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The Employee Ownership Update

Corey Rosen

January 30, 2004

(Corey Rosen)

IRS Takes Further Steps Against ESOP S Abuses

In Revenue Ruling 2004-4, the IRS ruled that ESOP S corporation structures in which individuals are given options to buy stock in subsidiaries of the parent corporation will be subject to rules limiting synthetic equity holdings of plan participants. The IRS specifically addressed three examples of these structures. In each case, a parent professional services corporation owned subsidiaries that had one or more employees. Customers are assigned to do business with the various subsidiaries. The employees of the subsidiaries are paid a salary much less than the income they generate; retained income from the subsidiary is assigned to the subsidiary rather than being paid out to the employee. One employee in each subsidiary retains stock options that can be exercised to buy the subsidiary. Because the parent is a 100% ESOP, no taxes are paid on earnings at the parent or subsidiary level. The number of employees with the options in the three examples is one, five, and eleven.

The IRS concluded that in each case, the option represents synthetic equity in the parent and that the individual option holders are disqualified persons, whether they a) own more than 10% of the deemed owned shares of the company or not and b) whether or not there are other employees in the subsidiary who participate in the ESOP. That is because the subsidiary structure gives them effective ownership of the profits of the subsidiary, and these subsidiaries are themselves the equivalent of S corporations owned by an ESOP. Putting actual employees in the subsidiary does not provide protection because the profits are being captured by the option holder, not the employee.

The IRS further announced that any structures of this type must be listed as tax shelters. Specifically, these include any cases in which the following characteristics are present: a) 50% or more of the stock is held by an ESOP in an S corporation, b) profits generated by a specific individual are accumulated and held for that individual's benefit in a subsidiary, c) the profits are not paid out within 2 1/2 months after the end of the year, and d) the individual has a right to acquire more than 50% of the subsidiary. Structures that are similar in intent also must be listed.

New Study Finds Options Effective in Up and Down Markets

In "Broad-Based Stock Options Before and After the Market Meltdown," James Sesil of Rutgers and Maya Krumova of the N.Y. Institute of Technology use NCEO lists of companies with broad-based options in 1998 and 2000 to evaluate the impact of these plans on productivity. In the 1995-1997 period, they found that companies with broad-based options had productivity levels 22% to 38% higher than comparable firms. Smallest companies had the lowest differential, medium-sized the highest, with large companies in the middle. In 2000-2002, medium and large-sized companies retained these differentials; small companies declined slightly from 22% greater to 18.6% greater.

The results indicate that the declining stock market did not undermine the impact of broad options. Moreover, contrary to popular perception that the incentive effects of options should be lower in larger companies (because individual employee efforts seem to matter less), company size does not seem to be consistently related to performance.

NCEO Issue Brief Looks at the Future of Broad-Based Stock Options

A new NCEO issue brief titled "The Future of Broad-Based Stock Options" looks at what is now the substantial body of research on this topic. The report begins with an assessment of what impact expensing stock options and other equity will have on stock prices. There are now several empirical studies, and they all conclude the impact will be minimal or none. Studies of companies that have voluntarily expensed options, in fact, show that those with a higher dilution actually showed a stronger stock price after announcing their earnings than did companies that issued less equity to employees.

Despite these findings, companies are clearly worried about the impact of expensing, as well as new shareholder approval rules for equity plans. Several surveys have been performed to asses just how companies will respond. They all conclude that about 40% of companies will reduce or eliminate broad-based equity plans, but almost none will reduce or eliminate executive plans. Whether the 40% can sustain that intention is unclear. If their competitors maintain their plans, it may be difficult to cut back on these benefits for employees.

Finally, the report looks at research on the impact of equity plan distribution on corporate performance. Studies of broad-based plans show a consistently positive impact; studies of executive plans are at best inconsistent; an assessment of 229 of these studies shows that most find a neutral or negative relationship with increasing amounts of executive equity awards.

The issue brief is available from the NCEO for $15 to members and $25 to non-members, plus shipping.

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