EMPLOYEE STOCK OPTIONS
ESOP BENEFIT PLANS
Employee Stock Ownership Plans are a tax saving means of corporate financing. The essence of the tax benefits: A firm sets up a plan that borrows money from a bank on a note guaranteed by the corporation. The plan describes the use of money for buying stock from the corporation.
The corporation makes contributions annually in cash or stock to the plan, for which it gets tax deductions. The contributions are used to pay off the bank loan. In effect, the corporation raises capital with tax deductible dollars.
The ESOP can be used as a personal financial planning tool for the shareholder/owners of a close corporation who are otherwise locked into the corporation.
If the corporation redeems part of their shares in an ordinary way, they are almost certain to be taxed at ordinary income rates. In addition, that transaction will be treated as a dividend distribution (that the corporation pays taxes on) rather than a sale or exchange taxable at capital gains rates.
The corporation itself faces a major problem on redemptions. It must accumulate the necessary funds. Normally, they can be accumulated only from after-tax dollars.
By interposing an ESOP, the picture changes dramatically. The shareholders have a market for their shares, the ESOP. The plan can be used to buy their shares with deductible contributions made with pre-tax dollars.
What’s more, the shareholder is not taxed at ordinary income rates but at capital gains rates on the sale to the ESOP. If there is not enough money in the ESOP at the time to effect the purchase, then the plan may borrow money from a bank in the procedure outlined above.
The same approach may be used by the shareholder’s estate as a means of realizing cash on stock held by the estate, without getting dividend treatment.
There are also significant benefits in using life insurance to strengthen this arrangement. The ESOP, as an alternative to borrowing to raise cash to purchase stock from the estate, may, according to current thinking among practitioners, carry life insurance on a key shareholder. If the corporation itself were to carry such insurance to facilitate redemption, the premiums paid would not be tax deductible. By interposing an ESOP, the premiums effectively become tax deductible, since they are paid by the plan out of tax deductible dollars contributed to it by the company.
The shareholder/executive will be able to participate in the plan personally and enjoy its benefits.
- The company makes tax-deductible contributions to plan
- The shareholder is not taxed until benefits are available
- The shareholder gets favorable tax treatment. This treatment is made on lump sum distributions through a special five or ten-year averaging formula
- The payout is required to be made in company stock. The shareholder will not be taxed on the unrealized appreciation in the stock over the cost to the plan until he or she sells the stock
- Plan benefits will not be included in estate taxes. On a transfer of plan benefits to the beneficiaries upon death, other than to the estate, benefits will not be includible in the estate and will escape estate taxes
ADDITIONAL ESOP BENEFITS ADD NEW CAPITAL AND DEDUCT IT AS AN OPERATING EXPENSE
If a corporation is earning more than $335,000 per year before taxes, it will pay income taxes at the rate of 34% or more on that part of its income over $335,000. This means that the government is paying at least 34% of any additional deductible expense item. When expenses increase by $1.00, net income is reduced by no more than 66 cents.
Thus, if a way can be found to invest a dollar of additional capital in the corporation and deduct it as operating expense, Uncle Sam will pay at least 34 cents of that dollar.
There is a way to do it. It has called an Employee Stock Ownership Plan. With an ESOP, the corporation can deduct amounts contributed to the plan as operating expense, if the plan is qualified under ERISA. In addition, money contributed to the plan may be invested in stock or securities of the corporation.
The ESOP is somewhat similar to a qualified pension or profit sharing plan, but the difference is that it buys or owns stock of the corporation. This stock may be new issues purchased directly from the company or stock in the possession of a corporate stockholder.
METHODS OF CONTRIBUTING TO THE PLAN
The corporation can contribute to the ESOP in either of two ways. It can contribute:
For every dollar of stock the corporation contributes, it increases its cash on hand by 34 cents (the amount of the tax saving on the value of the stock contributed).
- Cash that is then used by the ESOP to buy stock
The company stock may be purchased from the corporation or from stockholders. The result is exactly the same for purchases of stock from the corporation:
Net cash outlay for ESOP contribution - $1.00
Cash received by the corporation from
the ESOP for purchase of stock + $1.00
Tax saving from plan deduction + .34
Net change in cash position .34
Furthermore, the ESOP may (if its charter permits) borrow money and use it to buy stock from the corporation or from stockholders. This is called a leveraged ESOP.
The program of contributing stock, or investing plan assets in stock, is entirely within the control of the company’s management and can be discontinued at any time. Even in the unlikely event that the plan trustees want to buy more stock than management wants them to have, they cannot force the company to sell it to them.
RULES OF EMPLOYEE STOCK OWNERSHIP PLANS
Every employee who qualifies must participate in the ESOP. Vesting cannot be delayed; all contributions to the plan for every employee must vest immediately, and the vested shares must be distributed to the employee upon retirement or termination (but not sooner than seven years after shares have been allocated to the participant).
Furthermore, no more than one third of the ESOP contributions for a year may be allocated to officers, stockholders or highly paid employees.
Moreover, the employer must offer to repurchase the shares at a price determined by a fair valuation formula established in advance. However, if the corporation’s charter or by-laws restrict ownership of stock to the ESOP or to employees only, the employee can only be offered a cash, not a stock, distribution.
This repurchase requirement could be very troublesome in some circumstances. Suppose, for example, the company encounters financial difficulties and starts running in the red. Large numbers of employees might demand to have their shares distributed and immediately repurchased, since it is very likely that the value would decrease as a result of the losses. Thus, just at a time when cash is critically short, a large cash outlay to repurchase shares would be required.
Less problematic but potentially difficult is the fact that, under an ESOP, voting rights must be passed through to the employees. That means that each employee has the right to vote the shares in which his or her ownership is vested, although the plan is nominally the owner of the shares. However, this rule does not apply to a profit sharing plan for acquisitions of stock. The employee continues to have voting rights if the shares that are distributed are retained - and this could mean trouble for the active owners of the corporation.
There is one plus in this situation. The employer corporation may be reimbursed by the plan for certain expenses incurred in establishing and administering the plan.
CHIEF PROBLEMS WITH ESOPS
No benefit plan is without limitations. Several problems exist with this type of plan:
- Valuation of shares on a sale to the ESOP
The stock must initially be appraised, which will have a cost. The valuation to support the subsequent contributions may also require the use of a qualified appraiser more frequently than you would like. One solution is to have a qualified appraisal performed periodically, and then use an established formula to make interim adjustments.
- Distribution of firm information to shareholders
If corporate progress is not to the liking of employees, you can expect worker dissatisfaction. Furthermore, as shareholders, even within their own ESOP account, the employees will be privy to corporate financial information. This can cause problems.
The concepts are new, but ESOP is one well worth exploring, especially for a profitable company seeking employee motivation.
Employer Fiduciary Responsibilities