Employee stock ownership plans (ESOPs) have generated a great deal of interest during the past few years, due in part to the additional favorable tax treatment for ESOPs and ESOP-related transactions enacted as part of DEFRA of 1984. These tax incentives remained untouched or enhanced by TRA 86. The OBRA of 1987, however, has reduced a few of these tax incentives. This primer will detail the tax incentives that are available to leveraged ESOPs and the qualification requirements of the IRC of 1986 that are unique to ESOPs.

What is an ESOP?

An ESOP is a qualified stock bonus plan or a combination stock bonus and money purchase plan that meets the qualification requirements generally applicable to pension, profit-sharing, and stock bonus plans and meets a number of special requirements applicable only to ESOPs. While the ERISA of 1974 prohibited employee benefit plans from acquiring or holding more than 10% of its assets in employer securities, individual account balance plans, such as profit sharing plans, stock bonus plans, 401(k) plans, and ESOPs, are allowed to invest 100% of their assets in qualifying employer securities. Only an ESOP, however, is permitted to borrow money from a related party, or have a loan guaranteed by a related party, to enable the ESOP to purchase stock of the employer.

Tax Incentives for Leveraged ESOPs

The reasons that ESOPs are so popular are the tax incentives granted to ESOPs over the past few years. These incentives are as follows:

Increased Deduction Limitations. The cost of financing obtained through an ESOP is substantially less than comparable financing obtained by a corporation without an ESOP. With an ESOP, an employer receives a tax deduction for principal payments on an ESOP loan, unlike a conventional loan to a corporation where principal payments are not deductible. The annual limitation on deductible contributions to a leveraged ESOP is an amount equal to the sum of: 1) 25% of compensation paid or accrued during the year to participants; and 2) such other amounts as are used to pay interest on the loan to the ESOP. ESOPs now are the only qualified plans where carryovers of excess contributions are permitted to be deducted in subsequent plan years to the extent contributions made in any subsequent year are less than the maximum allowed.

Exclusion of 50% of Interest on Loans Made to ESOPs. Loans made to ESOPs are made at more favorable interest rates than conventional loans to corporations since certain lenders may exclude from gross income an amount equal to 50% of the interest received on a "securities acquisition loan." A "securities acquisition loan" is any loan to an ESOP, or to the sponsor of an ESOP who in turn relends the proceeds to an ESOP on substantially similar terms, for which the proceeds are used to purchase employer securities. If the term of the loan to the sponsor is less than seven years, the repayment terms of the sponsor's loan to the ESOP may be more rapid than the bank financing. Lenders eligible for this exclusion are banks, including savings and loan associations, insurance companies, regulated investment companies, and corporations actively engaged in the business of lending money. An otherwise eligible lender that sponsors an ESOP for the benefit of its employees cannot receive the exclusion on any interest received on any loan that it makes to that ESOP. This also applies to loans to ESOPs established by other members of the lender's controlled group.

Deduction for Dividends. Dividends paid on stock held by an ESOP are deductible by the sponsoring corporation (or other corporation under common control) if they are: 1) paid directly in cash to ESOP participants and beneficiaries; 2) paid to the ESOP which in turn distributes the cash to participants and beneficiaries; or 3) used to make payments on a loan used to purchase employer securities. This tax incentive, however, will be of little use in a highly leveraged company which will not pay dividends due to loan agreement restrictions on the payment of dividends.

Deferral of Tax on Sale of Employer Securities to an ESOP. A person who sells employer securities to an ESOP may elect to defer recognition of long-term capital gain on the sale. The securities that were sold must be issued by a domestic corporation with no stock trading on an established market either one year before or one year after the sale to the ESOP and must not have been received from a qualified plan or the exercise of an incentive stock option. The person who sells to the ESOP must reinvest the proceeds in any securities (debt or equity) issued by a domestic corporation which does not have passive investment income exceeding 25% of gross receipts within a time frame of between three months before the sale and 12 months after the sale. After the sale, the ESOP must own at least 30% of the total value of the employer securities outstanding at that time. Finally, the sponsoring employer must agree in writing to certain tax penalties if the ESOP allocates the purchased securities to a family member of the seller or another major holder of employer securities. The seller's gain on the sale to the ESOP is deferred until a subsequent sale of the replacement securities.

Exclusion from Estate's Gross Income of 50% of Proceeds of Sale to ESOP. Fifty percent of the proceeds of the sale by an estate of employer securities to an ESOP will be excluded from the taxable gross estate. OBRA 87 added certain restrictions to this estate tax exclusion. These restrictions are that the exclusion is not available for transfers to an ESOP unless: 1) the decedent directly owned the employer securities just prior to death; and 2) after the sale, the employer securities are allocated to plan participants or are held for future allocation in connection with a terminated defined benefit plan. OBRA 87 limits the exclusion to sales of securities of employers whose stock is not publicly traded. The deduction is limited to 50% of the taxable estate, and, in addition, the amount of estate taxes may not be reduced by more than $7.5 million by reason of the reduction. If the securities for which this exclusion is claimed are disposed of by the ESOP within three years of the sale to the ESOP, an excise tax equal to 30% is imposed on the ESOP. If these securities are disposed of by the ESOP within one year of the sale, the estate tax exclusion will be reduced by the excess of the proceeds the ESOP received from its sale over the purchase price the ESOP paid for the securities.

Assumption of Estate Tax Liability by ESOP. If employer securities are transferred to a leveraged ESOP on the death of the individual owning such securities, the ESOP is permitted to assume the estate tax liability of the individual's estate up to the value of the securities transferred or the total estate tax. The employer sponsoring the ESOP, however must guarantee in writing the ESOP's obligation for the estate tax.

Special Requirements for Leveraged ESOPs

While ESOPs are granted certain tax incentives, they still must operate as qualified plans. There are special qualification requirements for all qualified plans, that ESOPs alone must satisfy. They are as follows:

Exempt Loans. The only way that an ESOP can borrow money to purchase employer stock from a party in interest or have a loan guaranteed by a party in interest is when the loan meets the "exempt loan" requirements. Some of the requirements of an "exempt loan" are that it is nonrecourse against the ESOP, is collateralized solely with the securities purchased, and has a reasonable interest rate.

Designed to Invest Primarily in Employer Securities. An ESOP must be designed to invest primarily in "employer securities." For a company whose stock is traded on an established market, employer securities means tradable common stock. For a company whose stock is not traded on an established market, employer securities means the common stock of the company having at least the greatest combination of voting power and dividend rights. Noncallable convertible preferred stock may also qualify as an employer security if it is convertible at any time into common stock described above at a reasonable price. TRA 86 allows nonvoting common stock of an employer whose stock is not publicly traded to qualify as employer securities if such nonvoting common stock has been issued and outstanding for at least 24 months. ESOPs may invest in securities which are not employer securities, however, the ESOP cannot borrow on an exempt loan basis to purchase those securities.

Suspense Account. All employer securities purchased with the proceeds of an exempt loan must be allocated initially to a suspense account and not allocated to individual participants' accounts. Each year, as the exempt loan is repaid, shares will be released from the suspense account and allocated to participants' accounts.

Pass Through of Voting Rights. With respect to employer securities held by the ESOP and carrying voting rights, each participant in the ESOP must be permitted to exercise those voting rights on shares of stock which have been allocated to his account. The issues upon which a pass through of voting is required differ depending on whether the sponsoring corporation has any stock traded on an established market. The trustees of the ESOP, or other party so designated in the plan document, will vote the remainder of the shares held in the suspense account, subject to the usual fiduciary considerations under ERISA.

Independent Appraiser. TRA 86 required that all employer securities acquired after December 31, 1986 which are not tradable on an established market must be valued annually by an independent appraiser. An independent appraiser is an individual who holds himself out to be an appraiser, is qualified to be an appraiser, and is not related to the company for which the appraisal is being made.

Put Option. The ESOP must grant each participant the right to demand his benefit be distributed in the form of employer securities and may grant participants the option to receive benefits in the form of cash payments. If the shares of stock distributed are not readily tradable on an established market, the participant may require that the employer repurchase the shares for fair market value. Although this put option right may pose a financial drain on a leveraged company, there are methods of stretching out the repayment schedule for at least five years.

Right of First Refusal. Nonpublicly traded shares distributed from the ESOP may be subject to a right of first refusal in favor of the ESOP, the company, or both. The selling price must not be less favorable to the seller than the greater of fair market value or the amount of a good faith third-party offer.

Investment Diversification. A new requirement of ESOPs is that an opportunity must be given, generally over a five year period, to employees who are over age 55 and who have participated in the ESOP for 10 or more years to direct the investment of a portion (up to 25%, increasing to 50% in the last year of the period) of their account already invested in employer securities. This diversification opportunity is required for all employer securities acquired after December 31, 1986. To satisfy the diversification requirements, the ESOP must provide either three investment funds where the employee may invest his funds or provide for a distribution of cash in the amount that the participant wants to diversify. While this requirement may initially seem to place cash-flow burdens on the sponsoring employer, effective employee communication can convince employees of the investment opportunities inherent in the stock of the employer.

Commencement of Distributions. Another requirement of TRA 86 is that distributions of a participant's ESOP balance must begin no later than one year after the plan year in which the participant retires, becomes disabled or dies, or no later than five years after the plan year in which the participant terminates service for other reasons. Unless the participant elects otherwise, the distribution must be made in substantially equal installments over a period not exceeding five years. This time period may be extended up to an additional five years if his account balance exceeds $500,000.

Conclusion

The ESOP will continue to be used as both an employee benefit and corporate financing vehicle. While there is often much attention on the tax incentives Congress has given ESOPs which will enhance a company's cash flow (such as the favorable interest rate on ESOP loans and the deductibility of principal payments), consideration must also be given to the cash outflows caused by the use of an ESOP in financing (such as the put option and investment diversification requirements). Even after weighing such considerations, many employers have decided to implement an ESOP as part of their employee benefit structure.