ESOP Appraisal Compliance Questions Highlight Agency Gray Areas

A longstanding vehicle for worker company ownership among retirement savers presents a wide range of compliance concerns for participants and employers, while federal agencies have let questions linger on how to properly appraise shares.

Recent litigation alleging the IRS “secretly” promulgated a “rule” that adds hurdles to the compliance process for employee stock ownership plans underscores a need for clear agency guidance, which both the IRS and Labor Department have stated is a priority, but haven’t yet addressed by issuing final rulemaking.

The DOL’s Employee Benefit Security Administration listed “worker ownership, readiness, and knowledge” on its spring 2024 regulatory agenda, as mandated by a SECURE 2.0 Act provision for DOL regulatory action on fair market valuation for ESOPs to clarify half-century-old gray areas in the text of the Employee Retirement Income Security Act.

“ESOPs can provide workers with a valuable retirement benefit and a financial stake in their company,” a DOL spokesperson said in an emailed statement. “To inform this rulemaking action, EBSA established a pre-rule outreach plan to broaden public participation and community engagement in the regulatory process.”

The SECURE 2.0 provision also requires EBSA to consult with the Treasury Department. The rulemaking process will also feature a comment period that provides “ample time” for feedback from stakeholders including employee-owned companies and advisory professionals.

Rulemaking Needed

The lawsuits filed in August against the IRS take aim at what they call the “Byers Rule,” alleging the agency violated the Administrative Procedure Act by imposing additional requirements for ESOP valuation without the proper notice and comment process.

IFL Capital Group founder Lex Byers has marketed a proprietary ESOP system to companies for nearly two decades, forming the plans for the S-Corporation owners who brought the two suits. More than 179 S-Corporation ESOPs have been formed through Byers’s work, using his pre-approved IRS documentation intended to comply with ERISA.

“Our case posits that the government has attempted to change—without Congressional authority and outside the purview of any public scrutiny—those well-established appraisal and appraiser rules specifically related to S-ESOPs,” said Joseph Dadich, the lawyer representing the S-Corps alleging the IRS violated the APA. “If there’s a perceived abuse, that’s up to Congress to make changes.”

The IRS has zeroed in on S-Corp ESOPs in a notice last year, highlighting “abusive transactions” involving those worker ownership structures and sending letters to certain S-Corp ESOP sponsors. The tax agency didn’t immediately respond to requests for comment.

“The IRS cautioned plan sponsors to be alert to compliance issues associated with ESOPs and the ESOP community freaked out, because any time the government is looking at ESOPs it’s terrifying,” said Allison Wilkerson, a partner at McDermott Will & Emery LLP.

The DOL has a track record of closely scrutinizing ESOPs as well. EBSA conducted more than 2,000 ESOP investigations between 2007 and 2017, according to data from the National Center for Employee Ownership.

Employee stock plan valuation issues alleged by the DOL have also occasionally spilled into open court, including in the US District Court for the District of Hawaii, where the agency alleged that the former owners of architectural firm Bowers + Kubota Consulting Inc. offloaded their stock to employees for the unfair price of $40 million. The architectural firm prevailed in 2021 following a trial, but litigation over attorneys’ fees for the case is ongoing.

Open Questions

ESOP valuation still technically follows ERISA’s statutory framework for appraising a plan’s stock based on fair market value “determined in good faith by a trustee,” which can be a thorny concept for lawyers and judges to grasp when litigating ESOP-related issues, according to Rick Pearl, a partner at Faegre Drinker Biddle & Reath LLP.

“‘Fair market value’ is a term of art that has a very specific meaning in the field of valuation,” he said. “Courts have commonly departed from those rules and it makes it very difficult for people in the ESOP community to understand what complies and what doesn’t comply.”

Working on his first ESOP-related cases, Pearl said he was “dumbfounded, confused, and frustrated” by the lack of guidance on appraisal and how a client should comply with the established standards.

EBSA last proposed new rulemaking on ESOPs in 1988, which was never finalized, leaving ESOP participants and appraisers without any update to best practices for valuation. Better defining the core concept of “adequate consideration,” which requires companies to secure a fair stock price for plan participants when establishing an ESOP, was a main focus of the proposed regulations.

“The Department of Labor has been more involved in this than the IRS. They’ve reached six different settlement agreements over the years and those have provided a lot more clarity about the process, the steps all the parties need to go through to make sure an initial valuation is acceptable,” said Loren Rodgers, executive director of the National Center for Employee Ownership. “So that’s helpful, I think, if we can turn those into new regulations.”

Since then ESOP transactions have continued on pace, as new companies establish plans while others sell to public companies or private equity firms, according to Rodgers.

If the Labor Department puts forth clear regulations, it could result in even more viable ESOP transactions and fewer exceptional cases, but there is also room for growth when it comes to public policy around employee ownership overall.

Progress Proves Elusive

Lawmakers like Sen. Bernie Sanders (I-Vt.) and Bill Cassidy (R-La.) have championed the cause of agencies prioritizing WORK Act provisions passed within SECURE 2.0, including ESOP reform and generally expanding access to employee ownership as a policy priority.

SECURE 2.0 included several provisions that impact larger groups of retirement savers than the ESOP community covers, according to Elizabeth Pancotti, director of special initiatives at the Roosevelt Institute, a former Sanders adviser and labor policy director of the US Senate Committee on Health, Education, Labor and Pensions.

“The attorneys I’ve spoken to who represent ESOP clients just want clarity, but there are certainly ESOP companies that have opinions on how strict it should be,” she said. “For the most part I think everybody just wants a rule written down.”

The Labor Department’s worker ownership center, also an outgrowth of a SECURE 2.0, was set up for EBSA to coordinate with stakeholders and other agencies. But inconsistencies between courts’ and agencies’ interpretations of ESOP appraisal gray areas persist.

“They already have case law that they’re operating under, but between district courts there’s a lot of variance,” Pancotti said. “District courts are not experts in ESOPs, whereas EBSA is a small but mighty dedicated office who really knows this stuff.”