The Employee Stock Ownership Plan: a New Trend in Employee Benefits and Corporate Finance (Part I)

by admin on August 28, 2012

An increasing number of companies are turning to employee stock ownership plan financing as a means to simultaneously raise low cost capital and provide increased employee incentives and retirement benefits while reducing the cost of qualified plan benefits. The employee stock ownership plan is a qualified plan under Section 401(a) of the Internal Revenue Code. As such it is in the same family as pension plans, profit sharing plans and stock bonus plans. Nevertheless, The Employee Stock Ownership Plan (which together with the Employee Stock Ownership Plan, is referred to as the “Trust” or “ESOP”) is qualitatively different from other types of “qualified plans,” both in its concept and in its applications.

Because of its inherent flexibility, because of its ability to facilitate and enhance corporate growth and because of its separate status under the recently enacted Pension Reform Act, the ESOP possesses an assortment of unique advantages not possessed by other qualified plans. As a consequence the ESOP is destined to become an increasingly popular form of employee benefit plan. A general working knowledge of the benefits, advantages and uses of the ESOP is a “must” for corporate loan officers, trust officers, estate planners, deferred compensation specialists, employee benefit specialists, corporate financial consultants, CPAs, CLUs and other income tax advisors.

Advantages of ESOP

Inherent Flexibility

The ESOP is at one and the same time a plan of corporate finance, an employee incentive plan, an executive compensation plan, and an employee retirement plan. Moreover, the ESOP may be used by either a public or a private company and may be used either with or without financing. In addition, the ESOP creates a market, comparable to that of a publicly traded company, for the sale of a minority or controlling interest in a closely-held company. By using an ESOP a company also avoids the funding problems inherent in certain other types of qualified plans. Because 3n ESOP can be designed to simultaneously serve all of these functions, the ESOP is inherently more flexible than other types of qualified plans.

Facilitating Corporate Growth

Today’s capital starved economy has created a host of problems for the growing company. In addition to the unprecedented need for additional capital for corporate growth and expansion, the corporation of today is also faced with increasing demands of employees for greater employee benefits, with declining employee incentives and productivity, and with a newly enacted Pension Reform Act, which substantially increases the costs of funding conventional employee benefit plans.

Properly designed, the ESOP can be the solution to all or most of these problems. Because The Employee Stock Ownership Plan is invested in company stock, for example, the company’s cash flow is increased rather than reduced. Thus the ESOP highlights the close relationship between corporate finance and the cost of providing employee benefits. Other qualified plans, for example, necessarily involve making a choice between the conflicting goals of providing for future corporate growth and of providing for employee benefits. With an ESOP on the other hand, the situation is reversed, and the corporation is enabled to simultaneously facilitate corporate growth, while also providing the employees with benefits which have a direct impact on employee incentives and which are at least equal to, and frequently greater than, the benefits that otherwise could have been provided.

Employee Incentive Plan

The ESOP also serves as a highly effective employee incentive device. By enabling employees to acquire an ownership interest in their employer, the ESOP provides employees with a direct and vested interest in the success of their company, creates an identity of interest between management and labor, permits employees to share in the capital growth of the company, builds employee loyalty and concern for corporate progress, and provides employees with a benefit the value of which can be influenced by their own efforts. A collateral benefit is that the ESOP often serves to diminish employee interest in unionization.

Executive Compensation Plan

Because trust benefits are allocated in proportion relative compensation, the ESOP favors the highly-compensated key employees more than the rank and file employees, and thus can be used to provide pre-tax executive compensation plans or to complement an existing executive compensation plan. Since the ESOP enables employees to acquire stock ownership with pre-tax funds, requires no employee contributions, avoids the necessity for employees to use accumulated savings or individually borrowed funds in order to purchase stock, and enables the corporation to deduct the full cost of the benefits, the ESOP is frequently superior as an executive compensation device to stock option plans, stock purchase plans, restricted stock purchase plans and other similar plans which reduce employees’ take home pay.

Employee Retirement Plan

Because trust benefits are normally distributed at retirement, the ESOP also serves to provide retirement benefits. In this respect the ESOP functions like a conventional qualified plan in relating retirement benefits to length of service. Thus an ESOP, like a conventional qualified plan enables the company to attract and retain highly qualified employees, to reduce employee turnover, to reward long service, and to provide for retirement security. Like a conventional qualified plan, the ESOP also permits the tax-free accumulation of income, and accumulated benefits are not subject to federal estate taxation if the participant dies prior to complete distribution.

Advantages Under the Pension Reform Act

The Pension Reform Act, with its new provisions for accelerated funding and for plan termination insurance, significantly increases the cost of adopting and maintaining pension plans. As a consequence, many employers will be discouraged from adopting a qualified pension plan, and benefits under existing plans will rise at a much slower pace than in the past. An ESOP, on the other hand, is self-funded and is exempt from the termination insurance provisions.’ Accordingly, the ESOP provides an alternative plan for the employer that would otherwise be unable to afford the cost of funding employee benefits.

In addition the Pension Reform Act requires most types of pension and profit sharing plans other than “eligible individual account plans” to dispose of all employer securities in excess of 10% of the market value of plan assets.’ Since an ESOP plan qualifies as an eligible individual account plan, the necessity for disposing of excess employer stock holdings and the prohibition against the acquisition of additional employer securities can be avoided by converting an existing plan into an ESOP. Existing plans. however. must be converted to an eligible individual account plan within one year from January I. 1975.

An additional advantage under the Pension Reform Act is that while the Act phases out capital gains treatment for the portion of a lump-sum distribution attributable to earnings of the trust. it continues capital gains treatment for the unrealized appreciation of employer securities. Moreover the capital gains tax is not incurred until the employee· subsequently sells the stock.

Private In-House Market

Since the purpose of an ESOP is to acquire employer securities. the ESOP also serves to provide a buyer for the purchase of company stock from controlling shareholders, minority shareholders and outside investors, thus eliminating one of the needs for a company to “go public. ”

Estate Planning Tool

Sales of employer stock to the ESOP qualify for capital gains treatment regardless of whether the shareholder sells all or only a part of his stock. Accordingly, the ESOP can be used to provide liquidity for estate planning purposes to provide a buyer for the purchase of shares from an estate or to provide the same liquidity as a Section 303 stock redemption plan at half the cost.

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