An employee stock ownership plan (“ESOP”) is an employee benefit plan qualified for tax-favored treatment under the Internal Revenue Code of 1986, as amended (the “Code”). A plan is “qualified” if it complies with various participation, vesting, distribution, and other rules established by the Code. Classified as a type of deferred compensation plan, an ESOP invests primarily in stock of the corporation that sponsors the ESOP. An ESOP also must comply with certain reporting and disclosure requirements and fiduciary responsibility rules of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). The requirements of the Code and ERISA collectively protect the interests of employees.

An ESOP is a “defined contribution plan,” meaning the employer’s contribution is defined (but, in most cases, is discretionary) and the employee’s benefit is variable. Each participating employee’s account is credited with an appropriate number of shares of company stock or cash contributions over the period of the employee’s employment. After retirement, death, disability, or other termination of service, the employee’s account is distributed to the former employee (or the former employee’s beneficiary) in shares of stock, cash, or a combination of both, with the amount determined by applying the current fair market value of the company stock allocated to the former employee’s account to the number of shares. An employee’s benefit, thus, is not defined (as with a defined benefit plan), but is dependent upon the value of the stock (and the value of other cash assets held for investment by the plan).

What Do Employees Receive From an ESOP?

All ESOP assets (company stock and other investments) are allocated each year to the accounts of all employee-participants in the ESOP by a formula usually based on the proportion of an employee’s salary to total covered payroll for all such employee-participants. Assets of the ESOP are held in an ESOP trust established pursuant to a written trust agreement and administered by a board of trustees or institutional trustee responsible for protecting the interests of employees (and their beneficiaries).

An employee is not taxed on contributions to the employee’s ESOP account (or income earned in that account) until the employee’s benefits are actually received. Even then, “rollovers” (e.g., to an IRA) or special averaging methods can reduce or defer the income tax consequences of distributions.

Similar to most employee benefit plans, an ESOP generally is designed to benefit employees who remain with the employer the longest and contribute most to its success. Therefore, an employee’s ownership interest (in company stock and other assets held in the ESOP trust) usually is based on the employee’s number of years of employment. The employee’s ownership interest in the ESOP (“vested benefit”) and the provisions determining the vested benefit are called the “vesting schedule.” Although there are various vesting schedules that may be used (extending for periods up to six years), most are designed so that the longer the employee stays with the employer, the greater his or her vested benefit becomes.

If an employee terminates employment for any reason other than retirement, death, or disability, the former employee’s vested benefit under the ESOP will be determined by referring to the vesting schedule. All company stock and other investments in which the former employee does not have a vested benefit (because he or she has not worked long enough) will be treated as a “forfeiture” to be allocated among the ESOP accounts of the remaining employee-participants on the same basis as employer contributions. If an employee retires, dies, or is disabled, the former employee usually will become 100% vested in his or her total account balance.

After an employee’s participation in the ESOP ends, the individual (or the individual’s beneficiary) is eligible to receive a distribution of his or her vested benefit. There are many permissible times and methods for making this distribution. For example, it may be made as soon as possible after an employee’s termination of employment, or it may be deferred for a period of up to six years. However, distribution of a former employee’s vested benefit must start in the year following his or her retirement, disability, or death. Payment may be made in a lump sum or in installments over a period of up to five years (which may be extended in certain instances for participants with large account balances). In a closely held company, distributions usually are made in cash or in shares of company stock that may be sold back to the company.

How Does an ESOP Benefit Employers?

As a technique of corporate finance, the ESOP can be used to raise new equity capital, to refinance outstanding debt, or to acquire productive assets through leveraging with third-party lenders. Because contributions to an ESOP trust are tax-deductible (subject to certain limits), an employer can fund the principal and the interest payments on an ESOP’s debt service obligations with pre-tax dollars.

Federal Income Tax Consequences of an ESOP for the Employer

Employer contributions to an ESOP trust are tax-deductible within the limitations of the Code. An employer may contribute to an ESOP trust and deduct up to 25% of covered payroll per taxable year. If the ESOP has borrowed and is leveraged, the employer may increase contributions beyond the 25% level to the extent the excess is used to pay the ESOP’s interest expense, except in the case of an S corporation ESOP.

In addition, cash dividends paid on ESOP stock are deductible by a C corporation if applied to the repayment of ESOP trust debt or if currently distributed in cash to ESOP participants.

Under Section 415 of the Code, the “annual additions” that may be allocated to the account of an individual ESOP participant each year normally may not exceed the lesser of 100% of his or her covered compensation or $53,000 (subject to cost-of-living adjustments for limitation years after 2016). The “annual additions” are aggregated among all defined contribution plans the employer sponsors and include employer contributions, any employee contributions (including 401(k) deferrals, if any), and certain forfeitures allocated to the employee’s account, although contributions used to pay loan interest usually will not be considered “annual additions.”

Tax Benefits to Selling Shareholders

An ESOP provides a market for stock of a closely held company. The Code provides a special tax incentive for certain sales of stock to an ESOP, subject to satisfying specific rules. Thus, a shareholder of a closely held C corporation may be able to sell stock to an ESOP, reinvest the proceeds in other securities, and defer taxation of any gain resulting from the sale (so long as special requirements are satisfied).

Voting Rights

In a closely held company, unless otherwise determined by the Board of Directors, employees have voting rights on allocated shares only as to certain major corporate events, such as a merger, certain substantial sales of assets, liquidation of the company, and recapitalizations. On other matters, ESOP shares usually are voted by the ESOP’s Trustee(s) appointed by the company’s Board of Directors. Many variations of this structure are used. In a publicly traded company, employees have voting rights on all shares allocated to their accounts under the ESOP.

Legislative Environment

ESOPs have existed since the 1950s, but were first formalized under federal law with the enactment of ERISA in 1974. Since then, significant ESOP incentives have been included in federal statutes. The preponderance of this legislation has been favorable for ESOPs and has served to expand their use. The intent of Congress was made abundantly clear when, in an unprecedented move, it included language in the Tax Reform Act of 1976 endorsing the use of ESOPs as techniques of corporate finance. The Tax Reform Acts of 1984 and 1986 included the most significant tax incentives ever provided for ESOPs and ESOP financing until the S corporation legislation of 1996 and 1997.

Under current law, S corporation ESOPs are exempt from the unrelated business income tax (UBIT). Thus, if an ESOP owns all of an S corporation, no current tax is imposed on the company’s income. (That income is eventually taxed because ESOP participants in S corporations are taxed on ESOP distributions, just as C corporation ESOP participants are so taxed.) The law restricts the abuse of this provision by plans designed to benefit only a small number of employees, whether in a very small company or where a small number of employees try to set-up an S corporation ESOP to benefit themselves while operating a larger company whose employees are not participating in the ESOP. The law permits S corporation ESOPs to apply S corporation distributions received on qualifying employer securities (whether allocated or not) to make share acquisition loan repayments, provided employer securities with a fair market value of not less than the amount of the distributions are allocated to participant accounts for the year in which the distributions would have otherwise been allocated to their accounts. However, S corporations are currently not entitled to deduct these distributions to an ESOP.

ESOP as a Financing Mechanism

An ESOP is defined in the enabling legislation as a “technique of corporate finance.” A company may make tax-deductible contributions in cash or stock to the ESOP trust. If the contribution is made in cash, the ESOP can use the cash to purchase stock from the company itself, from existing shareholders, or from retiring or terminated employees who have received distributions of stock from the ESOP. If this contribution is made in company stock, the resulting tax deduction increases the company’s cash flow and the additional cash can be used for any corporate purpose.

Upon termination of employment, a participant’s vested benefit may be paid from the ESOP in cash or in stock. While a participant may have the right to demand to receive his distribution in stock, to mitigate the problems associated with creating a group of outside shareholders through ESOP distributions, the corporate charter or bylaws of a closely held company often can be modified to require that substantially all the company’s stock be owned by employees. This will allow the ESOP to make distributions solely in cash.

Corporate Finance Uses of ESOPs

An ESOP is mandated by law to invest its contributions primarily in stock of the sponsoring employer. It is also the only qualified employee benefit plan permitted to borrow funds on employer credit in order to acquire company stock. These differences provide flexibility for a company using the ESOP in corporate finance and to accomplish corporate and shareholder objectives not readily achievable through other methods.

Some of these objectives include:

Acquisition Financing: ESOP contributions allow the acquirer to amortize the principal payments on acquisition debt with pre-tax dollars. Because the ESOP thus generates more capital internally, the company enjoys a healthier cash position and financing is easier to obtain for transactions, including leveraged buyouts of publicly traded and closely held companies.

After acquisition financing has been amortized, the ESOP can provide a market for stock of the founding shareholder group using pre-tax dollars. Absent this market, it might be necessary to sell the company or take it public in order for the founders to obtain a return on their investment.

Acquisition of Assets or General Business Financing Using Pre-Tax Dollars: ESOP contributions can be used to shelter principal payments on normal corporate debt, effectively allowing the corporation to take tax deductions on principal payments, which can reduce the after-tax cost of borrowing. In a leveraged ESOP transaction, the company may effectively amortize the loan out of pre-tax income of the business because the corporation’s payments are treated as employee benefit plan contributions that are tax-deductible (subject to applicable limits). In a conventional loan, interest is deductible only by the borrowing corporation. Assuming a marginal income tax rate of 40%, a corporation would have to earn approximately $10 million pre-tax to provide funds to amortize principal on a $6 million loan. Pre-tax income of only $6 million is needed to generate funds to amortize the $6 million principal of an ESOP loan. Thus, cash flow to service acquisition debt is increased substantially in a properly structured ESOP transaction.

Purchase of Stock from Major Shareholders: The ESOP can provide a market for stock of major shareholders and their estates. Using the ESOP to buy the shares of principal shareholders has advantages over direct redemption by the company. The company’s contribution to the ESOP is tax-deductible, so the stock purchase is accomplished with pre-tax dollars, thus conserving the company’s cash and net worth. Controlling shareholders receive capital gains treatment on sales of their stock to an ESOP when selling only a small portion of their holdings. Conversely, if the shares were redeemed by the company, the distribution may be treated as a dividend to the selling shareholder. If certain conditions are met, selling shareholders may defer or avoid capital gains tax on sales of stock to an ESOP.

An Alternative to Going Public: Analogous to going public “internally,” an ESOP can provide a market for stock of current shareholders or for the purchase of newly issued shares. This can be accomplished without the problems and expenses normally associated with being a publicly traded company. However, the ESOP does not prevent a future sale, merger, or public offering of the company.

Publicly Traded Companies: In recent years, publicly traded companies have increasingly utilized ESOP financing to accomplish a wide variety of corporate objectives. Included are uses of ESOPs in leveraged recapitalizations, stock repurchase programs, and as components of a takeover defense strategy.