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Our post on a recent Technical Advice Memorandum (TAM) shared some best practices when making share distributions. It also discussed the put option (participant's right to demand a stock distribution) and the net unrealized appreciation (NUA) tax benefits of making share distributions.

Some ESOP companies have opted to pay their participants with a lump sum share distribution, with the shares immediately put to the company in exchange for a promissory note. Reasons for doing this include:

  • To provide NUA treatment;
  • To comply with the share distribution requirements;
  • To protect the participants from the fluctuations in company stock when they are no longer with the company;
  • To reduce the number of shares in the trust; and/or
  • For other repurchase planning reasons

In order to use a promissory note and spread the payments over a period of time, you have to satisfy the put option requirements of IRC Section 409(h)(5) - Right to demand employer securities; put option - Payment requirement for total distribution:

(h) Right to demand employer securities; put option

(5) Payment requirement for total distribution

If an employer is required to repurchase employer securities which are distributed to the employee as part of a total distribution, the requirements of paragraph (1)(B) shall be treated as met if—

(A) the amount to be paid for the employer securities is paid in substantially equal periodic payments (not less frequently than annually) over a period beginning not later than 30 days after the exercise of the put option described in paragraph (4) and not exceeding 5 years, and

(B) there is adequate security provided and reasonable interest paid on the unpaid amounts referred to in subparagraph (A).

For purposes of this paragraph, the term "total distribution" means the distribution within 1 taxable year to the recipient of the balance to the credit of the recipient's account.

29 CFR 2550.408b-3(l) - Loans to Employee Stock Ownership Plans provides additional guidance:

(l) Other put option provisions—

(1) Manner of exercise. A put option is exercised by the holder notifying the employer in writing that the put option is being exercised.

(2) Time excluded from duration of put option. The period during which a put option is exercisable does not include any time when a distributee is unable to exercise it because the party bound by the put option is prohibited from honoring it by applicable Federal or State law.

(3) Price. The price at which a put option must be exercisable is the value of the security, determined in accordance with paragraph (d)(5) of 26 CFR 54.4975-11.

(4) Payment terms. The provisions for payment under a put option must be reasonable. The deferral of payment is reasonable if adequate security and a reasonable interest rate are provided for any credit extended and if the cumulative payments at any time are no less than the aggregate of reasonable periodic payments as of such time. Periodic payments are reasonable if annual installments, beginning with 30 days after the date the put option is exercised, are substantially equal. Generally, the payment period may not end more than 5 years after the date the put option is exercised. However, it may be extended to a date no later than the earlier of 10 years from the date the put option is exercised or the date the proceeds of the loan used by the ESOP to acquire the security subject to such put option are entirely repaid.

(5) Payment restrictions. Payment under a put option may be restricted by the terms of a loan, including one used to acquire a security subject to a put option, made before November 1, 1977. Otherwise, payment under a put option must not be restricted by the provisions of a loan or any other arrangement, including the terms of the employer's articles of incorporation, unless so required by applicable state law.

The promissory note must have a reasonable interest rate and provide adequate security. One of the ways that many ESOP companies used to attempt to provide adequate security was by purchasing surety bonds to serve as collateral. As of 2002, "the principal issuer of surety bonds in this market…indicated it will no longer issue the surety bonds."

Another way some ESOP companies have tried to satisfy the requirement is by pledging the stock of the company. Purchasing a Participant's ESOP Stock With a Promissory Note: Is Your "Adequate Security" Really Adequate? explores the problems with the stock pledge and adequate security requirement:

First, a question arises as to whether the stock is really "adequate security." Some will argue that pledging the stock of the employer is not "adequate security" because if the employer runs into financial difficulty and cannot make payments on the note, the value of its stock will undoubtedly decrease as well. However, if the employer is the purchaser, the company's assets are often given as collateral for the original ESOP loan, and there may be no other available assets to use as collateral, other than the stock purchased from the participant.

Second, IRS and Department of Labor ("DOL") regulations provide that the only collateral the ESOP may give as security is the stock purchased with the loan (in this case, the promissory note). If pledging the stock as collateral is not "adequate security," the result would be the ESOP cannot use a promissory note to purchase the participant's stock at all, which appears contrary to the statutory authority.

Third, neither the IRS nor the DOL has issued formal guidance regarding whether the pledge of employer stock will be considered "adequate security." Therefore, the plan sponsor and the ESOP is pretty much on its own in attempting to determine what will pass as "adequate security."

It notes that little guidance and case law is available, but does cite an IRS ruling that "a company's "full faith and credit" is not adequate security". It also cites two cases, including Craig v. Smith, 2009 WL 438635 (S.D. Ind. Feb. 20, 2009), a case where the company issued 10-year promissory notes with an acceleration clause requiring payment in full if there is a default in payments, and ponders whether that constitutes adequate security. Putting the shares to the ESOP instead of the company may also provide a stronger case of adequate security since the ESOP will own the security.

Using Promissory Notes to Repurchase ESOP Stock Becomes More Difficult also cites TAM 9438002 and Internal Revenue Manual Part 4. Examining Process, Chapter 72. Employee Plans Technical Guidelines, Section 4. Employee Stock Ownership Plans (ESOPs) as additional guidance:

  1. Check that employer securities not readily tradeable on an established market can be put to the employer.

  2. Make sure the put is exercisable for two 60 day periods: 60 days following the date the employer securities were distributed and 60 days in the following plan year.

  3. If the employee puts shares to the employer received in a total distribution, make sure the employer provides adequate security and pays reasonable interest on the unpaid portion. A put option is not adequately secured if it is not secured by any tangible assets.

    • For example, adequate security may be an irrevocable letter of credit, a surety bond issued by a third party insurance company rated " A" or better by a recognized insurance rating agency, or by a first priority perfected security interest against company assets capable of being sold, foreclosed upon or otherwise disposed of in case of default. Promissory notes secured by a company's full faith and credit are not adequate security. Nor are employer securities adequate security.

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