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The Employee Ownership Update

Corey Rosen

May 8, 1995

(Corey Rosen)

IRS Issues ESOP Examination Guidelines

The Internal Revenue Service has issued examination guidelines for its agents to use when assessing ESOPs. There are no surprises in the guidelines, which, in any event, do not have regulatory force. They do, however, provide a good overview of basic ESOP procedures. The text was printed in the April 24 issue of the BNA Pension Reporter.

Ouch! Court Upholds 125% Excise Tax in Improper ESOP Valuation Case

In Eyler v. Commissioner, the U.S. Tax Court ruled that a taxpayer (Gary Eyler) must pay a tax of 100% of the transaction plus an additional tax of 5% per year for the five years the tax was delinquent on a $10,000,000 sale to an ESOP. Eyler was chairman, CEO, and principal stockholder of CTS Corporation. In December of 1986, he sold shares to an ESOP for $10 million at $14.50/share. Before the sale, CTS had tried to go public, but withdrew the offer when there was only enough interest at a $13 to $16 price range to sell $1 million worth of stock. The stock was then sold to the ESOP. No independent valuation was performed; instead the board relied on the statement of the CFO that the $14.50 price was a fair. In 1989, the company went bankrupt.

The decision is not precedential, but still provides important guidance. For example, the court ruled that the mere fact of a put option does not eliminate a repurchase discount, as the company argued. More important, perhaps, the decision concludes that the excise tax should be on the entire value of the transaction, not just the amount the ESOP overpaid.

Employees Often Exercise Stock Options Early

According to economic theory, an employee given a stock option would be "irrational" to sell the option too soon before it expires. Models for pricing the value of options, in fact, typically assume they are held until the expiration date. In a study of eight companies with broadly granted options, Professors Steven Huddart and Mark Lang of the University of Michigan and the University of North Carolina looked at the behavior of 50,000 employees granted options. They found tremendous variation in when people actually exercised the options. Employees sacrificed half the value options would be projected to have based on the most popular option pricing model (Black-Scholes). While exercise patterns ranged considerably from company to company, significant upward movements in stock prices were a primary factor in explaining early exercise.

The results are important not only in understanding employee behavior, but also in pricing options for what will likely be required accounting footnote disclosures. Models now assume that the full value of the options is realized; in fact, the data show this does not typically occur.

Getting Rich by Giving Away the Store

Most employee ownership plans involve someone selling stock to an employee plan. Paul Merriman just gave it away. Merriman bought a tiny operation called HISCO, a Houston industrial supply company, in 1974 for $100,000. He believed other people deserved to be owners as well, so he started issuing new shares to an ESOP each year. The dilution has resulted in his now owning only 25% of the stock. Merriman says it was the smartest thing he's ever done. HISCO now has 158 employees and is worth $16 million. Last year alone, the average ESOP account statement increased $20,000 to $30,000.

Get This Book

John Case of Inc. magazine has been one of the outstanding chroniclers of the revolution taking place at work. His seminal cover story for Inc., "Emancipation Capitalism," provided a compelling framework for why businesses now have to create "companies of business people," not just employees told what to do. Case has a new book due out in June called Open-Book Management. Published by HarperCollins ($22.00), the book provides case studies, theory, and practice on how companies are using the sharing of financial information to get people for fully involved.

Author biography and other columns in this series

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