Benefiting From Unique Attributes of ESOPs

Editor: Albert B. Ellentuck, Esq.

An employee stock ownership plan (ESOP) is a stock bonus plan or a combination of a stock bonus plan and money purchase pension plan. This type of plan is designed to invest primarily in stock of the employer. Contributed cash is used to purchase the corporation’s stock or retire debt incurred to acquire the corporation’s stock. Assuming all the technical requirements are met, the corporation’s contributions to the ESOP are tax deductible. The general qualified retirement plan rules regarding minimum participation, nondiscrimination, and vesting apply equally to ESOPs.

Stock acquired by the ESOP is allocated to participants’ accounts, typically on the basis of their compensation. Participants usually have two accounts in an ESOP: (1) a company stock account to which is credited the number of shares of the company’s stock that have been acquired by the ESOP and allocated to the participants, and (2) an other investments account to which is credited the monetary value of all assets other than the company’s stock that have been acquired by the ESOP and allocated to the participants, including the trust income or loss.

Since the ESOP is a qualified retirement plan, the amount allocated to the participants’ account is not included in the participants’ gross income in the year it is contributed. Instead, it accumulates tax deferred until a participant retires, dies, becomes disabled, or otherwise terminates employment. Then, depending on the distribution policy established by the administrative committee and subject to the statutory requirements, the stock is either distributed to the participant or converted to cash, and the proceeds distributed to the participant.

There are some misconceptions about ESOPs. The phrase “employee stock ownership plan” implies that the employees buy the company’s stock. In reality, the employer contributes stock or cash that is used by the ESOP to purchase stock. These amounts are held by the ESOP for the employees’ benefit. The employer-provided funds do not come from employees’ wages. This has led some employers to feel that some of the stricter ERISA rules should not apply to them since the stock is free to the employees. However, all of the ERISA qualification, fiduciary responsibility, and other rules apply to ESOPs.

Some people will be concerned that an ESOP gives employees voting control of the company. This has not been the case. Under most ESOPs, the ESOP trustee votes the shares as directed by an administrative committee appointed by the company’s board of directors. Although the voting of the shares is subject to the fiduciary duty provisions of ERISA, election of directors and approval of routine corporate matters rarely involves anything controversial. Note, however, that ESOP participants are entitled to direct the ESOP trustee on the voting of allocated shares on certain major corporate issues.

Another concern is that the ESOP requires disclosure of confidential information about the company and the compensation of the principals. Actually, the only financial disclosure that is required is the same as for other qualified retirement plans. The company’s financial statements do not have to be disclosed. However, many ESOP companies publish selected financial data about the business to motivate the employees and give them a sense of participation.

Understanding ESOP Advantages

The unique advantages of an ESOP are as follows.

  1. Employee ownership in the employer is incentive for greater employee productivity and loyalty.
  2. The corporation enjoys deductions for dividends paid on ESOP-owned securities (under Sec. 404(k)) and for loan repayments (subject to the deduction limitation explained below).
  3. Perhaps most important, an ESOP offers a ready market for the employer corporation’s stock along with a big tax break for withdrawing shareholders. Specifically, gain is not recognized on the sale of qualified securities to an ESOP if the proceeds from the sale are reinvested in qualified replacement property (Sec. 1042(a)) during a period beginning three months before the sale of the qualified securities to the ESOP and ending 12 months after the sale (Sec. 1042(c)(3)).

In general, qualified securities (the securities sold to the ESOP) are common stock or certain convertible preferred stock issued by a domestic corporation whose stock is not readily tradable on an established securities market. The selling shareholder cannot have received the securities sold to the ESOP in a distribution from a qualified retirement plan or under an option or other right to acquire stock granted by the employer (Sec. 1042(c)(1)). In addition, the securities sold to the ESOP must have been held by the selling shareholder for at least three years as of the sale date (Sec. 1042(b)(4)). For the sale of securities to the ESOP to qualify for nonrecognition of gain, the ESOP must hold at least 30% of the outstanding stock immediately after the sale (Sec. 1042(b)(2)). None of the stock can be allocated by the ESOP to the selling shareholder or certain related parties (Sec. 409(n)(1)(B)).

Replacement property (the securities purchased with proceeds from the sale of stock to the ESOP) is qualified if it consists of securities of a domestic operating corporation that had passive investment income of no more than 25% of its gross receipts for the tax year preceding the year in which the securities were purchased (Sec. 1042(c)(4)). However, the replacement securities cannot be issued by the corporation (or a member of the same controlled group of corporations) that issued the qualified securities that were sold to the ESOP.

Understanding ESOP Disadvantages

Some of the disadvantages of ESOPs are as follows:

  1. Owners of closely held corporations may not want stock held by outsiders.
  2. The employer stock must be appraised annually by an independent qualified appraiser to determine fair market value, and professional fees (legal, financial, and accounting) can be significant.
  3. Dividends paid by a corporation to an ESOP are deductible under Sec. 404(k). However, a court decision (Snap-Drape Inc., 105 T.C. 16 (1995), aff’d, 98 F.3d 194 (5th Cir. 1996)) indicates that dividends paid to an ESOP are not deductible in computing adjusted current earnings (ACE). Since a portion of ACE is a preference item in the calculation of the corporate alternative minimum tax (AMT), some of the expected tax benefits may be lost when the employer corporation is subject to AMT.

Deducting Stock Redemption Payments to an ESOP

The IRS ruled that stock redemption payments made to an ESOP (to be used for ESOP cash requirements) could not be deducted because they were made in connection with the reacquisition of the company’s stock. The IRS stated the payments did not constitute applicable dividends for purposes of Sec. 404(k) (which would be deductible) because applicable dividends do not include amounts paid to redeem stock held by an ESOP (Rev. Rul. 2001-6). In a 2003 decision, the Ninth Circuit disagreed and allowed an employer corporation to treat redemption payments to an ESOP as applicable dividends that the employer corporation could deduct under Sec. 404(k) (Boise Cascade Corp ., 329 F.3d 751 (9th Cir. 2003)).

In January 2008, a Minnesota district court held that a corporation could deduct payments to redeem stock held in its ESOP (General Mills, Inc., No. 06-3547(DSD/SRN) (D. Minn. 2008)). The court also found that Rev. Rul. 2001-6, which was issued by the Office of Chief Counsel, was invalid because the Office of Chief Counsel had not been delegated the authority to issue the revenue ruling. Therefore, the revenue ruling did not disallow the Sec. 404(k) deduction. But the Eighth Circuit overturned the district court’s decision, holding that Sec. 162(k)(1) barred the taxpayer from deducting payments to its ESOP. The court viewed the payment to the ESOP and the cash distribution to the terminating employee as “‘two segregable transactions,’ ‘not ineluctably linked,’ and ‘entirely separate’” (General Mills, Inc., 554 F.3d 727, 729 (8th Cir. 2009), quoting Boise Cascade, 329 F.3d at 757).

There is a general consensus among ESOP practitioners that, if the Supreme Court hears the issue, it will hold that the payments are not deductible. This consensus is supported by the Eighth Circuit’s decision (Nestle Purina Petcare Co., 594 F.3d 968 (8th Cir. 2010)) that the cash distribution redemptive dividends may not be deducted.

Understanding Special ESOP Features

Up to 25% of aggregate employee compensation can be contributed by the sponsoring employer to the ESOP (and deducted by the employer) to allow the ESOP to repay principal on ESOP loans (Secs. 404(a)(3), (a)(7), and (a)(9)). Employer contributions used by the ESOP to pay ESOP loan interest are not subject to the 25% limitation. They are deductible in addition to the contributions applied toward principal repayments. The amount of contributions allocated to any individual participant generally cannot exceed the limitation on annual additions. However, Sec. 415(c)(6) excludes contributions used for interest payments from the definition of annual additions. This favorable exception is available when no more than one-third of employer contributions for the year are allocated to highly compensated employees.

The company can make contributions in stock or cash, and contributions can be fixed or discretionary from year to year. Benefits are generally distributable in stock, although the plan may provide for a cash distribution option. Participants can demand a distribution in securities (Sec. 409(h)); however, nonpublic companies may have the option to purchase the stock.

Participants must have voting rights on major issues (Sec. 409(e)(3)).

Generally, the ESOP trust is exempt under ERISA Section 408(b)(3) from the rules on prohibited transactions (i.e., the extension of credit or loans between the employer and the plan) and under ERISA Section 404(a)(2) from the ERISA diversification of investments requirements. However, qualified participants (those who have completed at least 10 years of plan participation and attained age 55) may elect to diversify investment of their account (Sec. 401(a)(28)(B); Notice 88-56).

An ESOP can be used in conjunction with debt financing. The trustee of the plan arranges a loan. In some cases, the loan is made to the employer, who then lends the money to the ESOP. The loan proceeds are used to purchase employer stock. The trustee repays the loan from employer contributions. The stock is collateral for the loan. Allocation of the stock to the accounts of participants is made as the principal amount of the loan is reduced. If the loan is made directly to the plan, the employer generally is required to guarantee the loan.

Identifying Clients That Could Benefit From an ESOP

The best candidate for an ESOP is a corporate employer that (1) is profitable and expects a profitable future, (2) is a closely held corporation with only a few shareholders but with a payroll large enough for the company to be able to make contributions sufficient to properly fund the ESOP, (3) is in a high tax bracket, (4) has substantial net worth and little debt, and (5) believes that employee ownership would boost morale and productivity.

This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 24th Edition, by Albert L. Grasso, R. Barry Johnson, Lewis A. Siegel, Mary C. Danylak, Timothy Fontenot, James A. Keller, Brian B. Martin, and Robert Popovitch, published by Thomson Tax & Accounting, Ft. Worth, Texas, 2011 (800-323-8724;



Albert Ellentuck is of counsel with King & Nordlinger LLP, in Arlington, Va.

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