The Employee Ownership Update
January 12, 2007
IRS Issues Final S ESOP Corporation Anti-Abuse RegulationsOn December 27, 2006, the IRS issued final regulations for compliance with S ESOP corporation anti-abuse rules (TD9302). Generally, the final rules make only minor changes to the existing proposed regulations. The rule is effective for plan years beginning on or after January 1, 2006, but the prior temporary rules still apply to prior plan years.
In addition to all the existing tax penalties, the new rules say that if an ESOP has a nonallocation year, it will lose not only its status as an ESOP but also its status as a qualified plan, creating an additional excise tax and voiding the S election.
There were several minor changes and clarifications in the new regulations. Family attribution rules were eased through a series of specific fact-pattern examples. Also, the triennial method for valuing synthetic equity originally proposed now can be modified in the case of a change in plan year, merger, consolidation, or transfer of ESOP assets.
To avoid a nonallocation year, companies must transfer assets out of employer stock in the ESOP to a separate plan or separate non-ESOP part of the ESOP. The new rules state that any transfers to avoid a nonallocation year must be effectuated by "an affirmative action taken no later than the date of the transfer," and all subsequent actions must be consistent with that transfer. The plan document must provide for the transfer.
In response to a comment, the IRS said that companies could not address a nonallocation year problem by targeted reshuffling (also called rebalancing) of shares within the accounts of the employees whose accounts hold too much stock and replacing it with cash from accounts of other employees. Many ESOPs do this on a plan-wide basis for reasons unrelated to the anti-abuse rules. The IRS, however, said that this involuntary movement out of assets already held by employees, even though they are replaced by other assets with the same value, was, absent special circumstances, a violation of the "current and effective availability" requirements of ERISA. This language only has specific application to how companies deal with anti-abuse issues. The question remains, however, whether the IRS would apply this same logic to any plan that uses rebalancing for other purposes. Experts we consulted generally believe it does not threaten such practices, provided that plan language has already been carefully drafted and submitted to the IRS enabling it, but some experts have always contended that rebalancing violates ERISA.
New Study Shows Continued Decline in Options UseWhile "Realities of Executive Compensation, 2006/2007," a new study from Watson Wyatt, focuses on executive compensation issues, the report also contains important findings on the use of options generally in large public companies. The study looked at the 793 companies in the S&P "Super 1500" for which there were data from 2001 through 2005. The study shows that the average option grant value per company had declined from $100 million to $29 million. The impact on earnings also declined, from 19 cents per share to 11 cents per share. Part of this was due to lower grant sizes. The average run rate, for instance, declined from 2.7% in 2001 to 1.6% in 2005. But part of the change was due to different assumptions about option valuation, with expected option lives now estimated to be down from 5.6 years to 5.2 years and volatility down from 47% to 38% from pre-FAS 123(R) requirements. These differing assumptions lower the reported impact of options on earnings.
Dilution from options, however, only declined from 9.7% to 9.1% over the period, largely because more options were being exercised while fewer were being forfeited. The result is that the gain realized on options is only marginally different from 2001. At the same time, companies are granting more restricted shares, primarily to executives.
The authors note that companies are reducing run rates in part by cutting off eligibility to lower-paid employees, a practice they say is counterproductive given the demonstrated value of broad-based plans.