By Rob Edwards
I. OVERVIEW OF LEGAL REQUIREMENTS
A. An Employee Stock Ownership Plan (“ESOP”) is usually structured as a tax-qualified “stock
bonus” plan. Properly designed, an ESOP can offer significant financial benefits to the
sponsoring corporation while also providing employees with a valuable stock ownership benefit
at no cost to them.
1. An ESOP must cover a nondiscriminatory classification of employees who have attained
age 21 and completed a year of service (2 years if the plan provides for 100% vesting).
Employees may not otherwise be excluded solely by reason of age or service. Effective in
2007, an ESOP must provide for either graduated vesting of participant accounts, with full
vesting required after 6 years of service, or cliff vesting of participant accounts, with full
and immediate vesting after 3 years of service. Nonvested benefits are subject to
forfeiture if the employee quits or is fired before normal retirement age.
2. Employer contributions to an ESOP can be made in the form of employer stock (valued at
fair market value) or cash. ESOP contributions are tax-deductible within prescribed limits
and may be made under a formula or in the employer’s discretion.
3. Assets held in an ESOP may include employer stock and other investments. ESOP plan
assets must be held in a trust. The ESOP trustee may be an individual or individuals
affiliated with the employer.
4. The ESOP must provide for allocating contributions among participants and for
distributing benefits upon a participant’s retirement, death, disability, or separation from
service.
5. Assets held in the ESOP must be valued at least annually.
6. Benefits may be distributed in the form of employer stock or cash. The participant must
have the right to receive a distribution of stock, unless the employer is an S corporation, or
a bank prohibited from repurchasing its own shares, or the employer’s charter or by-laws
restrict ownership of substantially all employer stock to current employees or to a trust
under a qualified plan. Generally, an ESOP participant must be permitted to elect to begin
receiving ESOP benefits not later than one year after the participant’s death or retirement,
or six (6) years after the participant separates from service for any other reason.
7. If ESOP benefits are distributed in employer stock that is not readily tradable on an
established market, the participant must have a limited right (the “put option”) to require
the employer to repurchase the stock at fair market value. The future cost of repurchasing
employer stock distributed from the ESOP under the put option is referred to as the
employer’s “repurchase liability”. Distributed shares may be subject to a right of first
refusal in favor of the employer and the ESOP.
8. Voting rights with respect to employer stock of a company that is registered under the
Securities Exchange Act of 1934 must be “passed through” on all shares that are allocated
to participants’ accounts. For employer stock that is not publicly traded, pass-through
voting is required for shares allocated to participants only on mergers, recapitalizations,
liquidations, dissolutions or similar major transactions. Unallocated shares, and allocated
shares voted on matters for which pass-through voting is not required may be voted by the
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ESOP fiduciary, on a pass through basis, or as provided in the plan document. An ESOP
established by a nonpublicly traded company may also provide for per capita voting (1
person 1 vote). If per capita voting applies, the percentage of votes cast will govern the
voting of all employer stock (both allocated and unallocated shares) held in the ESOP.
9. If the employer is a member of a controlled group of corporations, the ESOP may be
established by one member with respect to the stock of another controlled group member.
10. Since 1998, ESOPs have been permitted to invest in S corporation stock without adverse
tax consequences.
11. State law often restricts the ownership of shares in a corporation which is authorized to
carry on certain professional practices (e.g., architecture, engineering, accounting,
medicine, etc.) to individuals who hold professional licenses. While ESOPs are prohibited
under the laws of most states from owning stock in such a corporation, the corporation
may be able to establish an ESOP if it qualifies to do business under the general business
corporation act of the state in which it is incorporated, if a “grandfathered” charter is
available, or if incorporation under the laws of another state is possible.
12. An ESOP may be part of a 401(k) plan or arrangement (a KSOP). KSOPs are common in
publicly-held companies. Some nonpublic companies have also adopted KSOPs to fund
matching contributions to their 401(k) plans in the form of employer stock, and to help
create a market for their stock. KSOPs which allow participants to elect to invest their own
salary reduction contributions in employer securities must comply with federal and state
securities laws.
13. An ESOP must comply with all Internal Revenue Service and Department of Labor rules
and requirements applicable generally to qualified employee benefit plans.
B. Special qualification requirements apply to “leveraged” ESOPs. A leveraged ESOP is designed to
use borrowed funds (an “exempt loan”) to purchase employer stock, with the loan repaid from
future employer contributions to the ESOP, plus dividends on the shares purchased with the
exempt loan proceeds. An exempt loan almost always involves a guarantee or extension of credit
(this may take the form of an installment purchase obligation) between the ESOP and a
“disqualified person” (usually the sponsoring employer and/or its shareholders) that would be
prohibited in any other kind of employee benefit plan.
1. A leveraged ESOP must be designed to invest primarily in “qualifying employer
securities”. This generally means either voting common stock with full dividend rights, or
preferred stock that is readily convertible into voting common.
2. A leveraged ESOP must provide for the release of financed shares that are held in the
ESOP’s suspense account as the exempt loan is repaid. The release of employer stock
under the ESOP must be made under one of two alternative methods. One method allows
the release of employer stock in proportion to the repayment of principal and interest on
the exempt loan. The other method allows for employer stock to be released in proportion
to the amount of principal only repaid on the exempt loan.
3. Employer stock of a company that is not publicly traded held in a leveraged ESOP must be
valued annually by an independent appraiser.
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4. A participant age 55 or older with 10 or more years of participation in a leveraged ESOP
must be offered the option to “diversify” his or her ESOP account. The option is
exercisable annually over a period of 5 years, and allows a qualified participant to direct
the investment of 25% of the employer stock that has ever been allocated to the
participant’s ESOP account (including any stock diversified under prior elections) into
investments other than employer stock. If the leveraged ESOP does not offer at least three
investment options inside the ESOP, the participant must be allowed to cash out the
diversified amount or to have the diversified portion of the account transferred to another
qualified plan which offers three or more investment options. In the sixth and final year of
the option period, the participant must receive a similar one-time option covering 50% of
the account. Cashout distributions are eligible to be rolled over into an IRA. KSOP
arrangements which allow investment in publicly traded stock are subject to more rapid
diversification requirements.
5. Leveraged ESOPs benefit from certain favorable rules:
(i) Effective for plan years beginning in 2002, the general limit on deductible
contributions to individual account plans was increased from 15% of covered
compensation to 25% of covered compensation. However, an employer taxable as a C
corporation may deduct all contributions to a leveraged ESOP which are used to pay
interest on an exempt loan, plus loan principal payments up to 25% of covered
compensation. S corporation deductible contributions are limited to 25% of covered
compensation
(ii) Dividends paid on employer stock held in a leveraged ESOP are tax deductible if they
are distributed currently to participants in cash, used to repay an exempt loan the proceeds
of which were used to acquire the employer securities with respect to which the dividend
is paid, or at the election of the participant, invested in the plan in employer stock.
Distributed dividends are also exempt from the 10% penalty tax on early distributions to
employees under age 59 1/2. Distributions with respect to employer stock of an S
corporation are not deductible, and are subject to the 10% penalty tax if the recipient is
under age 59 1/2.
(iii) Dividends on C corporation stock and S corporation distributions may also be used to
repay an exempt loan, provided that employer stock equal in value to the dividends (or
distributions) paid on allocated shares is allocated to the participants’ accounts.
(iv) A leveraged C corporation ESOP is permitted to allocate forfeitures and interest on an
exempt loan under a special provision of Section 415 of the Internal Revenue Code, if not
more than one-third of employer contributions for the year are allocated to highlycompensated
employees. If this special rule applies, the only amount taken into account
for Section 415 purposes is the principal reduction on the exempt loan. Interest on the
exempt loan, deductible dividends and forfeitures of employer stock acquired with an
exempt loan are not included in calculating the maximum permissible allocation. A stock
bonus or profit-sharing plan, in contrast, must include all allocations of principal, interest
and forfeitures in computing the Section 415 limitations.
(v) An ESOP participant who receives a lump sum distribution of employer stock will
only be taxed on the ESOP’s cost basis for the stock. The “net unrealized appreciation”
(the difference between its fair market value at the date of distribution and its cost to the
ESOP) is not taxable until the stock is sold. This favorable tax treatment extends to
distributions from stock bonus and profit-sharing plans.
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6. To guard against the possibility of self-dealing, leveraged ESOP transactions are subject to
special regulatory scrutiny to ensure that the transaction is primarily for the benefit of
ESOP participants and their beneficiaries. Purchases and sales of employer stock held in a
leveraged ESOP are subject to fiduciary rules enforced by the Department of Labor,
including the requirement that the ESOP cannot pay more than “adequate consideration”
for employer stock.
7. For newly formed ESOPs, and existing ESOPs after 2004, severe tax penalties are
imposed on S corporation ESOP sponsors for any year in which “disqualified persons”
collectively own or are deemed to own 50% or more of the corporation. A “disqualified
person” is a person who (i) individually owns 10% or more of the S corporation’s
“deemed-owned” shares, or (ii) collectively with other family members owns 20% or more
of its deemed-owned shares. Deemed-owned shares are the individual’s allocated ESOP
shares, a proportionate share of any unallocated ESOP shares, and any “synthetic equity”
owned by disqualified persons. Synthetic equity is broadly defined to include the right to
acquire stock of the corporation or to share in the corporation’s value or growth through
equity-based compensation. These rules are complex, but will generally preclude small S
corporations with ten or fewer employees from adopting an ESOP. Corporations with up
to 50 (or more) participating employees will also need to carefully monitor their ESOP
program to ensure compliance.
II. ADVANTAGES OF LEVERAGED ESOP FINANCING
A. Section 1042 Rollover for Selling Shareholder. If a leveraged ESOP owns at least 30% of the
company after purchasing employer stock, a selling shareholder who has held (for at least 3 years)
employer stock that was not acquired in a distribution from a qualified plan or in an employmentrelated
transfer, may qualify for nonrecognition of gain under Section 1042 of the Internal
Revenue Code if the seller reinvests in “qualified replacement property”. Qualified replacement
property includes stocks, bonds, notes and other evidence of indebtedness issued by active U.S.
operating companies. In order to qualify for the rollover, the qualified replacement property must
be purchased within a 15-month period beginning 3 months before the sale, and the employer must
consent to the nonrecognition treatment and agree to pay a 10% excise tax in case of certain
premature dispositions of the acquired securities within 3 years after the sale. In addition, the
seller, the seller’s family members and 25% or more shareholders are prohibited (or restricted in
certain cases involving a selling shareholder’s lineal descendants) from receiving allocations of
acquired shares. Sales of S corporation stock are not eligible for the tax free rollover.
B. Tax Benefits for ESOP Sponsor. Because the ESOP sponsor can deduct its entire ESOP
contribution, principal as well as interest paid on the ESOP loan becomes, in effect, tax-deductible.
This affords ESOP financing an immediate advantage over a conventional loan, although the
liquidity necessary to fund the employer’s future repurchase liability (see I.A. 7.) needs to be
considered. In addition, the increased contribution and allocation limits, and deductible dividends
available to leveraged C corporation ESOPs (See I.B.5) add even more flexibility to leveraged
ESOP financing.
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III. PRINCIPAL REASONS FOR A COMPANY TO ADOPT AN ESOP
A. Business Succession. A leveraged ESOP creates an immediate market for the sale of a founder’s
stock. The founder benefits by deferring income tax on the sale proceeds, and the employees
benefit by acquiring a significant interest in the employer without any cost to them.
B. Financing Vehicle. A leveraged ESOP can be used as a vehicle to obtain financing for the
employer, with a full tax deduction allowed for ESOP contributions used to repay principal as
well as interest.
C. Employee Productivity. An ESOP can serve as a means of enhancing employee productivity by
providing substantially all employees with an economic stake in the financial success of their
employer. A sound ESOP communications program is essential to help ensure that this benefit is
realized.
IV. ILLUSTRATION OF ESOP BENEFITS
A. Leveraged ESOP. Assume that DEF Engineering, a C corporation, is valued at $2,000,000 and
that D, the principal owner, wants to sell a 70% interest in the company to an ESOP for
$1,400,000. The ESOP will borrow the funds and repay the loan in level annual installments over
7 years at 9%. The following table illustrates the potential ESOP tax savings in this transaction
compared with a stock redemption:
COMPANY
REDEMPTION ESOP
1. TOTAL INTEREST AND PRINCIPAL PAYMENT $2,013,018 $2,013,018
2. TAX DEDUCTIBLE PORTION $613,018 $2,013,018
3. TAX BENEFIT AT 34% $208,426 $684,426
4. NET AFTER-TAX COST (1 – 3) $1,804,592 $1,328,592
As illustrated above, the potential federal tax savings to the Company in this example is $476,000, which
represents the difference between the after-tax cost of a stock redemption loan versus an ESOP loan.
B. Additional Rollover Benefits. If D makes a qualifying Section 1042 rollover, the total tax
benefits in the transaction are significantly increased. If D had only a nominal tax basis in his
stock of DEF, his federal tax savings could be as much as $280,000. The total federal tax
benefits for the employer and the selling shareholder in the $1,400,000 transaction illustrated
could amount to as much as $756,000, or 54% of the sale proceeds. Additional tax savings for
both the employer and the selling shareholder may be available under state law.
C. Nonleveraged ESOP Financing Alternative. As an alternative to the leveraged ESOP illustrated
in IV. A. above, it is possible to obtain many of the ESOP’s financing advantages with a
nonleveraged ESOP or even a profit-sharing plan in conjunction with a loan to the company.
This technique involves a redemption of stock by the company which then makes tax-deductible
contributions of employer stock to a qualified plan each year in an amount equal to the principal
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value paid down on the loan during the year. Because the fair market value of contributed stock
is tax-deductible, the company has, in effect, obtained a deduction for the principal repaid on its
loan. This alternative method has some advantages and some limitations in comparison with
leveraged ESOP financing:
1. Advantages.
(i) Avoids prohibited transactions problems.
(ii) Allows use of a profit-sharing or traditional stock bonus plan.
(iii) If the value of stock increases over the loan period, the number of contributed
shares is reduced. This results in less dilution of shareholders’ equity, and spreads
dilution over a greater period.
(iv) Greater flexibility.
2. Limitations
(i) A selling shareholder cannot obtain a tax-free rollover.
(ii) Financing may be more difficult to obtain for a stock redemption than for an
ESOP.
(iii) Higher deduction limits apply to a leveraged ESOP, so larger deductible
contributions are permitted.
(iv) A leveraged ESOP may have a greater effect on employee productivity.
Rob Edwards is a partner with Steiker, Fischer, Edwards & Greenapple, P.C.
The Foundry Corporate Office Center
235 Promenade Street, Ste. 497,
Providence, RI 02908
tel. – 401/632-0480
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