Employee Ownership Q&A: February 2023

Q: We are a 100% S Corp ESOP and want to provide certain employees with synthetic equity but are having difficulty deciding between phantom stock and stock appreciation rights (SARs). It seems SARs are more common. How do we decide?

A: Phantom stock provides employees with the value of a certain number shares; stock appreciation rights only the increase in value. The present value of SARs is much less than the present value of phantom stock because SARs only have value if the stock goes up; phantom stock has value even if the price goes down. There is no easy way to equate how many SARs would be needed to provide the same value as phantom stock, but there are formulas your accountant can use to calculate the present value of your awards that can help determine what the ratio might be in your company.

SARs are much more leveraged than phantom stock. Let’s say that one phantom share is equal to three SARs (a common ratio). Al has 100 phantom shares; Melissa has 300 SARs. The stock is $50 at grant. At the end of the five-year term for either award, it is $75. Al gets $7,500 (100 × $75); Melissa gets $7,500 too (the $25 increase × 300). But if the share price goes to $100, Sal gets $10,000 (100 × $100) and Melissa gets $15,000 (300 × $50). If the share price only went to $60, Al gets $6,000; Melissa gets only $3,000. And if it goes down, Al gets something and Melissa nothing.

A main argument for SARs is that they encourage a focus on stock price growth, but there is little evidence or reason to believe that these grants, unless they are exceptionally large, will significantly alter the decisions people make. It makes more sense to think about the grants in terms of risk management. Phantom stock is less risky for people and can make more sense in a company where rapid share price growth is unlikely. SARs have more risk for employees (and more potential gain) but reduce risk for the company because they only pay out if you grow.

There is no right or wrong approach, but it is worth working through some expected scenarios to see how these numbers might work for you and then decide which approach best fits your philosophy.

Q: One of our former owners is the trustee for our plan. He still wants to play an active role as trustee in managing the company, including getting reports from management directly to him. This is making us uncomfortable. Is this common or appropriate, and what can we do?

A: Former or current owners should not be ESOP trustees. There is too much potential for a perceived or actual conflict of interest. In litigation, either will be an issue. You should either have an outside trustee or a committee of, usually, three people (some companies, however, just have a single internal trustee, often the CFO).

Trustees very rarely get involved in day-to-day management or strategic management. While they are shareholders, they can only challenge decisions made by the company if they are an egregious waste of assets, a tough legal standard. Their primary role is overseeing the valuation, investing any cash assets prudently, and making sure the plan is operated according to the law and the rules. They also elect the board, almost always voting for those the board nominates.

The board has the authority to replace this individual. Of course, that will create tensions. So it is better to have this kind of conversation with a mutually trusted third party present, such as an ESOP advisor.

Q: We have had the same independent trustee for several years, but recently, we have been concerned that the trustee is not doing a very good job. The review of the appraisal has not taken into account some concerns we have with methodology, and we have had a hard time getting timely responses to our questions. What are the risks of finding a new trustee?

A: The board has the duty to hire and, if necessary, replace the trustee. The board is also responsible for monitoring the trustee to make sure it does its job properly. On the other hand, replacing a trustee because the board disagrees with the valuation could make it appear you are replacing the trustee’s judgment with your own for reasons not in the best interests of the plan participants the trustee is required to protect.

If the only issues are that the trustee is not responding in a timely fashion or not providing evidence of a careful review of the valuation, you are on solid ground finding a new one. But if the issue is more about the valuation itself, take steps to document your concerns and be clear that you are not second-guessing the valuation, but rather have concerns about the process used to assess it by the trustee (such as a trustee not providing a good answer to a concern about comparable companies or the discount rate used). If you take these steps, your risks will be minimal.

Q: We would like to offer a one-time early diversification option as a way to get more shares back into the plan. We want to limit this to people with at least 10 years in the plan, but at any age. Can we do this?

A: Companies can offer one-time diversifications as often as they like. As long as the rules you establish (such as this one) are not set up to favor more highly compensated individuals (a legal term that currently applies to those who made $135,000 or more in 2022), then you can go ahead with this plan.

Q: If the value of the stock declines after a leveraged ESOP, can the employer choose to use the higher cost basis for the shares in accounting for the ESOP contribution?

A: For tax reporting purposes, the employer contribution to a leveraged ESOP is normally equal to the amount of the principal paid on the loan for the purpose of calculating “annual additions.” Where the stock value is rising, this results in a lower contribution value for reporting to the IRS and DOL than the actual allocation to employees. When the stock value declines, you can use the higher cost basis for the shares, but only for tax reporting purposes and only if the plan provides that the employer can choose to use either the fair market value of the stock allocated or the actual contribution made by the employer. The employer can’t change approaches from one year to another; it has to be in the plan document and used on a consistent basis.