ESOPs (Portfolio 354)

Tax Management Portfolio, ESOPs, No. 354-8th, describes the federal income tax consequences of establishing and maintaining an Employee Stock Ownership Plan (ESOP) under §401(a) and a leveraged ESOP under §§409 and 4975.

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Tax Management Portfolio, ESOPs, No. 354-8th, describes the federal income tax consequences of establishing and maintaining an Employee Stock Ownership Plan (ESOP) under §401(a) and a leveraged ESOP under §§409 and 4975. The Portfolio covers the requirements for initial and continuing qualification under §401(a). The Portfolio also examines the ESOP incentive provisions contained in tax legislation. Finally, the Portfolio covers uses of funds or securities contributed to a leveraged ESOP and techniques for using a leveraged ESOP to provide financing to the employer corporation or as an alternative to a corporation's redemption of outstanding securities. For federal tax consequences that are not unique to ESOPs, but are common to other qualified retirement plans, see 351 T.M., Plan Qualification—Pension and Profit-Sharing Plans; 352 T.M., Specialized Qualified Plans—Cash Balance, Target, Age-Weighted and Hybrids; and 370 T.M., Qualified Plans—Taxation of Distributions.


Jared Kaplan

Jared Kaplan, University of California at Los Angeles (A.B. 1960), Harvard University (LL.B. 1963); member, Illinois Bar. Past Chairman, Legislative and Regulatory Advisory Committee, The ESOP Association.

Gregory K. Brown

Gregory K. Brown, University of Kentucky (B.S. 1973), University of Illinois (J.D. 1975); member, Illinois Bar. Past Chairman, member, Legislative and Regulatory Advisory Committee, The ESOP Association. Past Member, Board of Directors, The ESOP Association. Past Chairman, Chicago Bar Association, Employee Benefits Committee. Member, ABA Tax Section, Employee Benefits Committee.

Luis Granados

Luis Granados, Brown University (A.B. 1975), Georgetown University Law Center (J.D. 1978); member, District of Columbia and Maryland Bars. Past Chairman, Legislative and Regulatory Advisory Committee, The ESOP Association.

Table of Contents

Detailed Analysis

I. Introduction

A. History of ESOPs

B. Uses of ESOPs

II. Basic Requirements of an ESOP

A. General Benefit Plan Requirements

1. Defined Contribution Plan / Stock Bonus Plan

2. Tax-Qualification Requirements of § 401(a)

3. Written Instrument and Trust Requirement

4. Prohibited Tax Shelter Transactions

a. Entity Manager Penalties

b. Disclosure Requirements

B. Specific ESOP Requirements

1. Designed to Invest Primarily in Employer Securities

2. Voting Rights

3. Distribution Requirements

4. Right to Demand Employer Securities; Put Option

5. Other Regulatory Requirements

6. Allocation of Shares Acquired with Loan Proceeds

C. The ESOP Loan Exemption

1. Statutory Requirements

2. Regulatory Requirements

3. Special Issues in ESOP Loans

a. Repayment of ESOP Loan with Dividends

b. Repayment of ESOP Loan with Sale Proceeds

c. Repayment of ESOP Loan with Employee Contributions

d. Refinancings with Extended Payment Terms

D. Other ESOP Rules

1. Independent Appraiser

2. Diversification

a. De Minimis Exception

b. Calculation of Diversification Portion

c. “Extra” Diversification

d. Treatment of Diversification Distributions

3. Form of Contributions

a. Contribution of Employer Securities

b. Contribution of Cash

4. Characteristics of the Sponsoring Employer

5. Special § 415 Provisions

6. Increased ESOP Contribution Deductions

7. Anti-Cutback Rules

a. General

b. Special ESOP Rules

III. Tax Attributes of ESOPs

A. Tax-Deferred Rollover Treatment on Sales to ESOPs

1. General

2. Qualified Sellers and Qualified Securities

3. Thirty Percent Ownership Test

4. Qualified Replacement Property

5. Replacement Period

6. Recognition of Gain on Disposition of Qualified Replacement Property

7. Basis of Qualified Replacement Property

8. Partial Rollover Election

9. Holding Period of Replacement Securities

10. Prohibited Allocation Rule

11. Procedural Election Requirements

12. Disposition by ESOP

13. Statute of Limitations

B. Deduction of Employer Dividend Payments

1. Dividends Paid to Participants

2. Dividends Reinvested in Employer Securities

3. Dividends Applied to Loan Payments

4. Reasonableness of Dividends

5. Applicability of the Alternative Minimum Tax

6. Redemptions Treated as Dividends

C. S Corporation ESOPs

1. General

2. Prohibited Allocations of Securities in an S Corporation ESOP

a. “Deemed-owned Shares”

b. “Synthetic Equity”

c. “Disqualified Person”

d. “Non-allocation Year”

e. “Impermissible Accrual”

f. “Impermissible Allocation”

g. Penalties

h. Avoidance or Evasion of § 409(p) Involving Synthetic Equity

i. Grandfathered Effective Date Abuses

j. Regulatory Effective Dates

D. Transfers from Terminating Defined Benefit Plans

E. ESOP Loan Interest Exclusion

IV. ERISA Fiduciary Rules

Introductory Material

A. Exclusive Purpose and Prudence Rules

1. Statute

2. Leading Cases

a. Donovan v. Bierwirth

b. Danaher Corporation v. Chicago Pneumatic Tool Co.

c. Eaves v. Penn

d. In re: Fairchild Industries, Inc.

e. Leigh v. Engel

f. Andrade v. The Parsons Corp.

g. Ershick v. Greb X-Ray Co.

h. Moench v. Robertson

i. Delta Star v. Patton

j. Tittle v. Enron Corp.

B. Diversification

C. Eligible Individual Account Plans

D. The “Sale” Exemption

1. General

2. Proposed Valuation Regulations

a. General Rule

b. Good Faith

c. Independence

d. Content

e. Special Factors

3. Leading ESOP Valuation Cases

a. Donovan v. Cunningham

b. Foltz v. U.S. News & World Report

c. Reich v. Valley National Bank of Arizona

d. Eyler v. Commissioner

e. Dole v. Farnum

E. Voting and Tender Offers

1. Background

2. Joint Statement on Tender Offers

3. Leading Voting and Tender Rulings

a. Carter Hawley Hale

b. Central Trust Co. v. American Avents

c. Reich v. NationsBank of Georgia

d. AFL-CIO Advisory Opinion

V. Leveraged ESOP Transactions

A. Description of Leveraged Transactions

B. Comparison of Leveraged ESOP Financing with Debt Financing

C. Equity Financing

D. Examples of Leveraged Transactions

1. General

2. Use of Leveraged ESOP in a Merger or Divestiture

3. Leveraged ESOP Purchase of a Shareholder's Interest

4. Charitable Contribution and Sale to Leveraged ESOP

5. ESOP § 1042 Seller-Financed Sale Followed by S Corporation Election

E. Alternate Financing Method

1. Problem of a Leveraged Transaction

2. Alternate Method

3. Advantages and Disadvantages of Alternate Financing Method

VI. Special Considerations

A. Conversion of Existing Plan to an ESOP

B. Sale of Financed Shares

1. Application of Sale Proceeds

2. Distribution Issues

C. Accounting Treatment of Employers with Leveraged ESOPs

1. Statement of Position 93-6

a. Share Issuance

b. Expense Recognition

c. Dividends on ESOP Shares

d. Earnings Per Share

e. Reporting Loans and Interest

f. Effective Date in Transition

2. FASB Statement No. 150

D. Securities Law and ESOPs

1. Participants’ Interests in an ESOP

a. Section 3(a)(2) Exemption from Registration

b. The “No Sale” Exemption from Registration

c. Other Exemptions from Registration

d. Registration

2. Plan Conversions

3. Employer Securities Acquired by an ESOP

4. Sales of Employer Stock by Plan

5. Resales by Plan Participants

6. Investment Company Act

7. Securities Exchange Act of 1934

a. Section 16(a) Reporting Requirements

b. Section 16(b) Short Swing Profit Provisions

c. Section 13(d) and Section 13(g) Filing Requirements

d. Rule 10b-18 Under the Exchange Act

e. Insider Information

f. Proxy Contests Involving ESOP Stock

E. Corporate Law Considerations

1. Norlin Case

2. Polaroid Case

a. Introduction

b. Factual Background

c. Standard of Review

d. Analysis of the Court

e. Significance of the Decision

3. NCR Case

a. Introduction

b. Factual Background

c. Analysis of the Court

4. Ervast v. Flexible Products Company

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 ABC Corporation Employee Stock Ownership Plan and Accompanying Trust Agreement

Worksheet 1A IRS Sample Plan Language For § 409(p) Transfers (Non-ESOP Portion of Plan)

Worksheet 2 Conference Committee Report on the Tax Reform Act of 1976, § 2701 - Employee Stock Ownership Plan Regulations, H.R. Rep. No. 1515, 94th Cong., 2d Sess. 539 (Sept. 13, 1976)

Worksheet 3 Conference Committee Report on § 141 of the Revenue Act of 1978 (P.L. 95–600), H.R. Rep. No. 1800, 95th Cong., 2d Sess. 208 (Oct. 14, 1978)

Worksheet 4 Senate Finance Committee Report, Explanation of Provisions of the Tax Reform Act of 1984. S. Rep. No. 169, Vol. I, 98th Cong., 2d Sess. 331 (March 21, 1984)

Worksheet 5 Conference Committee Report on § § 541–545 of the Tax Reform Act of 1984 (P.L. 98–369), H.R. Rep. No. 861, 98th Cong., 1st Sess., 1181 (June 23, 1984)

Worksheet 6 Senate Finance Committee Report to Accompany H.R. 3838, S. Rep. No. 313, 99th Cong., 2d Sess. 1027–1038 (May 29, 1986)

Worksheet 7 Conference Report on the ESOP Provisions of the Tax Reform Act of 1986, H.R. Rep. No. 841, 99th Cong., 2d Sess. II–550–560 (Sept. 18, 1986)

Worksheet 8 Technical Corrections to Employee Stock Ownership Plan Provisions, Explanation of Technical Corrections to the Tax Reform Act of 1984 and Other Recent Tax Legislation, (Title XVIII of H.R. 3838, 99th Cong., P.L. 99–514), Staff of Joint Committee on Taxation, 100th Cong., 1st Sess. 151–164 (May 13, 1987)

Worksheet 9 Conference Report on the Omnibus Budget Reconciliation Act of 1989, H.R. Rep. No. 101–386, 101st Cong., 1st Sess. 572–582 (Nov. 21, 1989)

Worksheet 10 DOL Information Letters on ESOPs [Raymond International, Blue Bell, Scott & Fetzer, Polaroid, and AFL-CIO]

Worksheet 11 SEC Rule 701

Worksheet 12 Department of Labor Field Assistance Bulletin 2002-1

Worksheet 13 Joint Department of Labor/Department of Treasury Statement on Pension Investments (January 31, 1989)

Worksheet 14 Unpublished TAM Regarding § 415 Application to Allocation of Amounts Remaining in ESOP Suspense Account After ESOP Debt Repayment

Worksheet 15 IRS Chief Counsel Notice 2004-038 (10/1/04)




Legislative History:

Treasury Regulations:

Labor Regulations:

Treasury Rulings:

IRS Notices, Etc.:

Department of Labor Interpretations:

Securities and Exchange Commission Rules, Releases, Letters, Etc.:

SEC Letters (No Action Letters):