It is important to note that there is no dilution.
(a) Where 100% of what will end up being all of the outstanding stock is being acquired using only funds transferred from other plans,
(b) And the seller is a C corporation (and thus not eligible to use 1042 to defer taxation of gains), and
(c) The Company is an S corporation (and is not, itself, a taxable entity), the initial investor-employee-participants come out better when the Company, rather than its ESOP, assumes the stock acquisition indebtedness debt necessary to acquire the stock (or assets, as the case may be).
If, however, the seller is other than a C corporation and sells to the ESOP in order to get 1042 treatment, the financed segment of the stock purchase would have to be implemented by the ESOP, rather than the company, using either, or both, outside borrowing or seller take-back notes. Under such circumstances, the stock represented by the financed portion of the purchase would start out in the ESOP suspense account and be released as the debt is repaid and then allocated, pro-rata to relative compensation, amongst all employees, including, but not limited to, the ones who personally supplied the non-financed portion of the purchase price. Accordingly, under these circumstances, the repayment of ESOP stock acquisition indebtedness will result in at least some element of dilution as to the transferring employees.
But, even where the seller is both eligible for and wants 1042, steps can still be taken to minimize the dilution that might otherwise apply to the detriment of investing employees. Initially, I suggest that, to the extent feasible, money be infused into the ESOP by means of dividends on ESOP stock (both allocated and unallocated). This is because dividends under 404(k), to the extent they are “reasonable” and do not activate the Alternative Minimum Tax (AMT), being income to the ESOP, can, and should, be allocated to participant accounts based upon relative account balances rather than pro-rata to compensation. Since account balances will be largely concentrated in the original participant-investors, dilution will be minimized.
Similarly, where the Company can, and does, elect to be taxed under Subchapter S, ESOP funding should be first in the form of distributions of income (i.e., the Accumulated Adjustment Account [AAA] balances), and thereafter as contributions under 401(a), which are allocated pro-rata based upon relative compensation.
It would also be sensible to use the principal and interest, rather than the principal only, suspense account release formula, since it is the faster of the two stock-release alternatives. While this is contra to the usual approach which favors slow release, it better suits the best interests of the participant-investors, again, because it is faster.
In short, efforts should be made to maximize the benefit accruing to those loyal employees who used their money in other plans to make the ESOP stock purchase possible. Contributions should, however, also be made to benefit all employees, including new ones and those who did not (or could not) make plan-to-plan transfers to the ESOP. An appropriate blend is best. Otherwise, the overall employee incentive that should accompany ESOP implementation will not materialize since employee ownership will not be shared by all employees only those who participated in initial stock acquisition.