By Jon Schultze, Andrew Oringer and Barry Salkin
Employee stock ownership plans (“ESOPs”) are retirement plans that provide employees with the opportunity to own stock of their employer. Congress has long encouraged the use of ESOPs under both the Employee Retirement Income Security Act of 1974 (“ERISA”) and the Internal Revenue Code of 1986 (the “Code”), but ESOPs present an unusual set of issues for retirement plans in that, unlike most plans, they are generally not diversified and instead are primarily invested in the stock of the plan sponsor. As a result of the risks surrounding single-stock investing and the complex rules that, in some cases, are subject to abuse, enforcement efforts, particularly by the Department of Labor (the “DOL”), have sometimes focused specifically on ESOPs.
The SECURE 2.0 Act of 2022 (“SECURE 2.0”) contains a number of provisions favorable to ESOPSs, showing that, despite possible DOL misgivings about ESOPs, Congress continues to incentivize them. For example, the DOL received $50 million in grants over a five-year period for new and existing state-law programs that encourage ESOP formation; the definition of “publicly traded securities” has been expanded; and beginning in 2028, selling stockholders of S corporations will be able to utilize Section 1042 of the Code, which allows selling stockholders of C corporations to defer taxable gains on certain sales of stock to an ESOP as an incentive to establish private-company ESOPs, to defer up to 10% of their taxable gains (rather than the 100% available to selling stockholders of C corporations).
One of the key requirements relating to ESOPs and other plans holding employer securities, concerns whether “adequate consideration” has been paid or received by the plan for the securities it acquires or sells. The DOL proposed regulations in 1988 on adequate consideration, but SECURE 2.0 now requires the DOL to issue regulations defining “adequate consideration.” Lisa Gomez, Assistant Secretary of Labor at the DOL, has told The ESOP Association in an April 12, 2023, letter that the DOL will indeed move forward with this important regulatory project.[1] The DOL has announced it will issue proposed regulations by the end of 2023.
In addition, the DOL announced a new initiative in July 2023 that includes the establishment of a Division of Employee Ownership (the “DEO”) to support the creation and expansion of worker-owned businesses. The DEO will support programs designed to promote employee ownership; provide education, outreach and training to inform employees and employers about the possibilities and benefits of worker ownership and business ownership succession planning; and provide technical assistance to employers and employees to help them explore the feasibility of employee ownership.
While SECURE 2.0 and the DOL’s new DEO initiative are positive developments for ESOPS, the DOL continues to challenge ESOP valuations aggressively. An important part of the DOL’s enforcement efforts has included litigation, with one of the key reference points being its 2014 settlement agreement with GreatBanc Trust Company.[2] A more recent example of the DOL’s litigation activity regarding ESOPs can be found with the recent settlement in the case of Walsh v. Reliance Trust Company.[3] The final “adequate consideration” regulations noted above should help alleviate the litigation by resolving longstanding disagreements between the DOL and service providers.
As part of the IRS’s expanded focus on tax avoidance and ensuring high-income taxpayers pay what they owe, on August 9, 2023, the IRS warned businesses and tax professionals to be alert to complex issues that can arise with respect to ESOPs.[4] The IRS indicated that its current compliance efforts have identified numerous concerns, such as valuation issues, prohibited allocations of shares to disqualified persons and a failure to follow Code provisions for ESOP loans that can cause the loans to be prohibited transactions subject to a 15% excise tax.
The IRS also indicated that it has identified potentially abusive arrangements. One such arrangement involves a business creating a management S corporation whose stock is owned by the ESOP for the sole purpose of diverting taxable income to the ESOP, which does not pay taxes on the income because an ESOP is a tax-exempt entity. The S corporation purports to provide loans to the business owners in the amount of the business income to avoid having the owners taxed on the business income directly. The IRS disagrees with the efficacy of this approach and would treat the purported loans as taxable income. The IRS also asserted that such an arrangement could cause the corporation to lose its S corporation status. The IRS may have been encouraged by the decision in Aspro v. United States,[5] in which the Court of Appeals for the Eighth Circuit upheld the IRS’s disallowance of a tax deduction for management fees paid by a C corporation to its shareholders, which was recharacterized as a disguised dividend. While not an ESOP case, the case involves the IRS’s focus on schemes used to avoid taxation of income.
In October 2023, Laura Warshawsky, Deputy Associate Chief Counsel at the IRS, clarified at a virtual conference hosted by the American Bar Association’s Tax Section that the IRS’s notice was not intended to indicate it would designate ESOPs or certain ESOP valuations as “listed transactions” for tax-avoidance purposes, and the IRS won’t go so far as to audit all worker-owned companies. However, tax regulators will target high-income employers that dodge paying taxable income by loaning it to worker participants through ESOPs.
Plan sponsors can legitimately seek to minimize their federal tax liability but should be careful about seeking tax advice from “promoters focused on marketing questionable transactions.” On the other hand, transactions that IRS might regard as abusive may still satisfy the technical requirements of the Code. If presented with a transaction that seems compliant on its face but seems too good to be true, we recommend proceeding with caution and seeking a disinterested professional for guidance.
We will continue to monitor Congressional and agency developments in the ESOP area. If you have any questions about ESOPs, or about the fiduciary provisions of ERISA and the Code generally, please feel free to contact us for assistance.
[1] The ESOP Association, “Department of Labor Agrees to Notice and Comment Rulemaking on Adequate Consideration Exemption for ESOPs,” https://www.esopassociation.org/articles/department-labor-agrees-notice-and-comment-rulemaking-adequate-consideration-exemption.
[2] https://www.dol.gov/sites/dolgov/files/ebsa/about-ebsa/our-activities/enforcement/esop-agreement-appraisal-guidelines.pdf
[3] See DOL Press Release No. 23-1950-NAT (Sept.13, 2023); see also Zuss, “Department of Labor Recovers $22.5 million for ESOP”, https://www.plansponsor.com/department-of-labor-recovers-22-5-million-for-esop/ (Sept. 13, 2023).
[4] See IR-2023-144, Aug. 9, 2023, https://www.irs.gov/newsroom/irs-cautions-plan-sponsors-to-be-alert-to-compliance-issues-associated-with-esops
[5] 32 F.4th 673 (8th Cir. 2022).