Hobbies and Games Inc. has had taxable income the last three years, but is break

Question

Hobbies and Games Inc. has had taxable income the last three years, but is breaking even this year. Sondra, the sole shareholder, has a $25,000 basis in her stock. After consulting with a local CPA, the corporation does the following:

a. Sets up an Employee Stock Ownership Plan (ESOP).

b. Contributes $40,000 to the ESOP, borrowed for the occasion from a local bank.

c. Deducts the $40,000 as a contribution to a qualified plan, thus creating a net operating loss of $40,000. The loss is carried back, resulting in a refund of taxes paid the last three years.

d. Permits all the ESOP to purchase 49 percent of Sondra’s stock; she reports a long-term capital gain of $27,750. (See IRS Letter Rulings 81477187 and 82222026)

Can all these transactions be executed under the rules applicable to employee stock ownership plans?

Explanation / Answer

Answer

An ESOP is a kind of employee benefit plan, similar to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible.

ESOPs are unique among benefit plans in their ability to borrow money. The ESOP borrows cash, which it uses to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible.

So following (a), (b) & (c) transactions are allowed.

a. Sets up an Employee Stock Ownership Plan (ESOP).

b. Contributes $40,000 to the ESOP, borrowed for the occasion from a local bank.

c. Deducts the $40,000 as a contribution to a qualified plan, thus creating a net operating loss of $40,000. The loss is carried back, resulting in a refund of taxes paid the last three years.

But there is one of rules as below the legal minimums required by law.

Vesting refers to the amount of time an employee must work before acquiring a non forfeitable entitlement to his or her benefit. Employees who leave the company before being fully vested will forfeit their benefits to the extent they are not vested in them. An ESOP must comply with one of the following two minimum schedules for vesting (plans may provide different standards if they are more generous to participants):

So considering above rules of vesting, following (d) transaction is not allowed.

d. Permits all the ESOP to purchase 49 percent of Sondra’s stock; she reports a long-term capital gain of $27,750.

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