Source: https://findley.com/2017/03/esop-right-my-organization/
Timestamp: 2020-08-06 13:51:56
Document Index: 752206385

Matched Legal Cases: ['§1042', '§1042', '§1042', '§1042', '§1042', '§1042', '§1042', '§1042', '§1042']

Is an ESOP Right for Your Organization? - HR Consultants | Findley
Employee Stock Ownership Plans (ESOPs) are unique among retirement plans. An ESOP merges the tax benefits of a qualified retirement plan with corporate finance, and aligns employees’ retirement benefits with corporate goals. This combination of tax-favored employee and corporate benefits is complex, but with planning and an expert team of advisors, it can be a win-win scenario for both employees and employers.
The technical definition of an ESOP is: A tax-qualified retirement plan designed to invest primarily in qualifying employer securities of the sponsoring employer. This simple definition belies the complexity of ESOPs.
Let’s examine the key elements of this definition.
First, an ESOP is a “tax-qualified retirement plan.” This means that all the provisions of the Internal Revenue Code, IRS regulations, and other government pronouncements that apply to tax- qualified retirement plans (such as “profit sharing” plans) apply to ESOPs. Therefore, an ESOP must satisfy the following requirements:
Plan assets must be held in trust for the benefit of the plan participants;
The plan may not discriminate in favor of “highly compensated” employees;
The plan must cover a reasonably broad cross section of the company’s employees;
Employees must become vested in their plan benefits according to minimum standards;
The employer and the trustee have a fiduciary responsibility to guard the interests of plan participants.
The second key element of the definition is the ESOP must be designed to “invest primarily in qualifying employer securities.”
This element raises two important questions; first, “What is a qualifying employer security?” This is generally the common stock of the company sponsoring the plan or a company that is part of the same “controlled group” with the sponsor. If this common stock is not readily tradable on an established market, it must possess voting power and dividend rights at least as favorable as any other class of common stock. Noncallable preferred stock can also be a qualifying employer security if it is convertible at any time into common stock satisfying the above requirements at a “reasonable” conversion price.
The other question that must be posed is, “What is meant by “invest primarily”? Neither Congress nor the IRS has provided a good answer to this question, but most experts agree that the plan should invest at least one-half of its assets in qualifying employer securities to satisfy the “invest primarily” requirement. The introduction of employer securities into a tax-qualified retirement plan opens the door to a hodge-podge of rules, regulations, and considerations.
Provide employees with a stock-based benefit plan;
Provide tax-favored corporate financing;
Provide a means for business perpetuation (e.g., when there is no buyer for a departing owner);
Provide a market for thinly traded stock;
Provide special tax advantages for shareholders selling stock in a closely held C corporation;
Make an S corporation essentially nontaxable;
Provide liquidity for estates of business owners;
Provide an anti-takeover device by keeping company stock in “friendly” hands;
Make dividends deductible at the corporate level.
Shareholders of closely held C corporations can sell qualifying employer securities to an ESOP and defer tax on the capital gains. Section 1042 of the Internal Revenue Code (IRC §1042) allows the seller to roll over the proceeds from the stock sale into “qualified replacement property.” No tax is paid until the replacement property is sold. (See “Tax-Favored Sales to an ESOP” section.)
An S corporation may sponsor an ESOP. Although many of the beneficial ESOP provisions described above do not apply to S corporations, the potential tax benefit to an S corporation that adopts an ESOP is enormous! (See “Slash Taxes with an S Corporation ESOP!” section.)
Deduction and maximum addition rules are relaxed. Generally, deductions for contributions to all defined contribution plans of an employer are limited to 25% of covered payroll. However, except for S corporations, interest payments on exempt loans are fully deductible and principal payments are deductible up to 25% of covered payroll. Thus, the total deductible amount (particularly in the early years of the loan) could greatly exceed the normal 25% of pay limit. These deductions are not reduced by deductions for contributions to other tax-qualified plans sponsored by the employer. Generally, the maximum amount that can be allocated to a participant’s account as contributions or forfeitures in a defined contribution plan is limited; however, if no more than one-third of the employer contribution is allocated to highly compensated employees, interest payments and the reallocation of certain forfeitures do not count toward this limit. Again, this exception to the general rule does not apply to S corporations. Furthermore, the amount allocated can be calculated based on the amount of the contribution made by the employer rather than the value of the shares of stock actually allocated to the participant’s account.
Paid in cash to the participants,
Paid to the plan and distributed in cash to the participants within 90 days after the end of the plan year,
Used to pay principal or interest on the exempt loan used to purchase the securities, or
At the election of the participants, reinvested in qualifying employer securities.
Participants in an ESOP sponsored by a closely held company must be able to sell their stock back to the company. With some key exceptions, benefits to participants under an ESOP are paid in the form of stock. When the stock of a nonpublicly traded company is distributed to a participant, that participant must be given a “put option” on the stock, which allows the participant to force the company to repurchase the shares at market value. When establishing an ESOP, many closely held companies do not consider the future repurchase obligation. Projecting and planning for this liability is crucial in determining the long-term viability of an ESOP. (See “ESOP Repurchase Liability” section.)
ESOP recordkeeping is complex. The special rules for tax deductions, §1042 transaction restrictions, loan balance tracking, suspense account maintenance, and general share accounting make ESOP recordkeeping complicated and relatively expensive. Also, there is the potential for significant liability if correct information is not maintained. An ESOP recordkeeper must have experience, expertise, and strong internal technical support. (See “ESOP Recordkeeping Issues” section.) Voting rights must be passed through to participants.
For publicly traded securities, each participant is entitled to direct the plan as to the voting of shares in the participant’s ESOP account. For nonpublicly traded securities, the participant must be able to vote the shares in his or her account with respect to any corporate merger or consolidation, recapitalization, reclassification, liquidation, dissolution, or sale of substantially all assets of the trade or business. The ESOP recordkeeper must be able to determine the number of shares held by plan participants and should be able to assist in producing proxy statements.
While participants must be allowed to vote shares held in their ESOP accounts, the trustee has a fiduciary responsibility to vote securities that are held in suspense. This can be a conflicted responsibility if a closely held company is being sold and the trustees are officers of the selling company. The ESOP may have a negative impact on the company’s balance sheet and income statement. The loan in a leveraged ESOP will typically be treated as a debt on the company’s balance sheet. If the loan is substantial relative to the company’s net worth, this debt can have a significant effect on its stock value. If this lowers the current account value of ESOP participants, the company could conceivably face a fiduciary issue as to whether the loan was in the best interest of plan participants. Leveraged ESOPs can also have a negative impact on the corporate income statement. These issues should be reviewed with the company’s accountant prior to the establishment of the ESOP.
All stock transactions must be based on fair market value. For a thinly-traded security, the proper valuation of the asset is a fiduciary responsibility. The plan trustee must be satisfied that the value being used is appropriate. Generally, an independent valuation by a qualified appraiser is sufficient; however, multiple valuations may be necessary for transactions between the ESOP and a “disqualified person” (e.g., the company, an owner of the company, a corporate officer, director, or a plan trustee). Stock valuations are expensive but the liability for a faulty (albeit cheap) valuation can be devastating.
Tax-favored sales of qualified securities to an ESOP. IRC §1042 allows an owner of a nonpublicly traded C corporation who sells “qualified securities” to an ESOP to defer recognition of the gain on that sale by purchasing qualified replacement property. A §1042 election can be a tremendous tax- and estate-planning tool for an individual who owns a substantial portion of a privately held corporate entity — especially if the entity has appreciated in value. For example, a young entrepreneur started Gizmos Inc. with $50,000 in capital. Over time, Gizmos has prospered and is now worth $1 million. If our still-youthful entrepreneur were to sell 50% of her “qualified securities” in Gizmos, the taxable gain on the sale would be $475,000. Instead, she decides to sell her shares to the Gizmos-sponsored ESOP and reinvest the proceeds in qualified replacement property — generally the stock of other U.S. corporations. By doing this, she can defer the gain on the sale of her shares until she sells the replacement property.
If she holds the replacement property until death, her heirs will enjoy a stepped-up basis on the inherited securities, and no income tax will be paid on the gain from the original §1042 transaction; however, the value of the replacement property is subject to estate tax at the time of death. As you might have guessed, §1042 and related Treasury regulations offer specific definitions for the terms “qualified securities” and “qualified replacement property.” There are also specific rules establishing the timeframe that a shareholder has to buy replacement property, as well as a rule that requires the ESOP to hold at least 30% of the value of the company’s stock after the sale in order for a shareholder to make a §1042 election. If you own a substantial portion of stock in a nonpublicly traded corporation that has appreciated in value and you are interested in transferring ownership of that stock to employees of the corporation, a §1042 election is an option you should consider.
Slash taxes with an S corporation ESOP! How would you like to exempt your company’s profits from Federal tax? That is exactly what you can do if you have an S corporation that is 100% ESOP-owned. The income of an S corporation is passed through and taxed to the individual shareholders. If the sole shareholder of an S corporation is a tax-exempt entity (i.e., an ESOP trust), tax on those profits is generally deferred until benefits are distributed from the trust.
Of course, Congress and the IRS do not offer such a unique tax saving opportunity without a price. For starters, an S corporation ESOP cannot make use of the relaxed deduction and maximum addition limits that are available to C corporation ESOPs. Congress has placed additional restrictions on the allocation of stock (or cash) in an S corporation ESOP. These restrictions are intended to ensure that stock ownership of the S corporation (and therefore, the tax benefit) is not concentrated within a very few individuals or families.
Another opportunity unique to S corporation ESOPs is the treatment of S corporation distributions (the equivalent of C corporation dividends). S corporation distributions generally are cash payments to the company’s shareholders to help them pay taxes on the corporate profits. Although these distributions are not necessary for ESOP shareholders, they can be an important source of cash within the plan without violating maximum contribution limits.
ESOP repurchase obligation. The ESOP repurchase obligation refers to the employer’s obligation to buy back the distributed shares of stock from participants who have terminated or who are eligible to diversify their account balances. This liability stems from the requirement that a participant in an ESOP in which company stock is not readily tradable on an established market must be given a “put” option, forcing the company to repurchase this stock.
“Diversification” refers to the statutory right of the participant, upon satisfying certain conditions, to reinvest a portion of his or her stock account within the ESOP into more diversified investment options.
It is important to estimate a company’s repurchase obligation to plan for the company’s future cash flow and profitability. An ESOP repurchase liability study is a forecasting model to help the company prepare for its ESOP repurchase commitment. This study will project the amount of cash needed to meet the obligation and the timing of plan cash flow. Such a study will form the basis for a corporate repurchase obligation strategy.
It is often beneficial to design a repurchase liability study to investigate several different scenarios to determine the best strategy for meeting the company’s obligation. Using this approach, a company can compare the impact of different contribution levels, different stock appreciation levels, and other parameters. Distinct scenarios can also be used to compare different methods of funding the repurchase liability. For example, one scenario might assume the company will contribute additional cash to the ESOP, which is used to repurchase the shares within the plan (referred to as “recycling” of shares). A second scenario might assume the direct purchase of shares by the company (i.e., the shares leave the plan); these shares can later be added back to the plan as a company contribution if desired.
Determine eligibility and vesting
Determine investment earnings, contributions, and forfeitures
Perform coverage and nondiscrimination testing
Prepare periodic participant statements
Prepare annual governmental forms and participant reporting
Lastly, the employer must understand all the technical requirements. If the desire is to “leverage” the plan by borrowing capital to invest in company stock, or the employer is an S corporation, the plan must be an ESOP. If the company is closely held and shareholders want to take advantage of the special IRC §1042 election to defer gains on the sale of their stock, ESOP provisions are required. In addition, an ESOP is necessary if the goal is to make dividends deductible, or to take advantage of higher deduction and maximum addition limits. However, the pass-through voting and benefit distribution requirements are less complicated if the plan does not incorporate ESOP provisions. In short, if to KSOP or not to KSOP is the question, the answer will require careful analysis and input from a team of knowledgeable advisors.
Of course, an ESOP is only as good as the company’s stock, and the worst case scenario is the ESOP of a company going into bankruptcy. In this situation, not only do employees lose their jobs, but their ESOP accounts are worthless. This is the major reason most benefit experts recommend that an ESOP not be the only retirement benefit vehicle offered by an employer.
If you would like more information about employee stock ownership plans or to learn if an ESOP is a good fit for your organization, contact the Findley professional with whom you regularly work or email us at info@findley.com.