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Update for July 31, 2008

By Corey Rosen

University of Pennsylvania Paper Finds S Corporation ESOPs Help Employees, Employers, and Taxpayers

In "S Corp ESOP Legislation Benefits and Costs: Public Policy and Tax Analysis," Steven Freeman and Michael Knoll of the University of Pennsylvania conclude that S corporation ESOPs add an annual $14 billion in additional compensation that would not have been paid absent an ESOP, lead to annual job stability gains worth another $3 billion, and provide an additional $34 billion in annual increases in account values from stock gains in the accounts held by participants. Employers pay for this out of firm-level performance gains of $33 billion per year. The increased performance of ESOP companies, plus the fact that foregone taxes on earnings are ultimately paid by employees when they start to take benefits out some time after termination, mean that S ESOPs are a net gain for taxpayers. In addition, when employees do pay tax on their distributions, they pay on the basis of (generally) appreciated stock, with part of that appreciation due to the company's ability not to pay taxes in the interim. Given assumptions about their tax rates, the authors conclude that, on balance, the Treasury is likely to end up with more revenue this way than if the income was taxed earlier. The paper is published by the University of Pennsylvania Center for Organizational Dynamics (Working Paper #08-07).

IRS Allows Price Protection for S Corporation ESOPs

In Private Letter Ruling 200827008, the IRS ruled that floor price agreements for S corporation ESOPs do not count as a second class of stock, which would disqualify the S election. S corporation rules in general do not consider stock rights that are agreements to redeem stock at death, divorce, disability, or termination of employment as creating an additional class of stock. The ruling said that floor price protection fell into this exception.

Many ESOP companies have multiple ESOP transactions. In some companies, after the first purchase of shares, often 30% to 50%, a second transaction is done to buy more shares. Other companies that are 100% ESOP-owned do additional leveraged transactions to acquire other companies. In either case, the new debt taken on can lower the price of the shares already in the plan. To deal with this, many ESOP companies offer some kind of price protection for existing participants. Sometimes that is limited to people over a certain age and/or to people getting distributions in the next x number of years. A floor price is set, and the company makes up the difference, if any, when the distribution is made.

IRS/Treasury Release Proposed ESPP and Incentive Stock Option Regulations

On July 29, the IRS and the Treasury Department released proposed regulations relating to options granted under an IRC Section 423 employee stock purchase plan (ESPP) and under IRC Sections 422 (ISOs) and 421 (taxation of stock transferred under IRC Sections 422 and 423). Most of the proposed regulations appear to be clarifications of treatment of an option due to inconsistent terms, shareholder approval, eligibility, pricing, grant date, and definition of "highly compensated employee." The proposed regulations also inquire whether a correction program for ESPPs is appropriate. The one item of note is in the preamble, where the IRS and Treasury Department state they do not believe they have the authority to allow the exclusion of citizens or residents of a foreign jurisdiction or collectively bargained employees. However, the proposed regulations do allow the exclusion of foreign citizens or foreign residents if the grant of the option is prohibited under the laws of the foreign jurisdiction (or compliance with the laws of the foreign jurisdiction would cause the plan to violate the requirements of Section 423). In addition, the terms of an option granted to a foreign citizen or resident may be less favorable if necessary to comply with the laws of a foreign jurisdiction.

Comments on the proposed requirements are due to the IRS by October 27, 2008, and the changes are set to be effective with grants made on or after January 1, 2010 (see here).

New FASB Staff Position on Dividends or Dividend Equivalents in Share Plans

In FASB Staff Position (No. EITF 03-6-1), Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities, the Financial Accounting Standards Board (FASB) states that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share under the two-class method. The guidance (see here for a copy) is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years.

Are You an Inner City 100 Company?

The NCEO is partnering with the Initiative for a Competitive Inner City (ICIC) on a project to encourage employee ownership in inner cities. One way we can bring more attention to the idea of employee ownership in these communities is to highlight examples of fast-growing employee ownership companies in these areas. The Inner City 100 is an annual list of the fastest-growing inner-city companies. The winners will receive considerable national attention, including in Business Week Small Business. Last year, an ESOP company and NCEO member, Giroux Glass, was one of the 100 companies and won the Dorothy A. Terrell Community Impact Award, named in honor of the ICIC's former President and CEO. Companies are judged for the extent to which they create jobs, income, and wealth for the residents of the inner-city locations in which they operate. Inner cities are defined as economically distressed urban areas. To apply, go here.

Ownership Thinking Conference September 18 and 19

Ownership Thinking, a consulting and training firm in Colorado dedicated to creating cultures of ownership thinkers, is having its second annual conference on September 18 and 19 in the Denver area. The NCEO is a cosponsor. Brad Hams, president of Ownership Thinking, has been a board member of the NCEO for some time and is one of our top-rated speakers at NCEO conferences. His conference features Kim Jordan, CEO of New Belgium Brewing Company (an NCEO Innovations Award Winner), as the keynote speaker this year. In addition, there will be 14 breakout session speakers (including Loren Rogers from the NCEO), with topics including strategic action planning, models of motivation, talent alignment, breaking the communications barrier, absolute honesty, and joyful business. For more information, you can go to their Web site at www.ownershipthinking.com or call their office at 303-984-1434.

NCEO Members-Only Online Services

The members-only area on the NCEO Web site provides a variety of tools for employee ownership companies and providers, including:

• A searchable referral service listing hundreds of employee ownership professionals
• A searchable archive of previous newsletters
• Case studies of companies with ESOPs and companies with stock options or other equity plans
• A legislative and regulatory status update
• An ESOP and equity plan glossary
• A discussion forum where you can post questions to experts
• Archives of "The Owners Page," a special report written for employee owners

You can sign up for membership online.

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