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A Detailed Overview of Employee Ownership Plan Alternatives

Employee Stock Ownership Plans (ESOPs)

What Is an ESOP?

An ESOP is a kind of employee benefit plan. Governed by ERISA (Employee Retirement Income Security Act), ESOPs were given a specific statutory framework in 1974. In the ensuing 12 years, they were given a number of other tax benefits. Like other qualified deferred compensation plans, they must not discriminate in their operations in favor of highly compensated employees, officers, or owners. To assure that these rules are met, ESOPs must appoint a trustee to act as the plan fiduciary. This can be anyone, although larger companies tend to appoint an outside trust institution, while smaller companies typically appoint a manager or create an ESOP trust committee.

The most sophisticated use of an ESOP is to borrow money (a "leveraged" ESOP). In this approach, the company sets up a trust. The trust then borrows money from a lender. The company repays the loan by making tax-deductible contributions to the trust, which the trust gives to the lender. The loan must be used by the trust to acquire stock in the company. Proceeds from the loan can be used by the company for any legitimate business purpose. The stock is put into a "suspense account," where it is released to employee accounts as the loan is repaid. However, for purposes of calculating the various contribution limits described below, the employee is considered to have received only his or her share of the principal paid that year, not the value of the shares released. After employees leave the company or retire, the company distributes to them the stock purchased on their behalf, or its cash value. In practice, banks often require a second step in the loan transaction of making the loan to the company instead of the trust, with the company reloaning the proceeds to the ESOP.

In return for agreeing to funnel the loan through the ESOP, the company gets a number of tax benefits, provided it follows the rules to assure employees are treated fairly. First, the company can deduct the entire loan contribution it makes to the ESOP, within certain payroll-based limits described below. That means the company, in effect, can deduct interest and principal on the loan, not just interest. Second, the company can deduct dividends paid on the shares acquired with the proceeds of the loan that are used to repay the loan itself (in other words, the earnings of the stock being acquired help pay for the stock itself). Again, there are limits, as described below in sections on the rules of the loan and contribution limits.

The ESOP can also be funded directly by discretionary corporate contributions or cash to buy existing shares or simply by the contribution of shares. These contributions are tax-deductible, generally up to 25% of the total eligible payroll of plan participants.

How ESOPs Are Used

The ESOP can buy both new and existing shares, for a variety of purposes.

Rules for ESOP Loans

ESOPs are unique among benefit plans in that they can borrow money. Typically, a lender will loan to the company, with the company reloaning the money to the ESOP. The ESOP then uses the loan proceeds to buy new or treasury shares of stock (when the ESOP is used to finance growth) or existing shares (when the ESOP is used to buy shares of current owners). Of course, the ESOP itself does not have any money to repay the loan, so the company makes tax-deductible contributions to the plan that the plan then uses to repay the lender. This means, in effect, the company can deduct principal and interest on the loan, provided the requirements described below are met.

The ESOP can borrow money from anyone, including commercial lenders, sellers of stock, or even the company itself. Any loan to an ESOP must meet several requirements, however. The loan must have reasonable rates and terms and must be repaid only from employer contributions, dividends on shares in the plan, and earnings from other investments in the trust contributed by the employer. There is no limit on the term of an ESOP loan other than what lenders will accept (normally five to ten years), and the proceeds from the sale of shares to the ESOP can be used for any business purpose.

Shares in the plan are held in a suspense account. As the loan is repaid, these shares are released to the accounts of plan participants. The release must follow one of two formulas. The simplest is that the percentage of shares released equals the percentage of principal paid, either that year or during whatever shorter repayment period is used. In such cases, however, the release may not be slower than what normal amortization schedules would provide for a ten year loan with level payments of principal and interest. The principal only method usually has the effect of releasing fewer shares to participants in the early years. Alternatively, the company can base its release on the total amount of principal and interest it pays each year. This method can be used for any loan, but it must be used for loans of over 10 years.

In either case, it is important to remember that the value of the shares released each year is rarely the same as the amount contributed to repay the principal on the loan. If the price of the shares goes up, the amount released will be higher, in dollar terms, than the amount contributed; if it goes down, the dollar value of the amount released will be lower. The amount contributed to repay the principal on the loan is what counts for determining if the company is within the limits for contributions allowed each year and for the purpose of calculating the tax deduction. The value of the shares released, however, is the amount used on the income statement, where it counts as a compensation cost.

Limitations on ESOP Contributions

First, it is important to understand that in a leveraged ESOP, the amount the company is considered to have contributed to the ESOP or that is defined as an "annual addition" to an employee's account is based on the amount of principal paid off each year attributable to each employee's account. The actual addition to an employee's account, however, is the value of the shares released, but this value is not the one used for contribution and annual addition testing.

Congress was generous in providing tax benefits for leveraged ESOPs, but there are limits. Generally, companies can deduct up to 25% of the total eligible payroll of plan participants to cover the principal portion of the loan and can deduct all of the interest income they pay. Eligible pay is essentially all the pay, including employee deferrals into benefit plans, of people actually in the plan, of $245,000 per participant or less (as of 2009; this figure is indexed for inflation). However, company contributions to other defined contribution plans, such as stock bonus, 401(k), or profit sharing plans, generally must be counted in this 25% of pay calculation. (In 2004, however, the IRS issued a private letter ruling stating that the 25% contribution limit for repaying an ESOP loan is separate from and in addition to the 25% limit for other defined contribution plans; this applies only to C corporations.) On the other hand, "reasonable" dividends paid on shares acquired by the ESOP loan can be used to repay the loan, and these are not included in the 25% of pay calculations. If employees leave the company before they have a fully vested right to their shares, their forfeitures, which are allocated to everyone else, are not counted in the percentage limitations. If the ESOP does not borrow money, the annual contribution limit is also 25% of covered pay. Again, contributions to other plans reduce this amount.

There is also a limit on the annual additions that can be made to an employee account. No one ESOP participant can get a contribution of the lesser of $49,000 (in 2009, indexed annually) or more than 100% of pay in any year from combined contributions to the ESOP and to other defined contribution plans, both from the employer and the employee.

Third, if not more than one-third of the benefits are allocated to highly compensated employees, as defined by the Internal Revenue Code (Section 414(q)), forfeitures are also counted in determining how much an employee is getting each year. If the company sponsoring the ESOP is an S corporation, interest is also not deductible.

Using Dividends to Repay the ESOP Loan

The 1986 tax act allowed companies to take a tax deduction when using "reasonable" dividend payments to repay the ESOP loan. These payments do not count against the contribution limits described above. While the term "reasonable" has never been defined, most consultants believe it is a percentage of share value consistent with what other companies in the industry would pay given similar levels of profits. Many companies are using preferred stock in their ESOPs to allow for higher dividend payments. Whatever kind of stock is used, the amount of the dividends must be allocated to employee accounts. Companies normally allocate these amounts in the form of shares released from the suspense account.

Companies can also "pass through" dividends directly to employees. Typically, companies would pay dividends on allocated shares (whether in a leveraged or non-leveraged plan). These dividends are also tax-deductible to the company. Finally, dividends that are voluntarily reinvested by the employee back into company stock in the ESOP are also tax-deductible to the company.

How ESOP Shares Get to Employees

The rules for ESOPs are similar to the rules for other tax-qualified plans in terms of participation, allocation, vesting, and distribution, but several special considerations apply. All employees over age 21 who work for more than 1,000 hours in a plan year must be included in the plan, unless they are covered by a collective bargaining unit, are in a separate line of business with at least 50 employees not covered by the ESOP, or fall into one of several anti-discrimination exemptions not commonly used by leveraged ESOPs. If there is a union, the company must bargain in good faith with it over inclusion in the plan.

Shares are allocated to individual employee accounts based on relative compensation (generally, all W-2 compensation is counted), on a more level formula (such as per capita or seniority), or some combination. The allocated shares are subject to vesting. Employees must be 100% vested after three years of service, or the company can use a graduated vesting schedule not slower than 20% after two years and 20% per year more until 100% is reached after six years. For contributions made before December 31, 2006, and for shares acquired by a loan in place on September 26, 2005 (for any plan year beginning before the earlier of the date the loan is fully repaid or the date on which the loan was scheduled to be repaid as of September 26, 2005), vesting can be slower: five-year cliff or seven-year graduated, starting at not less than 20% per year after the third year.

When employees reach age 55, and have 10 years of participation in the plan, the company must either give them the option of diversifying 25% of their account balances among at least three other investment alternatives or simply pay the amount out to the employees. At age 60, employees can have 50% diversified or distributed to them.

When employees retire, die, or are disabled, the company must distribute their vested shares to them not later than the last day of the plan year following the year of their departure. For employees leaving before reaching retirement age, distribution must begin not later than the last day of the sixth plan year following their year of separation from service. Payments can be in substantially equal installments out of the trust over five years or in a lump sum. In the installment method, a company normally pays out a portion of the stock from the trust each year. The value of that stock may go up or down over that time, of course. In a lump sum distribution, the company buys the shares at their current value, but can make the purchase in installments over five years, as long as it provides adequate security and reasonable interest. ESOP shares must be valued at least annually by an independent outside appraiser unless the shares are publicly traded.

Closely held companies and some thinly traded public companies must repurchase the shares from departing employees at their fair market value, as determined by an independent appraiser. This so-called "put option" can be exercised by the employee in one of two 60-day periods, one starting when the employee receives the distribution and the second period one year after that. The employee can choose which one to use. This obligation should be considered at the outset of the ESOP and factored into the company's ability to repay the loan.

ESOP Voting Rules

Voting is one of the most controversial and least understood of ESOP issues. The trustee of the ESOP actually votes the ESOP shares. The question is "who directs the trustee?" The trustee can make the decision independently, although that is very rare. Alternatively, management or the ESOP administrative committee can direct the trustee, or the trustee can follow employee directions.

In private companies, employees must be able to direct the trustee as to the voting of shares allocated to their accounts on several key issues, including closing, sale, liquidation, recapitalization, and other issues having to do with the basic structure of the company. They do not, however, have to be able to vote for the board of directors or other typical corporate governance issues, although companies can voluntarily provide these rights. Instead, the plan trustee votes the shares, usually at the direction of management. In listed corporations, employees must be able to vote on all issues.

Voting rights are more complicated than they seem. First, voting is not the same as tendering shares. So while employees may be required to vote on all issues, they may have no say about whether shares are tendered. In public companies, this is a major issue. Almost all public companies now write their plans to give employees the right to direct the tendering, as well as voting, of their shares, for reasons to be explained below.

Second, employees are not required to be able to vote on unallocated shares. In a leveraged ESOP, this means that for the first several years of the loan, the trustee can vote the majority of the shares, if that is what the company wants to do. The company could provide that unallocated shares, as well as any allocated shares for which the trustee has not received instructions, should be voted or tendered in proportion to the allocated shares for which directions were received.

What this all means is that for almost all ESOP companies, governance is not really an issue unless they want it to be. If companies want employees to have only the most limited role in corporate governance, they can; if they want to go beyond this, they can as well. In practice, companies that do provide employees with a substantial governance role find that it does not result in dramatic changes in the way the company is run.

ESOP Valuation

In closely held companies and some thinly traded listed companies, all ESOP transactions must be based on a current appraisal by an independent, outside valuation expert. The valuation process assesses how much a willing buyer would pay a willing seller for the business. This calculation is performed by looking at various ratios, such as price-to-earnings, at discounted future cash flow and earnings, at asset value, and at comparable companies, among other things. It is then adjusted to reflect whether the sale is for control (owning a controlling interest in a business is worth more than owning a minority interest, even on a per share basis) and marketability (shares of public companies are worth more than closely held firms because they are easier to buy and sell). ESOP company shares have better marketability than non-ESOP firms, however, because the ESOP provides a market, albeit not as active a one as a stock exchange.

ESOP Tax Benefits for the Selling Shareholder

One of the major benefits of an ESOP for closely held firms is Section 1042 of the Internal Revenue Code. Under it, a seller to an ESOP may be able to qualify for a deferral of taxation of the gain made from the sale. Several requirements apply, the most significant of which are:
  1. The seller must have held the stock for three years prior to the sale.
  2. The stock must not have been acquired through options or other employee benefit plans.
  3. The ESOP must own 30% or more of the value of the shares in the company and must continue to hold this amount for three years unless the company is sold. Shares repurchased by the company from departing employees do not count. Stock sold in a transaction that brings the ESOP to 30% of the total shares qualifies for the deferral treatment.
  4. Shares qualifying for the deferral cannot be allocated to accounts of children, brothers or sisters, spouses, or parents of the selling shareholder(s), nor to other 25% shareholders.
  5. The company must be a "C" corporation.

If these rules are met, the seller (or sellers) can take the proceeds from the sale and reinvest them in "qualified replacement securities" within 12 months after the sale or three months before and defer any capital gains tax until these new investments are sold. Qualifying replacement securities are defined essentially as stocks, bonds, warrants, or debentures of domestic corporations receiving not more than 25% of their income from passive investment. Mutual funds and real estate trusts do not qualify. If the replacement securities are held until death, they are subject to a step-up in basis, so capital gains taxes would never be paid.

Increasingly, lenders are asking for replacement securities as part or all of the collateral for an ESOP loan. This strategy may be beneficial to sellers selling only part of their holdings because it frees the corporation to use its assets for other borrowing and could enhance the future value of the company.

It is also important to note that people taking advantage of the "1042" treatment cannot have stock reallocated to their accounts from these sales if they remain employees. Other 25% shareholders and close relatives of the seller also cannot receive allocations from these sales.

Financial Issues for ESOP Participants

When an employee receives a distribution from the plan, it is taxable unless rolled over into a traditional (not Roth) IRA or another qualified plan. Otherwise, the amounts contributed by the employer are taxable as ordinary income, while any appreciation on the shares is taxable as capital gains. In addition, if the employee receives the distribution before normal retirement age and does not roll over the funds, a 10% excise tax is added.

While the stock is in the plan, however, it is not taxable to employees. It is rare, moreover, for employees to give up wages to participate in an ESOP or to purchase stock directly through a plan (this raises difficult securities law issues for closely held firms). Most ESOPs either are in addition to existing benefit plans or replace other defined contribution plans, usually at a higher level of pay.

Determining ESOP Feasibility

Several factors are involved in determining if a company is a good ESOP candidate:

Repurchase Considerations

One of the major issues ESOPs must face is the obligation that companies sponsoring them provide for the repurchase of shares of departing employees. The legal obligation rests with the company, although it can fund this by making tax-deductible contributions to the ESOP, which the ESOP uses to repurchase the shares. Most companies either do this or buy the shares back themselves and then recontribute them to the ESOP (and take a tax deduction for that). Either way, shares continue to circulate in the plan, providing stock for new employees. Some companies, however, buy back the shares and retire them or have other people buy them (a manager, for instance).

The repurchase obligation may seem like a reason not to do an ESOP (people often ask, "you mean we have to buy back the shares continually"). In fact, all closely held companies have a 100% repurchase obligation at all times. An ESOP simply puts it on a schedule and allows the company to do it in pretax dollars. Nonetheless, repurchase can be a major problem if companies do not anticipate and plan for it. A careful repurchase study should be done periodically to help manage this process.

ESOPs in S Corporations

While ESOPs in S corporations operate under most of the same rules as in C corporations, there are important differences.

First, interest payments on ESOP loans count toward the contribution limits (they normally do not in C companies). Dividends (S corporation "distributions") paid on ESOP shares are also not deductible.

Second, and most importantly, sellers to an ESOP in an S corporation do not qualify for the tax-deferred rollover treatment.

On the other hand, the ESOP is unique among S corporation owners in that it does not have to pay federal income tax on any profits attributable to it (state rules will vary). This can make an ESOP very attractive in some cases. It also makes converting to an S corporation very appealing when a C corporation ESOP owns a high percentage of the company's stock.

For owners who want to use an ESOP to provide a market for their shares, generally it will make sense to convert to C status before setting up an ESOP. Where selling shares is not a priority, or where the seller either does not have substantial capital gains taxes due on the sale or has other reasons to prefer staying an S corporation, an S ESOP can provide significant tax benefits. However, owners must keep in mind that any distributions paid to owners must be paid pro-rata to the ESOP. The ESOP can use these distributions to purchase additional shares, to build up cash for future repurchases of employee shares, or just to add to employee accounts.

While the S corporation rules make an ESOP very attractive, legislation passed in 2001 makes it clear that these rules are not meant to be abused by companies seeking to create the ESOP primarily to benefit a few people. For instance, some accountants promoted plans in which a company would set up an S corporation management company owned by just a few people that would manage a large C corporation. The profits would flow through the S corporation, which would then not be taxed.

The rules Congress enacted are complicated, but boil down to two essential points. First, people who own more than 10% of the company (including ESOP shares), or who own 20% counting their family members, are considered "disqualified" persons. The ESOP ownership is defined to include synthetic equity as well, such as options. Second, if these disqualified people together own more than 50% of the company's shares (counting their synthetic equity), then they cannot get allocations in the ESOP without extraordinary tax penalties. Congress also directed the IRS to apply this onerous tax treatment to any plan it deems to be substantially for the purpose of evading taxes rather than providing employee benefits.

Steps to Setting Up an ESOP

If you have decided an ESOP is worth investigating, there are several steps to take to implement a plan. At each point, you may decide you have gone far enough and that an ESOP is not right for you.
  1. Determine whether other owners are amenable. This may seem like an obvious issue, but sometimes people take several of the steps listed below before finding out if the existing owners are willing to sell. Employees should not start organizing a buyout unless they have some reason to think the parent firm is willing to sell (it may not be, for instance, if its goal is to reduce total output of a product it makes at other locations). Or there may be other owners of a private firm who will never agree to an ESOP, even if it seems appealing to the principal owners. They could cause a good deal of trouble down the road.
  2. Conduct a feasibility study. This may be a full-blown analysis by an outside consultant, replete with market surveys, management interviews, and detailed financial projections, or it may simply be a careful business plan performed in-house. Generally, full scale feasibility studies are only needed where there is some doubt about the ESOP's ability to repay the loan. Any analysis, however, must look at several items. First, it must assess just how much extra cash flow the company has available to devote to the ESOP, and whether this is adequate for the purposes for which the ESOP is intended. Second, it must determine if the company has adequate payroll for ESOP participants to make the ESOP contributions deductible. Remember to include the effect of other benefit plans that will be maintained in these calculations. Third, estimates must be made of what the repurchase liability will be and how the company will handle it.
  3. Conduct a valuation. The feasibility study will rely on rough estimates of the value of the stock for the purpose of calculating the adequacy of cash and payroll. In public companies, of course, these estimates will be fairly accurate because they can be based on past price performance. In private companies, they will be more speculative. The next step for private firms (and some public companies as well) is a valuation. A company may want to have a preliminary valuation done first to see if the range of values produced is acceptable. A full valuation would follow if it is. Doing a valuation before implementing a plan is a critical step. If the value is too low, sellers may not be willing to sell. Or, the price of the shares may be too high for the company to afford. The valuation consultant will look at a variety of factors, including cash flow, profits, market conditions, assets, comparable company values, goodwill, and overall economic factors. A discount on value may be taken if the ESOP is buying less than 50% of the shares.
  4. Hire an ESOP attorney. If these first three steps prove positive, the plan can now be drafted and submitted to the IRS. You should carefully evaluate your options and tell your attorney just how you want the ESOP to be set up. This could save you a considerable amount of money in consultation time. The IRS may take many months to issue you a "letter of determination" on your plan, but you can go ahead and start making contributions before then. If the IRS rules unfavorably, which rarely happens, normally you just need to amend your plan.
  5. Obtain funding for the plan. There are several potential sources of funding. Obviously, the ESOP can borrow money. Banks are generally receptive to ESOP loans, but, as with any loan, it makes sense to shop around. Sellers or other private parties can also make loans, but do not qualify for the interest income exclusion. Larger ESOP transactions can also tap the bond market or borrow from insurance companies. Another source of funding is ongoing company contributions, outside of loan repayments. While ESOPs must, by law, invest primarily in employer securities, most ESOP experts believe they can temporarily invest primarily in other assets while building up a fund to buy out an owner. A third source is existing benefit plans. Pension plans are not a practical source of funding, but profit sharing plans are sometimes used. Profit sharing assets are simply transferred in part, or entirely, into an ESOP. Many ESOP companies do this, but it must be done cautiously. If employees are given no choice in the switch, trustees of the plan must be able to demonstrate that the investment in company stock was prudent; if they are given a choice, there could be a securities law issue. Finally, employees can contribute to the plan, most commonly by wage or benefit concessions. Most ESOPs do not require these, but they are necessary in some cases. Clearly, this is an issue that must be handled very carefully.
  6. Establish a process to operate the plan. A trustee must be chosen to oversee the plan. In most private companies, this will be someone from inside the firm, but some private and most public companies hire an outside trustee. An ESOP committee will direct the trustee. In most companies, this is made up of management people, but many ESOP firms allow at least some nonmanagement representation. Finally, and most important, a process must be established to communicate how the plan works to employees and to get them more involved as owners.

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