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The Employee Ownership Update

Corey Rosen

August 2, 1999

(Corey Rosen)

Tax Bills Preserve ESOP S Corporation Benefits

Neither the House nor Senate tax cut bills now being debated contain the President's proposal to require ESOPs in S corporations to pay unrelated business income tax (UBIT) on their pro-rata share of company earnings. As the law stands now, earnings attributable to the ESOP's ownership are not currently taxed (although they presumably are effectively taxed when employees get their distributions). The Senate bill, however, contains a provision drafted by ESOP S corporation reform advocates that would disqualify plans that allocate stock to individuals who alone or in aggregation with their family members own more than 20% of the company's stock or who individually own more than 10% of the company's shares. The provision is intended to prevent the use of ESOPs as a tax-avoidance scheme in which few employees who are not already owners actually get any benefits.

Both the House and the Senate bills also have provisions allowing a deduction for dividends in ESOPs even if they are reinvested in 401(k) plans. Currently, only dividends passed through to employees or used to pay an ESOP loan are deductible. Some public companies have obtained private letter rulings for a "dividend switchback" program that, in effect, allows employees to reinvest deductible dividends through a 401(k) program, although there are some limitations on this approach. The legislation, if passed, would not exempt the reinvestment from potential securities laws issues that could limit their appeal to private companies (although recent securities rules changes could lessen these concerns).

Both bills also contain a number of other provisions dealing with benefit plan law, most notably allowing higher contribution limits for 401(k) plans when the company also sponsors other defined contribution plans. Prospects for the overall tax bill are, of course, uncertain, but there is no virtually no chance that S corporation ESOPs will be required to pay UBIT.

New Surveys on Options Issues

A new study by Credit Suisse First Boston of the impact of stock options on profitability in banks shows that not showing the cost of options on income statements in 47 banks resulted in earnings being 4% higher than would have been the case if the present value of the options were accounted for using FASB-approved formulas.

Meanwhile, a Pearl Myers and Partners survey of mutual funds managers shows that 49% of the respondents say they often or always consider repricing policies in making investment decisions; 45% said they sometimes did. When the issue is only repricing for senior management, 64% said repricing was never justifiable, while only 43% said that repricing for non-management options was never justifiable.

Finally, a new William M. Mercer study found that 32 publicly traded Internet companies had an average of 15.7% of their total shares reserved for options and other stock-based compensation.

ESOP Case Gives Warning on Excessive Executive Pay

A district court has ordered the former president and chairman of Delta Star, Inc. to repay $3,300,000 to the company's ESOP. In Delta Star, Inc. v. Patton (U.S. District Court for the Western District of PA, 6/10/99), the current ESOP trustee of Delta Star, whose ESOP owns over 98% of the company's stock, brought suit against the former president and chair of the company, charging that the defendant used his position as ESOP trustee to pay himself excess compensation. The court found that the company's earnings were flat during this period primarily because of his pay.

The decision was based both on ERISA and Delaware corporate law. Under ERISA, as outlined in a Department of Labor memo on this topic, ESOP trustees do have the responsibility to act to protect shareholder interests by considering such issues as executive compensation. While the facts here are extreme, the case highlights the importance of not allowing senior management to set its own compensation in an ESOP company. Board compensation committees or, at the least, a compensation advisor, should be use to set salaries or establish objective guidelines.

Author biography and other columns in this series

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