PLR 1038001: IRS disregarded an ESOP valuation rule in testing S corporation stock classes

Plain-English summary

An S corporation had an employee stock ownership plan that acquired the company's stock in two purchases, with the second purchase financed by a loan. A plan provision protected the value of the shares from the first purchase from the loan balance when participant distributions were calculated. The IRS ruled that this provision could be disregarded when determining whether the corporation had more than one class of stock. The corporation therefore would not be treated as violating the S corporation one-class-of-stock requirement solely because of the provision.

Ruling snapshot

• Question: Did the ESOP valuation provision create a second class of stock for purposes of the S corporation rules?
• Outcome: Approved
• Key authorities: IRC § 1361(b)(1)(D); Treas. Reg. §§ 1.1361-1(l)(1), 1.1361-1(l)(2)(iii)(A), and 1.1361-1(l)(2)(iii)(B)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201038001 Third Party Communication: None
Release Date: 9/24/2010 Date of Communication: Not Applicable
Index Numbers: 1361.01-04, 1362.04-00
Person To Contact:
---------------------------- -----------------------, ID No. -------------------
---------------------------------------- ---------------------------------------------------
-------------------------------- Telephone Number:
------------------------------------ ---------------------
Refer Reply To:
CC:PSI:B03
PLR-100165-10
Date:
June 21, 2010

LEGEND

Company = ---------------------------------------------------------------------------------------------
------------------------

ESOP = ---------------------------------------------------------------------------------------------
--------------------------------------------------------------

Provision A = --------------------------

Provision B = -------------------------------

State = --------------

Date1 = ----------------------

Date2 = ----------------------

Date3 = ------------------

Date4 = --------------------------

Date5 = ----------------------

Dear --------------:

This letter responds to a letter dated December 28, 2009, and subsequent
correspondence, submitted on behalf of Company by its authorized representative,
requesting a ruling under § 1361(b)(1)(D) of the Internal Revenue Code.

PLR-100165-10 2

                                     FACTS

Company was incorporated in State on Date1. Company was taxed as a C corporation
from its incorporation until Date5. Company elected to be treated as an S corporation
effective Date5.

On Date2, while it was still taxed as a C corporation, Company adopted an employee
stock ownership plan, ESOP. On Date3, ESOP purchased a minority interest in
Company's stock (First Purchase Shares). Company has one class of common stock
outstanding and all shares have identical rights to distribution and liquidation proceeds.

On Date4, Company undertook a series of transactions that resulted in ESOP becoming
the sole owner of Company's outstanding stock. First, Company made a loan, secured
by Company stock, to ESOP (ESOP Loan). Next, ESOP used the ESOP Loan
proceeds to purchase all of the remaining outstanding shares of Company stock
(Second Purchase Shares).

Among its provisions, ESOP provides generally that benefits are distributed to
participants at stated periods of time following their termination of employment due to
retirement, disability, death, or other reason. Provision A of ESOP provides generally
that for purposes of distributions under the plan, the value of the shares held by ESOP
is determined by an independent appraiser. The independent appraiser calculates the
fair market value of ESOP’s assets and reduces that value by any liabilities of ESOP,
including the outstanding balance of the ESOP Loan.

Provision B of ESOP provides a special valuation rule with respect to First Purchase
Shares for purposes of distributions under the plan. Provision B provides that the value
of Company shares purchased in connection with the First Purchase Shares will not be
decreased or otherwise affected by the outstanding balance of the ESOP Loan
proceeds used to purchase the Second Purchase Shares.

Company represents that the purpose of Provision B is to protect the value of the First
Purchase Shares from a steep decline in value that is normally associated with a highly
leveraged employee stock ownership plan transaction. Company further represents
that a serious employee relations problem would have occurred if a voluntary corporate
action had the effect of reducing the value of First Purchase Shares already owned by
ESOP. This would have negatively impacted employees who were close to retirement
or who had previously terminated employment and were waiting for distributions.
According to Company, First Purchase Shares continue to fluctuate in value with the
fortunes of Company and general market conditions, as would occur in the absence of a
leveraged employee stock ownership plan transaction.

Company requests a ruling that Company will not be considered to have a second class
of stock in violation of § 1361(b)(1)(D) solely as a result of Provision B.

PLR-100165-10 3

                                LAW & ANALYSIS

Section 1361(b)(1)(D) provides that for purposes of subchapter S, the term "small
business corporation" means a domestic corporation which is not an ineligible
corporation and which does not have more than one class of stock.

Section 1.1361-1(l)(1) of the Income Tax Regulations provides that a corporation that
has more than one class of stock does not qualify as a small business corporation.
Except as provided in § 1.1361-1(l)(4) (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.

Section 1.1361-1(l)(2)(i) provides that 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 § 1361(b)(1)(D) and § 1.1361-1(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.

Section 1.1361-1(l)(2)(iii)(A) provides, in part, that 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 § 1361(b)(1)(D) and
§ 1.1361-1(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 fair market value of the stock
and, thus, are disregarded in determining whether the outstanding shares of stock
confer identical rights.

Section 1.1361-1(l)(2)(iii)(B) provides that 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

PLR-100165-10 4

§ 1.83-3(b)) is treated as outstanding under § 1.1361-1, 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.

Under ESOP's distribution provisions, Company's agreement to redeem First Purchase
Shares pursuant to the special valuation rule in Provision B is activated by a distribution
from ESOP. Under ESOP’s distribution provisions, plan participants are generally
entitled to receive a distribution of the participant’s vested balance attributable to
Company’s shares upon retirement, death, disability, or other reason for separation.
Under § 1.1361-1(l)(2)(iii)(B), agreements to redeem stock upon termination of
employment are disregarded. In disregarding agreements that provide for redemptions
upon termination of employment, § 1.1361-1(l)(2)(iii)(B), in effect, distinguishes between
redemption agreements for stock of employee shareholders and redemption
agreements for stock of investor shareholders.

In this case, the shareholders whose First Purchase Shares are redeemed through the
special valuation rule in Provision B are employee shareholders, rather than investor
shareholders. Though specifically referencing redemptions upon termination of
employment, as well as death, divorce, and disability, § 1.1361-1(l)(2)(iii)(B) also
anticipates that other types of bona fide agreements to redeem stock may be
disregarded by the Service. In addition, a redemption agreement is disregarded under
§ 1.1361-1(l)(2)(iii)(A) where the principal purpose of the agreement is not to avoid the
one class of stock requirement or when the agreement sets a purchase price that does
not greatly vary from the fair market value of the stock.

                                  CONCLUSIONS

Based on the facts submitted and representations made, we conclude that Provision B
will be disregarded in determining whether the outstanding shares of Company stock
confer identical rights. Therefore, for purposes of § 1361(b)(1)(D), Company will not be
considered as having more than one class of stock as a result of ESOP’s adopting
Provision B.

Except as specifically set forth above, we express or imply no opinion concerning the
federal tax consequences of the foregoing facts. Specifically, we express or imply no
opinion on whether Company otherwise qualifies as an S corporation under § 1361. In
addition, we express or imply no opinion on whether ESOP is qualified under § 401(a)
or whether the redemption of First Purchase Shares under Provision B may violate the
nondiscrimination requirements of § 401(a)(4).

Pursuant to a power of attorney on file with this office, a copy of this letter is being sent
to Company's authorized representatives.

PLR-100165-10 5

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                  Sincerely,

                                  /s/

                                  Leslie H. Finlow
                                  Senior Technician Reviewer, Branch 3
                                  Office of the Associate Chief Counsel
                                  (Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes

cc: