The Employee Ownership Update
July 31, 2008
University of Pennsylvania Paper Finds S Corporation ESOPs Help Employees, Employers, and TaxpayersIn "S Corp ESOP Legislation Benefits and Costs: Public Policy and Tax Analysis," Steven Freeman and Michael Knoll of the University of Pennsylvania conclude that S corporation ESOPs add an annual $14 billion in additional compensation that would not have been paid absent an ESOP, lead to annual job stability gains worth another $3 billion, and provide an additional $34 billion in annual increases in account values from stock gains in the accounts held by participants. Employers pay for this out of firm-level performance gains of $33 billion per year. The increased performance of ESOP companies, plus the fact that foregone taxes on earnings are ultimately paid by employees when they start to take benefits out some time after termination, mean that S ESOPs are a net gain for taxpayers. In addition, when employees do pay tax on their distributions, they pay on the basis of (generally) appreciated stock, with part of that appreciation due to the company's ability not to pay taxes in the interim. Given assumptions about their tax rates, the authors conclude that, on balance, the Treasury is likely to end up with more revenue this way than if the income was taxed earlier. The paper is published by the University of Pennsylvania Center for Organizational Dynamics (Working Paper #08-07).
IRS Allows Price Protection for S Corporation ESOPsIn Private Letter Ruling 200827008, the IRS ruled that floor price agreements for S corporation ESOPs do not count as a second class of stock, which would disqualify the S election. S corporation rules in general do not consider stock rights that are agreements to redeem stock at death, divorce, disability, or termination of employment as creating an additional class of stock. The ruling said that floor price protection fell into this exception.
Many ESOP companies have multiple ESOP transactions. In some companies, after the first purchase of shares, often 30% to 50%, a second transaction is done to buy more shares. Other companies that are 100% ESOP-owned do additional leveraged transactions to acquire other companies. In either case, the new debt taken on can lower the price of the shares already in the plan. To deal with this, many ESOP companies offer some kind of price protection for existing participants. Sometimes that is limited to people over a certain age and/or to people getting distributions in the next x number of years. A floor price is set, and the company makes up the difference, if any, when the distribution is made.
IRS/Treasury Release Proposed ESPP and Incentive Stock Option RegulationsOn July 29, the IRS and the Treasury Department released proposed regulations relating to options granted under an IRC Section 423 employee stock purchase plan (ESPP) and under IRC Sections 422 (ISOs) and 421 (taxation of stock transferred under IRC Sections 422 and 423). Most of the proposed regulations appear to be clarifications of treatment of an option due to inconsistent terms, shareholder approval, eligibility, pricing, grant date, and definition of "highly compensated employee." The proposed regulations also inquire whether a correction program for ESPPs is appropriate. The one item of note is in the preamble, where the IRS and Treasury Department state they do not believe they have the authority to allow the exclusion of citizens or residents of a foreign jurisdiction or collectively bargained employees. However, the proposed regulations do allow the exclusion of foreign citizens or foreign residents if the grant of the option is prohibited under the laws of the foreign jurisdiction (or compliance with the laws of the foreign jurisdiction would cause the plan to violate the requirements of Section 423). In addition, the terms of an option granted to a foreign citizen or resident may be less favorable if necessary to comply with the laws of a foreign jurisdiction.
Comments on the proposed requirements are due to the IRS by October 27, 2008, and the changes are set to be effective with grants made on or after January 1, 2010 (see here).