Can an LLC Adopt an Employee Stock Ownership Plan (ESOP)?

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By Justin W. Stemple, Esq.

Warner Norcross & Judd LLP, Grand Rapids, MI

Many clients ask if they can adopt an employee stock ownership plan (ESOP) as a limited liability company (LLC) or if they must first convert to a corporation. The conventional answer has been that an LLC must convert to a corporate organization before adopting an ESOP. It's an employee "stock" ownership plan, after all. The conversion allows the company to have "qualifying employer securities," as defined in §4975(e)(8), which is one of the basic requirements for an ESOP.

The IRS, however, allows LLCs to be taxed as a corporation under the Internal Revenue Code for other purposes, so a reasonable argument can be made to allow treatment as a corporation for ESOP purposes. As it turns out, the IRS agrees. The IRS recently issued PLR 201538021 allowing an LLC to adopt an ESOP. This is the IRS of course, so the ruling included several conditions.

Conditions

A private letter ruling may only be relied upon by the taxpayer requesting the ruling and private letter rulings must be inherently fact-specific. This ruling was very careful to recite certain aspects of the LLC that the IRS clearly wanted to emphasize in approving the LLC's request to adopt an ESOP. The IRS recited the following necessary features of the LLC:

  •  The LLC has elected to be taxed as a corporation.
  •  The LLC issues ownership interests to its members in the form of unit shares.
  •  The unit shares allocate profits and losses in proportion to the number of unit shares held by each "shareholder."
  •   Distributions (i.e., dividends) on unit shares are paid in proportion to the outstanding unit shares.
  •  The unit shares have identical liquidation rights.
  •  The unit shares have identical voting rights.
  •  The unit shares have the greatest voting and dividend rights of any class of unit shares issued by the LLC.

Ruling

The IRS concluded that because the LLC satisfies the above requirements, then it may adopt a tax-qualified ESOP. This ruling also suggests that an LLC must be structured similar to a corporation in order to adopt an ESOP. This begs the question: Is there any benefit to remaining an LLC rather than converting to a corporation before adopting an ESOP? In some cases, the conversion from an LLC to a corporation can be done in a tax-free manner with a carryforward of tax basis.  But, in other cases, there are adverse tax consequences from the conversion that could provide reasons to avoid the conversion. An LLC wanting to adopt an ESOP should consider the downsides to converting to a corporation, the benefits to remaining an LLC and whether it should apply for a private letter ruling of its own.

For more information, in the Tax Management Portfolios, see Kaplan, Brown, and Granados, 354 T.M., ESOPs,  and in Tax Practice Series, see ¶5560, Specialized Retirement Plans.

© 2015 Warner Norcross & Judd LLP.