IRS rules on LLC sponsorship of an ESOP
INSIGHT ARTICLE |
This article was last updated May 12, 2021
To be a qualifying employee stock ownership plan (ESOP), a plan must be primarily invested in employer securities, which are generally defined as certain common stock of employers. In private letter ruling 201538021, the IRS ruled that the LLC units of a taxpayer that had elected to be taxed as an association would qualify as employer securities, thereby giving the taxpayer the ability to implement an ESOP.
The ruling provides welcome clarity for LLCs that have long wondered whether a full corporate conversion was necessary to take advantage of sponsoring an ESOP or whether a check-the-box election to be taxed as a corporation was adequate. However, it is important to note that traps for the unwary that are not addressed in the ruling can have severe tax consequences.
A check-the-box transaction can be a tax-free event so long as the requirements of section 351 are met. See our April 29, 2015, article on this topic for an explanation of this easily overlooked trap. Although the ruling does not specify the dates on which the LLC elected association status or the ESOP sale will occur, it appears the ESOP sale terms had not yet been fully arranged as the facts state simply that the company intends to adopt an ESOP. Nonetheless, the qualification under section 351 is not addressed in the ruling and is still an important factor in such a transaction.
In addition, the taxpayer represented that its LLC Operating Agreement provides identical rights to distributions, dividends and liquidation proceeds, and that voting rights would be amended to also be identical. These are important factors in qualifying as employer securities for private companies in which ESOPs must own securities with rights at least equal to the highest voting and highest dividend rights. Thus, LLCs with more flexible operating agreements must amend the unit rights and possibly change the economics of allocations to have an ESOP.
Overall, the ability of an LLC to check-the-box and qualify to sponsor an ESOP is simpler, and likely less costly, than needing to do a full corporate conversion. However, if the check-the-box election is the only consideration prior to selling units to an ESOP, the taxpayer risks include tax on any built-in appreciation in assets, unrelated business income tax to the ESOP, loss of ESOP status, loss of S corporation status if elected, and potentially other penalties. Thus, taxpayers considering such a transaction should consult closely with their tax advisors to ensure no details are overlooked that may jeopardize the overall tax position.