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.

In the News: Planning for the Future and Selling to an ESOP While Retaining Control, Existing Management, and the Board of Directors

Air Tractor (Olney, TX)

Air Tractor to become employee owned discusses how Air Tractor, a Texas producer of aircraft, is being sold to an ESOP. The article notes that the seller will remain as president and the existing management and board of directors will remain as well.

"About a year ago, we began to make plans for the future to assure that Air Tractor will continue to be a strong, financially healthy company serving agriculture and the firefighting industry," said Snow. "The existing management and board of directors of Air Tractor will stay in place. I plan to continue in my existing capacity for as long as I am physically and mentally fit. We are excited about this change and are hopeful it will bring added strength, security, and long term benefits for Air Tractor, our employees, and the community."

In the News: Characteristics of a Strong ESOP Candidate, Minnesota Employee Ownership Fund

Windings Inc. (New Ulm, MN)

We previously discussed the Windings Inc. ESOP and the Minnesota Employee Ownership Fund in In the News: Increased Management Accountability, Succession Planning, Addressing ESOP Misconceptions. Passing torch to those who made your business work identifies some of the characteristics that made that the company a strong ESOP candidate:

• The owner mentored his management team
• The owner's children have their own careers
• The owner wanted the company to remain in New Ulm
• The owner wanted its employees to share in the gains of the company
• The owner wanted to maximize the chances that the employees will retain their jobs
• The owner wanted his legacy to be the future success of the company in New Ulm
• The owner accepted the fact that he could possibly "have gotten more faster" if he pursued a third party sale

The article notes that it takes time to plan for an ESOP (although I want to point out it is possible, but not ideal, to close an ESOP transaction in six months):

"You can't retire at 65 and say 'I want to do an ESOP by the end of the year,'" Northland CEO Scott Martin said. "It's fixed-rate, multiyear financing. We will come in behind and help the owner and bank understand how it works," he said. "We will make subordinate loans in participation with local lenders to finance the sale of owners' stock. You need time to plan and do these right."

It also provides more information on the Fund:

Martin said Northland has one active ESOP loan and many inquiries after conducting just a few seminars around the state.

The Minneapolis-based Community Reinvestment Fund, which pools community-development debt and sells it to institutional investors, has agreed to buy and sell the ESOP credit, which generates more capital.

Characteristics of a Strong ESOP Candidate

Here is a list of characteristics of a strong ESOP candidate:

1. Strong balance sheet to absorb ESOP debt
2. Sufficient cash flow to cover debt payments
3. Taxable income sufficient to benefit from tax deductions
4. Minimum of 15-20 employees
5. Sufficient payroll to support ESOP debt (contributions are generally limited to 25% of payroll)
6. S Corporation or C Corporation
7. Effective communication between management and employees
8. Owners and management support employee ownership
9. Successor management in place

U.S. Sugar ESOP Update: Florida Purchasing U.S. Sugar Land

We recently discussed the U.S. Sugar ESOP Issues. Florida to Buy U.S. Sugar's Land To Aid Everglades discusses how Florida is purchasing land from U.S. Sugar Corp. and leasing it back for the next six years before turning over the land for conservation purposes, effectively shutting down the company:

The state of Florida, stepping up its efforts to restore the Everglades wetlands, offered to purchase 300 square miles of land now used for sugar-cane production for $1.75 billion from U.S. Sugar Corp., effectively moving to shut down the largest grower of the crop in the U.S.

The Clewiston, Fla.-based company and the South Florida Water Management District on Tuesday signed a "statement of principles" that would allow U.S. Sugar, which has farmed the land since 1931, to continue growing cane and producing sugar for the next six years. If final terms are settled as expected in the coming months, the company would then turn over the land for conservation purposes at the end of that period.

The state plans to pay $50 million in cash and finance the rest of the purchase's $1.7 billion through debt.

The article also notes the presence of the ESOP and the fact that the offer was compelling enough for the board of directors to proceed, even if it meant the end of the company:

The private company -- owned by descendents of its founder, Charles Stewart Mott, and an employee-ownership plan -- had invested more than $500 million in recent years to upgrade its facilities on the land and had no intention of shutting down until Gov. Crist, in meetings with executives in recent months, "suggested he buy us out," said Robert Coker, senior vice president of U.S. Sugar.

The terms of the state's offer, he added, were compelling enough for U.S. Sugar's board of directors to authorize moving ahead with the plan, even if it meant the end of the company.

Until the six-year period ends, Mr. Coker added, U.S. Sugar will continue to grow and produce sugar and will provide an incentive plan to retain employees. It currently has 1,700 employees. "It will be business as usual...but then we'll hand over the keys," he said.

Booting US Sugar from the Everglades also discusses the transaction.

Kirschbaum v. Reliant Energy, Inc., No. 06-20157 (5th. Cir. 4/25/2008) (5th. Cir., 2008)

ERISA Class Action Defense Cases–Kirschbaum v. Reliant Energy: Fifth Circuit Affirms Summary Judgment In Favor Of Defense In ERISA Class Action Complaint Holding Class Action Claims discusses Kirschbaum v. Reliant Energy, Inc., No. 06-20157 (5th. Cir. 4/25/2008) (5th. Cir., 2008), a stock drop case that ruled in favor of the defense because the claims that they should not have invested in company stock ran counter to ERISA and because negligent misrepresentations were not made:

Plaintiff filed a class action against his employer, Reliant Energy, Inc. (REI) and the Benefits Committee of his employer's savings plan alleging violations of ERISA (Employee Retirement Income Security Act). The Plan is an Eligible Individual Account Plan (EIAP) under ERISA, and the class action complaint alleged that defendants breached fiduciary duties owed to current and former participants in the Plan in that defendants "had a fiduciary duty to liquidate the Common Stock Fund and cease purchasing REI shares, notwithstanding the Plan's express contrary requirements." Kirschbaum v. Reliant Energy, Inc., ___ F.3d ___, 2008 WL 1838324, *1 (5th Cir. April 25, 2008). The district court granted plaintiff's motion to certify the litigation as a class action, id. Defense attorneys moved for summary judgment on the ground that defendants satisfied their legal duties to the class: The district court granted summary judgment as to all class action claims, and entered judgment in favor of defendants on the class action complaint. Id. Plaintiff appealed, and the Fifth Circuit affirmed.

Kirschbaum v. Reliant Energy: Fifth Circuit Adds to Growing Body of Law Imposing Substantial Hurdles to Fraud-Based Employer Stock Drop Claims discusses how this decision builds on other recent Circuit Court decisions:

Reliant Energy builds on recent Circuit Court decisions that have suggested claims of fraud will not make out a fiduciary breach claim unless the fraud challenges the company's survival. For example, in Edgar v. Avaya, Inc., 503 F.3d 340 (3d Cir. 2007), the Third Circuit recently dismissed a claim that fiduciaries knew or should have known the stock was inflated prior to an earnings warning that resulted in a 25% one-day drop in the stock price, reasoning that this was not the type of "dire circumstance" that would overcome Moench's presumption of prudence. Similarly, in Pugh v. Tribune Co., 2008 WL 867739 (7th Cir. Apr. 2, 2008), discussed in last month's Newsletter, the Seventh Circuit concluded fiduciaries may reasonably rely on the company's investigation and reporting of fraud absent some reason to believe the corporate reporting process was broken. Although ERISA fiduciary suits continue to be filed when a company with an employer stock fund in its 401(k) plan suffers a substantial setback, these cases suggest that there will be substantial defenses to these claims.

Court Gives ERISA Plan Fiduciaries Presumption of Prudence discusses the following:

1. Stock Drop Led to ERISA Claims
2. Investment Policy May Have Created Fiduciary Discretion
3. Plaintiffs Must Bear a "Heavy Burden" to Override Plan Terms
4. Misrepresentation Claim Rejected Because Prospectus Was Not an SPD

It also discusses lessons for plan sponsors:

• Less discretion may be best. Plan sponsors whose 401(k) plan or ESOP features an employer stock fund should consider having their applicable investment policies, as well as the Plan documents, require that company stock be purchased for this fund. Companies that do so may have a stronger defense against claims that their plan's company stock fund should not have invested in company stock.
  
• Bailing out may be necessary when the ship is sinking. ERISA fiduciaries remain bound to override the plan's terms and divest holdings of employer stock when the plan sponsor's existence as a going concern is threatened or the stock is in danger of becoming essentially worthless.
  
• Consider issuing a separate SPD. Plan sponsors and fiduciaries should avoid the shortcut of using a 10(a) Prospectus as a Summary Plan Description. Instead, the plan should issue a separate SPD that does not incorporate by reference the plan sponsor's SEC filings.

The DOL also filed an Amicus Brief for this case.

In the News: Improving Performance by NOT Focusing on Financial Goals

Eileen Fisher, Inc. (Irvington, NY)

Eileen Fisher: Teamwork and a Focus on Employee Well-Being Fuel this Successful Company discusses Eileen Fisher, Inc., an Irvington, NY women's clothing retailer, and how their ESOP fit into their non-traditional company culture. The company has consistently increased sales, even during tough times, by NOT focusing on financial goals:

"We don't talk like that here."…How do they do it? Susan says employees do not focus on financial goals; instead they work to find success by constantly striving toward their mission: "To inspire simplicity, creativity and delight through connection and great design." She shared how many aspects of an employee-ownership culture were already in place long before becoming an ESOP company, such as encouraging participation in all areas of the company and working in collaborative teams.

The article also discusses the company's focus on employee well-being and development opportunities, both personal and professional, and their commitment to giving back to the community.

Study Asserts Broader Employee Ownership and Participation Improves Company Performance and Social Welfare

A press release announced that Employee ownership and participation effects on firm outcomes, a study conducted by Brent Kramer, provides evidence that majority employee-owned businesses are more productive than their traditionally-owned counterparts:

Many theorists have suggested that the rarity of employee ownership is prima facie evidence that such firms could not be as efficient as traditional firms, because otherwise they would be more common. But institutional and financing constraints may be a more realistic explanation for their rarity, and it is important for policy purposes to investigate efficiency objectively...

Using a matched-pair differences test, sales per employee is substantially and significantly higher for the employee-owned group of firms. This "employee-owned advantage" is significantly greater among smaller firms, and (holding firm size constant) improves as the dollar value of the average employees' ownership stake in firm stock goes up. Holding both firm size and employee stake constant, the employee-owned advantage is substantially (though not significantly) greater in the large group of firms which are 100% owned by their ESOP Trusts...

Resistance to broadening employee ownership may come in part from academic arguments that such a structure must reduce firm (and thus social) efficiency. This study belies those unjustified theoretical arguments. Broader employee ownership and employee participation in firm management, which have intrinsic social benefits, improve firm outcomes—and thus social welfare—as well.

Here is a copy of the press release:

WASHINGTON, June 18 /PRNewswire-USNewswire/ -- Recent research by Brent Kramer, a doctoral candidate at the City University of New York, provides strong evidence that majority employee-owned businesses have a significant advantage over comparable traditionally-owned businesses in sales per employee. The average advantage, $44,500, means that a typical 200 person ESOP firm could be expected to have an almost $9 million annual sales advantage over its non-ESOP counterpart. Sales per employee is the total of a companys sales divided by the number of employees, and is a commonly used measure of a companys productivity.

A few highlights of the study:

• Using standard statistical methods, it was found that the average sales advantage for the ESOP firms in the study was $44,500, or an average of an 8.8% sales per employee advantage over their non-ESOP counterparts in the same industry and of the same size.
  
• It was found that firms that ask for non-management employee input into innovation in work processes have a greater employee-owned advantage in sales per employee.
  
• Kramers research indicates the sales per employee advantage for the 50% plus ESOP companies compared to non-ESOP companies is less for larger employers.

What is important about this study is that it substantiates what we have been saying about ESOP companies being more productive for the past 30 years. When matched along side non-ESOP firms, employee owned companies are more productive as defined by the traditional productivity measure of sales per employee, said J. Michael Keeling, President of The ESOP Association.

The study, Employee Ownership and Participation Effects on Firm Outcomes, was conducted by Brent Kramer, an economics doctoral candidate at the time of the study and now a Ph.D. The Employee Ownership Foundation, the 501(c)(3) affiliated foundation of The ESOP Association provided funding for the research and The ESOP Association contributed membership information for the study. A total of 328 ESOP firms and over 2,000 matching non-ESOP firms were included in the study.

Updated List of Largest Majority Employee-Owned Companies

The NCEO’s The Employee Ownership 100 has been updated and is now online:

America's Largest Majority Employee-Owned Companies
June 2008

Companies must have at least 50% of their stock owned by an ESOP, a stock purchase plan in which most full-time employees can participate, a profit sharing plan or other trust, or some combination of such plans. Companies are ranked by the number of total employees in the U.S. and worldwide.

The latest Employee Ownership Report notes that, consistent with prior years, employment at the 87 returning companies grew at twice the rate of the economy as a whole. It also provided a breakdown of the major industries represented in the list: manufacturers (15), engineering companies (14), construction companies (10), and supermarkets (9).

Effectively and Proactively Managing the Board of Directors

Earlier this week we discussed the ESOP Ownership Structure, Corporate Governance, and the Relationship between the Trustee, Board of Directors, and the ESOP Administrative Committee. Managing a Board discusses the Board of Directors from the perspective of an entrepreneur. This perspective also applies to the founder of a company who has sold a controlling interest to an ESOP. It discusses the three obligations of an effective Board of Directors:

• a duty to care, that is, to do the work required to fully understand the issues of the company
• a duty of loyalty, that is, to act in a way that serves the best interests of all the shareholders
• a fiduciary duty, that is, to take responsibility to ensure the legal and ethical operation of the business.

The article discusses signs that the Board is losing confidence in the current CEO:

• "pre-board" meetings without the entrepreneur, to discuss company issues
• new board members brought on without consulting the entrepreneur
• increasing questions about why the company is not hitting its projections
• talk about succession planning.

It also notes that the best way to avoid this issue is to retain control, meet or exceed financial projections and the expectations of the Board, and effective and proactively managing the Board of Directors:

• Conduct your own due diligence on every board member. Learn their strengths and weaknesses, and especially their particular areas of expertise.
• Build trust by avoiding surprises. Keep board members informed of important developments in the company and, especially, brief them personally on any bad news. Don't wait for regularly scheduled board meetings to convey information. Contact members by phone.
• Talk to your directors individually to solicit their opinions and to understand their unique concerns and issues. Build a personal relationship with each board member.

California’s Franchise Tax Board (FTB) Notice 2008-4 – Resolution of Certain ESOP Transactions

California's Franchise Tax Board (FTB) recently announced that taxpayers who filed a tax return that included "certain ESOP transactions" should resolve their accounts to avoid penalties:

The Franchise Tax Board (FTB) announced that taxpayers who filed a state income tax return or an amended return that included a state tax benefit from transactions referred to as either "bogus optional basis" (BOB) transactions or certain "employee stock ownership plan" (ESOP) transactions may qualify for relief from the noneconomic substance transaction (NEST) penalty.

Eligible California taxpayers have from June 23 to September 12, 2008, to resolve certain transactions that may be subject to the NEST penalty. To participate, taxpayers must submit a signed and completed closing agreement (FTB Notice 2008 - 4) on or before September 12, and pay all tax, penalties, and interest relating to the conceded tax benefits in full.

If a taxpayer previously received a Notice of Proposed Assessment (NPA) that included a 40 percent NEST penalty, FTB's Chief Counsel will use his authority under the tax code to reduce the NEST penalty from 40 percent to 20 percent. To receive the penalty reduction, the taxpayer must pay the revised penalty amount in full when submitting the closing agreement.

For taxpayers who paid a 40 percent NEST penalty prior to the date of this notice, FTB's Chief Counsel will reduce the penalty to 20 percent and refund any overpayment that is within the applicable statute of limitations. The taxpayer must fully comply with the terms of FTB Notice 2008–4.

If the taxpayer previously received an NPA that included a 100 percent interest-based penalty, FTB will abate the penalty if the assessment is still pending.

Taxpayers who have not been mailed an NPA for a BOB or ESOP transaction, whether they are under audit or not, should comply with the requirements of FTB Notice 2008–4. For taxpayers who comply, FTB will assess a 20 percent accuracy related penalty and will not assess the 100 percent interest-based penalty and will be relieved of other potential penalties relating to their participation in the eligible transactions including penalties under Revenue and Taxation Code Sections 19164(c), 19164.5, 19772, 19777, 19778, and former 19773.

FTB estimates that abusive tax shelters cost California $500 million in lost tax dollars each year. FTB will continue to aggressively pursue taxpayers and the promoters who participate in or recommend these tax shelters.

FTB Notice 2008 - 4 – Resolution of Bogus Optional Basis (BOB) Transactions and Certain Employee Stock Ownership Plan (ESOP) Transactions describes the eligible and ineligible transactions:

ESOP Transactions. Transactions involving the use of employee stock ownership plans (ESOPs) that could be subject to a NEST penalty and were not eligible to participate in California's Tax Shelter Resolution Initiative, FTB Notice 2006-1. Three transactions involving ESOPs that were eligible under FTB Notice 2006-1 and that are not eligible under this Notice are: (1) transactions covered by Revenue Ruling 2003-6, 2003-1 C.B. 286; (2) transactions covered by Revenue Ruling 2004-4, 2004-1 C.B. 414; and (3) Management S corporation ESOP transactions described in the IRS's Transaction-specific Frequently Asked Questions released as part of IRS Announcement 2005-80, 2005-2 C.B. 967. The eligible transactions described in this paragraph may be referred to as "certain ESOP transactions."

Transactions, or any part, step or intermediate transactions, that are the same as, or substantially similar to, the following: (1) an ESOP purchases or otherwise obtains, or purports to have obtained, shares of stock or other equity interests in an entity (ESOP Entity) that is or was owned by Taxpayer and/or one or more of its related parties, directly or indirectly, at any time (ESOP Equity Purchase); (2) in one or more of the Taxable Years at Issue, fifty percent or more of the taxable income of the ESOP Entity is or was allocated, directly or indirectly, to the ESOP (ESOP Income Allocation); and/or (3) in one or more of the Taxable Years at Issue, Taxpayer recognized less taxable income from or attributable to (a) the ESOP Entity, and/or (b) the stock or other property transferred to the ESOP Entity than Taxpayer would have otherwise recognized without the ESOP Income Allocation.

One example of an eligible ESOP transaction is the following. Taxpayer A holds 100 percent of the outstanding stock of XYZ Corporation (an S corporation) on December 30, 2000. On December 31, 2000, Taxpayer A forms an ESOP. On January 1, 2001, Taxpayer A sells stock in XYZ Corporation to the ESOP. During tax years 2001 through 2004, Taxpayer A assigns income to XYZ Corporation or otherwise provides services through XYZ Corporation. All income earned or assigned to XYZ Corporation during tax years 2001 through 2004 is allocated to the ESOP. Prior to or on December 31, 2004, XYZ Corporation obligates itself to compensate Taxpayer A for prior services. Such obligation substantially reduces the fair market value of XYZ Corporation. Taxpayer A purchases one or more shares of XYZ Corporation stock from XYZ Corporation. XYZ Corporation repurchases the ESOP's shares of XYZ Corporation stock for substantially less than the fair market value of XYZ Corporation's assets due to its obligation to Taxpayer A. Taxpayer A again holds 100 percent of the outstanding stock of XYZ Corporation. Other variations of this transaction use different methods or obligations to reduce the value and/or increase the adjusted tax basis of XYZ Corporation or its outstanding stock.

Related Links

• FTB Notice 2008 - 4 – Resolution of Bogus Optional Basis (BOB) Transactions and Certain Employee Stock Ownership Plan (ESOP) Transactions
  
• FTB Notice 2006-1 – California Tax Shelter Resolution Initiative – California's Program for Participants in Internal Revenue Service (IRS) Settlement Initiative. Revenue Ruling 2003-6, 2003-1 C.B. 286
  
• IRS Announcement 2005-80, 2005-2 I.R.B. 967 – Settlement Initiative – Management S Corporation ESOP Transactions (Transactions where the taxpayer has claimed that it is entitled to exclude income of an operating business by asserting, incorrectly, that the taxpayer had established, on or before March 14, 2001, an employee stock ownership plan entitled to an exemption from unrelated business income and an S corporation that is a management corporation, and whatever actions that were taken to attempt to establish an employee stock ownership plan and a management S corporation were taken on or before March 14, 2001
  
• IRS Revenue Ruling 2004-4, 2004-6 I.R.B. 414 – Prohibited Allocations of Securities in an S Corporation – Transactions that involve segregating the business profits of an employee stock ownership plan (ESOP)-owned S corporation in a qualified subchapter S subsidiary, so that rank-and-file employees do not benefit from participation in the ESOP
  
• IRS Revenue Ruling 2003-6, 2003-3 I.R.B. 286 – Prohibited Allocations of Securities in an S Corporation – Certain arrangements involving the transfer of ESOPs that hold stock in an S corporation for the purpose of claiming eligibility for the delayed effective date of § 409(p)
  
• FTB Notice 2008-4 Closing Agreement (fill-in PDF)
  
• Instructions for Completing FTB Notice 2008-4 Closing Agreement
  
• Frequently Asked Questions: FTB Notice 2008-4
  

• IRC Section 409(p) Anti-Abuse Testing, History of Regulations, and Private Letter Ruling (PLR) 200804023
  
• Missouri Building LLC v. Clark (In re Seferyn), B.A.P. 10th Cir., No. KS-07-094 (May 15, 2008)
  

ESOP Ownership Structure, Corporate Governance, and the Relationship between the Trustee, Board of Directors, and the ESOP Administrative Committee

I am often asked about how the ESOP ownership structure works. This post will explore corporate governance and the relationship between the Trustee, Board of Directors, and the ESOP Administrative Committee. Let's start with some terminology:

• Corporate Governance – Corporate governance is "the set of processes, customs, policies, laws and institutions affecting the way a corporation is directed, administered or controlled."
  
  
• Shareholders – The shareholders are the owners of the company. One of their primary responsibilities is to elect the members of the Board of Directors.
  
  
• Board of Directors – The Board of Directors represents the shareholders, is the highest level of management in a company, and is responsible for governing the company. A Board of Directors can consist of inside members (usually executive management) and/or outside members (not employed by the company, brought in for expertise and/or an impartial perspective). Some of their responsibilities include:
  
  • Preserving shareholder value
    
  • Selecting, reviewing the performance of, and approving the compensation of the chief executive.
    
  • Approving the financial statements of the company
    
    
• ESOP – An employee stock ownership plan (ESOP) is a qualified retirement plan as provided under the Employee Retirement Income Security Act (ERISA).
  
  
• Plan Fiduciary – Any person exercising discretionary authority or control over the management of the plan or plan assets.
  
  
• ESOP Plan Sponsor – The employer.
  
  
• Plan Administrator – The individual(s) with authority and discretion over the management of the plan. Unless another individual or entity (e.g. ESOP Administrative Committee) is specifically assigned, the Plan Sponsor is the Plan Administrator. The administrator(s) is a Plan Fiduciary.
  
  
• ESOP Administrative Committee – The ESOP Administrative Committee is usually appointed by the Board of Directors and serves as the Plan Administrator.
  
  
• Trustee - The ESOP assets, which primarily consist of the stock of the company, are required to be held in a trust by a Trustee. The Trustee is the individual(s) with authority and discretion over the plan assets. The Trustee(s) is a Plan Fiduciary. For many ESOPs, including many small, closely held companies, a member of management acts as the Trustee.
  
  
• Sole Benefit of Plan Participants – The Trustee, as a Plan Fiduciary, is required to act in the sole interest of plan participants, maximizing the long-term value of the assets of the trust (the stock of the company).
  
  
• Legal Shareholder – The Trustee is the legal shareholder of the ESOP's shares.
  
  
• Legal Voting Requirements – The Trustee is legally required to pass-thru voting to the employees for major issues (e.g. liquidation, sale of all or substantially all the assets, recapitalization, merger)
  
  
• Plan Document – The plan document specifies the voting rules. Unless provided by the plan document, the Trustee is not required to pass-thru other decisions such as voting for the Board of Directors, selling the stock, etc., and generally exercises the voting rights. The Trustee will generally vote according to the direction of the ESOP Administrative Committee.
  

So, what is the relationship between the Trustee, Board of Directors, and the ESOP Committee? The Trustee is selected by the Board of Directors or management (which is selected by the Board of Directors). The Trustee votes the ESOP shares for the election of the Board of Directors. The ESOP Administrative Committee is usually selected by the Board of Directors and generally consists of members of management. This "circular" selection process often leaves the same people in charge of the company and the ESOP.

Is Your 402(f) Safe Harbor Special Tax Notice Out of Date?

We recently discussed how the 402(f) Safe Harbor Special Tax Notice is out of date. Caution: IRS Model Special Tax Notice is Out of Date summarizes several law changes that must be incorporated into the Safe Harbor Explanation:

1. The automatic rollover requirements under IRC Section 401(a)(31) - Direct transfer of eligible rollover distributions
   
2. Information regarding Rollovers to Roth IRAs, as provided by IRS Notice 2008-30 - Miscellaneous Pension Protection Act Changes
   
3. Changing the days a 402(f) Safe Harbor Special Tax Notice may remain in effect from 90 to 180, as provided by Pension Protection Act of 2006 (PPA) (Public Law 109–280—Aug. 17, 2006)
   
4. "Rollover rules for Roth 401(k) and 403(b) deferrals"

Here is the Explanation to Recipients Before Eligible Rollover Distributions (Section 402(f) Notice) section of the Instructions for Forms 1099-R and 5498 (2008):

The requirements of section 402(f) do not apply to direct rollovers by nonspouse designated beneficiaries.

For qualified plans, section 403(b) plans, and governmental section 457(b) plans, the plan administrator must provide to each recipient of an eligible rollover distribution an explanation using either a written paper document or an electronic medium (section 402(f) notice). The explanation must be provided no more than 90 days (as much as 180 days for plan years that begin after December 31, 2006) and no fewer than 30 days before making an eligible rollover distribution or before the annuity starting date. However, if the recipient who has received the section 402(f) notice affirmatively elects a distribution, you will not fail to satisfy the timing requirements merely because you make the distribution fewer than 30 days after you provided the notice as long as you meet the requirements of Regulations section 1.402(f)-1, Q/A-2. The electronic section 402(f) notice must meet the consumer consent requirements as provided in Regulations section 1.401(a)-21(b).

The notice must explain the rollover rules, the special tax treatment for lump-sum distributions, the direct rollover option (and any default procedures), the mandatory 20% withholding rules, and an explanation of how distributions from the plan to which the rollover is made may have different restrictions and tax consequences than the plan from which the rollover is made. The notice and summary are permitted to be sent either as a written paper document or through an electronic medium reasonably accessible to the recipient; see Regulations section 1.402(f)-1, Q/A-5.

For periodic payments that are eligible rollover distributions, you must provide the notice before the first payment and at least once a year as long as the payments continue. For section 403(b) plans, the payer must provide an explanation of the direct rollover option within the time period described above or some other reasonable period of time.

Notice 2002-3, which is on page 289 of Internal Revenue Bulletin 2002-2 at http://www.irs.gov/pub/irs-irbs/irb02-02.pdf contains model notices that the plan administrator can use to satisfy the notice requirements.

Notice 2002-3 has not yet been updated for requirements related to plans that accept designated Roth account contributions. For distributions from designated Roth accounts, the section 402(f) notice must contain the rollover and taxation rules for the distribution of designated Roth contributions.

The notice also has not yet been updated for the requirements of the Pension Protection Act of 2006.

Involuntary distributions. For involuntary distributions paid to an IRA in a direct rollover (automatic rollover) you may satisfy the notification requirements of section 401(a)(31)(B)(i) either separately or as a part of the section 402(f) notice. The notification must be in writing and may be sent using electronic media in accordance with Q/A-5 of Regulations section 1.402(f)-1. Also see Notice 2005-5, Q/A-15.

The article provides a link to an updated Relius Special Tax Notice.

2009 Change in Reporting Distributions of 404(k) Dividends on IRS Form 1099-R

IRS Announcement 2008-56 – Change in Reporting Section 404(k) Dividends states that beginning with 2009 distributions, 404(k) dividend distributions must be reported on an IRS Form 1099-R that does not report any other distributions.

New Reporting

Distributions from a plan that are made in 2009 or later years and that are § 404(k) dividends must be reported on a Form 1099-R that does not report any other distributions, in accordance with the instructions to the form. Accordingly, if there are other distributions from the plan in such years that are not § 404(k) dividends, they must be reported on a separate Form 1099-R. It is anticipated that the instructions will require a special code in box 7 of the form to indicate the special tax treatment and rollover restrictions applicable to § 404(k) dividends. Payments of § 404(k) dividends made directly from the corporation to the plan participants or their beneficiaries are reported on Form 1099-DIV in accordance with the instructions to that form.

Effect on Other Documents

Announcement 85-168 is revoked.

ESOPs Mentioned in Joint Committee on Taxation Report (JCX-48-08)

ESOPs were mentioned a few times in a report last week by the Joint Committee on Taxation, Tax Reform: Selected Federal Tax Issues Relating to Small Business and Choice of Entity (JCX-48-08), June 4, 2008:

This document, prepared by the staff of the Joint Committee on Taxation, provides data on the number and size of business entities in the United States, as well as a description of present law, issues, and analysis relating to choice of business entity, conversions of entity form, and payroll taxes.

The report was prepared for C, K, or S: Exploring the Alphabet Soup of Small Business Choices in Advance of Tax Reform, a public hearing conducted by the Senate Committee on Finance on federal tax issues related to small business and choice of entity.

The ESOP-related references can be put into two categories:

1. BIG - Built-In Gains Tax
   
   Page 49: Conversion from C corporation to S corporation - Proposals to reduce built in gain holding period Some have suggested shortening the 10-year period after conversion from C corporation to S corporation status, during which the built-in gains tax is imposed. For example, several bills have been introduced that would shorten the time period to 7 years following a conversion to S corporation status.92 The present-law