In addition to providing employees with ownership interests in the business, an employee stock ownership plan (ESOP) can provide significant tax benefits to the corporation and pre-ESOP shareholders. Specifically, for a shareholder selling qualifying shares of a C corporation to an ESOP, section 1042 provides a tax-deferral opportunity. Operation as an S corporation, if qualified and elected after the sale to the ESOP, has the added benefit of preserving passthrough treatment for tax purposes, thereby eliminating corporate- and shareholder-level taxes on the business's earnings (ignoring entity-level S corporation taxes such as built-in gains tax), because an ESOP is generally tax-exempt. These tax advantages make ESOPs an attractive ownership transition tool for all parties involved.
As its name indicates, an ESOP must hold stock, which precludes a partnership from implementing an ESOP without restructuring. Taxpayers may argue that an LLC that has elected to be taxed as a corporation for federal tax purposes can implement an ESOP without formally restructuring; however, this position is unclear, and this item does not address whether it is acceptable. In the event an election to be taxed as a corporation qualifies the entity to implement an ESOP, the election is treated the same for tax purposes as a conversion to corporate status. Specifically, the check-the-box election deems steps to occur that are consistent with a section 351 transaction in which property is contributed to a corporation in return for stock. Section 351 is discussed in this item, because if the requirements of section 351 are met, the transaction is tax-free.
Where the existing owners and employees of a partnership or LLC taxed as a partnership wish to implement an ESOP ownership structure, careful planning is necessary to avoid traps for the unwary that could lead to unintended tax consequences. This item explores the main issues a partnership should consider from a restructuring perspective when considering such a transaction.
An ESOP is a qualified retirement plan that simultaneously offers employee benefits and an ownership transfer mechanism. Specifically, some or all of the company's stock is transferred from existing shareholders or the company to the ESOP, which holds the stock in a retirement plan for the employees. Through the financing mechanisms generally used to fund the ESOP's purchase of company stock, the operating company in effect ends up with tax-deductible principal payments on a loan because the amounts paid on the loan represent contributions to a qualified retirement plan.
Implementation of an ESOP results in a new employee benefit plan, which may replace or supplement other employee benefits. In addition, it often increases cash flow to the company as a result of the associated tax benefits (e.g., no corporate-level federal income tax, if an S election is made following the ESOP acquisition) and enhances employee performance. Employees who participate in the ESOP receive retirement benefits in the form of appreciation in the value of employer stock, usually at no cost to themselves. By forming an ESOP, the current company owners create a market for their stock and may receive a deferral under section 1042 on any gain from the sale of stock to the ESOP, if it is structured appropriately.
ESOPs are especially attractive to owners of profitable businesses looking to transfer ownership to a qualified workforce in place while providing the owners a tax deferral under section 1042. Section 1042 generally allows taxpayers to defer gain on sales of C corporation stock to an ESOP if (1) the ESOP owns at least 30 percent of the company following the sale, and (2) the taxpayer reinvests the proceeds in qualified replacement property within the replacement period. This tax-deferral opportunity may heavily influence an owner's decision to sell to an ESOP rather than to an outside party. If it is currently taxed as a partnership, the company must incorporate prior to the sale for the section 1042 deferral provisions to apply.
If tax deferral under section 1042 is not desired or important, an ESOP is easily implemented through forming a corporation to acquire the assets or units of the LLC or partnership in conjunction with the formation of the ESOP. The sale of the company's assets or ownership interests to the newly formed corporation would be a taxable sale for the existing owners. However, where owners wish to benefit from section 1042 tax deferral upon the sale of stock to the ESOP, the incorporation should be structured to qualify for tax deferral as well. Otherwise, the owners have simply replaced one taxable transaction with another. The following analysis explains what structuring factors to consider prior to a partnership's moving forward with an ESOP implementation plan when section 1042 tax deferral is desired.
Case study: Partnership structuring to implement an ESOP
Facts: Company P is an LLC taxed as a partnership. P has an exceptional workforce in place and low turnover rates. P is owned 5 percent by A, 5 percent by B, and 90 percent by C, all individuals. The current owners have been operating the business for several years and have decided they are ready to retire. After exploring various options, A, B, and C decide an ESOP would provide everything they want-a buyer for their shares in a sale structured to provide potential gain deferral, an incentive to their employees, and, hopefully, a bright future for P through increased productivity and cash flow. P engages an investment banker and spends significant time and money arranging for financing, ESOP formation, and transaction structuring.
Issues: P must be a corporate employer to implement an ESOP. One solution is for P to form a new corporation (Newco) and contribute all of its assets to Newco in exchange for all of the stock in Newco, thereby converting P into a corporation. Other options could include a state law conversion to a corporation or the merger of P into Newco under state law. On its face, this conversion of P from a partnership to a corporation appears to represent a tax-free section 351 transaction. Section 351 generally provides for nonrecognition treatment when property is contributed to a corporation in return for stock in the corporation, as long as the transferors are in control of the corporation immediately after the contribution. In this example, property is transferred to Newco for stock in Newco, and the owners of P own 100 percent of Newco immediately after the transfer. However, the subsequent sale of Newco stock by A, B, and C to the ESOP may be problematic for the owners' tax-deferral goal.
Analysis: Rev. Ruls. 70-140 and 79-70
While the conversion to corporate form seems straightforward, and a clear and substantial business purpose for incorporating P exists (i.e., P must be a corporation to allow for ESOP ownership), these facts alone are not enough to establish that the incorporation satisfies section 351. For example, Rev. Rul. 70-140 shows that section 351 cannot be taken for granted in such a conversion. In the ruling, A contributed a sole proprietorship to Corporation X in exchange for X stock. Pursuant to a prearranged plan, A then transferred all of his X stock to Y in exchange for Y stock. The ruling held that "the two steps of the transaction . . . were part of a prearranged integrated plan and may not be considered independently of each other for Federal income tax purposes." When the two steps were considered together,A did not satisfy the control requirement for the incorporation. Thus, under this fact pattern, A was treated as selling assets to Y and was required to report gain or loss accordingly under sections 1001 and 1002. Similarly, the IRS held in Rev. Rul. 79-70 that a sale of 40 percent of the stock of a newly created company occurring pursuant to an integrated plan and subject to a binding agreement precluded section 351 treatment because the control requirement was not met.
In the context of a conversion of a partnership to a corporation in a section 351 transfer, followed by a sale of the corporation's stock to an ESOP, if the sale is treated as a deemed sale of assets rather than as a sale of stock, any gain on the transaction will not qualify for tax deferral under section 1042, which allows deferral of tax on the gain from the sale of stock. Accordingly, determining whether the incorporation of P represents a tax-deferred section 351 transfer and allowing for deferral of gain on the section 1042 sale of P's stock to the ESOP hinges on whether a prearranged plan exists for A, B, and C to lose control of P through a sale to the ESOP. If such a plan exists, particularly one occurring pursuant to a binding agreement, section 351 treatment likely would not be available. Determining control immediately after a transaction is ultimately a facts-and-circumstances analysis.
The first problematic factor in determining whether a prearranged plan exists is the decision to incorporate altogether. Would such a conversion occur without the sale to the ESOP? Without a prearranged plan to sell to the ESOP, it may be difficult to establish a good reason that A, B, and C, who have held P as a passthrough entity, would want to subject P to taxation as a C corporation. While a business purpose may not be not required to incorporate in a valid section 351 transfer, a lack of business purpose could indicate that the sale occurred pursuant to an integrated plan to sell. In too many situations, A, B, and C are willing to incorporate and give up passthrough treatment only when they are certain that the ESOP transaction will close and funding for the transaction is in place. Factors to consider include:
- What negotiations have occurred between P, the owners of P, and the ESOP prior to the conversion?
- Has a value been agreed upon?
- Has the ESOP transaction funding been arranged so as to establish that the conversion and sale by A, B, and C to the ESOP is part of a prearranged plan?
In addition to the rulings mentioned above, a line of case law addresses the section 351 "immediately after" requirement (see, e.g.,Hazeltine Corp., 89 F.2d 513 (3d Cir. 1937), and Intermountain Lumber Co., 65 T.C. 1025 (1976)). In Intermountain Lumber, the Tax Court held that whether a subsequent stock transfer should be integrated with a previous contribution to the corporation "depends upon the obligations and freedom of action of the transferee with respect to the stock when he acquired it from the corporation" and that "it is immaterial how soon thereafter the transferee elects to dispose of his stock or whether such disposition is in accord with a preconceived plan not amounting to a binding obligation." Reading this language, which uses "binding obligation" rather than "prearranged integrated plan" (used by the IRS in Rev. Rul. 70-140), one may draw a conclusion that P's proposed transaction above would be respected as meeting the section 351 requirements, even if the sale to the ESOP occurs the next day, as long as a binding agreement does not exist. It would seem prudent for taxpayers and their advisers to consider at what point a binding agreement exists, what may distinguish a prearranged plan from a binding agreement, and whether lack of a written agreement binding the parties to execute the transaction is sufficient to avoid failing the control requirement.
Analysis: Rev. Rul. 79-194
While Rev. Ruls. 70-140 and 79-70 may be problematic, as with so many areas of tax law, a slight change in facts could have a significant impact on the analysis. The facts in Rev. Rul. 79-194 differ slightly from those in Rev. Rul. 70-140. In Situation 1 of Rev. Rul. 79-194, corporation A and investor group B transfer property to a corporation (Newco) in exchange for 80/20 ownership. Following the transfer and pursuant to a prearranged plan, B acquires 31 percent of Newco from A, resulting in A's owning 49 percent and B's owning 51 percent of Newco. While it would appear that A did not retain control of Newco and lost control pursuant to a prearranged plan, the ruling held that the control test was satisfied because B was also a transferor to Newco and changes in shareholdings between transferors are generally disregarded. In Situation 2 of the ruling, B acquired only 1 percent of Newco (as opposed to 20 percent) prior to the acquisition from A. The ruling held that B was not a transferor, and the section 351 control requirement was not satisfied.
Compare this analysis to P's situation above, with the exception that C is willing to retain an interest in the business after the transaction. Assume the ESOP would be formed prior to the corporate conversion and would contribute cash for a 10 percent interest in the corporation. A, B, and C would contribute all of their ownership units in P to the corporation in exchange for the remaining 90 percent interest. Thus, A, B, C, and the ESOP would all be transferors in the incorporation. Following the incorporation, the ESOP could purchase all of the shares owned by A and B and a majority of the shares from C, resulting in ownership of 90 percent by the ESOP and 10 percent by C. Based on Rev. Rul. 79-194, this purchase would not appear to cause a failure to meet the control requirement because transferors had control both before and after the purchase. With that said, there is no direct guidance providing that 10 percent is a large enough interest for the ESOP to initially acquire or C to ultimately retain, and the specific facts and circumstances of each case need to be carefully considered.
Results: Restructuring considerations
If the incorporation of a partnership prior to the sale to an ESOP fails to qualify as a section 351 transfer, the significant benefit of a section 1042 deferral is lost. However, with careful planning, a tax-free conversion to corporate status as well as section 1042 tax deferral may be available to partnership owners. It is important that selling owners be aware that a slight change in transaction facts can have a significant effect on the tax treatment of the transaction, which is often a critical piece of any ESOP-related transaction.
Excerpted from the April 2015 issue of The Tax Adviser. Copyright © 2015 by the American Institute of Certified Public Accountants, Inc.