[Code of Federal Regulations]
[Title 26, Volume 17]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR54.4975-7]

[Page 262-267]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 54_PENSION EXCISE TAXES--Table of Contents
 
Sec. 54.4975-7  Other statutory exemptions.

    (a) [Reserved]
    (b) Loans to employee stock ownership plans--(1) Definitions. When 
used in this

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paragraph (b) and Sec. 54.4975-11, the terms listed below have the 
following meanings:
    (i) ESOP. The term ``ESOP'' refers to an employee stock ownership 
plan that meets the requirements of section 4975(e)(7) and Sec. 
54.4975-11. It is not synonymous with ``stock bonus plan.'' A stock 
bonus plan must, however, be an ESOP to engage in an exempt loan. The 
qualification of an ESOP under section 401(a) and Sec. 54.4975-11 will 
not be adversely affected merely because it engages in a non-exempt 
loan.
    (ii) Loan. The term ``loan'' refers to a loan made to an ESOP by a 
disqualified person or a loan to an ESOP which is guaranteed by a 
disqualified person. It includes a direct loan of cash, a purchase-money 
transaction, and an assumption of the obligation of an ESOP, 
``Guarantee'' includes an unsecured guarantee and the use of assets of a 
disqualified person as collateral for a loan, even though the use of 
assets may not be a guarantee under applicable state law. An amendment 
of a loan in order to qualify as an exempt loan is not a refinancing of 
the loan or the making of another loan.
    (iii) Exempt loan. The term ``exempt loan'' refers to a loan that 
satisfies the provisions of this paragraph (b). A ``nonexempt loan'' is 
one that fails to satisfy such provisions.
    (iv) Publicly traded. The term ``publicly traded'' refers to a 
security that is listed on a national securities exchange registered 
under section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f) 
or that is quoted on a system sponsored by a national securities 
association registered under section 15A(b) of the Securities Exchange 
Act (15 U.S.C. 78o).
    (v) Qualifying employer security. The term ``qualifying employer 
security'' refers to a security described in Sec. 54.4975-12.
    (2) Statutory exemption--(i) Scope. Section 4975(d)(3) provides an 
exemption from the excise tax imposed under section 4975 (a) and (b) by 
reason of section 4975(c)(1) (A) through (E). Section 4975(d)(3) does 
not provide an exemption from the imposition of such tax by reason of 
section 4975(c)(1)(F), relating to fiduciaries receiving consideration 
for their own personal account from any party dealing with a plan in 
connection with a transaction involving the income or assets of the 
plan.
    (ii) Special scrutiny of transaction. The exemption under section 
4975(d)(3) includes within its scope certain transaction in which the 
potential for self-dealing by fiduciaries exists and in which the 
interests of fiduciaries may conflict with the interests of 
participants. To guard against those potential abuses, the Internal 
Revenue Service will subject these transactions to special scrutiny to 
ensure that they are primarily for the benefit of participants and their 
beneficiaries. Although the transactions need not be arranged and 
approved by an independent fiduciary, fiduciaries are cautioned to 
exercise scrupulously their discretion in approving them. For example, 
fiduciaries should be prepared to demonstrate compliance with the net 
effect test and the arm's-length standard under paragraph (b)(3)(ii) and 
(iii) of this section. Also, fiduciaries should determine that the 
transaction is truly arranged primarily in the interest of participants 
and their beneficiaries rather than, for example, in the interest of 
certain selling shareholders.
    (3) Primary benefit requirement--(i) In general. An exempt loan must 
be primarily for the benefit of the ESOP participants and their 
beneficiaries. All the surrounding facts and circumstances, including 
those described in paragraph (b) (3) (ii) and (iii) of this section, 
will be considered in determining whether the loan satisfies this 
requirement. However, no loan will satisfy the requirement unless it 
satisfies the requirements of paragraph (b) (4), (5), and (6) of this 
section.
    (ii) Net effect on plan assets. At the time that a loan is made, the 
interest rate for the loan and the price of securities to be acquired 
with the loan proceeds should not be such that plan assets might be 
drained off.
    (iii) Arm's-length standard. The terms of a loan, whether or not 
between independent parties, must, at the same time the loan is made, be 
at least as favorable to the ESOP as the terms of a comparable loan 
resulting from arm's-length negotiations between independent parties.

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    (4) Use of loan proceeds. The proceeds of an exempt loan must be 
used within a reasonable time after their receipt by the borrowing ESOP 
only for any or all of the following purposes:
    (i) To acquire qualifying employer securities.
    (ii) To repay such loan.
    (iii) To repay a prior exempt loan. A new loan, the proceeds of 
which are so used, must satisfy the provisions of this paragraph (b).

Except as provided in paragraph (b) (9) and (10) of this section or as 
otherwise required by applicable law, no security acquired with the 
proceeds of an exempt loan may be subject to a put, call, or other 
option, or buy-sell or similar arrangement while held by and when 
distributed from a plan, whether or not the plan is then an ESOP.
    (5) Liability and collateral of ESOP for loan. An exempt loan must 
be without recourse against the ESOP. Furthermore, the only assets of 
the ESOP that may be given as collateral on an exempt loan are 
qualifying employer securities of two classes: those acquired with the 
proceeds of the loan and those that were used as collateral on a prior 
exempt loan repaid with the proceeds of the current exempt loan. No 
person entitled to payment under the exempt loan shall have any right to 
assets of the ESOP other than:
    (i) Collateral given for the loan,
    (ii) Contributions (other than contributions of employers 
securities) that are made under an ESOP to meet its obligations under 
the loan, and
    (iii) Earnings attributable to such collateral and the investment of 
such contributions.

The payments made with respect to an exempt loan by the ESOP during a 
plan year must not exceed an amount equal to the sum of such 
contributions and earnings received during or prior to the year less 
such payments in prior years. Such contributions and earnings must be 
accounted for separately in the books of account of the ESOP until the 
loan is repaid.
    (6) Default. In the event of default upon an exempt loan, the value 
of plan assets transferred in satisfaction of the loan must not exceed 
the amount of default. If the lender is a disqualified person, a loan 
must provide for a transfer of plan assets upon default only upon and to 
the extent of the failure of the plan to meet the payment schedule of 
the loan. For purposes of this subparagraph (6), the making of a 
guarantee does not make a person a lender.
    (7) Reasonable rate of interest. The interest rate of a loan must 
not be in excess of a reasonable rate of interest. All relevant factors 
will be considered in determining a reasonable rate of interest, 
including the amount and duration of the loan, the security and 
guarantee (if any) involved, the credit standing of the ESOP and the 
guarantor (if any), and the interest rate prevailing for comparable 
loans. When these factors are considered, a variable interest rate may 
be reasonable.
    (8) Release from encumbrance--(i) General rule. In general, an 
exempt loan must provide for the release from encumbrance under this 
subdivision (i) of plan assets used as collateral for the loan. For each 
plan year during the duration of the loan, the number of securities 
released must equal the number of encumbered securities held immediately 
before release for the current plan year multiplied by a fraction. The 
numerator of the fraction is the amount of principal and interest paid 
for the year. The denominator of the fraction is the sum of the 
numerator plus the principal and interest to be paid for all future 
years. See Sec. 54.4975-7(b) (8) (iv). The number of future years under 
the loan must be definitely ascertainable and must be determined without 
taking into account any possible extensions or renewal periods. If the 
interest rate under the loan is variable, the interest to be paid in 
future years must be computed by using the interest rate applicable as 
of the end of the plan year. If collateral includes more than one class 
of securities, the number of securities of each class to be released for 
a plan year must be determined by applying the same fraction to each 
class.
    (ii) Special rule. A loan will not fail to be exempt merely because 
the number of securities to be released from encumbrance is determined 
solely with reference to principal payments. However, if release is 
determined with reference to principal payments only, the following 
three additional rules apply.

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The first rule is that the loan must provide for annual payments of 
principal and interest at a cumulative rate that is not less rapid at 
any time than level annual payments of such amounts for 10 years. The 
second rule is that interest included in any payment is disregarded only 
to the extent that it would be determined to be interest under standard 
loan amoritization tables. The third rule is that this subdivision, (ii) 
is not applicable from the time that, by reason of a renewal, extension, 
or refinancing, the sum of the expired duration of the exempt loan, the 
renewal period, the extension period, and the duration of a new exempt 
loan exceeds 10 years.
    (iii) Caution against plan disqualification. Under an exempt loan, 
the number of securities released from encumbrance may vary from year to 
year. The release of securities depends upon certain employer 
contributions and earnings under the ESOP. Under Sec. 54.4975-11(d)(2) 
actual allocations to participants' accounts are based upon assets 
withdrawn from the suspense account. Nevertheless, for purposes of 
applying the limitations under section 415 to these allocations, under 
Sec. 54.4975-11(a)(8)(ii) contributions used by the ESOP to pay the 
loan are treated as annual additions to participants' accounts. 
Therefore, particular caution must be exercised to avoid exceeding the 
maximum annual additions under section 415. At the same time, release 
from encumbrance in annual varying numbers may reflect a failure on the 
part of the employer to make substantial and recurring contributions to 
the ESOP which will lead to loss of qualification under section 401(a). 
The Internal Revenue Service will observe closely the operation of 
ESOP's that release encumbered securities in varying annual amounts, 
particularly those that provide for the deferral of loan payments or for 
balloon payments.
    (iv) Illustration. The general rule under paragraph (b)(8)(i) of 
this section operates as illustrated in the following example:

    Example. Corporation X establishes an ESOP that borrows $750,000 
from a bank. X guarantees the loan, which is for 15 years at 5% interest 
and is payable in level annual amounts of $72,256.72. Total payments on 
the loan are $1,083,850.80. The ESOP uses the entire loan proceeds to 
acquire 15,000 shares of X stock which is used as collateral for the 
loan. The number of securities to be released for the first year is 
1,000 shares, i.e., 15,000 shares x $72,256.72/$1,083,850.80 = 15,000 
shares x 1/15. The number of securities to be released for the second 
year is 1,000 shares, i.e., 14,000 shares x $72,256.72/$1,011,594.08 = 
14,000 shares x 1/14. If all loan payments are made as originally 
scheduled, the number of securities released in each succeeding year of 
the loan will also be 1,000.

    (9) Right of first refusal. Qualifying employer securities acquired 
with proceeds of an exempt loan may, but need not, be subject to a right 
of first refusal. However, any such right must meet the requirements of 
this subparagraph (9). Securities subject to such right must be stock or 
an equity security, or a debt security convertible into stock or an 
equity security. Also, the securities must not be publicly traded at the 
time the right may be exercised. The right of first refusal must be in 
favor of the employer, the ESOP, or both in any order of priority. The 
selling price and other terms under the right must not be less favorable 
to the seller than the greater of the value of the security determined 
under Sec. 54.4975-11(d)(5), or the purchase price and other terms 
offered by a buyer, other than the employer or the ESOP, making a good 
faith offer to purchase the security. The right of first refusal must 
lapse no later than 14 days after the security holder gives written 
notice to the holder of the right that an offer by a third party to 
purchase the security has been received.
    (10) Put option. A qualifying employer security acquired with the 
proceeds of an exempt loan by an ESOP after September 30, 1976, must be 
subject to a put option if it is not publicly traded when distributed or 
if it is subject to a trading limitation when distributed. For purposes 
of subparagraph (10), a ``trading limitation'' on a security is a 
restriction under any Federal or state securities law, any regulation 
thereunder, or an agreement, not prohibited by this paragraph (b), 
affecting the security which would make the security not as freely 
tradable as one not subject to such restriction. The put option must be 
exercisable only by a participant, by the participant's donees, or by

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a person (including an estate or its distributee) to whom the security 
passes by reason of a participant's death. (Under this subparagraph 
(10), participant means a participant and beneficiaries of the 
participant under the ESOP.) The put option must permit a participant to 
put the security to the employer. Under no circumstances may the put 
option bind the ESOP. However, it may grant the ESOP an option to assume 
the rights and obligations of the employer at the time that the put 
option is exercised. If it is known at the time a loan is made that 
Federal or state law will be violated by the employer's honoring such 
put option, the put option must permit the security to be put, in a 
manner consistent with such law, to a third party (e.g., an affiliate of 
the employer or a shareholder other than the ESOP) that has substantial 
net worth at the time the loan is made and whose net worth is reasonably 
expected to remain substantial.
    (11) Duration of put option--(i) General rule. A put option must be 
exercisable at least during a 15-month period which begins on the date 
the security subject to the put option is distributed by the ESOP.
    (ii) Special rule. In the case of a security that is publicly traded 
without restriction when distributed but ceases to be so traded within 
15 months after distribution, the employer must notify each security 
holder in writing on or before the tenth day after the date the security 
ceases to be so traded that for the remainder of the 15-month period the 
security is subject to a put option. The number of days between such 
tenth day and the date on which notice is actually given, if later than 
the tenth day, must be added to the duration of the put option. The 
notice must inform distributees of the terms of the put options that 
they are to hold. Such terms must satisfy the requirements of paragraph 
(b) (10) through (12) of this section.
    (12) Other put option provisions--(i) Manner of exercise. A put 
option is exercised by the holder notifying the employer in writing that 
the put option is being exercised.
    (ii) Time excluded from duration of put option. The period during 
which a put option is exercisable does not include any time when a 
distributee is unable to exercise it because the party bound by the put 
option is prohibited from honoring it by applicable Federal or state 
law.
    (iii) Price. The price at which a put option must be exercisable is 
the value of the security, determined under Sec. 54.4975-11(d)(5).
    (iv) Payment terms. The provisions for payment under a put option 
must be reasonable. The deferral of payment is reasonable if adequate 
security and a reasonable interest rate are provided for any credit 
extended and if the cumulative payments at any time are no less than the 
aggregate of reasonable periodic payments as of such time. Periodic 
payments are reasonable if annual installments, beginning with 30 days 
after the date the put option is excercised, are substantially equal. 
Generally, the payment period may not end more than 5 years after the 
date the put option is exercised. However, it may be extended to a date 
no later than the earlier of 10 years from the date the put option is 
exercised or the date the proceeds of the loan used by the ESOP to 
acquire the security subject to the put option are entirely repaid.
    (v) Payment restrictions. Payment under a put option may be 
restricted by the terms of a loan, including one used to acquire a 
security subject to a put option made before November 1, 1977. 
Otherwise, payment under a put option must not be restricted by the 
provisions of a loan or any other arrangement, including the terms of 
the employer's articles of incorporation, unless so required by 
applicable state law.
    (13) Other terms of loan. An exempt loan must be for a specific 
term. Such loan may not be payable at the demand of any person, except 
in the case of default.
    (14) Status of plan as ESOP. To be exempt, a loan must be made to a 
plan that is an ESOP at the time of such loan. However, a loan to a plan 
formally designated as an ESOP at the time of the loan that fails to be 
an ESOP because it does not comply with section 401(a) of the Code or 
Sec. 54.4975-11 will be exempt as of the time of such

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loan if the plan is amended retroactively under section 401(b) or Sec. 
54.4975-11(a)(4).
    (15) Special rules for certain loans--(i) Loans made before January 
1, 1976. A loan made before January 1, 1976, or made afterwards under a 
binding agreement in effect on January 1, 1976 (or under renewals 
permitted by the terms of the agreement on that date) is exempt for the 
entire period of the loan if it otherwise satisfies the provisions of 
this paragraph (b) for such period, even though it does not satisfy the 
following provisions of this section: the last sentence of paragraph (b) 
(4) and all of paragraph (b) (5), (6), (8) (i) and (ii), and (9) through 
(13), inclusive.
    (ii) Loans made after December 31, 1975, but before November 1, 
1977. A loan made after December 31, 1975, but before November 1, 1977 
or made afterwards under a binding agreement in effect on November 1, 
1977 (or under renewals permitted by the terms of the agreement on that 
date) is exempt for the entire period of the loan if it otherwise 
satisfies the provisions of this paragraph (b) for such period even 
though it does not satisfy the following provisions of this section: 
paragraph (b) (6) and (9) and the three additional rules listed in 
paragraph (b) (8) (ii).
    (iii) Release rule. Notwithstanding paragraph (b) (15) (i) and (ii) 
of this section, if the proceeds of a loan are used to acquire 
securities after November 1, 1977, the loan must comply by such date 
with the provisions of paragraph (b) (8) of this section.
    (iv) Default rule. Notwithstanding paragraph (b) (15) (i) and (ii) 
of this section, a loan by a disqualified person other than a guarantor 
must meet the requirements of paragraph (b) (6) of this section. A loan 
will meet these requirements if it is retroactively amended before 
November 1, 1977 to meet these requirements.
    (v) Put option rule. With respect to a security distributed before 
November 1, 1977, the put option provisions of paragraph (b) (10), (11), 
and (12) of this section will be deemed satisfied as of the date the 
security is distributed if by December 31, 1977, the security is subject 
to a put option satisfying such provisions, the security is subject to a 
put option satisfying such provisions. For purposes of satisfying such 
provisions, the security will be deemed distributed on the date the put 
option is issued. However, the put option provisions need not be 
satisfied with respect to a security that is not owned on November 1, 
1977, by a person in whose hands a put option must be exercisable.

(Sec. 4975 (e) (7), (88 Stat. 976; 26 U.S.C. 4975 (e) (7)))

[T.D. 7506, 42 FR 44391, Sept. 2, 1977]