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What is a price protection or floor price agreement?

When an ESOP borrows money, the debt and related interest expense taken to finance the shares is an additional liability of the company. Although this liability will be partially offset by the tax benefits of an ESOP, it will still reduce the post-transaction value of the company. This temporary reduction in value will get smaller as the loan is repaid.

When an ESOP enters into a second stage transaction (a.k.a. any purchase after the initial one), the value of the company will experience another post-transaction reduction in value. This decline could negatively impact ESOP participants and the other shareholders of the company if they are looking to take a distribution of their account or sell their shares. In order to protect the participants holding the pre-transaction ESOP shares, the ESOP can negotiate a price protection agreement, often referred to as a floor price agreement, which would provide that the company would repurchase the pre-transaction ESOP shares at a minimum guaranteed price. The purpose of the floor price is to protect the participants' accounts, particularly accounts who will be taking a distribution in the near future, from the decline in value from the leveraged transaction. The price can be a fixed price, an adjusted price determined by a formula, or the value determined by the independent appraiser adjusted to remove the effect of the related ESOP debt.

A recent private letter ruling (PLR), PLR 200827008, found that a floor price agreement would not create an additional class of stock for purposes of IRC Section 1361(b)(1)(D) - S corporation defined - In general.

PLR Analysis

  • Precedential status - IRC Section 6110(k)(3) - Precedential status provides that a private letter ruling cannot be "used or cited as precedent."

  • Background – The Corporation that requested the PLR originally formed an ESOP as a less than 100% ESOP-owned C Corporation. In a second-stage transaction, the corporation acquired the remaining shares of the company to become 100% ESOP-owned and became an S Corporation.

    In order to protect the participants holding the "Pre-Transaction ESOP Shares", the Company entered into a "Floor Price Agreement". The Floor Price Agreement provided that the company would repurchase the Pre-Transaction ESOP shares at a minimum price. The minimum price was the value determined by the independent appraiser without considering the effect of the ESOP debt used to acquire the remaining shares.

  • One class of stock requirement – IRC Section 1361(b)(1) - S corporation defined - In general defines the term small business corporation (S Corporation) as a domestic corporation which does not have more than one class of stock:

    (b) Small business corporation

    (1) In general

    For purposes of this subchapter, the term "small business corporation" means a domestic corporation which is not an ineligible corporation and which does not—

    (A) have more than 100 shareholders,

    (B) have as a shareholder a person (other than an estate, a trust described in subsection (c)(2), or an organization described in subsection (c)(6)) who is not an individual,

    (C) have a nonresident alien as a shareholder, and

    (D) have more than 1 class of stock.

  • Identical rights to distribution – Treasury Regulations, Subchapter A, Sec. 1.1361-1(l)(1) S corporation defined provides that a corporation is treated as having only one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds:

    (l) Classes of stock—(1) General rule. A corporation that has more than one class of stock does not qualify as a small business corporation. Except as provided in paragraph (l)(4) of this section (relating to instruments, obligations, or arrangements treated as a second class of stock), a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock. Thus, if all shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.

  • Identical rights to distribution and liquidation – Treasury Regulations, Subchapter A, Sec. 1.1361-1(l)(2)(i) S corporation defined defines how the determination of whether stock confers identical rights to distribution and liquidation proceeds is determined:

    (2) Determination of whether stock confers identical rights to distribution and liquidation proceeds—(i) In general. The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions). A commercial contractual agreement, such as a lease, employment agreement, or loan agreement, is not a binding agreement relating to distribution and liquidation proceeds and thus is not a governing provision unless a principal purpose of the agreement is to circumvent the one class of stock requirement of section 1361(b)(1)(D) and this paragraph (l). Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances

  • Redemption agreements are disregarded in determining whether shares of stock confer identical rights to distribution – Treasury Regulations, Subchapter A, Sec. 1.1361-1(l)(2)(iii) S corporation defined provides that certain agreements are disregarded in determining whether shares of stock confer identical rights to distribution and liquidation proceeds:

    (iii) Buy-sell and redemption agreements—

    (A) In general. Buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation's outstanding shares of stock confer identical distribution and liquidation rights unless—

    (1) A principal purpose of the agreement is to circumvent the one class of stock requirement of section 1361(b)(1)(D) and this paragraph (l), and

    (2) The agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock.

    Agreements that provide for the purchase or redemption of stock at book value or at a price between fair market value and book value are not considered to establish a price that is significantly in excess of or below the fair market value of the stock and, thus, are disregarded in determining whether the outstanding shares of stock confer identical rights. For purposes of this paragraph (l)(2)(iii)(A), a good faith determination of fair market value will be respected unless it can be shown that the value was substantially in error and the determination of the value was not performed with reasonable diligence. Although an agreement may be disregarded in determining whether shares of stock confer identical distribution and liquidation rights, payments pursuant to the agreement may have income or transfer tax consequences.

    (B) Exception for certain agreements. Bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation's shares of stock confer identical rights. In addition, if stock that is substantially nonvested (within the meaning of §1.83–3(b)) is treated as outstanding under these regulations, the forfeiture provisions that cause the stock to be substantially nonvested are disregarded. Furthermore, the Commissioner may provide by Revenue Ruling or other published guidance that other types of bona fide agreements to redeem or purchase stock are disregarded.

    (C) Safe harbors for determinations of book value. A determination of book value will be respected if—

    (1) The book value is determined in accordance with Generally Accepted Accounting Principles (including permitted optional adjustments); or

    (2) The book value is used for any substantial nontax purpose.

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