ESOPs
The rules and regulations on Employee Stock Ownership Plans ("ESOPs") are complex and can vary depending on a particular set of facts. In order to help you better understand ESOPs, we have set out below:
- An Overview of ESOPs;
- What an ESOP Can Accomplish;
- How an ESOP Works;
- ESOP Tax Incentives; and
- Additional Important ESOP Information.
The discussion is general in nature and is not a substitute for professional advice. If you have any questions or comments concerning the information provided, please do not hesitate to contact Mark Bogart at (312) 609-7878 or mbogart@vedderprice.com.
AN OVERVIEW OF ESOPs
An ESOP is a qualified retirement plan designed to invest primarily in stock of the corporate sponsor of the ESOP (referred to here as the "Employer"). An ESOP invests in Employer stock in different ways. It can purchase the stock directly from an existing shareholder or from the Employer. An Employer can also contribute stock to the ESOP and claim a tax deduction for the contribution. When an ESOP purchases the stock, it usually uses money it has received either through tax-deductible Employer contributions or through a loan that is repaid through tax-deductible Employer contributions.
Like any qualified plan, ESOPs are governed by the plan qualification rules under the Internal Revenue Code (the "Code") and the Employee Retirement Income Security Act of 1974 ("ERISA"). Under the Code, there are several tax benefits that are designed to encourage ESOPs. For example, in comparison to other qualified plans, there are expanded contribution limits for ESOPs.
Another tax incentive permits a shareholder to avoid paying any capital gains tax on the sale to the ESOP if the seller uses the money it receives from the ESOP to purchase securities (stocks or bonds) of another domestic operating corporation (i.e., one that does not have most of its profits derived from investments in other companies that it does not control). The replacement securities must be purchased no later than 12 months after the sale to the ESOP.
An ESOP can provide an exit strategy for a shareholder who may have concerns about selling his or her business in more conventional methods. For example, some shareholders only want to sell a portion of their stock, are concerned about the tax consequences of selling their businesses (including the ability to generate sufficient funds to pay estate taxes if their businesses are not sold prior to death) or are concerned about the impact that selling their businesses may have on their employees. These issues can often be addressed with an ESOP.
In addition to the Code and ERISA ESOP rules, ESOPs can also involve other areas of the law. For example, because an ESOP will become a shareholder of the Employer, state corporate laws often need to be considered along with the Code and ERISA ESOP rules. Sometimes an ESOP transaction may raise issues under federal and state securities laws. Just like any other transaction involving the purchase or sale of a business, an ESOP transaction requires knowledge of many different areas of the law. However, unlike other transactions, it is also essential to have the assistance of sophisticated legal counsel who is familiar not only with the specific ESOP rules, but also with the other qualified plan and ERISA rules that apply to all plans - including ESOPs.
WHAT AN ESOP CAN ACCOMPLISH
Employee Retirement Benefits
Because it is a qualified plan, one of the primary purposes of an ESOP is to provide retirement benefits to plan participants. Similar to a profit sharing plan, an ESOP is a defined contribution plan in which there is a separate account for each participant. The amount of the retirement benefit is based on the value of the account. For ESOPs sponsored by Employers that are not publicly traded corporations, the stock in the account is eventually repurchased by the Employer or the ESOP when the participant is entitled to a distribution (usually upon termination of employment). The participant can then roll over these funds to an IRA or another qualified plan.
Exit Strategy for a Shareholder of a Private Corporation
Often a shareholder may have limited alternatives when the goal is only to sell a portion of his or her stock, the Employer is reluctant to become a public company, the shareholder is unable to find a buyer for the company or, if there is a buyer, the terms imposed by the buyer are not desirable. Not only can an ESOP address many of these concerns, but it can also help to ensure continuity in the operations of the company, particularly in comparison to selling to a competitor or an investment group. When the tax incentive of avoiding capital gains tax on the sale to the ESOP is considered, the advantages of an ESOP are even more compelling.
Corporate Financing Tool
ESOPs are frequently used in leveraged buyouts. With an ESOP, both the principal and interest debt incurred in a leveraged buyout are effectively repaid on a pre-tax basis. This is because the Employer's contributions to the ESOP are used for loan repayments and are tax deductible. In contrast, only the interest in a traditional leveraged buyout is deductible. Also, most of the transaction costs incurred by an Employer in an ESOP transaction are deductible because they are incurred in connection with establishing an employee benefit plan. In contrast, many of the transaction costs incurred in a traditional leveraged buyout are capital expenditures that are not immediately deductible.
Vehicle to Promote Employee Ownership
One of Congress' goals in enacting ESOP legislation was to promote employee ownership. Several studies have shown that an ESOP in conjunction with management techniques that facilitate employee participation can have a positive economic impact on a business. An ESOP usually involves indirect employee ownership, because the stock is legally owned by the ESOP trustee (for the beneficial interest of the ESOP participants) until it is distributed to the participant. At that time, the overwhelming majority of participants elect to sell the stock to the Employer or the ESOP, and the Employer has a right of first refusal in the unlikely event that the participant wants to sell the distributed stock to a third party. It is even possible to design an ESOP so that only the cash value of the stock is distributed instead of the actual shares of stock. Nevertheless, the participants' financial stake in the value of the stock has been shown to be a major factor toward increasing employee motivation and productivity. For companies that are not publicly traded, securities laws can make it cumbersome to implement broad-based employee ownership through means other than ESOPs.
Estate Planning Options
An ESOP can be an important tool in estate planning. For example, when a selling shareholder uses the sale proceeds from the ESOP to purchase replacement securities that are held until death, the heirs receive a step-up in basis for tax purposes. That is, if an heir then sells the inherited replacement securities, his or her tax basis in the replacement securities is the value at the time of the decedent's death and not the basis of the stock that the decedent sold to the ESOP. As a result, the capital gains tax that was deferred in the sale to the ESOP avoids recognition altogether. ESOPs have also been used in connection with a shareholder making a tax-deductible donation of appreciated stock to a charitable institution, which then offers to sell the stock to an ESOP. When properly structured, this permits the shareholder to claim a deduction for a donation to his or her favorite charity while at the same time promoting the continuity of the business through the ESOP.
HOW AN ESOP WORKS
Ability of ESOPs to Borrow Money to Purchase a Large Block of Stock
As a general rule, a defined contribution plan must have all of its assets allocated as of the end of the plan year. This precludes an Employer from being able to "pre-fund" a plan for future years. However, ESOPs are permitted to borrow money from the Employer (or a shareholder) or from an outside lender (such as a bank) with a guarantee from the Employer (or a shareholder). This enables the ESOP to purchase a large block of Employer stock, which is allocated to participants over a number of years as the loan is repaid. For other plans, the loan would be illegal under the prohibited transaction rules, but these rules have a special exemption for ESOP loans that are used to purchase Employer stock.
ESOP Loan Rules
A typical ESOP loan involves a two-step process consisting of: (1) a loan from a bank to the Employer and (2) followed by a loan from the Employer to the ESOP. This is often referred to as a "back-to-back loan." Another structure often used is a "direct loan," where the bank makes a loan to the ESOP and the Employer guarantees the loan to the bank. Because the only assets that an ESOP can pledge as collateral for the loan are the unallocated shares, and shares can no longer be used as collateral once they are allocated to the participants' accounts, a bank usually requires that a direct loan be guaranteed by the Employer or the selling shareholder.
The shares of Employer stock purchased by the ESOP are initially accounted for in an unallocated account called a "suspense account," and are usually pledged to the lender as collateral for the loan. The shares are released from the suspense account and collateral for each plan year generally based on how much of the loan is repaid for that year. There are two formulas that can be used for determining the actual number of shares released for each year. The first formula: (1) takes the number of shares in the suspense account, (2) multiplies that by the principal and interest payments made for the year, and (3) then divides that figure by the principal and interest payments made for the year plus those that will be made for all future years. The second formula that the Employer can elect to use is based on principal payments only, but this formula can only be used if the loan does not exceed 10 years and has level principal amortization payments. The shares released from the suspense account are then allocated to the accounts of the participants who are active employees. This allocation method is usually made in proportion to compensation.
Additionally, the law requires that the ESOP loan must also meet the following requirements:
- It must be a term loan payable on demand only if the ESOP is in default.
- If the lender is a related party to the ESOP (such as the Employer), the amount of plan assets (shares in the suspense account) that can be transferred after a default cannot exceed the amount of the loan payment in default. As a result, if the Employer is the lender, it cannot accelerate the loan upon a default.
- Recourse against the ESOP for a default must be limited to unallocated shares in the suspense account plus Employer contributions (and earnings) that were made for loan payments.
- The loan to the ESOP must be as favorable as a loan would be between independent parties.
Determining Purchase Price
The determination of the purchase price in an ESOP transaction must meet certain requirements. In general, an ESOP is precluded by law from paying more than fair market value for the stock it acquires, and it must receive at least fair market value for the stock that it sells. The law requires that an independent appraiser be used in determining fair market value for an ESOP transaction if the stock is not publicly traded. The basic approach that an independent appraiser will use in valuing ESOP stock is based on what a hypothetical willing buyer would pay to a hypothetical willing seller when neither party is under any compulsion to enter into the transaction and both parties are fully informed about the transaction. The appraiser will evaluate commonly used valuation techniques such as comparable publicly traded companies, reported acquisitions of other companies, a discounted cash-flow analysis and book/liquidation value. The appraiser will then issue a fair market value opinion (and often a fairness opinion) to the ESOP trustee, as of the date of the actual transaction, supplemented by a written report. The report will detail whether and to what extent the appraiser applied certain discounts (such as a marketability discount) or premiums (such as a control premium). Fair market value must be determined as of the date of the transaction, and an updated appraisal must be obtained for each plan year.
ESOP TAX INCENTIVES
Avoiding Capital Gains Tax on a Sale to an ESOP
Under section 1042 of the Code, a shareholder can elect to avoid the capital gains tax on a sale of Employer stock to an ESOP by purchasing stocks or bonds of another domestic operating company (government bonds, mutual fund shares or bank certificates of deposit do not qualify). The following is a summary of the major requirements under section 1042:
- The selling shareholder may not be a C corporation or an underwriter of securities.
- The Employer sponsoring the ESOP cannot be an S corporation at the time of the sale to the ESOP. However, section 1042 is available if the Employer revokes its S corporation status and becomes a C corporation immediately before the transaction. Moreover, if the Employer was a C corporation before a section 1042 transaction, it may be able to make an S corporation election after the transaction.
- Immediately after the sale, the ESOP must own at least 30% of the stock of the Employer (on a fully diluted basis).
- The seller must have owned the stock for at least three years prior to its sale to the ESOP.
- The stock sold to the ESOP may not have been acquired by the seller as compensation for performing services for the Employer. (For example, through a stock option, discounted stock purchase or stock distributed from an ESOP.) However, in a private letter ruling, the IRS stated that stock granted by an employer to an employee at no cost to the employee is eligible under section 1042.
- During the one-year period before and after the sale to the ESOP, the Employer may not have any of its stock traded on a public market.
- The replacement securities must be purchased during a time period starting three months before the sale and ending 12 months after the sale, and notarized statements must be obtained within 30 days after a purchase of replacement securities.
- Various election forms and notices must be filed with the IRS on behalf of the seller and the Employer.
Note that section 1042 must be elected by the seller; it is not automatic. Also, if the replacement securities are sold before death, then the seller's basis in the securities is his or her basis in the stock sold to the ESOP, which is typically very low. Accordingly, it is important to select replacement securities carefully.
Expanded Deduction Limits for ESOPs
The Code imposes limits on how much an Employer can deduct for qualified plan contributions each year (and imposes a 10% excise tax on nondeductible contributions) and on the amount of employer contributions and forfeitures that can be allocated to each participant's account each year. The following is a summary of these rules for ESOPs:
- The maximum amount that an Employer can contribute to an ESOP for a year is 25% of the compensation of all active participants.
- Employer contributions used for interest payments are not counted toward the 25% limit, unless the "one-third" allocation limit discussed below is exceeded or the Employer is an S corporation.
- The maximum amount of Employer contributions and forfeitures that can be allocated to a participant for a year cannot exceed the lesser of 100% of his or her compensation or $40,000. For a leveraged ESOP, neither reallocated forfeiture shares nor Employer contributions used for interest payments are included in this limit as long as no more than one-third of the Employer's contributions for a year are allocated to highly compensated employees and the Employer is not an S corporation.
Note that the maximum amount allocated to participants is usually based on the amount of Employer contributions and not on the value of shares released from the suspense account and allocated to the participants. However, recent IRS rulings have permitted the share value to be used.
- If an Employer maintains another defined contribution plan, including a 401(k) plan, an ESOP will have to be combined with the other plan in applying these limits. However, employee pre-tax contributions to a 401(k) plan no longer count towards the Employer's 25% of compensation deduction limit.
- Dividends paid by an Employer on stock owned by the ESOP may be deductible if used for loan payments or paid to the participants without being counted toward the contribution and allocation limits. An ESOP sponsored by an S corporation may use dividends paid on the unalloted shares in the suspense account for loan payments, but not the dividends paid on the shares already allocated to the participants.
Deduction for Dividends Paid to ESOP
An Employer that is a C corporation can claim a tax deduction for dividends paid to an ESOP if certain requirements are met. The deduction can be claimed if the dividends are used by the ESOP for loan repayments. However, dividends paid on allocated shares can only be used for loan payments if, in exchange, the fair market value of stock allocated to participants in lieu of the dividends at least equals the amount of the dividends. A C corporation can also claim an ESOP dividend deduction if the dividends are: (i) paid directly to the participants, (ii) paid to the ESOP and then distributed to the participants within 90 days or (iii) at the participant's election, reinvested in Employer stock in the ESOP or paid to the participant.
ESOPs Sponsored by S Corporations
Most of the ESOP tax incentives under the Code do not apply if the Employer is an S corporation. Tax law changes enacted in 1996 and 1997 permit an ESOP to be sponsored by an S corporation. An ESOP that is an S corporation shareholder is not taxed on its proportionate share of the corporate income that is otherwise passed through to shareholders. Particularly for Employers that are 100% owned by an ESOP, there are major tax advantages to being an S corporation.
ADDITIONAL IMPORTANT ESOP INFORMATION
Requirements for Class of Stock Purchased by an ESOP
When an ESOP acquires Employer stock with a loan, the stock must meet certain requirements. If the Employer has stock that is publicly traded, the ESOP must purchase either that class of stock or preferred stock that is convertible at any time into that class of stock. If the Employer does not have any publicly traded stock, the ESOP must purchase either the class of common stock with the greatest voting and dividend rights or preferred stock convertible at any time into that class of common stock.
Other shareholders can own shares in the same class of stock owned by the ESOP but, with the ability to use tax-deductible dividends for ESOP loan repayments, there are advantages to an ESOP being the only shareholder of a class of stock. This prevents the Employer from having to pay nondeductible dividend payments to other shareholders, as that would often violate bank loan agreements. An ESOP transaction can be structured so that, once the loan is paid off, the ESOP's separate class of stock would no longer have greater dividend rights over other classes of stock. If a new class of stock needs to be created for the ESOP, it should be done through a tax-free recapitalization immediately before the ESOP transaction.
This technique is not feasible for an ESOP sponsored by an S corporation, because an S corporation may only have one class of stock.
Moreover, careful planning is needed to implement this technique in connection with a section 1042 transaction, which may preclude certain participants from receiving allocations in the ESOP. One group of participants impacted by this rule includes any person who owns 25% of any outstanding class of stock of the Employer, even if this is less than 25% of all outstanding shares of stock.
Determining Which Employees Will Participate in the ESOP
In general, employees who have attained age 21 and completed one year of service are eligible to participate in the ESOP, although an Employer can adopt more liberal eligibility requirements. Like other qualified plans, an ESOP does not have to be extended to all employees. As long as the ESOP meets a minimum coverage test, certain employee classification groups can be excluded from participation, other than part-time employees as a group. Whether collectively bargained employees are eligible to participate depends on the terms and conditions of their collective bargaining agreement.
In planning an ESOP transaction, an Employer should make sure that the eligible participants have a sufficient compensation base to enable the Employer to make large enough contributions for loan payments. As a general rule of thumb, the total compensation base is multiplied by 25% to determine the amount of principal payments that can be made for a year. (This assumes that no adjustments are necessary for other plans maintained by an Employer and the one-third allocation rule previously discussed is satisfied.) If additional funds are needed for loan payments, then the ESOP should consider acquiring a separate class of stock in order to use dividends for loan payments.
When a selling shareholder makes an election to defer capital gains tax on an ESOP sale under Code section 1042, certain employees may not be able to participate in the ESOP. These employees include the seller, his or her family members (except that a small percentage of the stock can be allocated to lineal descendants of the seller) and any person who owns 25% of the total value of the Employer or 25% of any class of stock of the Employer. The compensation of these employees is excluded from the calculations in the preceding paragraph.
Nonallocation Rules For ESOPs Sponsored By S corporations
Because ESOPs sponsored by S corporations are exempt from taxation, Congress enacted rules to ensure that these ESOPs have broad employee participation and avoid ownership dilution in the Employer. The rules consist of a nonallocation rule within the ESOP, a prohibition on receiving a make-up allocation under another plan and a restriction on equity compensation arrangements outside of the ESOP. In general, these rules apply to a "Disqualified Person" for any year when the total ownership of all Disqualified Persons in the S corporation is 50% or more. Ownership is determined broadly on a fully diluted basis, and includes both allocated and unallocated stock in the ESOP. In general, a Disqualified Person is a person who, along with family members, own at least 20% of the employer (in this case all family members will be Disqualified Persons). Alternatively, when family members are not considered, a Disqualified Person is one who owns at least 10% or more of the employer.
For any year that the 50% ownership test by Disqualified Persons is met, then the Disqualified Persons may neither receive an allocation of stock within the ESOP nor receive a make-up allocation under another qualified plan unless it is available to all the other participants. In addition, the Disqualified Persons may not own any "Synthetic Equity" outside of the ESOP, such as stock options, stock appreciation rights, restricted stock, etc.
For S corporation ESOPs in effect on March 14, 2001, these rules do not apply until 2005.
Participant Voting Rights
Occasionally, participants have "pass-through voting rights" in an ESOP. This means that the participants can direct the ESOP trustee on how to vote shares allocated to their accounts, but not the unallocated shares in the suspense account. If the Employer is not a public corporation, participants need only have pass-through voting rights on major corporate issues such as a merger, recapitalization, dissolution, sale of substantially all of the corporation's assets or liquidation, but not on the election of the board of directors. When an ESOP is sponsored by a public company, the participants have pass-through voting rights on all shareholder voting issues.
ESOP Distributions: Availability
Unlike a 401(k) plans where an Employer often prefers to see distributions made as soon as possible after termination of employment, Employers often prefer to delay ESOP distributions as long as possible. This is because the Employer may have to repurchase the stock distributed from the ESOP or a participant may have a relatively large account value. When a distribution is due to the retirement, death or disability of a participant, it must be available after the end of the plan year following the year of the event. If the participant quits or is discharged, distributions do not have to made available until the end of the sixth plan year following the event. However, when the stock is acquired with a loan, distributions under the preceding sentence can be delayed until the loan is paid off. An ESOP can be designed so that distributions are made in a lump sum or in periodic payments. However, periodic payments cannot exceed five years unless the account balance is relatively large.
ESOP Distributions: Form
The general rule is that participants have the right to receive a distribution in the form of stock, but it is possible to structure the ESOP so that only cash distributions are made if the Employer is not a public company. In this case, the ESOP would need to have sufficient funds to make a cash distribution either through Employer cash contributions (assuming that the contributions' limits have not been exhausted) or through a purchase by the Employer (at a current valuation) of the stock that would otherwise be distributed. It is also possible to distribute the stock to the participant and then require the participant to sell it back to the Employer immediately.
Right of First Refusal. If the Employer is not a public company, it has a right of first refusal to prevent stock distributed from the ESOP from being sold to a third party. After being notified of a pending offer, the Employer has 14 days to exercise its right of first refusal at the same price offered by the third party or, if greater, the stock's current fair market value. The ESOP may honor the right of first refusal instead of the Employer, but the ESOP cannot be obligated to do so.
Put Option Rules. If the Employer is not a public company, it must offer to repurchase stock distributed from the ESOP. The put option rules permit the distributee to require the Employer to purchase the stock within 60 days of the distribution or during a 60-day period after the next valuation is performed. Afterwards, the put option expires, and the Employer is not obligated to repurchase the stock. If the put option is exercised, the Employer must pay for the stock within 30 days. However, if the distribution was made in a lump sum, the Employer can pay for the stock over a five-year period if it provides interest and adequate security on the unpaid balance.
Comparing Cash vs. Stock Distributions
For Employers that are not public companies, stock distributions from an ESOP are usually easier to administer, and most participants elect to sell their stock back to the Employer since there is really no market for the stock. Nevertheless, some Employers are concerned that a participant may decide to remain a shareholder or try to sell the stock to a competitor. Even with the right of first refusal, this concern is not always alleviated because the participant may theoretically be offered a very high price by the competitor.
This may result in an Employer selecting the cash distribution method, but this can be more complicated to administer if the ESOP has to sell stock to the Employer to obtain the cash necessary to make the distribution. Because the price of the stock sold by the ESOP to the Employer must be based on a current valuation, the distribution process is often coordinated with the annual valuation process to avoid the additional expense of obtaining another valuation.
In-Service Distributions to Participants
Since the ESOP is a retirement plan, the law requires that at a certain stage participants be permitted to diversify their stock accounts. In general, after attaining age 55 and completing 10 years of participation, a participant must be offered the opportunity to diversify a portion of his or her stock account over a six- year period. The amount of the stock subject to diversification is 25% in the first five years and 50% in the sixth year, but in each case reduced by amounts diversified under prior elections. The diversification requirements are satisfied by either distributing the diversified shares to the participant (who can elect to roll over the distribution to an IRA) or transferring the fair market value of the diversified shares to another defined contribution plan maintained by the Employer with at least three diversified investment funds (other than an Employer stock fund). The Employer may decide which method will be used by the ESOP.
|
