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Generally, ESOP participants may demand that their distributions be paid in stock, but if the stock is not publicly traded, participants have the right to demand that the company purchase any employer stock distributed to them. The ESOP is not required to distribute stock if (a) the company is an S corporation or (b) a provision in its corporate charter or bylaws limits the ownership of stock to the ESOP (or another qualified plan) and employees of the company. In that case, the ESOP will make cash distributions (funded by employer contributions) to terminated participants or the company will re-purchase the shares simultaneously with their distribution. If the employer re-purchases the shares directly (instead of contributing to the ESOP), it will only have to re-purchase each ESOP share once, but the payments will not be tax deductible. When re-purchased stock remains in the plan, stock ownership inside the ESOP tends to concentrate in the accounts of shareholder and top management employees because they are typically long-term employees. Complexity and Cost. Unfortunately, ESOPs and ESOP transactions can be complicated and there are additional costs to adopt and maintain an ESOP, including engaging an independent trustee or other fiduciary and getting an annual appraisal. Unless the company and the amount involved in the transaction are large enough, the benefits may not justify the costs. S Corporation ESOP. An S Corporation may adopt an ESOP, but special rules prohibit contribution allocations to be made to any “disqualified person” (a participant who owns at least 10 percent of the ESOP shares) in any “non-allocation year,” in which at least 50 percent of the stock in the S corporation is owned by disqualified persons. As a result, it may never be possible to allocate shares to any disqualified persons. If that is a concern, it is essential to do a feasibility study before an S corporation adopts an ESOP or a C corporation with an ESOP makes an S election. On the positive side, there will be no tax on the corporation’s income passed through to the ESOP in its capacity as a stockholder. Non-Corporate Employer. Only corporate stock can be qualifying employer securities so limited liability company (LLC) or partnership interests would not qualify as employer securities for ESOP purposes. Nevertheless, an LLC can still establish an ESOP by forming a C corporation to which the LLC’s members will contribute their LLC interests in exchange for stock of the corporation, so the corporation becomes the LLC’s parent.
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