9. Employee Stock Ownership Plans Introduction An employee stock ownership plan (ESOP) allows companies to share ownership with employees without requiring the employees to invest their own money. With an ESOP, shares of company stock are contributed to the ESOP on behalf of the employees. Although other employment-based plans, such as stock bonus and profit-sharing plans (covered in chapter 6), may contain company stock, an ESOP is required to invest primarily in company stock. ESOPs are unique among employee benefit plans in another way: they may borrow money. This feature can be beneficial as a corporate finance tool. Because of special tax benefits accorded ESOPs, they can also lower the cost of financing corporate transactions. Louis O. Kelso is generally credited with creating the ESOP concept. Kelso believed that by providing employees with access to capital credit, ESOPs would broaden the distribution of wealth through free enterprise mechanisms. Employees who were made owners of the productive assets of the business where they work, Kelso reasoned, would benefit from the wealth produced by those assets and would thus acquire both a capital income and an incentive for being more productive. Kelso attracted a powerful ally in Sen. Russell Long (D-LA), who used his influence to spearhead legislative efforts to promote ESOPs. Political support for the ESOP concept has grown steadily, and through the end of the 1980s Congress encouraged ESOPs through a number of favorable laws, including the Employee Retirement Income Security Act of 1974 (ERISA), the Tax Reduction Act of 1975, the Tax Reform Act of 1976, the Revenue Act of 1978, the Economic Recovery Tax Act of 1981, the Deficit Reduction Act of 1984, and the Technical and Miscellaneous Revenue Act of 1988. However, in 1989, ESOPs came under congressional scrutiny when the large amount of debt incurred by some ESOPs was connected with heavy corporate takeover activity. Congress considered major ESOP changes that would have dramatically reduced their attractiveness to corporations but ultimately passed relatively minor tax changes in the Omnibus Budget Reconciliation Act of 1989 (OBRA 89). These changes are discussed later in this chapter. Types of ESOPs Leveraged ESOPs An ESOP that borrows funds to acquire stock is called a leveraged ESOP and usually works in the following way. Funds are borrowed to acquire employer securities. This can be accomplished in one of two ways (chart 9.1). An employer may arrange to sell the ESOP a specified amount of qualified employer securities at fair market value. The ESOP then borrows the funds needed to purchase the stock. The lender may be a bank or regulated investment company or the employer or shareholders in the employing company. The loan may be guaranteed by the employer, or the stock may be pledged as collateral; it is common for both to occur. The loan is typically repaid with the employer s tax-deductible contributions to the ESOP. Non tax-deductible funds may be used to repay the loan, although it is not a very common practice. As the ESOP loan is repaid, shares of stock are allocated to participants accounts. Unallocated shares remain in the ESOP trust and can continue to serve as collateral for the remaining loan balance. Alternatively, the employer may borrow the money and transfer stock to the ESOP in exchange for the promissory note. The employer makes deductible contributions to the ESOP, which uses these contributions to pay off the note. These repayments to the employer, in turn, are used to pay off the employer s loan.
In contrast to a nonleveraged ESOP, where stock is acquired slowly through employer contributions, a leveraged ESOP generally acquires a large block of stock purchased with the borrowed funds; the shares are held in trust and allocated to participants as the loan is repaid. A leveraged ESOP can acquire a large share of ownership in a company much faster than a nonleveraged ESOP. Furthermore, if the loan is used to buy stock from the employer (rather than from outside existing stockholders), the ESOP transaction provides a cash infusion for the employer. Leveraged ESOPs have been responsible for much of the overall growth of ESOPs over the past several years. The National Center for Employee Ownership attributes this growth to several factors. There was a general increase at the end of the 1980s in merger and acquisition activity, of which leveraged ESOPs are sometimes a part. Tax incentives passed in 1984 and 1986 have made leveraged ESOPs a more attractive means of borrowing money and nonleveraged ESOPs less attractive in general. For a minority of the companies (probably under 1 percent of all ESOPs and 15 percent of public company ESOPs), ESOPs are part of a defense against hostile takeovers. Many employers have come to believe that sharing ownership with employees helps to create a more productive work environment. Other ESOPs Some companies establish ESOPs that are not leveraged. A company sets up a trust, to which it periodically contributes. The company may contribute stock directly or cash, which the fund uses to purchase the stock. The stock is allocated to individual accounts for employees. ESOPs that are not leveraged but can be are sometimes called leverageable ESOPs. The Tax Reduction Act of 1975 allowed an extended investment tax credit equal to qualified contributions to a special nonleveraged ESOP called a TRASOP (Tax Reduction Act stock ownership plan); the allowed credit was increased in the Tax Reform Act of 1976. Under the Economic Recovery Tax Act of 1981, beginning in 1983 the basis for the allowed tax credit was shifted from investment to payroll, replacing the TRASOP with the PAYSOP (payroll-based employee stock ownership plan). However, the Tax Reform Act of 1986 repealed the PAYSOP tax credit for compensation paid or accrued after December 31, 1986. Plan Qualification Rules ESOPs are a type of defined contribution plan and qualify with the Internal Revenue Service as either a stock bonus plan or a stock bonus/money purchase pension plan combination. As with all tax-qualified plans, ESOPs must establish a trust to receive the employer s contributions to the plan, and the plan must be created exclusively for the benefit of employees. ESOPs are subject to the general ERISA rules governing eligibility, vesting, participation and coverage, and reporting. (See chapter 3 on ERISA and chapter 12 on pension plan nondiscrimination and particpation requirements.) But ESOPs also must comply with additional requirements aimed at the plans specific characteristics. Investment of Assets As mentioned earlier, ESOPs must invest primarily in qualified securities of the employer. In practical terms, this means that at least 51 percent of a plan s assets must be so invested. Qualified employer securities may include readily tradeable common stock, stock with voting power and dividend rights, preferred stock that is convertible into qualified common stock, and stock of affiliated corporations if certain requirements are met. Debt instruments are not included. Diversification For stock acquired after 1986, ESOPs must provide means for qualified participants nearing retirement to diversify part of their ESOP account balance. In
general, beginning with the plan year following the participant s attainment of both age 55 and 10 years of participation, the participant must be provided the opportunity to diversify at least 25 percent of the total account. Five years later, the participant must be allowed to diversify at least 50 percent. Alternatively, the ESOP may distribute the amount that could be diversified. Voting Rights ESOP participants must be allowed certain voting rights. For stock that is readily tradeable (stock of a public company), full voting rights for all allocated shares must be passed through to participants. For stock of closely held companies (those whose voting stock is held by a few shareholders), voting rights must be passed through on all major corporate issues, specifically those that must be decided by more than a majority vote. Shares not voted by participants may be voted by the ESOP trustee. Distributions ESOPs are permitted to make distributions in either stock or cash. Unless the sponsoring company s charter or bylaws require that substantially all of the company s stock be owned by employees, participants must be allowed to take their distributions in stock. 1 Generally, the full amount must be paid out over no more than five years, although the participant can elect to extend this period. Also, the period can be extended up to an additional five years for account balances in excess of $500,000, as indexed. A participant receiving nonpublicly traded stock must be given an option to sell the stock to the employer at an independently appraised fair market value (a put option). For stock acquired after 1986, the employer can pay for the stock in annual installments, over a period of up to five years (beginning no later than 30 days after the sale), and pay interest at a reasonable rate. The employer must provide security for the unpaid balance of deferred payments. The employer and the ESOP may exercise a right of first refusal to repurchase nonpublicly traded stock distributed by the ESOP. Special Tax Advantages ESOPs enjoy a variety of tax advantages over other defined contribution plans. Deductions for Contributions ESOP contributions that are used to repay an ESOP loan are not subject to the usual 15 percent of covered compensation deduction limit. (For further discussion of deduction limits, see chapter 4 on pension plans). Instead, employers can deduct contributions used to pay the loan principal, up to 25 percent of compensation. Unlimited deductions are permitted for contributions used to pay loan interest. Dividend Deduction Employers generally may also deduct dividends paid on ESOP stock to the extent that the dividends are distributed in cash to participants or used to repay the principal on the ESOP loan. However, to be deductible, the dividends must be on employer securities acquired with the ESOP loan (generally effective for securities acquired after August 4, 1989). These liberal deduction limits are designed to help accelerate the rate at which ESOPs can repay loans, thereby allowing more rapid allocation of ESOP stock to participants accounts. Lender Incentive Under prior law, qualified lenders banks and regulated investment companies could exclude from gross income 50 percent of the interest earned on ESOP loans. Some of this advantage was passed on to the ESOP through lower interest rates. However, OBRA 89 permits this interest exclusion only if three conditions are satisfied: (1) the ESOP owns more than 50 percent of each class of outstanding stock of the corporation issuing the securities or more than 50 percent of the total value of all outstanding stock of the corporation immediately after the acquisition of employer securities with the proceeds of such loans; (2) the term of the loan is not more than 15 years; and (3) voting rights on allocated shares are passed through to participants. The provision is
generally effective for loans made after July 10, 1989. Certain exceptions apply for loans pursuant to certain written binding commitments in effect on that date (or on June 6, 1989) and for loans after which the ESOP owns at least 30 percent of the company and the loan was made by November 17, 1989. The Small Business Job Protection Act of 1996 repealled the exclusion for new loans. Any loans in effect before June 10, 1996 were grandfathered under the previous law. Certain refinancing of ESPO loans will be exempt from the changes. A number of other tax incentives are provided to encourage the use of ESOPs to broaden corporate ownership, as follows. Incentives for Sale of Stock to an ESOP Shareholders of corporate stock can defer taxes on the gain from the sale of stock to an ESOP if, on the completion of the sale, the ESOP owns at least 30 percent of the company and the seller reinvests the proceeds from the sale in qualified domestic securities within one year after (or three months before) the sale. In addition, the seller must have held the securities for at least three years before the sale of the stock (effective for sales after July 10, 1989). This provision allows owners of closely held businesses who are approaching retirement age to, in essence, create a market for their stock and to diversify their investments, on a tax-deferred basis, while providing their employees with a significant benefit and assuring the continued independence of the business. Until 1989, estates that sold employer stock to an ESOP could exclude from taxes 50 percent of the proceeds received on the sale, up to $750,000. This was repealed in OBRA 89, effective for estates of decedents dying after December 19, 1989. Early Distribution Tax Lump-sum distributions paid to ESOP participants prior to January 1, 1990, are exempt from the 10 percent penalty tax imposed on employees for early withdrawal (prior to age 59 1 /2). Conclusion ESOPs can provide employees with substantial financial benefits through stock ownership while providing companies with attractive tax advantages and a powerful corporate finance tool. By making employees partial owners of the business, a company also may realize productivity improvements, since workers benefit directly from corporate profitability and are thus working in their own interest. Although the advantages of ESOPs are attracting growing numbers of companies, there is also some risk to consider. Because the ESOP is invested primarily in employer securities, its success depends on the long-term performance of the company and its stock. There is, therefore, a greater degree of risk involved because of the concentration of employee capital. An ESOP is not appropriate in every circumstance, but the many benefits of employee ownership and ESOP financing merit close consideration of this concept. Bibliography Blasi, Joseph R. Employee Ownership: Revolution or Ripoff? Cambridge, MA: Ballinger, 1988. Employee Benefit Research Institute. Databook on Employee Benefits. Third edition. Washington, DC: Employee Benefit Research Institute, 1995. Council of Institutional Investors. Does Ownership Add Value? 100 Empirical Studies. Washington, DC: Council of Institutional Investors, 1994.
Kelso, Louis O., and Patricia Hetter Kelso. Democracy and Economic Power: Extending the ESOP Revolution Through Binary Economics. Lanham, MD: University Press of America, 1991. Piacentini, Joseph S. Employee Stock Ownership Plans: Impact on Retirement Income and Corporate Performance. EBRI Issue Brief no. 74 (Employee Benefit Research Institute, January 1988). Quarrey, Michael. Employee Ownership and Corporate Performance. Oakland, CA: National Center for Employee Ownership, 1991. Rosen, Corey, and Karen M. Young, eds. Understanding Employee Ownership. Ithaca, NY: ILP Press, 1991. Young, Karen, ed. The Expanding Role of ESOPs in Public Companies. New York, NY: Quorum Books, 1990. Additional Information Employee Stock Ownership Association 1726 M Street, NW Washington, DC 20036 (202) 293-2971 National Center for Employee Ownership 1201 Martin Luther King, Jr. Way Oakland, CA 94612 (510) 272-9461 1 Unless the separating participant elects otherwise, distributions attributable to stock acquired after December 31, 1986, must begin within one year following the plan year in which the participant retires, dies, or becomes disabled or within five years after the participant separates from service for any other reason (if not reemployed with the same company).