ESOPs in LLCs, Partnerships, PEOs, Professional Corporations, and Subsidiaries

Can a leasing company (also called a Professional Employer Organization, or PEO) have an ESOP for its employees?
A PEO employee working for a client organization (CO), known as a “worksite employee”, is often considered a common-law employee of the CO, as is the case for a worksite employee works full time at the CO, is under the CO’s control, and does work normally done by the CO’s employees. If a PEO’s defined contribution plan (such as an ESOP) covers worksite employees who are common-law employees of the COs where they work, the plan can be disqualified because it violates the exclusive benefit rule (which provides that the plan trust must be for the exclusive benefit of employees of the sponsoring company).
In Revenue Procedure 2002-21 (amplified in Revenue Procedure 2003-86), the IRS stated that to prevent disqualification, PEOs could either terminate their single-employer defined contribution plans or convert them to multiple employer plans. However, ESOPs cannot be multiple employer plans, so it is doubtful that a PEO can have an ESOP that covers worksite employees.
It appears that a PEO can have an ESOP covering only its back-office employees, but it is important to determine whether such a plan complies with the discrimination testing rules (see the question “Who must be included in the ESOP? What are the minimum ESOP participation rules?”).

Can a Limited Liability Company (LLC) have an ESOP or other qualified plan be an owner or issue stock options?
A Limited Liability Company is an entity sanctioned by most states that combines the attributes of a Subchapter S corporation and a partnership. Like an S corporation or a partnership, taxes are passed through to individual owners. Because LLCs do not have stock (they have membership interests or units), they cannot have ESOPs, stock options, or other stock-based plans. However, LLCs taxed as corporations can have an ESOP, as detailed in a separate question in this section.

Can a professional corporation have an ESOP or other broad ownership plan?
In general, state laws prohibit majority ownership of a professional corporation, except by a member of the profession, from being an owner of a professional corporation, and the ESOP trust is considered the owner of the ESOP’s shares. Minnesota, Virginia (except for medical practices and law firms), and North Carolina are exceptions. In Minnesota, if the trustee of the ESOP is from the relevant profession, that qualifies the plan. In Virginia, the trustee must be from that profession, employees cannot receive stock distributions, and non-professionals cannot get more than one-third the allocations in accounting firms and one-half in other firms.
In most states, accounting and some other firms can have ESOPs provided that the ESOP is trusteed by an accountant and owns less than 50% of the shares. See also the question “How can a professional corporation with an ESOP allowed on one state operate in a state where it is not allowed?”

Can an ESOP own stock if the parent firm is a foreign company?
Yes. If the ESOP is part of a U.S. incorporated firm, it can set up an ESOP for its U.S. employees that holds the stock of the foreign corporation parent.

Can an LLC that chooses to be taxed as corporation have an ESOP?
LLCs taxed as corporations do qualify for an ESOP. In PLR 201538021 (Sept. 18, 2015), the IRS ruled that an LLC that elects to be taxed as an S corporation can set up an ESOP. The LLC ownership is held as unit shares, not stock. All unit shares have the same rights to distributions, dividends, and liquidation proceeds. Under prior rules, some unit shares had different voting rights, but this will be amended so they all have the same rights. The IRS ruled that because the company has no common shares meeting the ordinary definition of eligible securities, its unit shares will qualify for this purpose.
Converting an LLC taxed as a partnership to an LLC taxed as a corporation can have adverse tax consequences under Section 351 of the Code, so consult with an attorney before making this change.

Can employees of a subsidiary of an LLC that chooses to be taxed as a corporation be in an ESOP?
In PLRs 200111053 and 199949046, the IRS ruled that employees of a subsidiary that is a limited liability company (LLC) but is not taxed as a corporation can participate in an ESOP. The rulings state that because the LLC is not taxed as a corporation, it is a “disregarded entity” and the LLC employees are considered part of the parent. These are private letter rulings, however, and while they provide guidance on how the IRS might act, they are not definitive.

How can a professional corporation with an ESOP allowed on one state operate in a state where it is not allowed?
Some companies that operate in multiple states, particularly engineering companies, find that in one state they can be ESOP owned and in another only members of the profession can be owners. In some of these states, if the trustee is a member of the profession, that will work. In others, companies may have to set up a one-person subsidiary whose employees are employees of the parent.
The issue is complex and various attorneys have come up worth varying solutions, so consult your advisors.

If a partnership chooses to be taxed as a corporation, can it have an ESOP?
It appears that it could, but the partnership would have to set up a subsidiary that had stock. A partnership interest would not be an employer security.

Is there any other way for a professional corporation to share ownership?
Professional corporations could provide “phantom stock” to employees, giving them a bonus based on the increase in equity value of the firm in periodic distributions. See the subhead “Phantom Stock” under “Alternatives to ESOPs” for more details.
Source: National Center for Employee Ownership (NCEO)

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