Cases & Rulings on

HIGHLIGHTS:

● Valuation Firm Must Pay Fiduciary

Insurer ● World Travel Lawsuit Settled ● Deadline for Plan Amendments

Extended ● DOD Issues Guidance on Pilot

Program for 100% ESOP Contractors Participation in the pilot program is subject to the following limitations: ● Only DOD Contracting Officers may submit an application to participate in the pilot program. ● To receive an award under the pilot program, the qualified business must have a minimum performance rating of Satisfactory (or the equivalent) for the predecessor contract in the

Contractor Performance Assessment

Reporting System (see Federal

Acquisition Regulation (FAR) Subpart 42.15, Contractor Performance

Information, page 2 of 3). ● Submissions will be accepted until

April 28, 2023, or until the DOD approves nine contracts for award under the pilot program. ● Any follow-on contracts awarded without providing for full and open competition under FAR 6.302-5 and this pilot authority shall be awarded no later than August 31, 2023. ● A qualified business will be limited to a single opportunity for the award of a sole source follow-on contract. ● Not more than 50% of the amount paid under the follow-on contract may be expended on subcontracts.

The Employee-Owned Contractors Roundtable (ECR), a group of 100% ESOP federal contractors, has led the effort in advancing this pilot program and other provisions targeted at promoting ESOP federal contractors. ECR members are expected to work in the new Congress to further perfect the pilot and are in active conversations with the DOD and Capitol Hill. For more information on ECR and Sec., 874, please email Matt Pearce. n

Stout Risius Must Pay Fiduciary Insurer: In Great American Fidelity Insurance Company v. Stout Risius Ross, Inc. et al., No. 2:19-cv-11294 (E.D. Mi, Nov. 1, 2022), a district court ruled the ESOP valuation firm Stout Risius must pay $60,000 in costs the company argued should have been covered by its insurer, Great American Fidelity Insurance Company. Great American had claimed it did not have to defend or indemnify the ESOP appraisal firm Stout Risius Ross over allegations about its valuation work for Appvion, an ESOP company that went bankrupt. All the federal claims under ERISA have been dismissed in the case, but state securities laws claims are still being litigated. Great American claims it is not liable because of an exclusion clause it claims exempts it if the defendant can be shown to have violated ERISA or securities laws.

The court found that Great American had failed to carry its burden of showing as a matter of law that an exclusion in its agreement “applied to at least two of the underlying claims in the Appvion ESOP action because they were statelaw tort claims, and to at least two of the underlying claims in the Appvion Trust action because they were bankruptcy claims.” However, the court approved an amended motion saying it was not required to defend Stout Risius Ross over securities law claims.

World Travel Lawsuit Settled: In Ahrendsen, et al. v. Prudent Fiduciary Services, LLC, et al., No. 2:21-cv-02157 (E.D., PA, Nov. 7, 2022), the plaintiffs agreed to settle a lawsuit in dispute over the company’s ESOP valuation. An ESOP bought World Travel from members of the Wells family in 2017 for $200 million. Plaintiffs alleged the plan overpaid because of faulty projections, including not accounting for liabilities for potential refunds of commissions to its clients, improper discount rates, and using the wrong discount rates. The plaintiffs also alleged that the ESOP paid for control it did not have because the sellers retained board control.

IRS Extends Deadlines for Certain Plan Amendments: In IRS Notice

2022-45, the IRS extended plan amendment deadlines for compliance with two recent laws. These include: ● Section 2022 of the CARES Act, which provided for COVID-related distributions, increased loan amounts, and delayed loan repayments. ● Section 302 of the Disaster Act, which provided favorable tax treatment for certain disaster-related loans or distributions.

Amendments for these CARES Act and Disaster Act provisions had been required by the end of the 2022 plan year. The notice also clarifies that CARES Act and Disaster Act amendments adopted before the new December 31, 2025, deadline will not cause the plan to fail to satisfy anti-cutback requirements.

Guidance Issued on New Department of Defense ESOP Pilot Contract Preference Program

The most recent National Defense Authorization Act created a pilot program, known as Sec. 874, that allows the DOD to award certain follow-on contracts without initiating a competitive process to an employee-owned business that meets the definition of a “qualified business.”

In an undated memo issued in November, the department provided guidelines under the program. The memo stated that “contracting officers supporting a program selected for participation in the pilot will be able to award a follow-on contract for the continued development, production, or provision of products or services that are the same or substantially similar to those procured by DOD under a previous contract with a ‘qualified business’ under the authority of § 3201(c)(5).” Correction

In the last issue, in the discussion of the case Best et al v. James, we said that a new inexperienced trustee, Steven James, was appointed in the case. We should have said plaintiffs alleged that. Mr. James in fact very experienced in this field. Our apologies for the error.

2023 Plan Limits Announced

In Notice 2022-55 (October 21, 2022), the IRS announced the largest increase in annual limits for retirement plans in many years. The new limits applicable to ESOP companies are in the table at right. A more detailed summary of all the plan limits is available on the IRS website.

The new plan limits mean employees and employers can contribute more to their defined contribution plans. The total contributions are still limited, however, to 25% of eligible payroll (the payroll of those in the plan making $330,000 or less in 2023). The highly compensated and key employee definitions are used for 401(k) testing and top-heavy plan testing purposes, while the five-year distribution limits allow companies to extend a normal five-year ESOP distribution for additional years if the distributable amount exceeds (in 2023) $1.33 million and the annual installment payment exceeds $265,000. SBA Says Main Street Employee Ownership Act Has Not Produced Many ESOP Loans

The 2018 Main Street Employee Ownership Act was intended to spur lending from the Small Business Administration for ESOP transactions. While the law seemed very clear that ESOPs should be included in the SBA’s 7(a) lending program (a program that allows borrowers to get loans through SBA-approved lenders rather than having to navigate the more cumbersome process of going to the SBA directly), SBA guidance on the act excluded ESOPs from the 7(a) program, as well as adding other requirements New Annual Limits for Retirement Plans 2022

2023 Maximum elective deferral to 401(k) plan $20,500 $22,500 Catch-up contribution for those 50 and older $6,500 $7,500 Annual addition limit (employer plus employee contributions) for all defined contribution plans $61,000 $66,000 Definition of highly compensated employee $135,000 $150,000 Definition of key employee for top-heavy plan testing $200,00 $215,000 Annual eligible compensation limit $305,000 $330,000 Five-year distribution limit for ESOPs $1,230,000 $1,330,000 Annual distribution dollar amount to determine five-year ESOP distribution limit $245,000 $265,000

for equity in the deal and a separate valuation, that have made the law cumbersome at best.

In a September 26, 2022, proposed rules change affecting non-ESOP transactions, the SBA reports that “over the past 4 completed fiscal years (FY 2018 through FY 2021), SBA processed a total of 206,415 7(a) loans, of which 31,940 loans (approximately 15.5%) included loan proceeds used to affect a change of ownership. ESOP loans (loans to assist an ESOP trust in acquiring 51 percent or more of the equity ownership in the small business concern) accounted for only 17 loans in the four years between FY 2018 and FY 2021, or fewer than five loans per year, and therefore ESOP loans have not made the anticipated impact in transitioning small businesses to employee ownership as originally intended by the Agency.” The language “as originally intended by the Agency” is ironic, of course, because while Congress intended the program to spur ESOP lending, SBA regulations had the opposite effect. Comments on the proposed changes can be made through December 27. While the changes do not affect ESOPs, because they are mentioned in the proposal, it would still be appropriate to comment. New Morgan Stanley Survey Shows HR Leaders and Employees See Equity Compensation as the Best Way to Engage Employees

A new financial wellness study from Morgan Stanley of 1,000 U.S. employed adults and 600 HR executives found that 95% of HR leaders (up from 92%) and 80% of employees (up from 75%) agree that equity compensation and stock ownership are the most effective ways for companies to keep employees motivated and engaged.

The survey report, The State of the Workplace Financial Benefits, comes from a survey of 1,000 U.S. employed adults and 600 HR executives. n

MEMBER TIP NCEO Document Library Has Essential Legal Documents for Any ESOP

You can save a lot of money—and learn best practices—on a variety of legal issues in our document library. The library covers a broad range of issues, including legal concerns. Documents include:

● A sample board charter and committee charters ● Voting documentation ● A fiduciary workbook ● Sample board letters in response to acquisition offers ● Sample ESOP administrative committee charter ● Sample trustee and appraisal checklists ● Sample CEO assessment surveys

All of these documents are available at no cost to NCEO members. n

Our new ESOP client says that the valuation date should be the date the valuation is completed. The plan year ends 12/31 and the valuation is done as of that date, with any distributions that occur prior to a new valuation priced at the most recently completed valuation. What is correct?

As lawyers often say, the answer is, “It depends,” although it would be odd to have the valuation date defined as when the appraisal is completed (and even then it should be when the trustee approves it, because it could be completed but then changed). Plans have specific valuation dates, not a movable target such as when the valuation is approved.

A key issue is what the plan requires and, if applicable, allows. If the plan says that all distributions occur as of the most recent valuation, then that is the one you use absent some special circumstances and only then if the plan allows for a significant change in economic circumstances. During the pandemic, we asked a number of experts about this, and they agreed that having an interim valuation is possible and supportable under court decisions if it is likely the stock price has significantly declined. The same argument could be made if there is reason to think the price should be a lot higher (if the company acquired a very large new customer, for instance). Some advisors suggest it is possibly even required as a prudent exercise.

If you do decide to have an interim valuation, one suggested approach is for the board of directors to amend the plan document (unless it already provides for this) to allow for an interim valuation to be done by the trustee. The board might also consider amending the plan to require an interim valuation, so that this is not an exercise of fiduciary decision, and less subject to challenge under ERISA.

Of course, all this is still tricky because the new appraisal takes time and things can change even more. That is why many advisors would say that using the valuation date specified in the plan should be the rule absent some major change. It is also important to understand that if a company does this, for instance, because it thinks its stock price is too high under the existing valuation, but then does not do it for the opposite circumstance, this course of action could be cause for litigation.

There are new tax credits for energy efficiency investments. As a 100% ESOP S corporation, can we get these credits? 100% ESOPs can get tax credits only if they are against payroll, so these credits are not useful.

Is there a required minimum mandatory annual contribution to an ESOP? There is no legally required minimum contribution to an ESOP, although if you are paying off a loan, of course, there is a required payment on that. If you stop making contributions to an ESOP for a few years (or any other ERISA plan), the plan can be considered terminated, however.

We have an ESOP where the seller chose the tax deferral option under Section 1042 of the Code. We have a 401(k) where we match employee deferrals with stock from the ESOP as the loan is repaid. Because we cannot reallocate shares to the seller or members of his family, can we instead make their matching contributions in cash? That is not allowable under Code Section 409(n) and could create an excise tax for the company. 409(n) is the Code section that prohibits reallocation, but it also prohibits any make-up allocations in other forms such as the one suggested here. The problem, of course, is that not making the match then violates the 401(k) rules. You would be better off making the match in cash and keeping the ESOP separate. If that is not affordable, you may need to drop the match while the reallocation period still applies.

We have an equity investor who may be interested in taking a stake in our 100% ESOP-owned company. But if we give the investor stock in return for the cash, we will end up about 70% ESOP-owned and have to make very large distributions to the ESOP so that the investors can get a distribution to pay taxes. Are there alternatives? There are a couple of possibilities to solve this problem. The investor could take warrants instead of shares. This gives the investor the chance to buy the right to a certain number shares for some years into the future at the price at the time of the investment. The investor would cash in the right at a future point if the share price goes up. The company remains 100% ESOP-owned at all times. A second option is to use the investment for a specific project and create a drawn-down entity that is owned by the parent but that the investor has a stake in.

We are moving to internal trustees. One option we are considering is having one or two employees sit in on trustee meetings but not be trustees. They would cycle onto the committee when current people leave in the future. Do they have any fiduciary liability? They would not. This is a very useful approach if you have enough interested people. It gives the incoming trustees a chance to learn the ropes without having to make decisions. A key issue is whether enough people want to do this. It does require significant time, and the employees should get some form of training (attending conferences, for instance). But it also means more people in the company will really understand the ESOP and be able to help explain it to their colleagues. n

Have a question about ESOPs? We welcome you to contact us by phone or email. We also maintain the online ESOP Q&A, an important member benefit containing answers to over 700 common—and not so common— questions about all aspects of ESOPs. You can browse by category or search for a topic.