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

by admin on August 28, 2012

Mechanics of the ESOP Plan

Statutory Definition

The term “employee stock ownership plan” is a newly-defined term under the Pension Reform Act. Under Section 407(a)(6) of the Act, the term is defined to mean an individual account plan “which is a stock bonus plan which is qualified or a stock bonus plan and money purchase pension plan both of which are qualified under Section 401 of the Internal Revenue Code of 1954, and which is designed to invest primarily in qualifying employer securities . . .” The term “eligible individual account plan” is defined by Section 407(d)(3)(a) of the Act to mean an “individual account plan which is (i) a profit-sharing, stock bonus, thrift or savings plan; or (ii) an employee stock ownership plan; … ” From the foregoing it is apparent that the central vehicle of an ESOP is the stock bonus plan.

A stock bonus plan is a qualified plan referred to in Section 40l(a) of the Internal Revenue Code along with pension and profit-sharing plans. Like a profit-sharing plan. the basic deduction limit for contributions to a stock bonus plan is 15% of compensation and annual additions, including contribution carryovers to a participant’s account, and may not exceed the lesser of $25,000 or 25% of a participant’s compensation. A stock bonus plan is defined in the Regulations as being a plan, which provides benefits “similar to those of a profit-sharing plan except that the contributions by the employer are not necessarily dependent upon profits and the benefits are distributable in stock of the employer company. ” Thus the two features that distinguish a stock bonus from a profit-sharing plan are that under a stock bonus plan company contributions need not be dependent upon profits. and benefits must be distributable in employer stock. The first feature means that the employer company may obligate itself to make contributions to a stock bonus plan irrespective of profits. It is this feature, which enables a stock bonus plan, unlike a profit-sharing plan, to engage in debt financing. The second feature means that while the investment of contributions in stock of the employer prior to the time of distribution of benefits is not specifically mandated, the trust must at a minimum acquire sufficient stock of the employer company to make the required distributions of company stock under the plan.

On the other hand, in recognition of the fact that the primary purpose of the stock bonus plan is employee incentive rather than retirement security, a stock bonus plan, unlike an ordinary profit-sharing plan, may be entirely invested in employer securities.

Acquiring and Holding Company Stock

The Exclusive Benefit Rule. Under Rev. Rul. 69-494, I.R.B. 1969-38, 9, the investment of funds of an exempt employee’s trust in stock of the employer corporation will violate the “exclusive benefit of employees” rule unless the investment meets the following four investment requisites: (1) the cost of the investment must not exceed its fair market value; (2) a fair return must be provided; (3) sufficient liquidity must be maintained to permit distributions in accordance’ with the terms of the plan; and (4) the safeguards and diversity that a prudent investor would adhere to must be provided. In the case of a stock bonus plan, the requirement of a fair return is specifically waived by Rev. Rul. 69-65, I.R.B. 1969ยท7,9. Similarly, since a stock bonus plan is designed to be primarily invested in employer securities and to permit distributions of employer stock, the very nature of a stock bonus plan eliminates the third and fourth requirements. Accordingly, the principal investment requisite in the case of a stock bonus plan is the requirement the stock be acquired for not more than adequate consideration. Because valuation is the principal investment requisite and because valuation frequently depends upon intangible factors, it is strongly recommended that the stock be valued by an independent appraiser. Further, the valuation method, once determined, should be consistently applied bath for purposes of contributions and for purposes of distributions.

The investment requisites of Rev. Rul. 69-494 have now been codified by Section 404(a) of the Pension Reform Act. In addition, Section 407(a) of the Act specifically prohibits ordinary pension and profit sharing plans from acquiring or holding more than 10% of the fair market value of plan assets in employer securities and employer real property, and requites such plans to dispose of at least 50% of their excess holdings by December 31,1979. Section 407(b), however, specifically exempts an eligible individual account plan, as defined in Section 407(d)(3), from this diversification requirement. Under Section 407(d)(3) an eligible individual account plan includes a stock bonus plan and employee stock ownership plan. It also includes a profit-sharing plan which is an individual account plan and which explicitly provides for the acquisition and holding of qualifying employer securities. (In effect, a profit sharing plan may qualify only if it uses individual accounts and follows accounting and allocation rules similar to those of a stock bonus plan.) Moreover, Section 407(d)(3)(B) permits a qualified plan to continue to hold excess employer securities if the plan is converted into an eligible individual account plan within one year from January 1, 1975.

Contributions of an ESOP

Because the ESOP is not restricted in acquiring employer securities or employer real property, contributions to an ESOP may be made entirely in common and/or preferred stock of the employer or in employer real estate. Contributions need not, however, be made entirely in employer property. Contributions may also be made in cash, in non-employer stock, in non-employer real property, or in any combination of the foregoing. A contribution of employer stock, however, is usually preferable to a contribution in kind of other property, since a contribution of other property results in taxable gain to the employer to the extent the fair market value of the property exceeds basis.

Contributions of employer stock are frequently combined with cash contributions. Cash contributions may be accumulated to acquire additional stock when available, to repurchase stock from terminating employees, to purchase key-man or buy-sell insurance, or to make temporary income producing investments.

Another significant feature of the Act is that the Act defines the term “employee stock ownership plan” to include a combination stock bonus plan and money purchase pension plan. This means that contributions of up to 25% of compensation may be made to an ESOP, without using contribution carryovers, since the deduction limit for a qualified combination plan is 25% of compensation.

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