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Roth ESOPs: Potential Challenges and Legal Risks

Sunlight Is the Best of Disinfectants

By Kelly O. Finnell, J.D., CLU, AIF® · EFS ESOP Consultants, LLC · September 2026

Contents

• • Introduction

• • Executive Summary

• • Roth ESOP Overview

• • Roth ESOP Potential Challenges
    • • The IRS Challenge to the Post-Transaction Valuation
    • • The IRS Challenge Based on Section 401(a)(4)
    • • The Department of Labor Challenge Based on Self-Dealing
    • • The Plaintiffs’ Bar and the Selling Shareholder’s Windfall

• • Conclusion

Introduction

Employee ownership has long offered working Americans an opportunity to build retirement wealth through an ownership interest in the companies where they work. ESOPs also provide a way to transition privately held businesses while preserving jobs, serving customers, and supporting communities. Congress has encouraged these outcomes through valuable tax incentives for selling shareholders, sponsoring companies, and ESOP participants. Those incentives rest on the premise that employees should receive meaningful benefits from employee ownership.

The promotion of the “Roth ESOP” is reminiscent of an earlier period in ESOP history. After Congress permitted ESOPs to own S corporation stock, some arrangements were promoted that used the resulting tax advantages while concentrating the economic benefits primarily among former owners and other highly compensated individuals. Rank-and-file employees received little or no meaningful benefit. Congress responded in 2001 by enacting Internal Revenue Code §409(p), commonly known as the S corporation ESOP anti-abuse rule, to address this concentration of benefits. The concern then, as now, was whether an arrangement presented as employee ownership primarily served the people who already owned or controlled the business.

The Roth ESOP uses a different mechanism, but it may raise a similar concern. In the arrangement examined in this paper, former owners and other highly compensated employees may be given the opportunity to transfer substantial assets from a 401(k) plan into the ESOP, acquire employer stock at a sharply reduced post-transaction value, and make an in-plan Roth conversion at that value. As the ESOP acquisition debt is repaid, the stock may appreciate substantially. If the applicable Roth distribution requirements are satisfied, the full value of that appreciated stock could ultimately be paid to those account holders free from federal income tax.

The potential tax benefit is significant, as are the questions it raises. They include whether the post-transaction stock value properly reflects all relevant facts; whether opportunities to acquire the stock are available to employees on a nondiscriminatory basis; and whether the arrangement satisfies ERISA’s fiduciary and prohibited-transaction rules. More broadly, the structure raises the question of whether tax incentives intended to promote broad-based employee ownership are being used to provide their most extraordinary benefits to former owners and a small group of highly compensated employees.

These questions arise at an important moment for the ESOP community. The Department of Labor has announced a more measured approach to fiduciary enforcement, and Congress has passed the Retire Through Ownership Act to provide greater clarity concerning ESOP stock valuations. Both developments reflect support for responsible employee ownership. Arrangements perceived as directing ESOP benefits principally to a select group could put that progress at risk. In the earlier S corporation ESOP episode, Congress acted. The more immediate challenges to the Roth ESOP are likely to come from the IRS, the Department of Labor, and participants represented by the plaintiffs’ bar. This paper examines those potential challenges.

Executive Summary

Justice Louis Brandeis famously observed that “sunlight is said to be the best of disinfectants,” expressing the enduring principle that transparency and scrutiny are often the most effective means of exposing and deterring questionable conduct. That principle is particularly apt in examining the Roth ESOP. The purpose of this paper is to bring the structure fully into the light of day by explaining how the transactions work, who benefits, how employer stock is valued, how value is transferred into Roth accounts, and what assumptions are necessary to produce the extraordinary tax results being promoted. Once these intricacies are understood, the Roth ESOP can be judged not by the attractiveness of its promised results, but by whether its substance withstands the requirements and purposes of the Internal Revenue Code and ERISA.

The Roth ESOP rests on a series of legal propositions that may each appear defensible when considered separately. The Internal Revenue Code permits designated Roth accounts and in-plan Roth conversions. A leveraged ESOP transaction legitimately reduces equity value by placing acquisition debt on the company. Participants may be permitted to transfer retirement assets and invest them in qualifying employer securities. Selling shareholders may finance the transaction, continue working for the company, and participate in the ESOP. None of these elements, standing alone, necessarily violates the Internal Revenue Code or ERISA.

The concern arises from their combination. In the promoted structure, a selling shareholder receives the negotiated value of the company, finances most of the purchase price with seller notes, retains control or substantial influence, transfers retirement assets into the ESOP, purchases stock during the post-transaction decline in value, and converts that stock to Roth status. The seller may then receive repayment of the seller notes while the same debt repayment restores the value of the stock held in the seller’s Roth account.

That combination creates several related vulnerabilities. The IRS may contend that the value used for the Roth conversion understates fair market value by overstating the risk associated with acquisition debt and failing to recognize foreseeable earnings, ESOP-related tax benefits, seller flexibility, and expected deleveraging. The IRS may also challenge whether the opportunity to acquire stock at the depressed value is offered to employees on a nondiscriminatory basis. The Department of Labor may contend that fiduciaries used plan assets and authority to confer a special personal benefit on the seller. Participants and the plaintiffs’ bar may argue that employees bore the debt and operating risk while the seller received the sales proceeds and captured a disproportionate share of the restored equity value.

The extraordinary result is itself likely to attract scrutiny. In the example used throughout this paper, an amount valued at $1.8 million when converted to Roth status becomes worth $18 million without organic growth, while the seller also receives $40 million for the company. When an arrangement promises a predictable, tax-free return far exceeding a market-rate tax-free return, regulators and courts may look beyond its individual steps and examine its economic substance, fiduciary process, valuation assumptions, and distribution of benefits.

A carefully structured transaction may have meaningful defenses. Those defenses will depend on a genuinely independent trustee, a contemporaneous and supportable valuation, full disclosure of material conflicts, equal and practical access for participants, careful separation of settlor and fiduciary functions, and persuasive evidence that the arrangement serves the interests of participants rather than principally advancing the tax objectives of the seller. The involvement of qualified professional advisers will be helpful only if their work is independent, critical, and fully informed.

The ultimate question is not whether Roth provisions can exist in an ESOP. The more consequential question is whether a retirement plan created for employees may be used to allow a controlling selling shareholder to receive the value of the company once through the sale and much of that value a second time through a personal Roth account. Bringing the structure into the light of day allows business owners, fiduciaries, advisers, regulators, and participants to determine whether the promised result reflects legitimate retirement planning or an impermissible transfer of value. Sunlight remains the best disinfectant.

Roth ESOP Overview

While the terms “Roth 401(k)” and “Roth IRA” are specifically referenced in the Internal Revenue Code, the term “Roth ESOP” does not appear in the Code or IRS regulations. There is no specific authority expressly allowing a Roth ESOP. This is not to suggest that a Roth provision cannot be included in an ESOP, as it can be in other forms of qualified retirement plans. It is important, however, to recognize that “Roth ESOP” is a relatively new term created by proponents of the concept rather than by Congress.

The concept of a Roth account is that contributions are made after tax, but qualified distributions are received tax-free. Individual retirement account holders and 401(k) participants can elect to make after-tax contributions or deferrals, or to make in-plan conversions of pre-tax accounts to Roth, paying tax on the value of the account at the time of conversion. Proponents of the Roth ESOP strategy generally rely on the account-conversion approach. They seek to take advantage of what ESOP practitioners commonly refer to as the post-transaction drop in ESOP value.

The post-transaction drop in value is best explained through an example. Assume a company has an enterprise value of $40 million. Its equity value, assuming no debt or excess cash, is also $40 million. In an ESOP transaction, the seller would receive the price negotiated with the ESOP trustee, which we will assume to be $40 million. What is the value of the company the day after the 100 percent leveraged ESOP transaction is completed? Logic might suggest that the equity value is zero because the company with $40 million of equity value also has $40 million of debt. Valuation professionals tell us, however, that the transaction creating the debt also creates a future stream of tax benefits for the company. Without becoming bogged down in the mathematics, assume those benefits produce a post-transaction equity value of $4 million, or 10 percent of the company’s value immediately before the leveraged transaction. This creates the opportunity proponents of the Roth ESOP seek to capitalize on. An ordinary leveraged-ESOP allocation, spread across participants in proportion to compensation, would not place anything approaching this share in a single account; the concentration assumed in this example arises only through the lateral-transfer or special-contribution mechanism described below. According to the proponents of this strategy, a participant whose account holds 45 percent of the shares can make an in-plan Roth conversion and pay tax on the account’s $1.8 million equity value. That value may increase dramatically even without organic company growth, based solely on the company’s deleveraging. If all debt is repaid in five years, the participant who was taxed on $1.8 million at conversion may ultimately receive an $18 million tax-free distribution. This produces a tax-free annualized rate of return of 58.49 percent. If the debt is repaid over 10 years, assuming no organic growth, the tax-free internal rate of return would be 25.89 percent. The chart below compares these Roth ESOP returns with a market-rate tax-free return measured by the average annual return on AAA-rated municipal bond funds beginning October 1, 1986.

Under the theory that one can never have too much of a good thing, even if that good thing seems too good to be true, proponents of this strategy recommend that business owners include a feature historically referred to in the ESOP community as a “401(k) lateral transfer.” Under this approach, participants may transfer all or a portion of their 401(k) accounts to their ESOP accounts, where the transferred assets become available to purchase company stock. The purchased stock may then be converted to Roth status at the post-transaction value. Alternatively, the company could make a special contribution to the ESOP which participants could elect to use to purchase shares of company stock for their ESOP accounts. This special contribution would be limited by the Section 415(c) annual additions limit.

To illustrate, assume Mr. Barnum sells 100 percent of his $40 million company in a leveraged ESOP transaction. He then liquidates $1.8 million of assets in his 401(k), with the cash transferred to his ESOP account and used to purchase company stock at the post-transaction value. Assuming a 90 percent decline, $1.8 million of transferred cash would purchase stock representing $18 million of the company’s pre-transaction value. Assuming a 10-year repayment of the ESOP loan and no organic growth, the $1.8 million after-tax investment grows to $18 million, which, assuming it is paid to him as a qualified distribution, Mr. Barnum receives from his Roth ESOP account tax-free. Over that period, Mr. Barnum receives $58 million in connection with the sale of his $40 million company.

Note that the amount that is transferred from 401(k) accounts to the ESOP will affect the ESOP debt since the transferred amount is an equity investment. Therefore, in our example, the $1.8 million dollar amount transferred to the ESOP will reduce the $40 million of ESOP debt to $38.2 million which will result in a 4.5 percent reduction in the post-transaction drop in value.

Instead of structuring the transaction as a sale by the shareholders to the ESOP, proponents of this strategy may also use a redemption/subscription structure where instead of having the ESOP purchase shares, the seller sells 99.9 percent of his shares to the company in a leveraged redemption. The seller then sells the remaining 0.1 percent of his shares to the ESOP.

Roth ESOP Potential Challenges

There are at least three potential challengers to the validity of the Roth ESOP: (1) the Internal Revenue Service; (2) the Department of Labor; and (3) the plaintiffs’ bar on behalf of ESOP participants.

The IRS Challenge to the Post-Transaction Valuation

The most direct IRS challenge would likely focus on the value assigned to the employer stock at the time of the Roth conversion. Section 402A of the Internal Revenue Code permits an eligible amount held in a qualified retirement plan to be transferred to a designated Roth account. The transfer is taxable as though the amount had been distributed and not rolled over. IRS Notice 2010-84 states that the amount included in the participant’s gross income is the fair market value of the property transferred, less any basis the participant has in that property. Thus, the success of the Roth ESOP strategy depends not merely on whether an in-plan Roth conversion is legally permitted, but on whether the reported conversion value constitutes the employer stock’s actual fair market value.

The IRS would not necessarily need to challenge the general proposition that a leveraged ESOP transaction causes a post-transaction decline in equity value. The acquisition debt is real and unquestionably affects the company’s equity value. A company worth $40 million before a transaction does not necessarily retain a $40 million equity value after incurring $40 million of acquisition debt. The issue is whether the claimed reduction—for example, from $40 million to $4 million—fully and fairly reflects all economic facts existing on the conversion date.

The acquisition debt cannot be evaluated as though it were ordinary third-party debt presenting ordinary repayment risk. In many ESOP transactions, selling shareholders receive 60 to 70 percent of the purchase price in seller notes, continue to control or substantially influence the company, and may also be the principal beneficiaries of the Roth conversion. Seller financing, continuing seller control, and the seller’s dual economic interest may substantially reduce the practical risk associated with the debt. These factors could therefore undermine the extraordinarily low post-transaction value used to determine the income recognized on the Roth conversion.

Fair market value is generally the price at which property would change hands between a willing buyer and willing seller, neither being under a compulsion to act and both having reasonable knowledge of the relevant facts. Revenue Ruling 59-60 requires the valuation of closely held stock to consider all relevant factors, including earning capacity, financial condition, dividend-paying capacity, goodwill, industry outlook, and comparable-company information. The IRS could argue that an appraisal concentrating principally on newly created debt, while failing to give sufficient weight to continuing earning power, anticipated tax benefits, expected debt repayment, and other transaction-related benefits, materially understates the value of the converted stock.

That alignment becomes even more significant when the selling shareholder is also the participant making the Roth conversion. The shareholder may simultaneously hold a large seller note and substantial employer stock in a Roth ESOP account. Successful debt repayment increases the likelihood that the seller note will be paid while also producing dramatic appreciation in the Roth account. The seller therefore has two powerful economic incentives to preserve the company’s profitability and direct available cash toward repayment of the acquisition debt.

Seller financing may also provide greater practical flexibility than independent commercial debt. A seller who remains committed to the company’s success may be willing to defer payments, extend maturity dates, restructure the notes, modify repayment terms, or refrain from exercising remedies after a technical default. The appraisal should consider these actual economic characteristics rather than treating the seller notes as inflexible third-party debt.

The extraordinary projected return could itself attract scrutiny. A high return does not, standing alone, establish that the original valuation was incorrect; leveraged equity can generate unusually high returns because it bears unusually high risk. The risk explanation becomes less persuasive, however, when most of the debt is owed to a selling shareholder who remains committed to the company’s success, retains control or influence, and expects to benefit from both repayment of the seller notes and appreciation in the Roth account.

The IRS could ask whether an unrelated investor, knowing all these facts, would really sell the employer stock for the value used in the Roth conversion. If the proponents of this strategy treat repayment and appreciation as predictable when marketing the strategy but portray those results as highly uncertain when valuing the shares, the inconsistency could become powerful evidence that the conversion valuation was result-oriented.

The timing of the valuation would also be important. If the conversion occurs shortly after the ESOP transaction, the IRS could insist on a contemporaneous valuation as of the actual conversion date. A prior year-end valuation, a mechanical reduction of the transaction price by the face amount of the acquisition debt, or even a post-closing appraisal may not suffice if it fails to account for all material information then known or reasonably knowable.

A defensible appraisal should recognize both sides of the transaction. It should reflect the amount, terms, priority, and genuine risk of the acquisition debt. It should also reflect the present value of anticipated earnings, ESOP-related tax benefits, debt-service capacity, and the selling shareholder’s continuing involvement and economic incentives. If the appraisal recognizes the debt at full face amount while inadequately recognizing the earnings and tax benefits available to repay it, or the flexibility associated with seller financing, the IRS could contend that the analysis is economically incomplete.

The IRS might also examine the steps as one integrated transaction. If the ESOP acquisition, seller notes, post-transaction appraisal, transfer of 401(k) assets, purchase of employer stock, and Roth conversion were planned together, the Service could argue that the steps should be evaluated according to their overall substance. Its position would be that a taxpayer should not be permitted to create a temporary and artificially depressed value, transfer the affected property into a Roth account during that narrow window, and receive the substantially anticipated restoration of value tax-free.

The taxpayer could respond that the debt is genuine; repayment depends on future performance; the stock is illiquid and highly concentrated; and neither continued earnings nor successful repayment is guaranteed. The taxpayer could also emphasize that a qualified independent appraiser used accepted methods and that the plan and Section 402A expressly permitted the conversion. These considerations could make it difficult for the IRS simply to disregard the post-transaction value and substitute the pre-transaction sale price.

The risk of an IRS valuation challenge is not merely theoretical. The IRS has expressly recognized that the amount taxable upon a Roth conversion involving property is generally the property’s fair market value on the conversion date. In Revenue Procedure 2006-13, addressing annuity contracts converted to Roth IRAs, the Service prescribed valuation methods intended to capture the contract’s full economic value—including additional benefits that might otherwise be omitted from the stated account value. Although that guidance concerns annuities rather than ESOP stock, it demonstrates that the IRS will scrutinize whether the value reported upon conversion reflects all of the property’s economic attributes, rather than accepting a nominal or mechanically derived value. (Rev. Proc. 2006-13)

The IRS has also directly challenged transactions that use questionable valuations to shift economic value into Roth accounts. In Notice 2004-8, the Service targeted arrangements in which business owners used inaccurately valued transactions to transfer value from a controlled business to a Roth IRA. The IRS stated that it could recast the shifted value as a taxable payment to the owner followed by an excess Roth contribution, invoke the arm’s-length standards of Section 482, impose excise taxes, and assert accuracy-related and promoter penalties. A Roth ESOP is not the transaction described in that notice, and no reported case appears to have addressed the precise post-transaction valuation technique considered here. Nevertheless, the notice establishes that the IRS views undervaluation combined with owner control and the transfer of future appreciation into a Roth account as an enforcement concern. The possibility of an IRS challenge to a Roth ESOP valuation therefore rests on an established enforcement principle, not simply on speculation.

Notice 2004-8 did more than describe the concern: it designated the abusive Roth IRA arrangement a “listed transaction.” If a Roth ESOP were treated as a listed or reportable transaction, participants and advisers could face disclosure obligations on Form 8886, penalties under Section 6707A, an extended statute of limitations, and material-advisor list-maintenance duties under Sections 6111 and 6112.

If the IRS establishes that the stock was undervalued, the participant could face additional ordinary income for the conversion year, interest, and potentially the accuracy-related penalties for a substantial or gross valuation misstatement under Section 6662. Reliance on an independent appraisal and professional advice could support a reasonable-cause defense, but may provide limited protection if unreasonable assumptions were supplied, material information was withheld, or the appraiser was selected principally to produce the desired result. If the arrangement were also challenged under the codified economic substance doctrine of Section 7701(o), the exposure would be greater still: the Section 6662(b)(6) penalty is 20 percent, rising to 40 percent for a transaction that is not adequately disclosed under Section 6662(i), and no reasonable-cause or good-faith defense is available for that portion. Related penalties could reach proponents of this strategy (Section 6700), advisers who aid an understatement (Section 6701), and return preparers (Section 6694).

The post-transaction decline is therefore both the engine of the strategy and its most obvious point of attack. The IRS would not need to establish that every post-transaction ESOP valuation is improper or that employer stock can never be converted to Roth status. It would need to establish only that the particular conversion value did not represent fair market value.

A CPA signing the return of a taxpayer who has made the type of in-plan Roth conversion described herein should strongly consider requiring a contemporaneous valuation opinion from an independent valuation firm before reporting the taxable amount of the in-plan Roth conversion.

The valuation should not merely apply the traditional ESOP convention of subtracting acquisition debt from the pre-transaction equity value. It should determine fair market value as of the actual conversion date and address all relevant economic facts, including:

• • The company’s continuing earning capacity and projected cash flow.

• • The expected ESOP-related tax benefits.

• • The terms, priority, subordination and repayment schedule of the acquisition debt.

• • The extent to which the debt consists of flexible seller notes rather than conventional third-party financing.

• • The selling shareholder’s continued control or influence over the company.

• • The shareholder’s dual interest in repayment of the seller notes and appreciation of the Roth-held stock.

• • The likelihood and expected timing of deleveraging.

• • The stock’s lack of marketability, minority status and other genuine risks.

• • The relationship between the transaction price, the post-transaction valuation and the extraordinary return being projected.

The opinion should be a full valuation report prepared specifically for the Roth conversion—not merely a calculation of value, a copy of the trustee’s transaction appraisal or an after-the-fact confirmation. It should reconcile the asserted post-transaction value with the price paid immediately before the conversion and explain why an informed unrelated investor would accept that value.

This would protect both the shareholder and the CPA. Circular 230 permits a return preparer to rely in good faith on information supplied by the client, but the preparer may not ignore known implications or inconsistencies and must make reasonable inquiries when information appears incomplete or questionable. An asserted 90 percent decline followed by an anticipated tenfold increase is precisely the type of unusual fact pattern that should prompt further inquiry. Circular 230, §10.34(d)

An independent appraisal would not guarantee that the IRS accepts the reported value, nor would it automatically eliminate penalties. The CPA must still evaluate whether the report’s assumptions and conclusions are reasonable. Nevertheless, a well-supported, genuinely independent valuation would provide considerably stronger evidence of reasonable cause and good faith than reliance on the promoter’s projections or a conventional post-transaction ESOP appraisal that did not consider the Roth conversion and the shareholder’s continuing economic interests.

The valuation firm should therefore be retained independently of the Roth promoter, receive no compensation contingent on achieving a particular value and be given all transaction documents and projections. Ideally, the plan’s Form 1099-R reporting and the participant’s income-tax return would use the same conversion-date value or clearly reconcile any difference.

The IRS Challenge Based on Section 401(a)(4)

One objective of Roth ESOP proponents is to engineer a structure that results in close to, but not more than, 50 percent of the ESOP’s value being placed in the accounts of a small group of key employees, including former owners who sold their shares to the ESOP. Once the stock is placed in their accounts, these participants can make an in-plan Roth conversion based on the stock’s asserted post-transaction value. If the acquisition debt is subsequently repaid as anticipated, a substantial portion of the company’s restored equity value may accumulate in the participants’ Roth accounts and ultimately be distributed tax-free. The 50 percent ceiling is not arbitrary. For an S-corporation ESOP, Section 409(p) treats a plan year as a “nonallocation year” if “disqualified persons”—broadly, individuals who own at least 10 percent, or whose families own at least 20 percent, of the ESOP’s deemed-owned shares—together hold 50 percent or more of the company. A nonallocation year triggers immediate taxation of the affected allocations and a 50 percent excise tax under Section 4979A. Structuring the selected accounts to just below 50 percent is therefore an effort to remain outside Section 409(p). Two caveats follow: the anti-abuse rule in the Section 409(p) regulations can disregard steps taken with a principal purpose of avoiding these consequences, and Section 409(p) applies only to S corporations—so a C-corporation structure would not be constrained by the 50 percent line, but also could not rely on it to explain the design.

Proponents of this strategy may accomplish this result in either of two ways. First, the plan may give a limited group of employees the right to transfer assets from their 401(k) accounts into the ESOP and use the transferred funds to purchase employer stock. Second, the company may make what is described as a “special ESOP contribution” to the accounts of all eligible employees but permit only the selected group to use that contribution to purchase employer stock at its depressed post-transaction value. Although every eligible employee receives the special contribution, only the selected group receives the potentially more valuable right to exchange that contribution for employer stock positioned to appreciate as the ESOP debt is repaid.

The universal availability of the special contribution does not necessarily resolve the nondiscrimination issue. The relevant benefit, right, or feature is not merely the receipt of the contribution; it is the right to use that contribution to purchase employer stock during the period in which the stock’s value is unusually low. Restricting that right, or the lateral-transfer alternative, to a selected group creates significant qualified-plan nondiscrimination issues under Section 401(a)(4) of the Internal Revenue Code. The selective design may also create separate ERISA fiduciary concerns if plan provisions or plan assets are used principally to benefit former owners or other key employees.

A lateral-transfer right or restricted stock-purchase right offered only to selected employees would probably be treated as an “other right or feature” under Treasury Regulation §1.401(a)(4)-4. Each feature would have to satisfy two separate tests: current availability and effective availability. Passing the numerical current-availability test alone would not be sufficient.

1. Identify the Benefit Right or Feature

The first step is to identify precisely what is being offered. Potentially separate benefits, rights, or features include:

• • The right to transfer assets from the 401(k) plan to the ESOP.

• • The right to use transferred assets to purchase employer stock.

• • The right to use a special contribution to purchase employer stock.

• • Any special transfer or purchase limit, timing window, valuation date, or investment election.

• • Any associated right to make an in-plan Roth conversion.

Materially different eligibility rules, limits, or timing provisions could create separate benefits, rights, or features, each of which must be tested independently. The fact that all employees receive the underlying special contribution does not establish that the separate right to invest that contribution in employer stock is available on a nondiscriminatory basis.

2. Test Current Availability

For each plan year in which the lateral-transfer or stock-purchase feature is available, the employer must identify all nonexcludable employees in the controlled group and divide them into highly compensated employees, or HCEs, and nonhighly compensated employees, or NHCEs. An employee is treated as benefiting if the right is available to that employee, whether or not the employee actually exercises it.

The ratio percentage is calculated as follows:

Ratio Percentage (Eligible NHCEs ÷ Total Nonexcludable NHCEs) ÷ (Eligible HCEs ÷ Total Nonexcludable HCEs)

The feature passes the ordinary ratio-percentage test if the result is at least 70 percent.

For example, assume the employer has 10 HCEs and 90 NHCEs. If the right is available to all 10 HCEs but only 30 NHCEs, the ratio percentage would be:

(30 ÷ 90) ÷ (10 ÷ 10) = 33.33 percent

That would not satisfy the 70 percent ratio-percentage test.

The feature might alternatively satisfy the nondiscriminatory-classification test. The selected group must first be defined using reasonable and objective business criteria, such as job category, salaried status, business unit, or geographic location. A list of selected individuals, or criteria effectively designed to identify particular individuals, is not a reasonable classification.

The resulting ratio percentage must then meet the applicable safe-harbor percentage under Treasury Regulation §1.410(b)-4. If the ratio falls between the applicable safe- and unsafe-harbor percentages, the classification must survive a facts-and-circumstances determination. If it falls below the unsafe-harbor percentage, the classification fails. The average-benefit-percentage test cannot be used to establish the current availability of a benefit, right, or feature.

3. Test Effective Availability

Even if the eligible group passes the numerical test, the feature must also be effectively available on facts and circumstances that do not substantially favor HCEs. This could be the more difficult test for a Roth ESOP.

Suppose the lateral-transfer or stock-purchase feature is nominally available to enough NHCEs to pass the current-availability test, but:

• • Only employees with very large 401(k) balances can acquire a meaningful amount of stock.

• • The plan requires a substantial minimum transfer or stock purchase.

• • Participants have only a short period in which to make the election.

• • Participants must have outside funds to pay the tax resulting from the Roth conversion.

• • The selected HCEs receive advance notice, individualized advice, financing, or other assistance unavailable to NHCEs.

• • The purchase window coincides with the unusually low post-transaction stock value.

• • The former owners and other HCEs are expected to acquire most of the stock available under the program.

Those circumstances could support an IRS argument that the feature, although formally available to a sufficient number of NHCEs, is effectively available primarily to the selling shareholders and other HCEs. The regulation specifically requires an examination of practical availability and provides examples in which a facially broad right fails because the surrounding circumstances substantially favor HCEs.

The effective-availability issue may be particularly pronounced when all employees receive the special contribution but only a favored group may invest it and amounts transferred from their 401(k) accounts in employer stock. The contribution itself may be uniform, but the selected group receives access to the investment expected to produce the extraordinary appreciation. Section 401(a)(4) testing should therefore focus on the economic right that distinguishes the selected employees: the right to acquire employer stock at the depressed post-transaction value, rather than merely on the contribution deposited into every participant’s account.

The Department of Labor Challenge Based on Self-Dealing

A second potential challenge could come from the Department of Labor, which could contend that the arrangement violates ERISA’s prohibition against fiduciary self-dealing. Unlike the IRS, which would focus primarily on taxable value, the Department would focus on the use of plan assets and fiduciary authority to create an extraordinary personal benefit for the selling shareholder.

Section 404(a)(1) of ERISA requires a fiduciary to act solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits and defraying reasonable plan expenses. Section 406(b) supplements those duties by prohibiting a fiduciary from dealing with plan assets in the fiduciary’s own interest, acting in a plan transaction on behalf of a party whose interests are adverse to the plan or its participants, or receiving consideration for the fiduciary’s personal account from a party dealing with the plan in connection with a transaction involving plan assets.

The potential conflict arises because the selling shareholder may occupy several positions. The seller may remain an officer or director, retain control or substantial influence, hold most of the purchase price in seller notes, and participate in the ESOP. The seller may then transfer substantial 401(k) assets into the ESOP, use those assets to purchase employer stock at the depressed post-transaction value, and convert the stock to Roth status. If the debt is repaid as expected, the seller receives payment of the seller notes while the restored stock value accumulates in the seller’s Roth account.

The Department could argue that the ESOP was being used for two different purposes. Its statutory purpose is to provide retirement benefits through employee ownership. In the Roth ESOP arrangement, however, plan provisions and transactions may be designed principally to allow the selling shareholder to place a disproportionate amount of stock into a personal Roth account during the brief period in which the stock has a depressed value.

The Department could focus particularly on the lateral transfer and subsequent stock purchase. The transferred cash may ultimately be used to repay acquisition debt, including debt owed to the seller, while the stock purchased with that cash is converted at the post-transaction value. The seller could therefore benefit on both sides: the plan receives cash that facilitates payment of the seller notes, while the seller receives stock positioned to appreciate inside a Roth account.

The relevant inquiry would include who designed the arrangement, selected the investment alternatives, authorized the stock purchase, approved the valuation, controlled the timing, and stood to receive the principal benefit. A participant’s voluntary election would not necessarily eliminate concerns arising from the fiduciaries’ design and implementation of the mechanism through which that election operated.

The extent to which the selling shareholder acted as a fiduciary would be critical. An employer generally acts in a nonfiduciary, or settlor, capacity when establishing or amending a retirement plan. The decision to permit Roth accounts, lateral transfers, or in-plan conversions therefore would not necessarily constitute fiduciary conduct by itself. The analysis changes when the seller exercises discretionary authority over plan management or administration or control over plan assets. Selecting or removing the trustee, influencing the appraisal, directing the timing or terms of the stock purchase, controlling the use of transferred cash, or otherwise implementing the arrangement may constitute fiduciary conduct.

The independent trustee would also face scrutiny. A trustee asked to approve a large employer-stock purchase for the selling shareholder’s account could not treat it as a routine administrative matter. The trustee would need to determine whether the purchase was authorized, whether the price represented adequate consideration, whether the valuation was current and reliable, whether the transaction served participants’ interests, and whether it improperly favored the seller.

One potential defense would be the statutory exemption in Section 408(e) of ERISA. That provision generally protects an ESOP’s acquisition or sale of qualifying employer securities from the prohibited-transaction rules if the transaction is for adequate consideration, no commission is charged, and the other requirements are satisfied. That defense would make valuation central to the Department’s case. If the stock was purchased at an artificially low value, the exemption might be unavailable.

Even if the acquisition satisfied Section 408(e), the exemption would not necessarily resolve the entire fiduciary-duty inquiry. Compliance with the ESOP exemption does not relieve fiduciaries of ERISA’s separate duties of loyalty and prudence. The Department could therefore challenge the overall process even if the shares were purchased for adequate consideration.

The unequal practical availability of the benefit could provide additional evidence. A Roth feature might be available to all participants in form but primarily valuable to the seller in practice. Most rank-and-file employees would not have a sufficiently large 401(k) balance to acquire a material amount of stock during the post-transaction decline, and many would lack outside funds to pay the resulting conversion tax. The seller, by contrast, may have substantial retirement assets, liquidity from the sale, continued control, and the financial ability to pay the tax.

A disproportionate benefit is not automatically a fiduciary breach. ERISA does not require every participant to achieve the same economic result. The Department’s argument would be stronger, however, if the evidence showed that the features were adopted and implemented principally to benefit the seller, other participants received little practical benefit, and fiduciaries subordinated participants’ interests to the seller’s tax objectives.

The central question would be whether the seller merely took advantage of plan provisions adopted in a nonfiduciary capacity or instead used fiduciary authority and plan assets to create and secure a personal benefit. The closer the seller comes to controlling the trustee, valuation, stock purchase, use of transferred cash, and conversion timing, the more plausible the Department’s self-dealing challenge becomes.

The Plaintiffs’ Bar and the Selling Shareholder’s Windfall

The third potential challenge could come from the plaintiffs’ bar on behalf of ESOP participants. The legal theories would likely resemble those available to the Department of Labor: breach of the duties of loyalty and prudence, prohibited self-dealing, failure to monitor fiduciaries, and participation in another fiduciary’s breach. Plaintiffs’ lawyers, however, would also construct a compelling factual narrative that the seller used the ESOP and its participants to finance the company purchase while arranging to capture an extraordinary and largely tax-free personal windfall.

The likely theme would be straightforward. The employees became owners of a highly leveraged company and bore the risks associated with repayment of the acquisition debt. The seller received the purchase price; retained most of the price in seller notes; continued to control or influence the company; and used retirement assets to purchase employer stock at its depressed post-transaction value. After converting that stock to Roth status, the seller stood to receive the restored value tax-free as the debt was repaid.

A plaintiffs’ lawyer might describe the arrangement more pointedly: the employees received the debt, while the seller received the sales proceeds, seller notes, continuing control, and a disproportionate share of the future appreciation. Whether that description is economically complete would matter less at the pleading stage than whether it supports a plausible inference that fiduciaries placed the seller’s interests ahead of participants’ interests.

The magnitude of the potential windfall would be central. In the example above, the seller transfers $1.8 million from a 401(k) account into the ESOP and uses it to acquire stock representing $18 million of the company’s pre-transaction value. The seller pays conversion tax on only the $1.8 million post-transaction value. If the company repays its debt over 10 years, that stock may again be worth $18 million without organic growth and may ultimately be distributed tax-free. Combined with the $40 million received for the company, the seller could receive as much as $58 million in connection with a company originally valued at $40 million—though only the $18 million distributed from the Roth account is necessarily tax-free, and then only if the distribution is qualified (a five-year holding period plus attainment of age 59½, death, or disability).

The complaint would contrast that result with the experience of rank-and-file participants. Most employees would not have $1.8 million in a 401(k), sufficient outside liquidity to pay tax on a large conversion, or millions in sales proceeds and seller notes. Although the provisions might be nominally available to everyone, plaintiffs could argue that they were designed to provide their greatest practical benefit to the seller.

The strongest legal claim would likely be that fiduciaries breached their duty of loyalty by using plan assets and procedures to confer a special benefit on the seller. Plaintiffs could allege that fiduciaries authorized the retirement-asset transfer, employer-stock purchase, unusually low valuation, and Roth conversion because those steps advanced the seller’s personal interests rather than the interests of participants generally.

Plaintiffs might also assert a prohibited-transaction claim under Section 406. If cash transferred into the ESOP was used directly or indirectly to repay acquisition debt owed to the seller, while the seller’s account received stock positioned for substantial Roth appreciation, plaintiffs could characterize the arrangement as self-dealing on both sides. The defense would likely rely on the Section 408(e) exemption, again making adequate consideration and valuation central issues.

The duty of prudence would provide another claim. Plaintiffs could allege that the trustee and other fiduciaries failed to investigate whether concentrating additional retirement assets in the stock of a highly leveraged company was prudent. They could challenge the appraisal, cash-flow projections, seller-note assumptions, timing, and capacity to satisfy repurchase obligations while servicing acquisition debt. They could also argue that fiduciaries failed to consider less conflicted alternatives.

A related claim could target those responsible for appointing and monitoring the trustee. Plaintiffs could allege that the trustee was selected because it was willing to approve the structure and that the appointing fiduciaries failed to monitor whether it independently evaluated the valuation, conflicts, and participant consequences. The seller’s authority to appoint or remove the trustee would be emphasized as evidence that the process lacked genuine independence.

Plaintiffs might further allege that participants were not given complete and understandable information. Participants may have been told that the Roth feature was available without being told that the structure was designed primarily for the seller, that transferred assets could facilitate repayment of seller debt, or that the seller expected to capture a large portion of the post-transaction appreciation. Communications emphasizing employee ownership while omitting the seller’s anticipated windfall could be characterized as misleading or incomplete.

The perception of unfairness could become nearly as important as the technical claims. A seller is ordinarily entitled to receive fair market value, retain seller notes, continue working, and participate in the ESOP if the plan permits. None of those facts alone establishes misconduct. Their combination, however, could create the impression that the ESOP allowed the seller to monetize the company and then reacquire much of its future value inside a tax-free retirement account.

A plaintiffs’ lawyer would likely reduce the case to a simple comparison: employees received ownership burdened by acquisition debt; the seller received the purchase price and seller notes; company cash flow repaid the debt owed to the seller; the seller retained control or influence; the seller purchased stock during the temporary decline; and, as the employees’ labor helped repay the debt, much of the resulting appreciation accumulated tax-free for the seller.

Plaintiffs would still need to establish more than an appearance of unfairness. ERISA does not prohibit a seller from receiving a favorable result, and disparity alone does not establish a fiduciary breach. Participants would need to identify fiduciary conduct, a breach or prohibited transaction, and injury to the plan or their accounts. They might allege that stock or appreciation otherwise allocable to employees was diverted to the seller; transferred cash accelerated repayment of seller debt; the arrangement diluted other accounts; the plan paid an improper price; or participants bore risks and expenses undertaken principally to produce the seller’s benefit.

The defendants would respond that the Roth provisions were available on nondiscriminatory terms, each participant made a voluntary election, the stock was purchased for fair market value, an independent trustee approved the transactions, and the seller’s conversion did not reduce other accounts. They could also argue that debt repayment increased the value of all stock held by the plan and therefore benefited the entire employee population.

Those defenses would be strongest if the fiduciary process was genuinely independent, the valuation conservative and well documented, the terms clearly communicated, and the seller did not control the trustee or implementation. They would be weaker if the evidence showed that the transaction began with a desired result for the seller and that the plan, valuation, and participant elections were designed around producing that result.

The plaintiffs’ bar may present the greatest practical threat because litigation would place the entire arrangement under discovery. Defendants could be required to disclose promoter materials, tax projections, appraisal drafts, communications concerning the post-transaction decline, estimates of the seller’s Roth appreciation, and discussions about how participant assets would be used. Even if the arrangement survived technical legal analysis, documents describing the seller’s anticipated windfall could make the case expensive to defend and difficult to explain.

Conclusion

The Roth ESOP rests on a series of legal propositions that may each appear defensible when considered separately. The Internal Revenue Code permits designated Roth accounts and in-plan Roth conversions. A leveraged ESOP transaction legitimately reduces equity value by placing acquisition debt on the company. Participants may be permitted to transfer retirement assets and invest them in qualifying employer securities. Selling shareholders may finance the transaction, continue working for the company, and participate in the ESOP. None of these elements, standing alone, necessarily violates the Internal Revenue Code or ERISA.

The concern arises from their combination. In the promoted structure, the seller receives the full negotiated value of the company, finances most of the purchase price with seller notes, retains control or substantial influence, transfers retirement assets into the ESOP, purchases stock during the post-transaction decline, and converts that stock to Roth status. The seller may then receive repayment of the seller notes while the same debt repayment restores the value of the stock held in the seller’s Roth account.

That combination creates four related vulnerabilities. The IRS may contend that the conversion valuation understates fair market value by overstating debt risk and failing to recognize foreseeable earnings, tax benefits, seller flexibility, and expected deleveraging. The IRS may also contend that the opportunity to acquire stock at the depressed value is not offered to employees on a nondiscriminatory basis, in violation of Section 401(a)(4). The Department of Labor may contend that fiduciaries used plan assets and authority to confer a special personal benefit on the seller. Participants and the plaintiffs’ bar may contend that employees bore the debt and operating risk while the seller captured the sales proceeds and a disproportionate share of the restored equity value.

The extraordinary result is itself likely to invite scrutiny. In the example used throughout this paper, a $1.8 million amount converted to Roth status becomes $18 million without organic growth, while the seller also receives $40 million for the company. When an arrangement promises a predictable, tax-free return far exceeding a market-rate tax-free return, regulators and courts may look beyond its individual steps and examine its economic substance, fiduciary process, valuation assumptions, and distribution of benefits.

A carefully structured transaction may have meaningful defenses. Those defenses will depend on a genuinely independent trustee, a contemporaneous and supportable valuation, full disclosure of material conflicts, equal and practical access for participants, careful separation of settlor and fiduciary functions, and persuasive evidence that the arrangement serves the interests of participants rather than principally the tax objectives of the seller. The involvement of qualified advisers will be helpful only if their work is independent, critical, and fully informed.

The ultimate question is not whether Roth provisions can exist in an ESOP. The more consequential question is whether a retirement plan created for employees may be used to allow a controlling selling shareholder to receive the value of the company once through the sale and much of that value a second time through a personal Roth account. Bringing the structure into the light of day allows business owners, fiduciaries, advisers, regulators, and participants to judge whether the promised result reflects legitimate retirement planning or an impermissible transfer of value. Sunlight remains the best disinfectant.

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Kelly O. Finnell, J.D., CLU, AIF® President, EFS ESOP Consultants, LLC kfin@execfin.com · 901.259.7979 Download contact card