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

by admin on August 28, 2012

Purchasing Employer Securities

In general, Sections 406 and 407 of the new Act prohibit the purchase of employer stock from a party-in-interest, which includes the employer corporation and any controlling shareholder.” In the case of an eligible individual account plan (i.e. stock bonus plan or ESOP), however, Section 408(e) specifically permits the purchase of employer securities from a party-in-interest so long as the purchase is for not more than adequate consideration.” Therefore, under an ESOP employer stock may be purchased from the company, on the open market, or from individual shareholders, including controlling shareholders. Thus an ESOP, unlike other plans, may be used to enable the employees to acquire a larger block of company stock than could otherwise be acquired if the plan were prohibited from purchasing from the company or from controlling shareholders.

In addition, from the standpoint of a controlling shareholder who sells less than his entire holdings to an ESOP, the sale qualifies as a sale and is not deemed to be a redemption by the corporation, since the trust is an independent entity. This author, for example, recently obtained a private letter ruling holding that the sale to the ESOP was a purchase by it and not a Section 302 redemption by the corporation. It is this feature of the ESOP which gives rise to its use in connection with estate planning for owners of privately held companies.

Debt Financed Acquisitions

The concept of having an employee’s trust borrow funds or otherwise obtain financing for the purpose of making investments is not new. As early as 1953 Rev. Rul. 46, CB. 1953-1,287 gave specific authority for an employee’s trust to borrow to invest in securities of the employer. This ruling was subsequently reaffirmed in 1971 in Rev. Rul. 71-311, I.R.B. 1971-29,86. This ruling has now been narrowed by provisions of the new Act, Section 406(a)( I)(A) of the Act now prohibits other types of qualified plans from engaging in any transaction which constitutes a direct or indirect “lending of money or other extension of credit between the plan and a party-in-interest.” If these provisions applied to an ESOP, an ESOP would be prohibited from purchasing employer stock from a controlling shareholder on an installment sale basis, and a bank loan could be obtained only if the trust were, able to obtain the loan without the employer company’s guarantee, Section 408(b)(3), however, specifically exempts an ESOP from this prohibition, provided that the loan is primarily for the benefit of participants and the interest rate is not in excess of a reasonable rate.”

In a growing company, an ESOP is almost always more beneficial to employees than an ordinary stock bonus plan. With a stock bonus plan, each year’s annual contribution must be used to purchase or acquire stock at its then present fair market value. An ESOP, on the other hand, by utilizing financing enables the trust to obtain ownership of a block of shares at the fair market value of the stock on the date of purchase. Hence, under an ESOP the trust is able to acquire a larger block of stock than could be purchased with a single year’s contributions. As a result, there is a larger investment that is subject to appreciation and the appreciation occurs over a longer period of time, In addition, employee incentive is greatly enhanced due to the fact that the employees have not merely an unspecified commitment from the company to make future contributions, but, in effect, have a funded trust and an identifiable interest in specifically segregated trust assets which can be “earned-out” by them over a period of years.


Distributions under an ESOP are made in much the same number as under a profit-sharing plan, Benefits may be distributed at retirement or death, upon disability, illness, lay-off, financial hardship, severance, or attainment of a stated age, or after a fixed number of years of participation in the plan (subject to a minimum period of participation of 2 years). Like a profit-sharing plan, distributions may be made either in a lump-sum or in installments, A lump-sum distribution of employer stock, however, is especially advantageous in that the unrealized appreciation is entitled to capital gains treatment when the employee sells the stock.

In order to provide a source of stock for future participants in the plan and to provide a market for shares distributed to terminated employees, the ESOP plan frequently provides for two special options on distributed shares. Under the first option, the company and or the trustee is given a “right of first refusal” to repurchase the stock if the employee decides to sell or transfer any of his stock. Under the second option. the employee is granted a “put” to sell his shares to the company and lor the trust within one year of distribution.

Plan Consolidations

Frequently it is desirable to suspend and replace an existing profit-sharing plan with an ESOP so that future contributions may be made in company stock or may be used to acquire an available block of stock for the employees. Similarly. in certain instances it may be desirable to suspend and replace an existing fixed benefit pension plan or money purchase pension plan with a combination stock bonus plan and money purchase pension plan. Properly structured. such plan consolidations do not result in a termination of the prior plan if the successor plan qualifies as a comparable plan under Reg. 1.401-6(b) and if, under Section 208 of the Pension Act, the benefit which a participant would receive if the plan then terminated is at least equal to the benefit he would have received if the plan had terminated prior to the consolidation.

Other Aspects

Under the ESOP plan, all voting rights on company stock held by the trust are exercised by the plan committee, which is appointed by the company’s Board of Directors. Voting rights on vested shares may, however. be passed through to the employees if the company so provides in the ESOP plan. In the alternative. the company may permit one or more employee representatives to serve on the plan committee.

So long as the plan is non-contributory and employees have no right to determine the manner of distribution under the plan, shares issued under the plan do not involve a “sale” or “offer to sell” within the meaning of Section 2(3) of the 1933 Act. This conclusion has been confirmed by a recent SEC no-action letter.

In adopting an ESOP, consideration should also be given to such matters as debt-financed income, allocation formulas for the allocation of interest expense, the treatment of dividends on unallocated shares and the distribution of pledged shares.


The ESOP is a complex but highly flexible tool. Because the ESOP concept is new and because the accounting procedures and method of allocating stocks differ from the methods and procedures used in an ordinary stock bonus plan or profit-sharing plan, the ESOP must be very carefully designed in order to avoid IRS difficulties. (I/R Code No. 2400.00)

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