Employee Stock Plans

1. Employee Stock Plans Kevin BallBryce PetersonAdam Wright

2. ESPP (Employee StockPurchase Plan) • What is it? • Employees use after-tax payroll deductions to acquire their company’s stock, usually at a discount (~15%) • Easy and convenient to setup

3. Types • Qualified (423) • Only employees of company can participate • Approved by board with 12 month interim • Employees with 5% or greater of stockholding in company cannot participate • All eligible employees must be allowed participation • The purchase price may not be less than the lesser of 85% of the fair market value of the stock 1) at the beginning of the offering period, or 2) on the purchase date • Limit to $25K in purchases per year per employee

4. Types • Non-Qualified • Simple payroll deductions allowing stock purchase, sometimes at a discount • No special tax treatment • Not necessarily available to all employees

5. What about taxes? • Qualified Plan • When you buy, you don’t owe taxes • When you sell, the discount that you received when you bought the stock is generally considered additional compensation, pay taxes on that as regular income • Any gains are taxable (capital gains tax – usually less than ordinary income rate) • < 2years grant date – considered compensation • > 2 years grant date – generally considered capital gain • See tax link in sources for more information… • Non-Qualified Plan • Difference between fair market value and amount you paid treated as normal compensation and taxed accordingly

6. Household Application • Example: • Income of $80,000 • Tax rate: 28% • 10% in ESPP: $8,000 • Fair market value: $100 • Discount price: $80 • Shares purchased: $8000/$80 = 100 • Spread: $20*100 = $2000

7. Remember • Volatility in company (beta)! • Diversify • My father-in-law at HP • Risk Tolerance

8. History of ESOP • Developed in the 1950’s by Louis Kelso, a lawyer and investment banker. • Based on the premise that the capitalist system would be stronger if all workers could own company assets • In 1974, the Employee Retirement Income Security Act established statutory framework for ESOPs.

9. ESOP Uses • To Buy Shares of a Departing Owner—Departing owners of private firms can use ESOPs to create a market for their shares. • To Borrow Money at a Lower After-Tax Cost—ESOPs borrow money to purchase stock and repay loan with tax-deductible contributions (both principal and interest!). • To Create and Additional Employee Benefit—Matching employee savings or contributions with ESOP shares

10. ESOP Rules • Company sets up a trust fund • Contributes new shares of company stock or cash to buy existing shares • Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan • Company contributions to the trust are tax-deductible, within certain limits • Shares in the trust are allocated to individual employee accounts • Generally all full-time employees over 21 participate in the plan • Allocations are made either on the basis of relative pay or some more equal formula

11. ESOP Rules Cont. • As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting • Employees must be 100% vested within five to seven years • When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (unless there is a public market for the shares) • Employees must be able to vote all issues • Companies can deduct up to 25% of eligible pay to defined contribution plans (ESOPs, 401(k), profit sharing, money purchase, and stock bonus plans). • The combination of employer contributions and employee deferrals into defined contribution plans (ESOPs, 401(k) plans, etc.) cannot exceed 100% of pay in any one year. This limit is constrained, however, by a second limit, which provides that not more than $40,000 can be added in 2002, a limit that is indexed for inflation in $1,000 increments thereafter.

12. Household Tax Incentives • Company contributions are deductible up to 25% of covered compensation. • Company can deduct dividends paid on ESOP shares (under certain criteria) • Employees pay no tax until ESOP disbursements • 59.5 yrs old rule applies • 10% penalty for early withdrawal • Can be rolled over into a traditional IRA

13. Household / Small Business Application • Evaluate all your alternatives—ESOPs can be very expensive! • What is the applicable tax bracket for the company? • How will the annual costs compare to the annual contributions? • Is our payroll adequate? • Do you have more than 20 employees?

14. Creating an ESOP For Your Business • Determine whether owners are amenable • Conduct a feasibility study • Conduct a valuation • Hire an ESOP attorney • Obtain funding for the plan • Establish a process to operate the plan

15. ESOP Drawbacks • The law does not allow ESOPs to be used in partnerships and most professional corporations • Private companies must repurchase shares of departing employees, and this can become a major expense • The cost of setting up an ESOP is also substantial -- $15,000 to $20,000 for the simplest of plans in small companies and on up from there • Any time new shares are issued, the stock of existing owners is diluted • ESOPs will improve corporate performance only if combined with opportunities for employees to participate in decisions affecting their work

16. ESOP Summary • Variety of applications to reduce taxable company income and “incentivize” employees • Carefully review the rules and procedures before creating an ESOP • Predominantly used in private companies (90% of plans and 60% of participants)

17. Sources • http://personal.fidelity.com/products/stockoptions/faqpurchase.shtml • http://personal.fidelity.com/products/stockoptions/stockpurchase.shtml • http://www.turbotax.com/articles/EmployeeStockPurchasePlans.html • http://www.nceo.org/esops/esop_articles.html (February 20, 2003)