Employee Stock Ownership Plan (ESOP)

Reprint permission granted by Joseph Petrucelli, LLM

Introduction

ESOPs are qualified retirement plans that corporate employers may establish to provide benefits in the form of ownership in the corporation for which the employee works and any of its related companies. Only corporations may establish ESOPs.

Interest by both employers and employees in ESOPs has increased in recent years because they offer something to both. For employers, they offer a means of providing deferred compensation to employees without an immediate heavy cash outlay (because benefits may be paid in the form of stock). Employers also benefit because these plans receive favorable tax treatment and because deductible contributions may be made in the form of employer securities, improving the employer’s cash flow (since tax liability is decreased but no out-of-pocket cost is incurred in issuing securities to the plan). Employees (as well as many employers) like ESOPs because they give employees an interest in the employer’s business, which may motivate employees to make the employer more profitable, thereby increasing the value of their stock. ESOPs also can make corporations less susceptible to takeover attempts, since they place the company’s stock into the hands of a broad group of employees and their beneficiaries.

As discussed below, there are many reasons that an ESOP may be more desirable than providing stock-based deferred compensation through an ordinary tax-qualified stock bonus plan. These include an ESOP’s ability to:

• acquire a block of securities in a single transaction;

• allow a shareholder to sell employer securities to the plan and defer paying tax on any gain;

• immediately distribute dividends on employer stock held by the plan (rather than accumulating them for at least two years as required under other types of defined contribution plans), and

• obtain a deduction for its sponsoring employer for any dividends that it pays on employer securities held by the ESOP.

Tax Advantages in Qualifying as an ESOP

An ESOP must be a qualified stock bonus plan or combination stock bonus/money purchase plan. A plan that qualifies as an ESOP receives certain tax benefits that clients might find useful. For instance, certain loans to an ESOP are exempt from ERISA’s prohibited transaction rules, permitting corporations to guarantee the plan’s payment to a third-party lender. Also, if a corporation were to adopt an ESOP that uses one or more loans to buy employer securities, it could make greater deductible contributions than it could make to an ordinary stock bonus plan. Further, ESOPs may engage in certain tax-favored transactions. For example, a shareholder could sell corporate securities to an ESOP and defer paying income tax on any gain from the sale if certain conditions are met. Finally, a C corporation could deduct any dividends that it pays on its securities held by its ESOP.

Requirements

All ESOPs are subject to:

• special rules that govern the form of benefit distributions; and

• special rules that apply to employer payments pursuant to the exercise of a “put option” (an option to require the employer to buy back the stock) by a participant or beneficiary.

In addition, an ESOP must be designed to invest primarily in “qualifying employer securities.” In ABC’s case, these would be either:

• any common stock of ABC or of a member of its controlled group that is traded on a stock exchange; or

• if no common stock is so traded, the class of common stock of ABC or of a member of its controlled group having a combination of voting power and dividend rights equal to, or greater than, both the class of common stock that has the greatest voting power and the class that has the greatest dividend rights.

Preferred stock which is convertible into the type of common stock described above can also qualify.

Voting Rights Pass-Through

In considering an ESOP, you should be aware that, if a corporation has a class of securities that must be registered with the Securities and Exchange Commission (a “registration-type class” of securities), its ESOP would have to pass-through to its participants and beneficiaries the right to vote all employer securities allocated to their accounts.

If a corporation does not have a registration-type class of securities, voting rights would have to be passed through only if its employer securities were not traded on a stock exchange and more than 10% of the plan’s assets consisted of employer securities.

Benefits Distributable in Securities or
in Cash Subject to Put Option

ESOP benefits must be distributed either in the form of employer securities or in cash (but subject to the recipient’s right to demand employer securities instead). As discussed above, some ESOPs contain a money purchase component as well as a stock bonus plan component. The benefits distributable from the money purchase part of an ESOP need not be in the form of employer securities.

Put Options and Rights of First Refusal

ESOPs must give participants and beneficiaries a “put option,” i.e., the right to require the employer to repurchase the individual’s securities in exchange for cash. In addition, if a corporation’s securities were not traded on a stock exchange, the corporation, its ESOP, or both could be given a “first right of refusal,” i.e., an option to buy any employer securities that the participant or beneficiary wishes to sell. The price that the corporation or the plan would have to pay for such securities, however, could not be less than the greater of the securities’ fair market value or the purchase price offered by an outside buyer making a good faith offer.

Diversification Election

An ESOP would have to give each employee with 10 or more years of participation who has reached age 55 the right each year to direct the investment of a portion of his or her account in investments other than employer securities. A corporation would have to offer at least three investment options to a participant who is eligible to diversify. If a corporation wished, it could provide for complete self-direction of a participant’s ESOP account, but this is not required.

In lieu of providing three investment options, a corporation could transfer the eligible portion of a participant’s account to another qualified defined contribution plan that it maintains if that plan allows participants to direct the investment of their accounts and makes the required three investment options available. Section §401(k) plans are often used if the plan transfer approach is used, since 401(k) plans often provide for self direction. Alternatively, a corporation’s ESOP could distribute to participants the employer securities that they have elected to diversify or an equivalent amount of cash.

Requirements for ESOPs Using Exempt Loans

ESOPs can use the proceeds of certain “exempt loans” to buy employer securities. An exempt loan is one that meets certain requirements that exempt it from ERISA’s prohibited transaction rules. ESOPs that do not use exempt loans need not meet these requirements. The requirements include:

• Suspense Account Requirement. An ESOP that uses an exempt loan must provide a suspense account to hold employer securities purchased with the loan’s proceeds until the securities are allocated to participants’ accounts. As the loan is repayed, a ratable portion of the securities allocated to the suspense account would be reallocated to participants’ accounts.

• Forfeiture of Securities. If an event occurs that requires a participant to forfeit a portion of his or her benefit, employer securities acquired with an exempt loan may be forfeited only after all other assets of a participant’s account have been forfeited.

Requirements for Exempt Loans

If the requirements discussed below are met, a loan to an ESOP would not constitute a prohibited transaction, even if the corporation were to guarantee payment of the loan. If not for this exemption, such a guarantee would be a prohibited transaction under ERISA, triggering excise taxes and requiring recession of the loan. As an alternative to guaranteeing the loan, a corporation could borrow funds from a lender, loan those funds to its ESOP, and have its ESOP use the loaned money to buy securities from the corporation. Without the exemption, such a loan also would be a prohibited transaction.

Exempt loans must be for a specific term. They cannot be payable upon demand, except where the plan fails to make a required payment. If a corporation’s loan agreement were to provide that the employer securities held in the suspense account would be released from that account only as the loan’s principal amount was repaid (rather than being released on the basis of principal and interest repaid), the loan’s term could not exceed 10 years.

The interest rate on an exempt loan must be reasonable. A variable interest rate can qualify as reasonable.

If a corporation’s ESOP used an exempt loan, it would have to use the loan proceeds within a reasonable time after their receipt to either buy employer securities, repay the loan, or repay a prior exempt loan. It could not use the proceeds of an exempt loan to pay plan administrative expenses.

An exempt loan may provide the lender with a right to repayment from three sources:

• employer contributions (other than employer securities) made to enable the plan to meet its loan obligations;

• earnings on such contributions; and

• earnings on any employer securities pledged as collateral for the loan.

The lender must have no rights against the plan other than those described above.

Default Provisions

ERISA extends certain protections to ESOPs that use exempt loans. For instance, the value of an ESOP’s assets that a lender may acquire upon a default on an exempt loan may not exceed the amount of the default. Thus, the lender could not obtain any appreciation in the value of any employer securities pledged as collateral; it could only attach the number of shares equal in value to the amount of the default.

An exempt loan can call for acceleration of the ESOP’s loan obligation if the ESOP fails to meet its payment schedule, unless the lender is a “disqualified person” under ERISA. Disqualified persons are certain parties having a close relationship to the plan, such as the employer or a large shareholder of the employer.

Certain Put, Call and Similar Options

If a corporation’s ESOP were to use an exempt loan, its plan document, in addition to giving participants and beneficiaries the right to exercise put options (described above) would have to provide that no employer securities acquired with the loan could be subject to any other put, call, or other option, or buy-sell or similar arrangement, while held by, and when distributed from, the ESOP.

Employer Deductions

If a corporation were to adopt an ESOP, it could deduct up to 25% of participants’ annual compensation for contributions that its ESOP used to repay the principal on an exempt loan and could deduct an unlimited amount for contributions used to repay the interest on the loan. ABC could also deduct any cash dividends that it paid on employer securities held by its ESOP if the dividends were either: (1) distributed to participants, (2) paid to the plan and distributed to participants within 90 days after the close of the plan year in which they are paid to the plan, or (3) paid to the plan and reinvested in employer securities. Normally, dividends paid outside a qualified plan are not deductible.

Note: From the employee’s perspective, ESOPs are subject to the general contribution limit on the maximum annual addition that may be made to a participant’s account under all qualified defined contribution plans maintained by the employer.

Faster Distribution of Dividends

An ESOP could, at any time, distribute to participants and beneficiaries dividends that it received on its employer securities. In contrast, ordinary stock bonus plans cannot distribute their assets until they have been in the plan for two years. If the ESOP held the dividends for two years or longer before distribution, it would have to distribute them in stock or in cash (subject to the recipient’s right to demand stock). An ESOP can also use dividends on employer securities to repay an exempt loan.

Nonrecognition of Gain on Sales of Stock to ESOPs

Federal tax law provides an incentive to encourage the transfer of employer securities to ESOPs that a corporation’s shareholders might find attractive: a shareholder may elect to defer paying income tax on any gain realized on a sale of employer securities to an ESOP if he or she acquires similar securities within a prescribed “replacement period.” Transfers of stock to a corporation’s ESOP would qualify for this election if:

• none of ABC’s stock were traded on a stock market;

• the shareholder did not obtain the stock in a distribution from a qualified retirement plan or by exercising a compensatory stock option; and

• immediately after the sale to the ESOP, the plan owned at least 30% of each class of ABC’s stock or at least 30% of the value of all of ABC’s stock.

This provision could help a corporation get a greater percentage of its stock into the hands of its employees and their beneficiaries. Please note, however, that no portion of the plan assets attributable to securities acquired in the tax-free sale may be allocated to the account of:

• the selling shareholder or certain related individuals; or

• any other person who owns more than 25% of (a) any class of ABC stock or of the stock of a member of its controlled group, or (b) the total value of any class of ABC stock or the stock of a member of its controlled group.

This allocation prohibition applies for 10 years after the stock is sold to the ESOP.

The period during which the taxpayer may buy replacement securities begins three months before the sale to the ESOP and ends 12 months after the sale. A taxpayer who acquires permissible replacement securities during the replacement period does not have to pay tax on any gain on the sale of the employer securities to the ESOP until he or she disposes of the replacement securities.

Additional Information

Those having questions or seeking additional information about ESOPs direct inquiries to our online forrm.

ESOP Terms

Employee Stock Ownership Plan (ESOP)
A plan formed to benefit and incentivize the employees of a business, and which can qualify for advantageous tax treatment.

Xesop
A very complex arrangement for holding an operating business, which combines an ESOP with an Xtreme LLC.

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