What Is An Employee Stock Ownership Plan (ESOP)?

What Is An Employee Stock Ownership Plan (ESOP)? • An ESOP is a type of qualified retirement plan that must invest its assets primarily in the employer’s securities • With an ESOP the employer may lend funds or use of its credit facilities to the ESOP to facilitate the purchase of employer securities • A trust must be established and a formal designation must be made to set up an ESOP • The trust may qualify as a tax-exempt employee trust

What Is An Employee Stock Ownership Plan (ESOP)? (cont’d) • An ESOP may be a shareholder of an S corporation • AN ESOP can offer favorable tax treatment and an exit strategy for business owners

When Is Use Of An ESOP Appropriate? • When a shareholder who is a substantial owner of a closely-held business would like to shift his investment, on a tax-deferred basis, into publicly traded securities • Tax free rollover of proceeds received from the sale of a business to an ESOP may be available if the proceeds are invested in another business

When Is Use Of An ESOP Appropriate? • When an employer would like to obtain an income tax deduction with little or no cash outlay • A current deduction is allowed within limits for both employer contributions of cash and contributions of stock or other property • Contribution of an employer’s stock generates a deduction equal to its FMV and may be carried back, potentially generating a tax refund for the corporation

When Is Use Of An ESOP Appropriate? • When an employer wants to create a market for its stock • Note: Participating employees must be entitled to exercise voting rights (on major corporate issues) of stock allocated to their accounts, where employer stock is not readily tradable and constitutes more than 10% of a defined contribution plan • When a corporation faces an accumulated earnings threat • An ESOP can be used to take cash out of a corporation • When an employer wants to motivate and compensate long service employees

When Is Use Of An ESOP Appropriate? • When shareholders with large amounts of corporate stock in their estate want liquidity • Stock may be sold to the ESOP in exchange for cash, thus providing liquidity to pay taxes and other debts • When a corporation desires to make payments of premiums for life insurance on key employees from deductible contributions • The insurance policy is an investment of the ESOP and may be a source of liquidity to buy the shareholder’s stock at death

When Is Use Of An ESOP Appropriate? • When an employer is seeking a means for financing corporate growth through the use of untaxed dollars • By selling rather than contributing stock to the ESOP, an employer can obtain a large amount of cash

What Are The Requirements? • ESOPs meeting certain requirements may distribute benefits in the form of employer stock or cash • Participants must be given the right to receive employer stock if they so desire, unless the employer’s charter or by-laws restrict the ownership of outstanding shares to employees and/or the ESOP • If employer stock is distributed, participants must be given a “put” option for a limited time, which allows them to purchase the stock from the employer at FMV

What Are The Requirements? • Plan must meet the same requirements as apply to other qualified plans, with respect to • Coverage • Nondiscrimination in contributions • Nonforfeitability or termination • Rules regarding forfeitures • Rules relative to the source of contributions • Integration with Social Security (none for ESOPs unless grandfathered) • ESOP must be in writing

What Are The Requirements? • The trust must be for the exclusive benefit of the employees and their beneficiaries • The trust must be a United States trust and not a foreign trust • The cost of employer stock purchased by the trustee must not exceed its FMV (may require an independent appraisal) • Participants must be entitled to vote employer stock that has been allocated to their accounts if the stock is registered under the Securities Exchange Act of 1934 or falls into the more than 10% of plan assets rule

What Are The Requirements? • Participants who have completed 10 years of participation in an ESOP must be given the opportunity to diversify 25% of their account balances beginning at age 55 and an additional 25% at age 60 • Generally, the plan must provide that if the participant elects, the distribution of a participant’s account balance will commence within one year after the plan year • in which participant separates from service by reason of normal retirement age, disability, or death, or • which is the fifth plan year following the plan year in which he otherwise separates from service

What Are The Requirements? • Plan must insure that in the case of “qualified sales” of employer securities by participant to the ESOP, no portion of the assets of the plan attributable to the securities purchased by the plan may accrue or be allocated during the nonallocation period for the benefit of • the taxpayer who made the election under former IRC Section 2057, or (2) any individual who is a member of the family (brother, sister, ancestor, lineal descendant) of the taxpayer or decedent, or

What Are The Requirements? (cont’d) • Plan must insure that in the case of “qualified sales” of employer securities by participant to the ESOP, no portion of the assets of the plan attributable to the securities purchased by the plan may accrue or be allocated during the nonallocation period for the benefit of ... (3) any person who owns, or is considered as owning under the attribution rules of Section 318(a), more than 25% of any class of outstanding stock of the employer or any corporation which is a member of the same control group of corporations as is the employer.

What Are The Requirements? • An ESOP can own stock in an S corporation, so long as the plan provides that no portion of the assets of the plan attributable to the employer securities accrue to the benefit of a “disqualified person” in a “nonallocation year” • A “disqualified person” includes • an officer or director, • a person who owns more than 10% or more of stock in the employer’s S corporation, and • a highly compensated employee earning 10% or more of the yearly wages of an employer

How Is It Done? Example 1: • Corporate client earns $200,000 per year • Corporation has no pension or profit-sharing plan • Employees would like to see some type of deferred comp. plan instituted • Due to expansion, periodically the corporation is cash poor • Establishing an ESOP gives the greatest increase in working capital

How Is It Done? Example 1 Comparison:

How Is It Done? Example 2: • Corporate client earns $200,000 per year • Corporation needs a new building that will cost approximately $250,000 • A loan would require amortization at a rate of $50,000 over five years • Interest paid to the bank would be deductible • Principal would have to be repaid with expensive (nondeductible) dollars

How Is It Done? Example 2 (cont’d): • An ESOP could borrow the $250,000 from the bank and use the proceeds to immediately purchase $250,000 of capital stock from the corporation • The corporation’s net working capital would be increased by $250,000 • The corporation would then make annual contributions to the ESOP on an annual basis and the ESOP would repay the bank • Corporation receives a deduction for the dollars it contributes to the ESOP

How Is It Done? Additional Examples: • An ESOP could also be used to purchase all or any portion of the stock owned by an estate and not create dividend consequences to the estate • Where the majority of the stock of a closely-held corporation is owned by one individual, and her spouse and/or children own the balance of the stock • In lieu of a buy-sell funded with life insurance, an ESOP can be directed by its investment committee to purchase key individual insurance on lives of all stockholders to provide the ESOP with liquid funds to purchase shares from their estate, at the then-FMV on the date of the shareholder’s death

Tax Implications • Corporation is allowed a deduction (within limits) for contributions made to the ESOP • An excess deduction may generate a net operating loss carryback with a resulting tax refund • An employer can generally deduct a contribution to a single ESOP of up to 25% of the total compensation paid to all participants in the plan, with carry forward for unused deductions

Tax Implications • Special deduction rules apply to C corporation plans that have incurred debt to purchase employer stock (Leveraged ESOP) • Employer may contribute as much as 25% of covered compensation to a single ESOP where the contributions are applied to make principal payments on the loan • Additional unlimited deductions are allowed for employer contributions used to pay interest on the loan (except for S corp. ESOPs) • Limitations on allocations to employee accounts may limit the availability of these special deduction limits in some circumstances

Tax Implications • The employer does not have to make the contribution to the ESOP in stock of the employer, but may use cash or any other property • A contribution of property may result in a prohibited transaction • Any forms of contribution will generate a deduction to the corporation equal to the FMV of the assets being transferred • If the corporation transfers assets to the ESOP that have appreciated in value (except for cash or employer stock), the gain will constitute income to the corporation

Tax Implications • Corporation is allowed a special deduction for cash dividends paid with respect to stock held on the dividend record date by an ESOP, provided the dividends • Are paid directly in cash to participants or their beneficiaries, or • Are paid indirectly to them through the plan within 90 days after the close of the plan year, or • Are used to make payments on a loan incurred to purchase qualifying employer securities

Tax Implications • Corporation is also generally permitted a deduction for dividends paid to the plan (or paid out to participants or beneficiaries) and reinvested in qualifying employer securities, if so elected by participants or their beneficiaries

Tax Implications • Individual may defer gain on the sale of closely-held stock to an ESOP under Section 1042 if • The sale would qualify for long-term capital gain treatment • After the sale, the ESOP owns at least 30% of the total value of the employer securities • Within a 15 month period “qualified replacement securities” are purchased, and • The taxpayer held the shares for three years or longer

Tax Implications • “Qualified Replacement Securities” are generally stock or bonds of a domestic corporation which does not have passive income of more than 25% of gross receipts • Beware of the 50% penalty tax that will be levied against the employer sponsoring the plan if any portion of the assets of the plan attributable to the sale accrue to certain persons during the “nonallocation period” discussed above

Tax Implications • If an ESOP has made an investment in an S corporation, allocations to a person who directly owns 10% or more of the S corp. stock (or owns 20% or more indirectly with members of his family) may result in significant penalties • Employer contributions are generally not currently taxable to the employees • ESOP trust assets grow tax free • An employee pays no tax until distribution is made to him or her

Issues In Community Property States • Benefits from ESOPs are generally held to be community property to the extent contributions are made by or on behalf of a married employee residing in a community property state • Death and divorce of an employee are not as clear, but it is generally accepted that a non-participant spouse personally retains a valid community property interest in qualified plan benefits

Issues In Community Property States • A spouse’s community interest in his spouse’s qualified plan benefits is included in his gross estate if he predeceases his spouse with the qualified benefits • Estate taxes apply even though the surviving spouse may have no immediate access to the benefit to provide funds to pay the tax • If an employee with a qualified plan predeceases his spouse and benefits are paid to a beneficiary other than the surviving spouse, the surviving spouse may be treated as making a gift of 50% of the benefits payable to the beneficiaries

Issues In Community Property States • Care must be taken to minimize the possibility that the IRS will claim that a spouse’s community share of plan benefits remaining in the trust is subject to federal estate tax at the spouse’s death • Different states vary on their position with regard to community property and valuing the qualified plan benefits for the purposes of division in divorce, especially where the employee’s interest has not yet vested

Purchase of Life Insurance by ESOP • ESOP may purchase key person life insurance on important employees of corporation, within limits • ESOP may purchase life insurance for participants as long as amount of insurance is deemed “incidental” (generally premiums not over 25% of amount allocated to ESOP account)

S Corporation ESOPs • Not required to grant participants the right to receive distributions in the form of stock, so long as distributions made in cash equivalent to FMV • Allocations to person owning 10% directly or 20% indirectly of S corp may trigger 50% excise tax and income taxation of allocation

S Corporation ESOPs: Anti-Abuse Rules • If “deemed owned” shares of S corporations that are attributable to “disqualified persons” result in a “non-allocation year,” significant penalties are triggered in the form of a 50% excise tax. • A “non-allocation year” results when “disqualified persons” are deemed to own more than 50% of the equity of the entity that sponsors the ESOP.

S Corporation ESOPs: Anti-Abuse Rules (cont’d) • The calculations that determine “deemed owned” shares include not only direct equity interests but also “synthetic equity,” which includes various other ways of funneling benefits to highly paid executives • The purpose of the anti-abuse rules is to ensure that ESOPs result in broad based employee ownership and meaningful benefits to rank & file employees

S Corporation ESOPs: Anti-Abuse Rules (cont’d) • “Synthetic equity” includes NQDC plans (whether stock based or not), allocated ESOP shares, unallocated ESOP shares, restricted stock, phantom stock, stock appreciation rights, qualified stock options, non-qualified stock options, warrants and other rights to acquire stock in the S corporation that sponsors the ESOP or any related entity to that S corporation.

What Is An Employee Stock Ownership Plan (ESOP)?