IRS Approves Amendment to ESOP to Provide Minimum Annual Allocation From CRT Suspense Account

IRS Approves Amendment to ESOP to Provide Minimum Annual Allocation From CRT Suspense Account

Article posted in Charitable Remainder Trust on 16 December 2014| comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 16 December 2014


An interesting confluence of CRT and ESOP presented by Richard Fox.

by Richard L. Fox, Esq.

Background on Transferring Remainder Interest in CRT to ESOP

IRC § 664(d) was amended by the Taxpayer Relief Act of 1997 to provide that, to the extent the remainder interest of a charitable remainder trust (CRT) is in “qualified employer securities,” upon the termination of the CRT, all or part of these securities may be transferred to an employee stock ownership plan (ESOP ) in a “qualified gratuitous transfer.”   A distribution of such securities to an ESOP would, therefore, be in lieu of the normal distribution regime upon the termination of a CRT, whereby the remainder interest passes to one or more designated charitable organizations. In providing for the amendment to IRC § 664(d) to allow a CRT to make a distribution upon its termination to an ESOP, the House Committee Report stated that the “Committee believes it is appropriate to encourage transfers of stock to an ESOP ” and that the bill “permits certain limited transfers of qualified employer securities by CRTs to ESOPs  without adversely affecting the status of the CRT under Code section 664.” The term “limited transfers” in the preceding sentence is certainly the case because a “qualified gratuitous transfer” is defined so narrowly that one could reasonably conclude that it was drafted only with certain specified transfers in mind as, in addition to a number of other requirements imposed thereunder, a “qualified gratuitous transfer” will only occur under IRC § 664(g) if the following factors apply:

  • The securities were transferred to the CRT from a decedent dying before January 1, 1999.
  • The ESOP  was in existence on August 1, 1996.
  • Immediately after the transfer, the ESOP  owns at least 60% of the value of the stock of the corporation.
  • At the time of the transfer to the ESOP , the decedent and members of his or her family own no more than 10% of the value of the outstanding stock of the company, directly or indirectly.
  • The ESOP  provides that, if it is terminated before all the transferred stock has been allocated, the remaining stock is to be transferred to one or more charitable organizations.

Proposed Amendment to ESOP Permitted Under Ltr. Rul. 201442067 to Provide Minimum Annual Allocation From CRT Suspense Account

In Ltr. Rul. 201442067, the ESOP apparently received a distribution from a CRT of “qualified employer securities” in a “qualified gratuitous transfer,” where, among other requirements, the securities were transferred to the CRT from a decedent dying before January 1, 1999 (here the decedent died in 1988) and the ESOP was in existence on August 1, 1996 (here the ESOP was established in 1962).   In accordance with IRC § 664(g)(3) and (7), Section 7.19 of Article VII of the plan provided that for each plan year, the number of shares allocated from the CRT “suspense account” (which is required to be maintained under IRC § 664(g)(3)(E)), to eligible participants have a fair market value equal to the lesser of (i) 25 percent of the participant's IRC § 415 compensation for such plan year, or (ii) $30,000, as adjusted for increases in the cost of living.  The issue in the ruling was whether Section 7.19 of Article VII of the plan could be amended to provide for a minimum amount to be released from the CRT Suspense Account each year, rather than the amount specified in IRC § 664(g)(3) and (7).  Specifically, the plan would be amended:

“to provide that for each plan year, the total amount of shares allocated from the CRT Suspense Account will be determined by the Board of Directors of Company C in a written resolution based upon the fair market value of the shares. Amended Section 7.19 further provides that the annual release formula from the CRT Suspense Account must be at least equal to the greater of 7.5 percent of the aggregate of all eligible Plan X participants' compensation for the plan year as determined under Code section 415, or the amount needed so that on a rolling five-year basis (including the current plan year and the prior four plan years), the average annual allocation from the CRT Suspense Account is at least 10 percent of the aggregate eligible Plan participants' compensation. However, the amount released each year, as determined by the Board of Directors, will be limited by the application of section 664(g)(7) of the Code.

The IRS determined that  in light of the narrow application of the  IRC § 664(g) requirements, “it is not unreasonable to treat the allocation amount set forth in sections 664(g)(3)(E) and (7) as the maximum amount that may be allocated, rather than the amount required to be allocated.” As a result of this determination, the IRS concluded that, to ensure the yearly release of shares from the CRT Suspense Account, it is reasonable for the plan to have a provision that establishes a minimum amount that must be released from the suspense account every plan year, such as the one proposed by company in the private letter ruling request.

Planning Point: IRC § 1042 Sale Followed by Contribution of Qualified Replacement Property to Charitable Remainder Trust

Under IRC § 1042, a taxpayer having purchased “qualified replacement property” following a tax-free sale of employer securities to an ESOP will recognize capital gain on the sale of the qualified replacement property. Therefore, although the sale to the ESOP is tax-free, any subsequent sale of the qualified replacement property is subject to tax. Such property may, however, be transferred to a CRT without the recognition of capital gain.[1] The property may, thereafter, be sold by the CRT on a tax-free basis, making a CRT a very effective method of effectuating the sale of a closely held business in conjunction with an ESOP (sometimes referred to as “the charitable ESOP”).  Although, given its narrow application, it is unlikely that an ESOP will qualify as a remainder beneficiary, “qualified replacement property” acquired with sales proceeds in connection with the sale of stock to an ESOP under IRC § 1042 can be used to fund a CRT. The IRS has also ruled that a CRT may sell stock to an ESOP  in which a “disqualified person” has an interest without triggering the self-dealing rules under IRC § 4941.[2]

[1] See Etkind, “ESOPs Create Liquidity for Shareholders and Help Diversify Their Assets,” 25 Est. Plan. 158 (May 1998); see also Ltr. Ruls. 9234023, 9438012, 9438002, 9515002, 9547022.

[2] Ltr. Rul. 9542040; see Rev. Rul. 81-76, 1981-1 CB 516.

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