18th Annual Ohio Employee
Ownership Conference
April 16, 2004, 10:30 am to 12:00 Noon
Akron/Fairlawn Hilton, Akron, Ohio
Employee Ownership Legal
Update
[Executive Summary]
Presented By:
David R. Johanson
Johanson Berenson LLP
707.226.8997
drj@esop-law.com
Joseph E. Marx
The Principal
Financial Group
877.262.4608
James G. Steiker
SES Advisors
866.316.ESOP(3767) x22
jim@sharedequity.com
marx.joseph@principal.com
Moderator: Ed Schmitt, Riesbeck Food Markets, Inc.
April 12, 2004
1
Significant Areas of
Attention During Past
Several Years
“S” Corporation Anti-Abuse Regulations
“Abusive” “S” Corporation ESOPs
“S” Corporation Distributions and IRAs
Sarbanes Oxley Act of 2002
The Jobs and Growth Tax Relief
Reconciliation Act of 2003
Proposed ADP/ACP Regulations
Scope of ESOP Fiduciary Duty
ESOP Loan Refinancing
Repayment of ESOP Loan
FASB Statement 150
Payment of Plan Expenses
Unanswered Questions
April 12, 2004
2
What We Have Learned
“S” Corporation Anti-Abuse
Regulations
Issued on July 21, 2003
 Extraordinarily broad definition of
“Synthetic Equity” includes
ordinary deferred compensation
 Normal “buy-sell” arrangements
among existing shareholders not
synthetic equity

April 12, 2004
3
What We Have Learned


Any right to receive compensation for
services performed for S corporation (or
certain related entities) that is deferred
beyond 2½ months after year in which
services are performed is considered
“synthetic equity”.
To determine synthetic equity
equivalent of non-qualified deferred
compensation, temporary regulations
provide that present value of deferred
compensation is converted into number
of shares of stock in corporation based
on fair market value of S corporation
shares on determination date, which
may be any date during plan year. This
calculation must be made on annual
basis.
April 12, 2004
4
What We Have Learned
By requiring a synthetic equity
calculation of non-qualified
deferred compensation on an
annual basis, a company could
unwittingly run afoul of Section
409(p) of IRC in year in which its
stock price suffers substantial
decline in value.
 Non-qualified deferred
compensation would equate to
much larger number of shares that
could push disqualified persons
over the 50% limit.

April 12, 2004
5
What We Have Learned
Regulations also emphasize that
right to acquire interests in
“related entity” is deemed to be
“synthetic equity”. An entity is
considered “related entity” if it is
only significant asset of S
corporation and S corporation is
only significant holder of stock of
“related entity”.
 “Synthetic equity” is counted only
if it would cause individual to be
“disqualified person”, or company
to have “nonallocation year”.

April 12, 2004
6
What We Have Learned



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Status of each individual tested without
regard to other individuals’ synthetic
equity holdings.
Regulations applicable for plan years
ending after October 20, 2003.
Section 409(p) of IRC was
grandfathered and is not applicable until
plan years ending after December 31,
2004, for S corporation ESOPs in effect
prior to March 14, 2001.
Regulations provide another
grandfathering rule which provides that
if any non-qualified deferred
compensation is paid out by July 21,
2004, it will not be treated as synthetic
equity for purposes of testing anti-abuse
provision.
April 12, 2004
7
What We Have Learned
“Abusive” “S” Corporation
ESOPs
On January 23, 2004, in Revenue
Ruling 2004-4, U.S. Treasury
Department and IRS issued
comprehensive ruling to shut
down certain identified abusive
transactions involving S
corporation ESOPs.
 Revenue Ruling 2004-4 also
makes these transactions “listed
transactions” for tax-shelter
disclosure purposes.

April 12, 2004
8
What We Have Learned
Benefit of “S” Corporation
ESOPs cannot accrue primarily to
shelter deferred executive
compensation
 IRS views “S” Corporation ESOPs
as potential tax shelters that can be
easily abused
 Apparently, compliant
arrangements at edge of line will
be attacked
 More than insubstantial benefits
must be provided to ESOP
participants

April 12, 2004
9
What We Have Learned
“S” Corporation Distributions and
IRAs



IRS will permit “S” Corporation stock
distribution to IRA and immediate sale
back to company w/o endangering “S”
Corporation Status
Revenue Procedure 2003-23
Requirements




April 12, 2004
ESOP participant elects to have stock
directly rolled over to IRA,
terms of ESOP require “S” Corporation to
immediately repurchase stock from IRA,
“S” Corporation actually repurchases stock
on same day as distribution, and
no income, loss, deduction or credit
attributable to “S” corporation stock is
attributed to IRA.
10
What We Have Learned
Structuring and Limiting
Warrants For Sub Debt in an S
Corporation
Lenders that agree to be
subordinated to company’s senior
lender usually demand much higher
interest rate on their loans. In
addition, to enhance their rate of
return on these loans, the sub debt
lender usually demands an “equity
kicker” for the extra risk they take.
Often, the equity kicker is in form of
warrant to buy stock for nominal
purchase price ($0.01).
April 12, 2004
11
What We Have Learned
Synthetic Equity and S
Corporation Single Class of
Stock
Use of warrant to enhance rate
of return creates two planning
challenges. First, structure must
not create second class of stock
for S corporation purposes.
Second, structure must be
designed to avoid IRC Section
409(p) excise tax.
April 12, 2004
12
What We Have Learned
Sarbanes Oxley Act
Corporate Governance for Private
Companies
 Public Companies going Private
 Blackout Notice Requirements
 Accelerated SEC Reporting
Requirements (Public Companies
Only)

April 12, 2004
13
What We Have Learned
The Jobs and Growth Tax Relief
Reconciliation Act of 2003





Reduced maximum income tax rate
imposed on long-term capital gains
Applies to dividends paid by most
domestic and foreign corporations
Exception for dividends described in
Section 404(k) & dividends distributed
from qualified retirement plans (e.g.
401(k) plans, IRAs, etc.)
These exceptions continue to be taxed
at ordinary income tax rates
Generally, applies to taxable years
beginning after December 31, 2002
April 12, 2004
14
What Have We Learned
Proposed ADP/ACP Treasury
Regulations
Issued July 17, 2003
 Under present law ESOPs are
required to be disaggregated
 Proposed regulations eliminate
required disaggregation for
purposes of ADP/ACP testing.
 Disaggregation still applies for
other nondiscrimination testing
 Effective no sooner than first plan
year beginning 12 months after
publication of final regulations

April 12, 2004
15
What We Have Learned
Scope of ESOP Fiduciary Duty
– the Case Law
No general affirmative duty to
diversify out of company stock
 Unclear whether company officers
or board members will be
considered fiduciaries
 Directed fiduciaries generally
exculpated unless following
instructions violates ERISA
 Empty head and pure heart still
not enough

April 12, 2004
16
What We Have Learned
Focus on process not taken under
time or third-party pressure
 Evolving law on duty of trustees
with inside information – conflict
between ERISA and SEC
 Duty to follow plan terms
 Duty to monitor actions of board
of directors
 Fiduciary status of independent
appraisers, financial advisors &
directed trustees

April 12, 2004
17
What We Have Learned
Existing case law generally
protective of ESOP fiduciaries
and directed fiduciaries
Post-Enron environment seems
more hostile; cases pending may
point the way in the future
April 12, 2004
18
What We Have Learned
ESOP Loan Refinancings
On September 26, 2002, U.S.
Department of Labor (the
“DOL”) released its first “Field
Assistance Bulletin” (“FAB”),
which addresses refinancing of
ESOP loans.
 The DOL announced that FABs
would be used in future to
publicize technical guidance that it
provides to its field enforcement
staff.

April 12, 2004
19
What We Have Learned
In FAB 2002-1 (the “FAB”), the
DOL addressed obligations of
plan fiduciary under Sections
404(a) and 408(b)(3) of Employee
Retirement Income Security Act
of 1974, as amended (“ERISA”),
when considering refinancing of an
ESOP’s existing securities
acquisition loan.
 DOL focuses on ensuring that
ESOP loan refinancings benefit
plan participants.

April 12, 2004
20
What We Have Learned
 Loan
extensions that delay
stock allocations while good
under traditional finance
theory (longer loans are better
for borrower) viewed as bad
for ESOP participants
because they reduce company
contributions
 Consider whether company
has contribution obligation
April 12, 2004
21
What We Have Learned
 The
FAB identifies various
inducements commonly
offered in ESOP loan
refinancings:
(1) “event protection” which means
that shares of company stock that are
held in the ESOP loan suspense
account longer than they would have
under terms of original loan may not
be sold and proceeds used to repay
outstanding portion of ESOP
refinanced loan if ESOP is
terminated;
April 12, 2004
22
What We Have Learned
(2) additional diversification rights to
ESOP participants;
(3) increased employer contribution
to either ESOP or another employer
plan; or
(4) payment of “dividend makewhole” to compensate ESOPs
participants and beneficiaries for
dividends to repay ESOP loan after
original maturity date of loan.
April 12, 2004
23
What We Have Learned
Repayment of ESOP Loan With
Proceeds of Sale of Company
Stock
Typically company stock
purchased with exempt loan serves
as collateral
 Even if unallocated company stock
is not collateral, the courts view is
that can still repay ESOP loan with
proceeds of sale of company stock
that was purchased

April 12, 2004
24
What We Have Learned
FASB 150
On May 15, 2003, the Financial
Accounting and Standards Board
(“FASB”) issued Statement No.
150
 Recently promulgated rules that
thought might apply to ESOP puts
 Liability vs. Equity
 Generally does not apply to ESOP
stock
 Future rules may change this result

April 12, 2004
25
What We Have Learned
Payment of Plan Expenses
Field Assistance Bulletin 2003-3
 IRS Revenue Ruling 2004-10
 Proper & Reasonable Expense
 What does the Plan Document &
SPD say?
 Individual vs. General Plan
Expenses
 Significant Detriment

April 12, 2004
26
Some Things We
Would Like to Know
Scope of Prohibited Transaction
Analysis when ESOP Acts as
Shareholder
EGTRRA Determination Letter
Applications
Effect of Cash Build-up on
ESOP Status
April 12, 2004
27
Some Things We
Would Like to Know
Boundaries on ESOP Loan
Terms and Effect on
Distributions
Diversification Time Frames
and Compliance with Statutory
Requirements
Segregation of Terminated
Participant Accounts
Rebalancing of Participant
Accounts
April 12, 2004
28