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ESOP valuations: does Farnum still live?

In August 1990, the employee stock option plan {ESOP) world was shaken by what was considered to be an ill-conceived challenge by the Department of Labor (DOL) in the U.S. District Court case of Farnum. The case involved an ESOP leveraged purchase of 80% of a corporation's stock from a former stockholder's estate. The DOL did not question the appraisal or the pricing of the stock prior to the ESOP's purchase. It did, however, find fault with the transaction itself because the ESOP's fiduciaries did not take into account the "cash drain" from anticipated future contributions to the ESOP to repay the ESOP loan and the company's guarantee of that loan.

This DOL position could jeopardize all leveraged ESOP loan transactions since they all rely on the methodology used in Farnura. It would render an ESOP unable to compete with any alternative purchaser willing to pay appraisal value for company stock.

The fundamental flaw in the DOL's position is that it would condition the fair market value (FMV) determination on the means by which the purchaser intends to pay the purchase price. Would this mean that a business is worth less because the purchaser intends to pay the seller principally through a financed stock redemption? Should a taxpayer pay less for a house because he intends to finance the purchase with a mortgage? Furthermore, would the DOL approve a company's redemption of its own stock from an ESOP for less than its appraised value because the company intends to finance the purchase through a bank loan that will, no doubt, cause a "cash drain" to repay? This is, no doubt the reason why the DOL declined to pursue its Farnum suit and has conceded that the Farnum action was "an aberration." Moreover, a civil suit by ESOP trustees based on the Farnum approach to ESOP appraisals was recently found to be without substance in the case of Scott v. Evins, DC Ala., 8/14/99..

Unfortunately, this latest ESOP chapter is not over. The IRS has now entered the picture, resurrecting Farnum by questioning the eligibility of a leveraged ESOP transaction for exemption from the prohibited transaction rules under Sec. 49751d)(13)on the grounds that the price it intends to pay, although supported by an unchallenged appraisal, exceeds FMV due to the previously discredited "cash drain" analogy. Moreover, there is still the question of the DOL's present position, despite its affirmative disavowal of its previous action in Farnum.

Meanwhile, leveraged ESOP transactions abound. Hopefully, the IRS and the DOL will abandon the Farnum rationale as the "aberration" it is, and allow it to "rest in peace."

From Louis H. Diamond, CPA, Keck, Mahin & Cate (not affiliated with DFK), Washington, D.C. Mr. Diamond is a member of the ESOP Working Group of the AICPA Tax Division's Employee Benefit Taxation Committee.
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Title Annotation:employee stock ownership plan purchases of company stock objected to by Labor Department
Author:Diamond, Louis H.
Publication:The Tax Adviser
Date:Oct 1, 1992
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