Qualified Employer Securities (QES) and IRC Section 409(l)

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Thu, Oct 13, 2011
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Here is the second question on the Employee Stock Ownership Plan Review Worksheet:

2. Does the plan define QES in accordance with IRC 409(l)?

IRC Section 409(l) has recently been referenced in the Final Definition of "Readily Tradable on an Established Market" as defined in IRS Notice 2011-19 - Definition of Readily Tradable On An Established Securities Market and the Final IRC Section 401(a)(35) Diversification Regulations. It is often referenced in PLRs and TAMs dealing with issues such as IRC Section 1042 Tax Deferred Sales of Stock to an ESOP and ESOP Stock Distributions. IRC Section 409(l) also provide guidance for when a C Corporation has multiple classes of stock (i.e. common stock and preferred stock).

The Internal Revenue Manual (IRM) defines 4 considerations for reviewing Qualifying Employer Securities (QES), including 2 related to IRC Section 409(l):

  1. An ESOP must invest primarily in qualifying employer securities. See IRC 4975(e)(7). There is no specific percentage that defines the term "primarily" . It is a flexible term that takes into account facts and circumstances such as the investment performance of the qualifying employer securities.

  2. An ESOP can sell qualifying employer securities or refrain from purchasing additional securities based on the investment performance of the securities. This would be consistent with the fiduciary duties under Title I of ERISA. The Department of Labor (DOL) stated in Advisory Opinion 83–6A (1/24/83) there may be instances where the investment of more than 50% of plan assets in qualifying employer securities would not satisfy the fiduciary responsibility requirements of Title I. The DOL Advisory Opinion concluded the " primarily" requirement must be satisfied over the life of the ESOP.

  • IRC 4975(e)(8) defines a "qualifying employer security " as an employer security within the meaning of IRC 409(l). IRC 409(l) provides that employer securities consist of the following:


    A. Common stock issued by the employer, or by a corporation within the same controlled group, which is readily tradeable on an established securities market. This requires that sales of the stock take place regularly and consistently based on the facts and circumstances.


    B. If there is no readily tradeable common stock, closely held common stock of the employer which has a combination of voting power and dividend rights equal to or in excess of the class of common stock of the employer having the greatest dividend rights.


    C. Noncallable preferred stock if the stock is convertible into stock which meets the requirements of a. or b. above, and if the conversion price is reasonable as of the date the ESOP acquired the preferred stock.

  • For purposes of IRC 409(l), a "controlled group of corporations " is defined at IRC 1563(a), but without regard to the insurance company rule at IRC 1563(a)(4) and without regard to the exception to the attribution from trusts rule at IRC 1563(e)(3)(C).


    A. IRC 409(l)(4) provides special circumstances in which a first tier subsidiary may be considered to be includable in a controlled group of corporations for purposes of IRC 409, even where the parent owns less than 80% of the first tier subsidiary. The effect of this provision is to permit the acquisition of the controlling corporation's stock by an ESOP maintained by the first tier subsidiary. If a corporation owns directly stock possessing 50% of the voting power in all classes of stock and at least 50% of each class of non-voting stock in the first tier subsidiary, then the first tier subsidiary (and all other corporations below it in the chain which would meet the 80% test of IRC 1563(a) if the first tier subsidiary were the parent) is considered to be an "includable corporation" for IRC 409 purposes


    B. IRC 409(l)(4) provides special circumstances in which a second-tier subsidiary may be considered to be includable in a controlled group of corporations for purposes of IRC 409. The effect of this provision is to permit the acquisition of the controlling corporation's stock by an ESOP maintained by the second-tier subsidiary. If a corporation owns directly stock possessing all of the voting power in all classes of stock and all of the non-voting stock of a first-tier subsidiary, and if the first-tier subsidiary owns stock possessing at least 50% of the voting power of all classes of stock and at least 50% of each class of non-voting stock of the second-tier subsidiary (and all other corporations below it in the chain which would meet the 80% test of IRC 1563(a) if the second-tier subsidiary were the common parent) is considered to be an "includable corporation" for purposes of IRC 409(l)


  • IRC Section 409(l) - Employer securities defined

    For purposes of this section—

    1. In general




      The term "employer securities" means common stock issued by the employer (or by a corporation which is a member of the same controlled group) which is readily tradable on an established securities market.


    2. Special rule where there is no readily tradable common stock


      If there is no common stock which meets the requirements of paragraph (1), the term "employer securities" means common stock issued by the employer (or by a corporation which is a member of the same controlled group) having a combination of voting power and dividend rights equal to or in excess of—


      (A) that class of common stock of the employer (or of any other such corporation) having the greatest voting power, and

      (B) that class of common stock of the employer (or of any other such corporation) having the greatest dividend rights.

    3. Preferred stock may be issued in certain cases


      Noncallable preferred stock shall be treated as employer securities if such stock is convertible at any time into stock which meets the requirements of paragraph (1) or (2) (whichever is applicable) and if such conversion is at a conversion price which (as of the date of the acquisition by the tax credit employee stock ownership plan) is reasonable. For purposes of the preceding sentence, under regulations prescribed by the Secretary, preferred stock shall be treated as noncallable if after the call there will be a reasonable opportunity for a conversion which meets the requirements of the preceding sentence.


    4. Application to controlled group of corporations



      (A) In general


      For purposes of this subsection, the term "controlled group of corporations" has the meaning given to such term by section 1563(a) (determined without regard to subsections (a)(4) and (e)(3)(C) of section 1563).


      (B) Where common parent owns at least 50 percent of first tier subsidiary


      For purposes of subparagraph (A), if the common parent owns directly stock possessing at least 50 percent of the voting power of all classes of stock and at least 50 percent of each class of nonvoting stock in a first tier subsidiary, such subsidiary (and all other corporations below it in the chain which would meet the 80 percent test of section 1563(a) if the first tier subsidiary were the common parent) shall be treated as includible corporations.


      (C) Where common parent owns 100 percent of first tier subsidiary


      For purposes of subparagraph (A), if the common parent owns directly stock possessing all of the voting power of all classes of stock and all of the nonvoting stock, in a first tier subsidiary, and if the first tier subsidiary owns directly stock possessing at least 50 percent of the voting power of all classes of stock, and at least 50 percent of each class of nonvoting stock, in a second tier subsidiary of the common parent, such second tier subsidiary (and all other corporations below it in the chain which would meet the 80 percent test of section 1563(a) if the second tier subsidiary were the common parent) shall be treated as includible corporations.


    5. Nonvoting common stock may be acquired in certain cases


      Nonvoting common stock of an employer described in the second sentence of section 401(a)(22)

      shall be treated as employer securities if an employer has a class of nonvoting common stock outstanding and the specific shares that the plan acquires have been issued and outstanding for at least 24 months.

    Topics: Compliance, ESOP, Plan Document, employee stock ownership plan

    Aaron Juckett, CPA, CPC, QPA, QKA
    Written by Aaron Juckett, CPA, CPC, QPA, QKA

    Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

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