PHILADELPHIA - Arcane tax rules could stop some participants in Conrail Inc.'s ESOP from collecting a piece of a $1.15 billion windfall expected from the company's impending acquisition by CSX Corp.
The windfall will be generated because CSX is buying out all Conrail shareholders at $115 a share, and the employee stock ownership plan acquired the shares around $28 each.
If all of the money in the ESOP's kitty - after paying off the outstanding $210 million loan it took to buy Conrail's shares - is divided equally among the participants, each employee would collect $312,333.
About 3,000 of Conrail's more than 20,000 employees participate in the ESOP.
But the Internal Revenue Service could dictate how much Conrail can give to the ESOP participants.
When the ESOP was set up in April 1990, it acquired 9.97 million Conrail shares with a $288 million loan from the company. As of Dec. 31, 1996, only 2.7 million, or 27% of the nearly 10 million shares had been allocated to employees covered by the plan, according to the company's 1996 annual report. A portion of the allocated shares already has been tendered to CSX, the report notes.
Because Conrail matches non-union employee contributions to the company's 401(k) plan in stock through the ESOP, the IRS is expected to maintain its traditional view that the spread between the merger price and the ESOP acquisition price is an employer contribution.
And because Section 415(c)(1) of the IRS code caps annual employer contributions at $30,000 or 25% of employee pay, it could take years for some of the employees covered by the ESOP to receive all of their share of the profits from the company's merger.
After the merger, CSX would have to keep Conrail's 401(k) plan intact and use the leftover profits on the unallocated shares as employer contributions until all former Conrail employees at the merged company received their portion of profits, experts say.
Lawyers at Arnold & Porter, the Washington law firm representing CSX, declined to comment.
"It's a way to deny participants a portion that is allocable to them," said Ronald L. Ludwig, partner at the San Francisco law firm of Ludwig, Goldberg & Krenzel.
"It's clearly bad interpretation of the law, but that is the position that the IRS has taken for years," said Mr. Ludwig, an ESOP expert.
The ESOP Association, a Washington trade association, has unsuccessfully battled this IRS position for years, said J. Michael Keeling, president.
Although there has been no legal challenge to the IRS position so far, some experts hinted the Conrail case might provide grounds for just such a lawsuit. And employees who lose their jobs in the course of the merger probably won't get any of the future proceeds from the currently unallocated shares, tax lawyers say.
"Once you leave, that's it," said Michael A. Thrasher, of counsel to the Washington law firm of Groom and Nordberg. "It's like any other defined contribution plan. You get what you got while you were there." Mr. Thrasher previously was assistant chief counsel in the IRS' division of employee benefits and exempt organizations.
Conrail matches 100% of non-union employee contributions to the 401(k) retirement plan in Conrail stock through the ESOP for the first 6% of pay. Union employees are not covered by the plan.
Conrail officials declined to comment on their discussions with the IRS. They wouldn't say whether they're seeking permission from the IRS to consider the net profits received by the ESOP trust as investment gains on employer stock, instead of employer contributions.
One solution would be for Conrail to determine a way to allocate the unallocated shares in the ESOP to employees before the merger, Mr Thrasher suggested.
"Once its allocated, everybody gets their money," he said.
The only way Conrail can allocate the remaining 7 million-plus unallocated shares to current participants is by forgiving the ESOP the outstanding loan balance.
"If you forgive the loan, the IRS would say it's an employer contribution, so you are right back where you started," explained Jared Kaplan, partner in the Chicago office of McDermott, Will & Emery.
The way the company probably set up the ESOP was to lend $288 million to the ESOP, which then used it to purchase newly issued convertible preferred stock from Conrail. Conrail, which set up the ESOP as an anti-takeover defense tactic, used the cash to repurchase a sizable portion of its outstanding shares. At the same time, the ESOP used dividends on the preferred stock, as well as Conrail's matching contribution to the 401(k) plan, to repay a portion of the 20-year $288 million loan each year.
The stock is held in a suspense account, and a portion is released each year to participants, as the ESOP pays down the loan.
"That's the most likely scenario," said Mr. Kaplan, who structured dozens of similar ESOPs at the time.
In an acquisition such as the Conrail deal, the ESOP is expected to tender all of the allocated and unallocated shares to CSX. Money from the sale of allocated shares will go directly to participants. The ESOP will use the remaining proceeds to pay off the outstanding loan, and then divide the profits on the unallocated shares among employees using a standard formula, usually as a percentage of pay subject to the IRS limits.
Some employees who expect to lose their jobs in the merger are contemplating a lawsuit against Conrail, said a Philadelphia lawyer seeking to represent them who declined to be identified. But, says Mr. Kaplan, "Conrail might have a good defense if all it is doing is following the IRS rules."