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The Employee Ownership Update

Corey Rosen

June 10, 2003

(Corey Rosen)

FAS Statement 150 Raises Appears to Require Booking of Repurchase Obligations for Stock Plans

In May of 2003, the Financial Accounting Standards Board (FASB) issued FAS 150, a new accounting guideline that appears to require companies with "mandatorily redeemable shares, which the issuing company is obligated to buy back in exchange for cash or other assets" to book the liability this obligation represents. The effective date of the proposal for new contracts is May 31, 2003; for existing obligations, it is for interim accounting periods starting after June 15, 2003. However, for closely held companies, the effective date for all obligations is December 15, 2003. While the guidelines are written for all kinds of financial instruments that require repurchase, it appears that they will affect ESOPs as well as any individual equity programs, such as restricted stock, phantom stock, SARs, or stock options having a mandatory repurchase feature that occurs on a determinable event (termination, death, retirement, etc.).

The proposal has received little public attention. A Google search yielded only one article about it. There is still a great deal of confusion about the proposal in the accounting community. For instance, paragraph 17 of the statement explicitly states that ESOPs subject to AICPA Statement of Position 96-3 accounting rules will not be covered by the guidelines. Becky Miller of McGladrey & Pullen, an expert on ESOPs and a prominent member of the accounting community, tells us that FASB staff nonetheless say the statement does apply to ESOPs. Its application to individual equity arrangements seems less controversial, but the specific method by which the obligations should be recorded and valued for different instruments with different conditions attached to them is still murky.

We will continue to follow this issue in the hopes of providing some clarity in the future.

Fidelity Survey Shows Many Employees Confused About Stock Option Plans

A newly released survey by Fidelity Investments shows that 25% of respondents say they have little or no understanding of their stock purchase plan and one-third have little or no understanding of their stock option plan. The study was performed for Fidelity by Richard Day Research and involved a nationwide survey of 896 household financial decision-makers in households having a stock option plan or stock purchase plan. The study projected that one million participants let their options expire between 1999 and 2002. More remarkably, a similar number turned down the grant of an option during the same time. Just over half of those who let an option expire did so because they did not understand the plan, mostly because they did not know how to exercise an option. In stock purchase plans, 32% did not purchase stock during the three-year period. Of these, just 10% said it was because they did not understand the plan. Only about 40% of respondents indicated they had a complete understanding of their plans.

For 74% of option holders and 76% of stock purchase plan participants, the plan was their first experience with investing, indicating just how basic communication must be about these programs. Only 39% of those with options have a strategy for exercising them, and only 10% think of them in terms of their overall financial picture. Participants in both kinds of plans, however, do monitor company stock price closely. A third check prices daily, half at least once a week, and two-thirds at least once a month. Most respondents said they wanted the company, not a third party, to provide more information about the plan, with about an even split preferring on-line, written, or face-to-face communications.

The study also revealed that about 8% of U.S. households with at least one full-time employed adult participate in a stock option plan. Ten percent are offered stock purchase plans, with 6% participating. These numbers translate into roughly similar estimates of the number of employees the NCEO believes currently hold options (about seven to 10 million) but somewhat lower than the number of employees offered stock purchase plans (we estimate it is 15 million; this survey suggests the number may be closer to 12). Translating from number of households into the number of employees, however, requires a few assumptions, such as the number of employed people in the household and how many of these people get options (more than one person in a household may receive options), so the NCEO and Fidelity data are not precisely comparable.

Ninth Circuit Allows Boise Cascade Tax Deduction for ESOP Distributions

In Boise Cascade Corp. v. U.S. (9th Cir., No. 01-36086, 5/20/03), the Ninth Circuit Court of Appeals ruled that Boise Cascade could take a tax deduction for distributions of convertible preferred stock from the company's ESOP. The issue dates back to 1989 when Boise Cascade transferred convertible preferred to the ESOP. As is always the case in the ESOP, the trustee was the sold legal owner. If the stock were transferred to another person than the trustee, it automatically converted to common. When a participant terminated, the vested convertible preferred was automatically redeemed. The company could choose to redeem the convertible preferred in cash or stock prior to actual distribution. All 1989 payments were in cash. Participants could then elect to take the distribution in cash or stock. Boise Cascade then filed an amended tax return asking to receive a refund for the amounts it believed it could take as a tax deduction for amounts distributed in cash to employees. The IRS disallowed it. A district court then ruled for the company, and the appeals court affirmed the ruling.

The court ruled that the redemption qualified as a refund under IRC Section 302(b) and thus was deductible as an ESOP dividend. Whether this ruling would apply in other applications of this theory at other companies is not clear. That section provides, among other things, that a payout of convertible preferred stock is a dividend as long as it does not result in a "meaningful reduction of the shareholder's proportionate interest in the corporation." It did not here, the court ruled, because the participants were not the owners, the trust was. At the time, participants were able to roll over the distributions into IRAs even though these distributions were considered dividends. That would no longer be the case. Companies would presumably (but would not be required to) give employees a choice of receiving the payout as a cash distribution as a dividend or a distribution in stock that could be rolled into an IRA (but would not be deductible to the company. The dividend would taxed as a dividend to the employee, not as a distribution.

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