The Employee Ownership Update
May 8, 1995
IRS Issues ESOP Examination GuidelinesThe 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 CaseIn 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The decision is not precedential, but still provides important guidance.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 EarlyAccording 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.