Ruling Finds That the Most Common Type of Price Protection Payment Cannot Be Treated as Qualified Plan Distribution
- Price protection agreements are designed to protect employee stock ownership plan (ESOP) participants from the transitory diminution in stock value that often follows a second-stage ESOP transaction.
- The IRS has ruled that when, as a result of a price protection agreement, an ESOP participant receives payment for distributed shares in excess of the shares' current fair market value, the excess amount must be treated as ordinary income from employment.
- As a result, the excess portion of the distribution cannot be rolled over to an IRA or another employer's plan, and employment taxes must withheld by the employer.
- The IRS describes an alternative approach to price protection that will permit favorable tax treatment, but the posited approach is unlikely to be feasible in most situations.
The IRS Office of Chief Counsel on Dec. 20, 2019, released a so-called Generic Legal Advice Memorandum (GLAM) that had been issued to Division Counsel within the IRS Tax Exempt and Government Entities Division. A GLAM is not binding authority and cannot be used or cited as precedent, but it does provide important insight as to how the IRS views a particular issue, as well as how that issue is likely to be analyzed by an IRS auditor.
In GLAM 2019-003, the Office of Chief Counsel provided advice with respect to "Price Protection Agreements," which it describes as agreements entered into between an employee stock ownership plan (ESOP) trustee and the sponsoring employer in order to provide additional payments to ESOP participants during a fixed period of time following a loan incurred by the employer in order to fund an existing ESOP's purchase of additional shares (sometimes referred to as a "second-stage" ESOP transaction). Because the additional debt taken on by the employer in order to finance the ESOP's second-stage stock purchase will negatively impact the value of the ESOP's existing shares, the Price Protection Agreement serves to underpin the value of the ESOP accounts of participants receiving distributions while the acquisition debt remains outstanding.
Operation of the Price Protection Agreement
The GLAM describes a fairly typical Price Protection Agreement – pursuant to which a participant who receives a distribution from his ESOP account upon separation from service by reason of attainment of normal retirement age, death or disability – will receive payment based upon the value of the shares allocated to his account determined without regard to the impact of the outstanding employer indebtedness incurred to finance the ESOP's second-stage stock purchase. The GLAM then describes two different methodologies that could be used by an employer to deliver the price protected amount (i.e., the difference between the current fair market value of the shares allocated to the participant's account and the value created by the Price Protection Agreement).
Under the first approach, the ESOP distributes the allocated shares to the participant, who then puts the shares to the employer for payment. The employer repurchases the shares from the participant at the price protected value. Under the second approach, the employer makes a special contribution, referred to as a "qualified non-elective contribution" (QNEC), to be allocated to the separated participant's ESOP account. This special contribution, equal to the difference between the price protected value and the current fair market value of the shares allocated to the participant's ESOP account, is then distributed to the participant directly from the ESOP.
The Issue Presented
Chief Counsel was asked to opine whether, under each of the payment approaches described above, the incremental portion of the payment received by the participant pursuant to the Price Protection Agreement would be treated as a qualified plan distribution and also as an eligible rollover distribution permitting the participant to defer current taxation by rolling the payment over to another employer's qualified plan or to an IRA.
As to the first approach, whereby the employer repurchases the distributed shares from the participant at the price protected value, Chief Counsel opined that the price protection element of the payment did not constitute a qualified plan distribution because it did not represent a component of the current fair market value of the participant's ESOP account. As a result, the incremental portion of the payment would be subject to current taxation as income from employment (meaning that the payment would be subject to income and employment tax withholding), and could not be rolled over to an IRA or another employer's plan.
Chief Counsel ruled, however, that the second approach, whereby the employer makes a special contribution of the price protection element to the account of the separated participant, would permit treatment of the entire distributed amount as a qualified plan distribution and an eligible rollover distribution. This is because the price protected amount would become, by means of the special employer contribution, a component of the participant's ESOP account before it was distributed by the ESOP to the participant.
Observations and Takeaways
It is our experience that, in most cases, Price Protection Agreements have been implemented by means of the first approach described in the GLAM (i.e., the shares are distributed by the ESOP to the participants, followed by the purchase of those shares by the employer at the price protected value). Many employers and practitioners have been comfortable in concluding that the Price Protection Agreement creates an element of value with respect to the put rights accorded to ESOP participants under the Internal Revenue Code and IRS regulations, and that payments received by participants pursuant to the exercise of those put rights are properly treated as qualified plan distributions.
The position stated by the IRS in the GLAM will make price protection payments less valuable to ESOP participants. Not only will such payments be subject to current taxation with no rollover opportunity, they will also be subject to employment taxes from which qualified plan distributions are exempt. The GLAM will also create communication and compliance challenges for both employers and participants. From a reporting perspective, the employer will need to issue both a Form 1099-R and a Form W-2 with respect to the payment made for the repurchased shares (with appropriate tax withholding for the latter), and participants – who likely have little or no understanding of the complexities of a Price Protection Agreement – will unexpectedly be in receipt of employment income from an employer with whom they are no longer associated.
The approach approved by the GLAM, whereby the employer makes a special contribution to the account of the price protected participant, is unlikely to be feasible in most cases. This is because the allocation of an employer contribution to the account of a qualified plan participant is subject to the limitations of Section 415 of the Internal Revenue Code. That provision states that so-called annual allocations to a participant's defined contribution plan accounts are limited to the lesser of $56,000 (an indexed amount) or 100 percent of the participant's compensation from the employer for the year. Unless the price protection contribution is made to the participant's account during a year in which he is still employed by the employer, which will not often be the case, the participant's Section 415 limit will be $0, thus precluding any employer contribution to fund the price protection value element. Moreover, such contributions, if they can be made, will be subject to the non-discrimination rules generally applicable to employer contributions to qualified plans. To the extent that price protection contributions might, in a particular year, be skewed in favor of highly compensated employees (former employees who were highly compensated employees when they separated from service generally retain that status after termination of employment), it may not be possible to make targeted contribution allocations to price protected participants without violating the applicable non-discrimination rules.
In sum, the positions taken in the GLAM reduce the value to ESOP participants and increase the complexity of a widely used approach to the implementation of Price Protection Agreements, and offer in lieu thereof a supposed solution that is unlikely to be feasible in the great majority of situations.