Description and Purpose of an ESOP
An employee stock ownership plan (“ESOP”) is an employee benefit plan which is qualified for tax-favored treatment under the Internal Revenue Code of 1986, as amended (the “Code”). A plan is qualified if it complies with various participation, vesting, distribution and other rules established by the Code to protect the interests of employees. An ESOP is classified as a type of deferred compensation plan which invests primarily in stock of the corporation that sponsors the ESOP. An ESOP also must comply with various reporting and disclosure requirements and fiduciary responsibility rules of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).
An ESOP is a “defined contribution plan.” That is, the employer’s contribution is defined (but in most cases discretionary) and the employee’s benefit is variable. Each participating employee’s account is credited with an appropriate number of shares of company stock and/or cash contributions over the period of his employment. After retirement, death, disability or other termination of service, the employee’s account is distributed to him (or his beneficiary) in shares of stock, cash, or a combination of both, with the amount determined by applying the current fair market value of the company stock in his or her account to the number of shares. An employee’s benefit, thus, is not defined - as with a pension plan - but is dependent upon the value of his stock (and other funds resulting from the investment of any cash contributions).
What do employees receive from an ESOP?
All ESOP assets (company stock and other investments) are allocated each year to the accounts of all employee participants in the ESOP, by a formula usually based on the proportion of an employee’s salary to total covered payroll for all such employee participants. Assets of the ESOP are held in an ESOP trust established under a written trust agreement and administered by a board of trustees responsible for protecting the interests of employees (and their beneficiaries).
An employee is not taxed on contributions to his or her ESOP account (or income earned in that account) until his or her benefits are actually received. Even then, “rollovers” (into an IRA, for example) or special averaging methods can reduce or defer the income tax consequences of distributions.
An ESOP, like most employee benefit plans, generally is designed to benefit employees who remain with the employer the longest and contribute most to the employer’s success. Therefore, an employee’s ownership interest (in company stock and other assets held in the ESOP trust) usually is based on his or her number of years of employment. The employee’s ownership interest in the ESOP is called his “vested benefit,” and the provisions which determine his vested benefit are called the “vesting schedule.” Although there are various vesting schedules which may be used (extending for periods up to six years), most are designed so that the longer the employee stays with the employer, the greater his vested benefit becomes.
If an employee terminates employment for any reason other than retirement, death or disability, his or her vested benefit under the ESOP will be determined by referring to the vesting schedule. All company stock and other investments in which the employee does not have a vested benefit (because he or she has not worked long enough) will be treated as a “forfeiture,” which is allocated among the ESOP accounts of the remaining employee participants on the same basis as employer contributions. If an employee retires, dies or is disabled, he or she usually will be 100% vested in his or her total account balance.
After an employee’s participation in the ESOP ends, he or she (or his or her beneficiary) is eligible to receive a distribution of his or her vested benefit. There are many permissible times and methods for making this distribution. For example, it may be made as soon as possible after an employee’s termination of employment, or it may be deferred for a period of up to six years. However, distribution of a former employee’s vested benefit must start in the year following his retirement, disability or death. Payment may be made in a lump sum or in installments over a period of up to five years. In a closely-held company, distributions are usually made in cash or in shares of company stock which may be sold back to the company.
How does an ESOP benefit employers?
As a technique of corporate finance, the ESOP can be used to raise new equity capital, to refinance outstanding debt or to acquire productive assets through leveraging with third-party lenders. Because contributions to an ESOP trust are tax deductible (subject to certain limits), an employer can fund both the principal and the interest payments on an ESOP’s debt service obligations with pre-tax dollars.
Federal Income Tax Consequences of an ESOP for the employer
Employer contributions to an ESOP trust are tax deductible within the limitations of the Code. An employer may contribute to an ESOP trust and deduct up to 25% of covered payroll per taxable year. If the ESOP has borrowed and is leveraged, the employer may increase contributions beyond the 25% level to the extent that the excess is used to pay the ESOP’s interest expense except in the case of an S corporation ESOP. In addition, cash dividends paid on ESOP stock are deductible by a C corporation if applied to the repayment of ESOP trust debt or if currently distributed in cash to ESOP participants. Under Section 415 of the Code, the “annual additions” which may be allocated to the account of an individual ESOP participant each year normally may not exceed the lesser of 100% of his covered compensation or $53,000 (as the Internal Revenue Service (“IRS”) may increase for cost of living adjustments for plan years after 2015). The “annual additions” are aggregated among all defined contribution plans that the employer sponsors and include employer contributions, any employee contributions (including 401(k) deferrals, if any) and certain forfeitures which are allocated to the employee’s account, although contributions used to pay loan interest will usually not be considered “annual additions.”
Tax Benefits to Selling Shareholders
An ESOP provides a market for stock of a closely-held company. The Code provides a special tax incentive for certain sales of stock to an ESOP, subject to satisfying a number of specific rules. Thus, a shareholder of a closely-held C corporation may be able to sell stock to an ESOP, reinvest the proceeds in other securities and defer taxation of any gain resulting from the sale (so long as a number of special requirements are satisfied).
In a closely-held company, unless otherwise determined by the Board of Directors, employees have voting rights on allocated shares only with regard to certain major corporate issues, such as merger, certain sales or liquidation of the company and recapitalizations. On other matters, ESOP shares are usually voted by the ESOP’s Board of Trustees which has been appointed by the company’s Board of Directors. Many variations of this structure are used. In a publicly-traded company, employees have voting rights on all shares allocated to their accounts under the ESOP.
ESOPs have existed since the 1950s, but were first formalized under federal law with the enactment of the Employee Retirement Income Security Act of 1974. Since that time, significant ESOP incentives have been included in numerous federal statutes, including:
- Tax Reduction Act of 1975
- Tax Reform Act of 1976
- Revenue Act of 1978
- Small Business Employee Ownership Act of 1980
- Economic Recovery Tax Act of 1981
- Deficit Reduction Act (Tax Reform Act) of 1984
- Tax Reform Act of 1986
- Small Business Jobs Protection Act of 1996
- Taxpayer Relief Act of 1997
- Economic Growth and Tax Relief Reconciliation Act of 2001
- American Jobs Creation Act of 2004
- Pension Protection Act of 2006
- Heroes Earnings Assistance and Relief Tax Act of 2008
- Worker, Retiree, and Employer Recovery Act of 2008
Under current law, as enacted in 1997 for years beginning on or after January 1, 1998, S corporation ESOPs are exempt from the unrelated business income tax (UBIT); thus, if an ESOP owns all of an S corporation, no current tax is imposed on the company’s income. (That income is eventually taxed because ESOP participants in S corporations are taxed on ESOP distributions, just as C corporation ESOP participants are.) The Economic Growth and Tax Relief Reconciliation Act of 2001, as amended, restricts the abuse of this provision by plans designed to benefit only a small number of employees, whether in a very small company or where a small number of employees try to set up an S corporation ESOP to benefit themselves while operating a larger company whose employees are not participating in the ESOP. The U.S. Treasury and the IRS issued Temporary and Proposed Regulations regarding S Corporation ESOPs on July 18, 2003, revised such regulations on December 17, 2004, and issued Final Regulations regarding S Corporation ESOPs on December 20, 2006. Effective for S corporation distributions made after December 31, 1997, the Code that permits S corporation ESOPs to apply such S corporation distributions received on qualifying employer securities (whether allocated or not) to make acquisition loan repayments, provided, however, that the plan document provides that “employer securities with a fair market value of not less than the amount of such distribution are allocated to such participant for the year which [otherwise] would have been allocated to such participant.” S corporations, however, still are not entitled to deduct such distributions.
The laws enacted since 2001 make funding defined contribution plans more flexible and attractive to employers, and permits substantially more dollars to be added to rank-and-file employees’ retirement plan accounts.