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A Detailed Overview of Employee Ownership Plan Alternatives



On a rainy business trip to Florida recently, I got up early and put on my Gore-Tex running outfit to go out for my morning jog. After showering, I threw my Crest Toothpaste into a bag and hurried over to Starbucks for coffee and a pastry. I needed to catch my Southwest Airlines flight soon, but I left my razor at home, so I rushed into the Publix Supermarkets and picked one up. It was going to be a long day, but I felt good that all the products and services I'd used so far had come from companies where the employees were substantial or principal owners.

I have to say my story is a fable, but it could have happened. But what has happened to employee ownership is no fable. There are now over 25 million employees who own stock in their companies through employee stock ownership plans (ESOPs), broadly granted stock options, or 401(k) plans with heavy concentrations of employer stock.

Why Employee Ownership Is Popular

There are a number of reasons for the popularity of employee stock plans. ESOPs provide attractive tax benefits. They allow companies to borrow money and repay it in pretax dollars. They provide a way for owners of closely held businesses to sell all or part of their interests and defer taxation on the gain. The ownership of an S corporation held by an ESOP is not subject to the requirement for other owners to pay their pro-rata share of taxes on corporate earnings. ESOPs also they make it possible for companies to provide an employee benefit simply by contributing tax-deductible shares of their own stock, among other benefits. Broadly granted stock options, restricted stock, stock appreciation rights, and phantom stock do not provide special tax benefits but give growing companies a way to compensate employees with equity or the equivalent of equity rather than more cash. Putting company stock in 401(k) plans provides a less expensive way for companies to match employee deferrals than matching in cash. Employee stock purchase plans (often called Section 423 plans, although not all such plans fall under this part of the tax code from which the name derives) allow employees to put aside part of their paychecks to buy stock, usually at a significant discount.

Just as important, however, are potential productivity gains. Studies consistently show that when broad employee ownership is combined with a highly participative management style, companies perform much better than they otherwise would be expected to do. Neither ownership nor participation accomplishes these significant gains on its own. Companies want employees to "think and act like owners." What better way to do that than to make them owners?

Finally, employees are beginning to expect equity, at least in some sectors. In technology firms, for instance, it is increasingly the norm to offer all employee stock options or other equity because companies that don't have a hard time attracting good people.

As a result of all this, during the last decade, the number of companies sharing ownership broadly with employees has grown substantially. While precise numbers are not available, we estimate that as of 2014 about 9 million employees had stock options, restricted stock, phantom stock, and/or stock appreciation rights. Data for the filing year 2014 from the Department of Labor shows there are 6,717 ESOPs in the U.S. covering over 14 million participants and 10.5 million active participants. They control more than 1.3 trillion dollars in assets. Of these, 8% are in publicly traded companies and 92% in closely held firms.

Percent ownership is difficult to determine precisely because this number is not reported. We estimate the median percentage ownership for ESOPs in public firms is about 5%. Most of these public firms maintain the ESOP along with other benefit plans. The median percentage ownership for private firms is about 30-50%, with about 4,000 companies now 100% employee owned by ESOPs (a percentage that is increasing steadily). While the typical firm has 20 to 500 employees, employees own a majority of the stock at a number of companies with thousands or tens of thousands of employees. About two-thirds the ESOPs in private firms are used to buy out an owner; the rest are typically used as a primary employee benefit plan, sometimes in conjunction with borrowing money for capital acquisition.

For some time, 401(k) plans were also heavily used to acquire employer stock, mostly in public companies. About 19% of 401(k) assets were held in employer stock in 2001, but that number fell to about 8% by 2013 in the wake of the accounting scandals at Enron et al. and, later, the stock market crash. Employees decided (wisely, we think) to be more careful about diversification in plans primarily designed for retirement. ESOPs and individual equity plans, meanwhile, remain good vehicles for asset building.

A significant number of companies provide stock options or other kinds of individual equity to most or all employees. Google, Southwest Airlines, and, Starbucks are among the better known examples. Finally, about 11 million employees participate in employee stock purchase plans, almost entirely in public companies. Typically, these plans allow employees to put aside payroll deductions for 6 to 12 months. Accumulated deductions can (but do not have to be) then used to buy stock, typically at 15% off the lowest of either the price at the end of the deduction period or the beginning. These plans have no special tax benefits for companies, but offer employees the potential to treat gains as capital gains. Unfortunately, there are no good data on the exact number of participants or the size of their holdings, but it would clearly be much less than 401(k) plan assets in company stock.

Because ESOPs are the most complicated and most powerful employee ownership tool, we will start this overview with an explanation of how they work, followed by a discussion of stock options and 401(k) plans.

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.

Stock Options

ESOPs are "qualified" plans, meaning they must meet federal rules to assure that participation in them does not excessively favor more highly compensated people. Not every company wants to abide by these rules, nor does every company want the additional tax benefits they can offer. Moreover, some companies believe ownership means more if employees have to put something up to get it. Some growing companies find that contributing or purchasing existing stock is too much of a strain on either their capital structure or their finances, or both. They would prefer to give employees a right to future ownership. Many growing private companies do not pay taxes, so the tax benefits of an ESOP may not be attractive, making the greater flexibility of options more appealing. Finally, options have very favorable accounting treatment, something of particular significance to public companies.

What Is a Stock Option?

A stock option gives an employee the right to buy shares at a price fixed today (usually the market price, but sometimes lower) for a defined number of years into the future. The options might be granted on a percentage of pay basis, a merit formula, an equal basis, or any other formula the company chooses. Most broad-based plans provide grants regularly (every one to three years), either on the basis of the passage of time (every year, for instance) or an event (promotion, meeting certain corporate or group targets, or a performance appraisal, for instance). The options are typically subject to three to five-year vesting, meaning that if someone is 20% vested, he or she can only exercise 20% of the options. An employee can usually exercise vested options at any time. Most options have a ten-year life, meaning the employee can choose to buy the shares at the grant price at any time they are vested for up to 10 years. The difference between the grant price and the exercise price is called the "spread."

Most public companies offer a "cashless exercise" alternative in which the employee exercises the option, and the company gives the employee an amount of cash equal to the difference between the grant price and the exercise price, minus any taxes that are due.

Options can also be exercised with cash, although employees must have enough to pay for the shares and taxes (if any), by exchanging existing shares employee own, or by selling just enough of the shares acquired through the options to pay the costs and taxes, then keeping the remaining shares.

In closely held companies, employees usually have to wait until the company is sold or goes public to sell their shares, although some companies have arrangements to purchase the shares themselves or help facilitate buying and selling between employees. When an employee exercises an option, however, this constitutes an investment decision subject to securities laws. At a minimum, these require "anti-fraud financial disclosure statements" and, in some cases, will require securities registration as well. For this reason, broad stock options are used primarily in closely held firms when the intention is to sell or go public.

For public companies, broad options can impose a substantial dilution for other shareholders as new shares are issued to satisfy option holders. Alternatively, if the company buys shares to satisfy option exercises, there is a significant cash cost. Companies sponsoring these programs, however, contend that shareholders should be satisfied because the costs will only exist if their share price has increased. Management of these companies believes the broad options more than pay for themselves in terms of increased corporate value.

Non-Qualified Options

Most broad-based plans provide employees with non-qualified stock options, options that do not qualify for any special tax consideration. Anyone, employees or non-employees, can be given a non-qualified option on any basis the company chooses. When a non-qualified option is exercised, the employee must pay ordinary income tax on the "spread" between the grant and exercise price; the company can deduct that amount.

For example, say that Joe makes $40,000 per year. Under his company's stock option plan, he gets options worth 10% of pay each year, which vest at 20% per year over five years. So Chip gets to buy $4,000 worth of company stock at current market prices for 10 years. We'll assume that they were trading at $40 when granted, so Chip has options on 100 shares ($40 x 100 = $2,000). Assume he holds onto these options for the full 10 years. At the end of 10 years, assume the shares are now worth $100. Joe can buy 100 shares worth $100 each for just $40, making a profit of $60 per share, or $6,000, on paper. To buy the shares at $40 each, he can borrow the money or use cash. If he has existing shares, he can exchange those for the new shares he is purchasing. However he acquires the shares, he must pay ordinary income tax on $6,000 in gain. The company gets a corresponding tax deduction. Alternatively, and most commonly, he can have PepsiCo buy the shares for him, pay his tax, and give him what is left.

Incentive Stock Options

With an incentive stock option (ISO), a company grants the employee an option to purchase stock at some time in the future at a specified price. With an ISO, there are restrictions on how the option is to be structured and when the option stock can be transferred. The employee does not recognize ordinary income at option grant or exercise (although the spread between the option price and the option stock's fair market value may be taxed under something called the alternative minimum tax purposes), and the company cannot deduct the related compensation expense. The employee is taxed only upon the disposition of the option stock. The gain is all capital gain for a qualifying disposition. For a disqualifying disposition (i.e., one not meeting the rules specified below for a qualifying disposition), the employee will recognize ordinary income as well as capital gain.

For a stock option to qualify as an ISO (and thus receive special tax treatment under Code Section 421(a)), it must meet the requirements of Section 422 of the Code when granted and at all times beginning from the grant until its exercise. The requirements include:

Tax Implications of ISOs for Employees

An employee receiving an ISO realizes no income upon its receipt or exercise. Instead, the employee is taxed upon disposition of the stock acquired pursuant to the ISO. A disposition of ISO stock generally refers to any sale, exchange, gift or transfer of legal title of stock. The tax treatment of the disposition of option exercise stock depends upon whether the stock was disposed of in a qualifying disposition within the statutory holding period for ISO stock. The ISO statutory holding period is the later of two years from the date of the granting of the ISO to the employee or one year from the date that the shares were transferred to the employee upon exercise. If the ISO is exercised more than three months after the employee has left the employ of the company granting the option, however, favorable tax treatment is not available. Upon a qualifying disposition, the employee recognizes capital gain, measured by the difference between the option exercise price and the sale proceeds. However, the gains on an incentive option are subject to Alternative Minimum Tax treatment.

If disposition occurs within two years of the employee's receipt of the option or within one year of receipt of the stock, the employee recognizes at the time of the disposition ordinary income measured by the difference between the option exercise price and the fair market value of the stock at the time of option exercise (the "bargain purchase element"), or the exercise price and the sale price, if the difference is lower. If the stock price rises between the exercise and sale dates, the increase is treated as a capital gain. If shares are held after a disqualifying disposition (as could be the case if they were transferred), then any additional gain or loss would be treated as a capital gain or loss.

An employer granting an ISO is not entitled to a deduction with respect to the issuance of the option or its exercise. If the employee causes the option to be disqualified (by disposing of his or her stock prematurely prior to the end of the requisite holding period), however, the employer usually may take a deduction for that amount recognized by the employee as ordinary income in the same year as the employee recognizes the income.

In addition, the employer that granted the ISO does not have any withholding obligation with regard to the ordinary income an employee recognizes upon a disqualifying disposition.

Employee Stock Purchase Plans

Millions of employees have become owners in their companies through employee stock purchase plans (ESPPs). Many of these plans are organized under Section 423 of the tax code and thus are often called "423" plans. Other ESPPs are "non-qualified" plans, meaning they do not have to meet the special rules of Section 423 and do not get any of the special tax treatment. Most of these plans, however, are very similar in structure.

Under Section 423, companies must allow all employees to participate, but can exclude those with less than two years' tenure, part-time employees, and highly compensated employees. All employees must have the same rights and privileges under the plan, although companies can allow purchase limits to vary with relative compensation (most do not do this, however). Plans can limit how much employees can buy, and the law limits it to $25,000 per year.

423 plans, like all ESPPs, operate by allowing employees to have deductions taken out of their pay on an after-tax basis. These deductions accumulate over an "offering period." At a specified time or times employees can choose to use these accumulated deductions to purchase shares or they can get the money back. Plans can offer discounts of up to 15% on the price of the stock. Most plans allow this discount to be taken based on either the price at the beginning or end of the offering period (the so-called "look-back feature"). The offering period can last up to five years if the price employees pay for their stock is based on the share price at the end of the period or 27 months if it can be determined at an earlier point.

Plan design can vary in a number of ways. For instance, a company might allow employees a 15% discount on the price at the end of the offering period, but no discount if they buy shares based on the price at the beginning of the period. Some companies offer employees interim opportunities to buy shares during the offering period. Others provide smaller discounts. Offering periods also vary in length. NCEO studies, however, show that the large majority of plans have a look-back feature and provide 15% discounts off the share price at the beginning or end of the offering period. Most of the plans have a 12-month offering period, with six months the next most common.

In a typical plan, then, our friend Joe might start participating in an ESPP plan when the shares are worth $40. He puts aside $20 per week for 52 pay periods, accumulating $1,040. The offering period ends on the 52nd week and Joe decides to buy shares. The current price is $45. Joe will obviously choose to buy shares at 15% off the price at the beginning of the offering period, meaning he can purchase shares at $34. For his $34, he gets shares now worth $45. If the share price had dropped to $38 at the end of the offering period, Joe could buy shares instead at 15% off $38.

The tax treatment of a 423 plan is similar to that of an incentive stock option. If Joe holds the shares for two years after grant and one year after exercise, he pays capital gains taxes when he actually sells the stock on all of the gain he has made except the 15% discount ($6 per share in our example). If he sells the shares after meeting the holding rules at a price less than $40, he would pay ordinary income tax just on the difference between the purchase and sale price. The company gets no tax deduction, even on the 15% discount.

If Joe does not meet these rules because he sells earlier, then he pays ordinary income tax on the entire difference between the purchase price ($34) and the exercise price ($45), plus long-term or short-term capital gains taxes on any increase in value over $45. The company gets a tax deduction for the spread between the purchase price and the exercise price ($11 per share in this case).
Non-qualified ESPPs usually work much the same way, but there are no rules for how they must be structured and no special tax benefits. The employee would pay tax on the discount as ordinary income at the time the stock is purchased and would pay capital gains on any subsequent gain. In our example, Chip would pay tax on $11 per share at the time the shares were purchased. The company would receive a corresponding deduction.

ESPPs are found almost exclusively in public companies because the offering of stock to employees requires compliance with costly and complex securities laws. Closely held companies can, and sometimes do, have these plans, however. Offerings of stock only to employees can qualify for an exemption from securities registration requirements at the federal level, although they will have to comply with anti-fraud disclosure rules and, possibly, state securities laws as well. If they do offer stock in a stock purchase plan, it is highly advisable they obtain at least an annual appraisal.

ESPPs are very popular in public companies as they offer a benefit to employees and additional capital to companies. Any dilution resulting from the issuance of new shares to satisfy the purchase requests, or from the company repurchasing outstanding shares and reselling them at a discount, is usually so small that shareholders do not object. Rates of participation vary widely, with the median levels around 30% to 40% of eligible employees. Because most employees do not commit large amounts to these plans, and many do not participate at all, ESPPs should generally be seen as an adjunct to other employee ownership plans, not a means in themselves to create an ownership culture.

Restricted Stock, Phantom Stock, and Stock Appreciation Rights

Restricted Stock

Restricted stock plans provide employees with the right to purchase shares at fair market value or a discount, or simply grant shares to employees outright. However, the shares employees acquire are not really theirs yet-they cannot take possession of the shares until specified restrictions lapse. Most commonly, the restriction is that the employee work for the company for a certain number of years, often three to five. The time-based restrictions may pass all at once or gradually. Any restrictions could be imposed, however. The company could, for instance, restrict the shares until certain corporate, departmental, or individual performance goals are achieved. With restricted stock units (RSUs), employees do not actually buy or receive shares until the restrictions lapse. In effect, RSUs are like phantom stock settled in shares instead of cash.

While the shares are subject to restrictions, companies can choose whether to pay dividends, provide voting rights, or give the employee other benefits of being a shareholder. When employees are awarded the restricted stock, they have the right to make what is called a "Section 83(b)" election, much as they can make this election for a stock option. If they make the election, they are taxed at ordinary income tax rates on the "bargain element" of the award at the time of grant. If the shares are simply granted to the employee, then the bargain element is their full value. If some consideration is paid, then the tax is based on the difference between what is paid and the fair market value at the time of the grant. If full price is paid, there is no tax. Any future increase in the value of the shares until they are sold is then taxed as capital gains, not ordinary income. If employees do not make the election, then there is no tax until the restrictions lapse, at which time ordinary income tax is due on the difference between the grant and exercise price. Subsequent changes in value are capital gains (or losses). RSUs do not allow employees to make the Section 83(b) election.

The employer gets a tax deduction only for amounts employees pay income tax on, regardless of whether a Section 83(b) election is made or not. A Section 83(b) election carries some risk. If the employee makes the election and pays tax, but the restrictions never lapse, the employee does not get the taxes paid refunded, nor does the employee get the shares.

Restricted stock accounting parallels option accounting in most respects. If the only restriction is vesting, companies account for restricted stock by first determining the total compensation cost at the time the award is made. So if the employee is simply given 1,000 restricted shares worth $10 per share, then a $10,000 cost is incurred. If the employee buys the shares at fair value, no charge is recorded; if there is a discount, that counts as a cost. The cost is then amortized over the period of vesting until the restrictions lapse. Because the accounting is based on the initial cost, companies with a low share price will find that a vesting requirement for the award means their accounting charge will be very low even if the stock price goes up.

If the award is more contingent, such as performance vesting, the value must be adjusted each year for the current stock price, then amortized over the estimated life of the award (the time estimated to meet the performance goal). Each year, the expected cost is amortized over the estimated remaining expected life. So if the stock is awarded at $10 and goes to $15 in the first year of an expected five-year term, then $15 1,000 .20 is recorded ($3,000). If the price goes to $18 the next year, the calculation is $18 1,000 .40 ($7,200). The prior $3,000 is subtracted from this amount, yielding a charge of $4,200 for that year.

Phantom Stock and Stock Appreciation Rights

Stock appreciation rights (SARs) and phantom stock are very similar plans. Both essentially are cash bonus plans, although some plans pay out the benefits in the form of shares. SARs typically provide the employee with a cash payment based on the increase in the value of a stated number of shares over a specific period of time. Phantom stock provides a cash or stock bonus based on the value of a stated number of shares, to be paid out at the end of a specified period of time. SARs may not have a specific settlement date; like options, the employees may have flexibility in when to choose to exercise the SAR. Phantom stock may pay dividends; SARs would not. When the payout is made, it is taxed as ordinary income to the employee and is deductible to the employer. Some phantom plans condition the receipt of the award on meeting certain objectives, such as sales, profits, or other targets. These plans often refer to their phantom stock as "performance units." Phantom stock and SARs can be given to anyone, but if they are given out broadly to employees, there is a possibility that they will be considered retirement plans and will be subject to federal retirement plan rules. Careful plan structuring can avoid this problem.

Because SARs and phantom plans are essentially cash bonuses or are delivered in the form of stock that holders will want to cash in, companies need to figure out how to pay for them. Does the company just make a promise to pay, or does it really put aside the funds? If the award is paid in stock, is there a market for the stock? If it is only a promise, will employees believe the benefit is as phantom as the stock? If it is in real funds set aside for this purpose, the company will be putting after-tax dollars aside and not in the business. Many small, growth-oriented companies cannot afford to do this. The fund can also be subject to excess accumulated earnings tax. On the other hand, if employees are given shares, the shares can be paid for by capital markets if the company goes public or by acquirers if the company is sold.

If phantom stock or SARs are irrevocably promised to employees, it is possible the benefit will become taxable before employees actually receive the funds. A "rabbi trust," a segregated account to fund deferred payments to employees, may help solve the accumulated earnings problem, but if the company is unable to pay creditors with existing funds, the money in these trusts goes to them. Telling employees their right to the benefit is not irrevocable or is dependent on some condition (working another five years, for instance) may prevent the money from being currently taxable, but it may also weaken employee belief that the benefit is real.

Finally, if phantom stock or SARs are intended to benefit most or all employees and defer some or all payment until termination or later, they may be considered de facto "ERISA plans." ERISA (the Employee Retirement Income Security Act of 1974) is the federal law that governs retirement plans. It does not allow non-ERISA plans to operate like ERISA plans, so the plan could be ruled subject to all the constraints of ERISA. Similarly, if there is an explicit or implied reduction in compensation to get the phantom stock, there could be securities issues involved, most likely anti-fraud disclosure requirements. Plans designed just for a limited number of employees, or as a bonus for a broader group of employees that pays out annually based on a measure of equity, would most likely avoid these problems. Moreover, the regulatory issues are gray areas; it could be that a company could use a broad-based plan that pays over longer periods or at departure and not ever be challenged.

Phantom stock and SAR accounting is straightforward. These plans are treated in the same way as deferred cash compensation. As the amount of the liability changes each year, an entry is made for the amount accrued. A decline in value would create a negative entry. These entries are not contingent on vesting. In closely held companies, share value is often stated as book value. However, this can dramatically underrate the true value of a company, especially one based primarily on intellectual capital. Having an outside appraisal performed, therefore, can make the plans much more accurate rewards for employee contributions.

401(k) Plans

Section 401(k) plans allow employees to defer part of their pay on a pretax basis into an investment fund set up by the company. The company usually offers at least four alternative investment vehicles. Because the law requires that participation in the plans not be too heavily skewed towards more highly paid people, companies generally offer a partial match to encourage broad participation in these voluntary plans. This match can be in any investment vehicle the company chooses, including company stock. There is a limit of 25% of eligible pay that the company can contribute to the plan on a tax-deductible basis. This limit is reduced by other employer contributions to defined contribution plans.

There are several factors that favor the use of a 401(k) plan as a vehicle for employee ownership in public firms. From the company's perspective, its own stock may be one of the most cost-effective means of matching employee contributions. If there are existing treasury shares or the company prints new shares, contributing them to the 401(k) plan may impose no immediate cash cost on the company; in fact, it would provide a tax deduction. Other shareholders would suffer a dilution, of course. If the company has to buy shares to fund the match, at least the dollars being used are used to invest in itself rather than other investments. From the employee standpoint, company stock is the investment the employee knows best and so may be attractive to people who either do not want to spend the time to learn about alternatives or have a strong belief in their own company. Balanced against these advantages, of course, must be an appreciation on both the part of the employee and the company that a failure to diversify a retirement portfolio is very risky.

For closely held companies, 401(k) plans are less appealing, although very appropriate in some cases. If employees are given an option to buy company stock, this can often trigger securities law issues most private firms want to avoid. Employer matches make more sense, but require the company to either dilute ownership or reacquire shares from selling shareholders. In many closely held businesses, the first may not be desirable for control reasons and the second because there may not be sellers. Moreover, the 401(k) approach does not provide the "rollover" tax benefit that selling to an ESOP does, and the maximum amount that can be contributed is a function of how much employees put into savings. That will limit how much an employer can actually buy from a seller through a 401(k) plan to a fraction of what the ESOP can buy.

401(k) contributions cannot be leveraged either, so a sale of company stock would have to proceed slowly in annual increments. For example, if a company can get 60% of its workforce to participate in a 401(k) plan, and they put up 5% of pay (a reasonable but fairly high amount in practice), the company might match this on a dollar for dollar basis, but this would still only come to perhaps 4% of payroll (assuming 401(k) participants tend to be higher paid than nonparticipants).

401(k) plans and ESOPs can also be combined, with the ESOP contribution being used as the 401(k) match. This can work on either a nonleveraged or leveraged basis. In the nonleveraged case, the company simply characterizes its match as an ESOP. That adds some set-up and administrative costs, but allows the company to reap the additional tax benefits of an ESOP, such as the 1042 rollover. In a leveraged case, the company estimates how much it will need to match employee contributions each year, then borrows an amount of money such that the loan repayment will be close to that amount. If it is not as much as the promised matching amount, the company can either just define that as its match anyway, make up the difference with additional shares or cash (if the loan payment is lower), or pay the loan faster. If the amount is larger, the employees get a windfall. Combination plans must meet complex rules for testing to determine if they discriminate too heavily in favor of more highly paid people.

Despite the advantages of 401(k) plans as an ownership vehicle, there are important disadvantages as well. These plans are meant to be diversified retirement plans and, as such, do not have the same fiduciary protection for plan trustees and corporate boards as do ESOPs. Heavy concentration of employer stock in a 401(k) plan is harder to defend in court, and in the last decade, well over 100 class-action lawsuits have been filed over company stock in the plans. The result has been that companies and employees are moving away from employer stock as a primary asset in 401(k) plans.

Moreover, the law now requires that in public companies, employees be able to move their 401(k) holdings out of company stock at any time if they have used their own money to buy shares or any time after three years for shares contributed by the employer.

Employee Ownership and Employee Motivation

During the early 1980s, the National Center for Employee Ownership conducted an exhaustive investigation of how employees react to being owners. We surveyed over 3,500 employee owners in 45 companies. We looked at hundreds of factors in an effort to determine whether it mattered to employees that they had stock in their company, and if so, when.

The results were very clear. Employees did like being owners. The more shares they owned, the more committed they were to their company, the more satisfied they were with their jobs, and the less likely they were to leave. Naturally, some employees in some companies liked being owners more than others. Individual employee response to ownership was primarily a response to how much stock they got each year. After that, employees responded more favorably if they had ample opportunities to participate in decisions affecting their jobs, worked in companies whose management really believed in the concept of ownership and not just the tax breaks, and were provided regular information about how the ownership plan operated.
By contrast, the size of the company, the line of business, demographic characteristics of the employees, seniority, job classification, presence or absence of voting rights or board membership, percentage of the company owned by employees (as opposed to the size of the annual contribution), and many other factors did not have any impact. Employees looked at the employee ownership plan and asked "how much money will I get from this?" and "am I really treated like an owner?" If they liked the answers to these questions, they liked being an owner.


The continued growth of employee ownership reflects, above all, a changing view of the role of employees in the workplace. To be sure, for some time companies have been saying that "people are our most important resource." This was little more than rhetoric, however, for all but a handful of companies. Investors, capital, technology, and, above all, top management, were really seen as the keys to the company's future. Employees would be laid off or have their compensation limited before these other assets were harmed. Increasingly, however, companies are coming to the view that attracting and retaining good people at all levels, then giving them the authority to make more decisions about more things, is essential to being an effective competitor. In large part, this is a function of technology. The vast amounts of information, and the speed with which it can be processed, leaves companies with little choice but to get more people involved in more things. As people are asked to take more responsibility for the company, it simply makes sense for them to be rewarded accordingly.
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