No. 3 ESOPS After ERISA 479 will set out some greater differences, which have become clear under ERISA: ... (1) Primary purpose. Rev. Rul. 69-65 states that the purpose of a stock bonus plan is "to give the employee-participants an interest in the ownership and growth of the employer's business. . . .” This distinction in purpose from pension plans and profit-sharing plans is important in interpreting the fiduciary responsibility provisions of ERISA. ERISA Section 404 (a) (1) requires fiduciaries to serve for the "exclusive purpose of providing benefits to participants” and to serve as a "prudent man acting in a like capacity . in the conduct of an enterprise of a like character and with like aims.” The purpose of ESOP financing is the use of corporate credit to acquire ownership of employer stock for participants, while financing capital requirements of the employer corporation. Both the “exclusive purpose" and "prudent man" requirements applicable to an ESOP (and the "exclusive benefit" rule of Code Section 401(a)) must be interpreted in light of this purpose. ESOP is required to acquire and hold employer stock, as the benefits to be provided to participating employees. ESOP is not primarily a "retirement plan” or a "plan for deferred profit sharing." See Rev. Rul. 69-494 for the applicability of the "exclusive benefit" rule to an investment in employer stock. ERISA Sections 404(a)(2) and 407(b)(1) permit an ESOP to be invested wholly in employer stock. (2) Financing vehicle. ESOP is the only qualified employees' plan permitted to receive loans or other extensions of credit from a party-in-interest for the acquisition of employer stock. The prohibited transaction exemptions in Code Section 4975(d)(3) and ERISA Section 408(b) (3) are available only to an ESOP and are not applicable to conventional stock bonus plans or profit sharing plans. Other qualified plans may not be used to finance corporate capital requirements and may not be used as vehicles for debt financing transactions involving parties-in-interest. (3) Second income for employees. An ESOP may be designed to currently distribute dividends on employer stock to participants. Such distributions result in increased spendable income for employees, without a corresponding increase in labor costs (through pay increases) for the employer corporation. (4) Employee motivation. Stock ownership may be a powerful tool for motivating employees. Through stock ownership provided on an accelerated basis under ESOP financing, employees are placed in a position where their work efforts can directly affect the 480 EMPLOYEE RELATIONS LAW JOURNAL Vol. 1 value of their deferred compensation benefits. Profit-sharing plans which invest in diversified investments result in benefits to employees which cannot directly reflect the profitability of the employer. ESOP provides employees with a "piece of the action," without requiring any personal investment or reduction in take-home pay. ESOP financing allows nonrecourse credit of the corporation to be made available for the purpose of building stock ownership into its employees. (5) Expense of deferred compensation. Conventional qualified plans are items of pure expense to the employer corporation. The incentive to the employer is often to minimize its contributions to conventional plans, and thereby its costs. Through use of ESOP financing, an employer may wish to maximize coverage of its employees and its employer contributions, thereby increasing its ability to finance capital requirements with pretax dollars and increase corporate cash flow. ESOP financing uses the same corporate pretax dollars to finance capital requirements as are used to finance deferred compensation benefits. (6) Contribution limits. Through use of a combination stock bonus plan and money purchase pension plan in ESOP financing, employer contributions may be tax-deductible to the extent of 25 percent of covered payroll, under Code Section 404 (a) (7). If No. 3 ESOPS After ERISA 481 credit carryovers are available under Code Section 404(a) (3) (A), a 25 percent deduction limit (30 percent for years beginning prior to January 1, 1976) may be achieved without the definite contribution formula required with a money purchase plan. However, for years beginning after December 31, 1975, the allocation limits of Section 415(c) and (e), applicable to both contributions and reallocated forfeitures under an ESOP, may reduce the allowable contributions below the maximum allowable for deduction purposes. Credit carryovers accrued under a qualified profit-sharing plan are available for use under an ESOP. Applications of the ESOP Financing Technique Capital Formation The basic ESOP model provides for financing new capital formation and corporate growth, with pretax dollars being used to repay loan proceeds supplied by outside lenders. The ESOP technique enhances the ability of the employer corporation to meet debt service requirements, as repayment of both principal and interest are made from pretax corporate dollars. Conventional loans require repayment of principal with after-tax dollars. ESOP financing makes use of corporate credit for the purpose of building ownership of common stock of the employer corporation into participating employees. Transfers of Ownership ESOP financing provides a vehicle for the acquisition of employer stock from existing shareholders, again using pretax corporate dollars. The selling shareholder is able to dispose of all or a portion of his shares, without the potential of dividend treatment which may apply to corporate redemptions under Code Section 302. Sales of employer stock to an ESOP by a shareholder are sales of capital assets which can be taxed as long-term capital gains. A corporate redemption not only involves the potential of dividend treatment, but also requires the use of after-tax corporate earnings. Funds for a financed purchase of employer stock from existing shareholders may be obtained from outside lenders, or the ESOP may acquire the stock under an installment sale agreement with the shareholder. 482 EMPLOYEE RELATIONS LAW JOURNAL Vol. 1 Refinancing Existing Debt If acceptable to a lender, an ESOP may be used to refinance existing corporate debt so that it is repayable with pretax dollars. In this situation, the employer corporation would issue new shares of its common stock to the ESOP equal in value to the amount of the debt principal assumed by the ESOP. The balance sheet of the corporation may be strengthened by the conversion of debt to equity. From the lender's viewpoint, the debt is more secure, being repayable with pretax dollars. Alternative to Going Public ESOP financing is an attractive alternative to selling stock to the public. Shares of employer stock may be acquired by the ESOP either from the corporation (to finance new capital) or from existing shareholders, or both. The costs of a public underwriting and registration with the Securities and Exchange Commission, and the expenses of operating as a publicly owned company, may be avoided through use of the ESÕP. In addition, the value of employer stock in an "in-house" market need not be subject to the fluctuations of a public market. Employee-owners are generally more loyal shareholders than outsiders. Financing of Acquisitions and Divestitures The ESOP technique may be used to finance the acquisition of other companies. The pretax earnings of the acquired company (and the increased employee compensation base) are available to repay debt incurred for financing the acquisition. ESOP financing provides a technique for divesting a division (or subsidiary) to a new corporation, owned by employees in whole, or in part, through an ESOP. The pretax earnings of the new corporation are available to "bootstrap" the purchase, which may be financed through loans from outside lenders or from the divesting company. "Going Private" ESOP financing provides a method for publicly owned corporations to "go private," using pretax corporate dollars to finance the No. 3 ESOPS After ERISA 483 transaction. Rather than using corporate after-tax dollars for stock redemptions, ESOP finances the transfer of ownership to employees with pretax dollars. Several publicly owned corporations have used ESOP as the vehicle for a tender offer to public shareholders, thereby replacing outsiders with employee-owners. Direct Stock Contributions An ESOP may be used to receive direct contributions of employer stock from the employer corporation. This results in tax deductions to the corporation equal to the fair market value of the contributed shares, without any cash outlay. The tax savings increases corporate cash flow for use in financing the business. Uses in Estate Planning For the closely held corporation which does not wish to (or cannot) go public, ESOP financing is useful in solving estate liquidity problems. The ESOP provides a ready market for the stock of a deceased major shareholder. Acquisitions of employer stock from the estate may be financed, through ESOP, using pretax corporate dollars, without the redemption restrictions under Code Sections 302 and 303. In addition, with an ESOP in operation, an acceptable valuation of employer stock for estate tax purposes may be established. Special Investment Tax Credit The Tax Reduction Act of 1975 provides for an additional one percent investment tax credit (above the 10 percent credit permitted during 1975 and 1976) to corporations which will contribute that one percent to an ESOP for the benefit of its employees. The contribution must be in employer stock, or in cash to be invested in employer stock, and is allocated to participants' accounts in proportion to their relative compensation, up to $100,000. The investment credit contributions to an ESOP must be nonforfeitable as to all participants, and participants must be given the right to direct the voting as to the shares of employer stock allocated to their accounts. This special investment tax credit provides 100 percent government financing of employee stock ownership. |