamwork, dedication, and never give up attitude.

The file will take a long time to load, so I recommend that you right click on the file and save it to your hard drive. The video was very well done and worth taking the time to watch, particularly if you are looking for some creative ways to inspire your team.

In the News: Merging Multiple ESOP Companies to Form a Holding Company, Reducing Costs and Providing Diversification

Marine Hydraulics International Inc. (Norfolk, VA) and Técnico Corp. (Chesapeake, VA)

2 ship repairers unite to form new holding company discusses how two complementary ESOP-owned companies merged to form a single holding company. Marine Hydraulics International Inc. and Técnico Corp. have merged to form American Maritime Holdings Inc. The companies will keep their separate identities and operations while reducing costs and providing a more secure investment for the 550 employee-owners of the two companies:

"It's like any other portfolio - if you diversify, you have a better opportunity for success," said Torrech, the former president of Técnico. That is even more important in today's uncertain economy, he said.

Both Marine Hydraulics and Técnico will keep their separate identities and operations, Torrech said. The Navy is the biggest customer of both.

Having joint ownership will offer ways to reduce costs, such as by pooling insurance coverage, said Gary Brandt, MHI's former top executive who is now American Maritime Holdings' chairman and chief executive. The companies may now team up to go after some projects that each could not do separately, he said.

Sample Plan Language for IRC Section 409(p) Transfers

Employee Plans News - Special Edition, July 1, 2008 announces that Sample Plan Language for Section 409(p) Transfers is now available:

Non-ESOP Portion of Plan

1. Non-ESOP Portion. Assets held under the Plan in accordance with this Section are held under a portion of the Plan that is not an employee stock ownership plan (ESOP), within the meaning of section 4975(e)(7) of the Internal Revenue Code. Amounts held in the portion of the Plan that is not an ESOP (the Non-ESOP portion) shall be held in accounts that are separate from the accounts for the amounts held in the remainder of the Plan (the ESOP portion). The statements provided to Participants and Beneficiaries to show their interest in the Plan shall separately identify the amounts held in each such portion. Except as specifically set forth in this Section, all of the terms of the Plan apply to any amount held under the Non-ESOP portion of the Plan in the same manner and to the same extent as to any other amount held under the Plan.

2. Transfers from ESOP to Non-ESOP Portion of Plan. (a) In the case of any event that the Plan Administrator determines would cause a nonallocation year (as defined in section xxx of the Plan) to occur (referred herein as a "nonallocation event"), shares of employer stock held under the Plan before the date of the nonallocation event, shall be transferred from the ESOP portion of the Plan to the Non-ESOP portion of the Plan as provided in (2)(a). Actions that may cause a nonallocation event, include, but are not limited to, a contribution to the Plan in the form of shares of employer stock, a distribution from the Plan in the form of shares of employer stock, a change of investment within a Plan account of a disqualified person (as defined in section xxx of the Plan) that alters the number of shares of employer stock held in the account of the disqualified person, or the issuance by the employer of synthetic equity as defined by section 409(p)(6)(C) of the Internal Revenue Code and section 1.409(p)-1(f) of the Treasury Regulations. A nonallocation event occurs only if (i) the total number of shares of employer stock that, held in the ESOP account of those Participants who are or who would be disqualified persons after taking into account the Participant's synthetic equity and the nonallocation event, exceeds (ii) 49.9% of the total number of shares of employer stock outstanding after taking the nonallocation event into account (causing a nonallocation year to occur as described in Section xxx of the Plan). No transfer under this section shall be greater than the excess, if any, of (i) over (ii). Before the nonallocation event occurs, the Plan Administrator shall determine the extent to which a transfer is required to be made and shall take steps to ensure that all action necessary to implement the transfer are taken before the nonallocation event occurs.

(b)(1) Except as provided for in (b)(2), at the date of the transfer, the total number of shares transferred, as provided for in (a)(1), shall be charged against the accounts of Participants who are disqualified persons (i) by first reducing the ESOP account of the Participant who is a disqualified person whose account has the largest number of shares (with the addition of synthetic equity shares) and (ii) thereafter by reducing the ESOP accounts of each succeeding Participant who is a disqualified person who has the largest number of shares in his or her their account (with the addition of synthetic equity shares. Immediately following the transfer, the number of transferred shares charged against any Participant's account in the ESOP portion of the Plan shall be credited to an account established for that Participant in the Non-ESOP portion of the Plan.

(2) Notwithstanding (b)(1), the number of shares transferred shall be charged against the accounts of Participants who are disqualified persons (1) by first reducing the account of the Participant with the fewest shares (including synthetic equity) who is a disqualified person and who is a Highly Compensated Employee (as defined in Section xxx of the Plan) to cause the Participant not to be a disqualified person, and thereafter reducing the account of each other Participant who is a disqualified person and a Highly Compensated Employee, in order of who has the fewest ESOP shares (including synthetic equity). A transfer under this (b)(2) only applies to the extent that the transfer results in fewer shares being transferred than in a transfer under (b)(1).

(c) (1) If two or more Participants described in (b) have the same number of shares, the account of the Participant with the longest service shall be reduced first.

(2) Beneficiaries of the Plan are treated as Plan Participants for purposes of this section.

3. Income Taxes. If the Trust owes income taxes as a result of unrelated business taxable income under section 512(e) of the Internal Revenue Code with respect to shares of employer stock held in the Non-ESOP portion of the Plan, the income tax payments made by the Trustee shall be charged against the accounts of each Participant or Beneficiary who has an account in the Non-ESOP portion of the Plan in proportion to the ratio of the shares of employer stock in such Participant's or Beneficiary's account in the non-ESOP portion of the Plan to the total shares of employer stock in the non-ESOP portion of the Plan. The Employer shall purchase shares of employer stock from the Trustee with cash (based on the fair market value of the shares so purchased) from each such account to the extent necessary for the Trustee to make the income tax payments.

More US Sugar ESOP and California’s Franchise Tax Board (FTB) Notice 2008-4

The July 1, 2008 Employee Ownership Update is online and discusses the following:

• Florida Agrees to Buy U.S. Sugar; Employees Will Get Windfall
  
• California Offers Settlement for Taxpayers in Abusive ESOPs
  
• NASPP Survey Shows ESPPs Somewhat More Conservative

The Update discusses how Florida is Purchasing U.S. Sugar Land and the latest news related to the U.S. Sugar ESOP Issues:

Laid-off hourly employees will get one year's severance pay, and salaried employees will get two years. Employees will receive incentives to stay on during the transition.

The price offered by the state, which amounts to about $350 per share, is a considerable premium over a previous bid of $293 per share. The approximately 3,800 U.S. Sugar ESOP participants (about 1,700 of which are current employees) own about 35% of the company through an ESOP, so they will divide approximately $650 million among them.

The Update also notes that ESOP valuation practices would have required that participants be paid at a non-control price:

They now say the current offer just proves their point, but ESOP valuation practices would have required these former employees to be paid out at a non-control price, whereas the offers all included a premium for control. The circumstances of the sale to the state, which clearly only had an interest if it could take full control, suggest that a substantial control premium could have been in order.

The Update also covers California's Franchise Tax Board (FTB) Notice 2008-4 – Resolution of Certain ESOP Transactions and notes that taxpayers seeking resolution need to file before September 13, 2008. It also discusses a 2007 equity compensation survey that shows that employee stock purchase plans (ESPPs) have become more conservative since accounting rule changes became fully effective in 2006.