An Introduction to ESOPs

8th ed. (2007); 50 pp. (5 1/2" x 8 1/2"), softcover. $2 for NCEO members; $3 for nonmembers (minimum order of 5 unless ordered with one of our ESOP books).

This booklet explains the rules, uses, benefits, and other aspects of employee stock ownership plans (ESOPs). It is useful as an introduction to the subject, as an accompaniment to a full-length book related to ESOPs, or as a concise reference for laypeople. Thousands are sold every year, making this our best-selling publication. When bought in quantity, they are usually purchased by consultants who give them to clients who are considering an ESOP; by people who give them out as part of an educational meeting on ESOPs; by companies who give them to employees who have some understanding of and interest in business topics; or by companies or consultants who give them to managers, boards of directors, or other company decisionmakers.

The 8th edition has been not only revised to take account of recent developments but also expanded; for example, the section on S corporations has been expanded from a brief section near the end to an independent six-page chapter.

Introduction
What Is an ESOP?
Types of ESOPs
ESOP Tax Incentives
Uses of ESOPs
ESOPs for S Corporations
Contribution and Allocation Limits
Employee Coverage and Entitlement to Benefits
Distributing Proceeds to the Participants
Fiduciary Matters
The Rights of ESOP Participants
Is an ESOP Right for Your Company?
Implementing and Administering an ESOP
A Final Caveat

Excerpts

From "What Is an ESOP?"

An ESOP is a qualified, defined contribution employee benefit plan that invests primarily in the stock of the employer company. ESOPs are “qualified” (i.e., tax-qualified) in that in return for meeting certain rules designed to protect the interests of plan participants, ESOP sponsors receive various tax benefits. ESOPs are “defined contribution plans” in that the employer makes yearly contributions that accumulate to produce a benefit that is not defined in advance, in contrast to defined benefit plans under which employees are guaranteed a specified benefit funded by the company through necessary contributions.

Technically, an ESOP is simply a variation of a stock bonus plan or combination stock bonus/money purchase plan that is designed to invest primarily in employer stock. Under a stock bonus plan, the employer pays out an employee benefit in the form of company stock. Money purchase pension plans are retirement-oriented plans that commit the company to a minimum annual contribution. An ESOP is the only type of qualified employee benefit plan that can also borrow money from or on the credit of the employer, provided the ESOP uses the money to buy employer stock.

From "Uses of ESOPs"

Aside from their obvious use as a tax-advantaged way of providing an employee benefit, ESOPs have a variety of special applications, such as the following.

For business continuity. The most common use of an ESOP is to sell part or all of an owner’s interest in a closely held company. In this situation, an ESOP provides substantial advantages over other alternatives:

It provides a ready market for the stock.
The company can fund the transaction with pretax dollars.
The owner(s) may sell to the ESOP partially, or in stages over a period of years so they can gradually ease out of the company—a particularly important consideration for sellers with management responsibilities.
In a C corporation, the selling owner(s) may defer taxation on the gains by using the Section 1042 “rollover” explained above.
In an S corporation, distributions that would otherwise be used for shareholders to pay taxes on S corporation income may be used to fund a portion of the ESOP share purchase.

As a tool of corporate finance. A leveraged ESOP can be used to borrow money that could be used to buy another company or new equipment, or to refinance debt. To accomplish these goals, the company issues new shares and sells them to the ESOP in a leveraged transaction, using the proceeds from the sale of new shares to finance acquisitions or to refinance debt.

The company raises new capital by allowing the ESOP to buy new shares, which is funded by corporate contributions to the ESOP that come from pretax company cash flow. While this dilutes the ownership of the non-ESOP shareholders, it allows a much less costly repayment of the loan and simultaneously provides an employee benefit plan. If properly structured, the corporation’s growth due to the additional capital will exceed the dilution caused by issuing new shares.

From "Distributing Proceeds to the Participants"

Distributions after leaving employment.The special rules for ESOP distributions provide that when a participant retires, becomes disabled, or dies, the ESOP must begin to distribute vested benefits during the plan year following the event. When employment terminates for other reasons, such as when an employee quits, distribution must start no later than the sixth plan year after the plan year in which termination occurred (unless the participant is re-employed by the same company before then). However, if the ESOP is leveraged and in a C corporation, distributions of shares acquired through the loan generally may be delayed until the plan year after the plan year in which the ESOP loan is fully repaid (it is unclear whether S corporations can do this).

Under the special ESOP rules, distributions may be made in a lump sum or in substantially equal payments (not less frequently than annually) over a period no longer than five years (i.e., six payments over five years). Distributions are made in the form of cash or stock.

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