The Employee Ownership Update
May 23, 2001
Senate Passes Retirement Reform As Part of Tax BillThe Senate-passed tax cut legislation has incorporated a revised version of the Comprehensive Retirement Income Security Act (S. 742) as part of its income tax reduction legislation. The tax bill incorporates just about all of S. 742's provisions, but some of them are phased in over longer periods of time than the House-passed version or the version that came out of the Senate Finance Committee.
On the ESOP front, the bill would make it much more difficult for sham S corporation ESOP transactions to occur. The complicated provision essentially provides severe tax disincentives to use an ESOP in an S corporation in such a way that only a few employees actually benefit from the plan. Under the proposal, a 50% corporate excise tax and individual income tax would kick in on allocations made to "disqualified individuals" in the plan, defined as those owning either more than 10% individually or 20% when considering attribution rules. Ownership includes synthetic equity (options, warrants, etc.), direct ownership, and ownership in the ESOP. In the Senate bill, for ESOPs set up after July 11, 2000, the effective date is the end of the plan year in which the plan was set up. The House bill's comparable provision is that the effective date for plans set up after March 14, 2001 is the end of the plan year in which the plan was set up. For plans set up prior to that, the Senate bill's effective date is December 31, 2002; the House bill is December 31, 2004.
Both bills also would allow employees to reinvest dividends on ESOP shares back into the ESOP to buy more company stock on a pre-tax basis. The Senate version of the bill, however, phases in the dividend reinvestment provision at 25 cents per dollar reinvested from 2002 through 2004, 50 cents from 2005 through 2007, 75 cents from 2008 through 2010, and 100% after 2010. The House bill provides a full deduction for each dividend dollar reinvested.
In addition, changes to contribution limits and other rules governing defined contribution plans would make it easier to combine an ESOP with a 401(k) plan. The major provisions that affect employee ownership are listed below:
- The annual limit on annual additions would be raised from $35,000 to $40,000 per year and thereafter indexed for inflation in $1,000 increments (both Houses).
- The current limit on salary defined as eligible pay for making contribution to employee accounts would be raised from its current $150,000 (in 1993 dollars) to $200,000 (in July, 2000 dollars), but the Senate bill would raise the limit in $5,000 increments, whereas the House bill makes the change immediately.
- The maximum amount an individual can defer to a 401(k) plan is increased to $11,000 in 2002 then in $500 increments until 2010, when it will be indexed for inflation, rounding up to the closest $500 increment annually. Individuals 50 and over could add another $5,000 annually to this amount. The House version would increase the limit in $1,000 increments.
- Elective deferrals no longer reduce the employer's limit on what can be contributed to a defined contribution pan, or combination of plans (both Houses).
- The current limit on annual additions to employee accounts in defined contribution plans of 25% of pay per year is increased to 100% per year in the House version; in the Senate version, the limits go to 50% from 2002 through 2010, then go to 100%.
- The current limit of 15% of eligible pay that can be contributed to plan participants in non-leveraged ESOPs and other defined contribution plans will be increased to 20% of pay in the House version and 25% in the Senate version. If combined with a money purchase plan under current law, that means a non-leveraged plan could contribute as much as 30% of pay.
- The definition of employees in the "top-heavy" group is simplified in both versions of the bill.
Tax Bill Makes Minor Changes in AMT CalculationsThe Senate-passed version of the tax bill would provide minor relief from the Alternative Minimum Tax (AMT) by allowing the enhanced child credit to be claimed against the AMT. Refundable tax credits would no longer be disallowed as well under AMT calculations. The AMT exclusion for married couples would increase by $6,000 per year through 2004 for married couples and $3,000 per year for single filers. The changes would have the effect of increasing the amount of income someone earns before being subject to the AMT.
Executive Fired Without Cause Can Exercise OptionsIn Scribner v. WorldCom, Inc. (9th Cir., No. 99-35239), the U.S. 9th Circuit Court of Appeals ruled that Donald Scribner, am executive at WorldCom, could exercise the unvested options he was holding at the time of his termination because he was terminated without cause. Scribner was terminated in 1997 when the division he managed was sold. He attempted to exercise his 10,000 unvested options, but the company said he could not, arguing that he had been terminated with cause. Scribner's contract specified that if he were fired without cause, he could exercise his options. The contract gave the employer the right to determine what constituted "with cause."
Scribner sued, but a district court sided with the company. The appeals court reversed the ruling, saying that Washington state law, which governed the contract, interpreted termination with cause to mean "some shortcoming on the part of the employee." WorldCom conceded there was not such a shortcoming in Scribner's case. The court concluded that the company had a duty to interpret the terms in good faith, not to simply define the term as would be convenient for them.
Unvested Options Are Marital AssetsOne of the most contentious stock options issues is whether unvested options should be included in marital property in divorce settlements. In Fisher v. Fisher (Pa. No. 170, 4/25/01), the Pennsylvania Supreme Court ruled that they were. James and Patricia Fisher were married in 1984, separated in 1993, and divorced in 1994. Fisher was an executive at Harley-Davidson and had $71,000 in unvested options. Patricia Fisher contended that she should receive a share of these unvested options when exercised. A trial court sided with the husband, but the Supreme Court reversed the ruling. The court concluded that unvested options were similar to unvested pension rights, rights that other states had included in divorce settlements. The court ruled, with dissenting opinions, that the value of the options should be divided if and when they are exercised. Dissenting opinions argued that the options should be valued at the time of divorce using some kind of present value approach and, in a separate opinion, that the wife should have some say in whether and when the options are exercised.
An even more dramatic sets of facts occurred in Warner v. Warner (Mo. Ct. App., No. SC 58469, 4/24/01). In this case, Charles and Sandra Warner dissolved their marriage December 31, 1998. Charles Warner took a job at America Online Inc. during the marriage dissolution proceedings and received options as part of his compensation. Sandra Warner then petitioned the court for a share of the options. A trial court divided the options between her and her husband. He appealed, but the court concurred with the trial court. Charles Warner contended that his employment at AOL did not start until the trial in the proceedings had begun and, in any event that his options had not even started to vest. The court concluded that Missouri law made it clear that options obtained before dissolution were community property. The fact that they had not yet vested was outweighed by the fact that Charles Warner's previous work experience while married had made him a candidate to receive options.
The decision did not indicate what formula was to be used to divide the options.