F I N A N C E

employee benefit plans

The Benefits of Employee

Stock Ownership Plans
A Primer for CPAs

By Warren M. Bergstein and

Wanda Williams

H
ow do employee stock ownership
plans (ESOP) differ from other
employee benefit plans? Other
employee benefit plans typically diversify
their holdings by investing in various types
of assets. Under section 407(a) of the
Employee Retirement Income Security Act
of 1974 (ERISA), such employee benefit
plans cannot invest more than 10% in an
employer’s securities; instead, they must fol-
low established rules of prudent investing.
In addition, other employee benefit plans
cannot leverage and deal with related parties
in order to acquire investment securities,
which are considered a prohibited transac-
tion under Internal Revenue Code (IRC) sec-
tion 4975(c)(1)(B) because they constitute
a direct or indirect lending of money or other
extension of credit between a plan and a dis-
qualified person. Thus, employers are barred
from using most qualified employee bene-
fit plans as a financing vehicle. These essen-
tial differences between other employee ben-
efit plans and ESOPs are what can make
ESOPs more favorable to both employees
and employers.
ESOPs are similar to employee stock this type of qualified plan even more favor-
Potential Benefits bonus plans, with two essential distinctions: able to employers; however, a qualified
ESOPs are equity retirement plans First, an ESOP is a qualified plan designed ESOP needs to meet the requirements of
designed to offer employees an ownership to invest exclusively in the employer’s secu- IRC section 401(a), as well as those
interest (with voting rights) in the compa- rities or one of its affiliates. Second, an ESOP under IRC section 4975(e)(7), Treasury
ny for which they work by investing pri- may be leveraged; this means that the plan Regulations section 54.4975-7, Treasury
marily in the stock of the employer. The is permitted to borrow money, generally Regulations section 54.4975-11, and por-
transfer of stock ownership from the from a commercial lender, in order to pur- tions of IRC section 409. An ESOP is a
employer to employees is tax free for the chase an employer’s securities. Thus, ESOPs defined contribution plan that can have the
shareholder. These plans can benefit both can become a financing vehicle and can be features of a stock bonus plan and a money
employers and employees by aligning their used as a planning tool for employers that purchase plan, both of which are qualified
interests—that is, ESOPs can increase want to generate capital through the plan’s under IRC section 401(a).
employee motivation and productivity, ability to borrow funds. When a company sets up an ESOP, it cre-
which can lead to improved corporate per- With the passage of ERISA, the Deficit ates a trust that holds the shares of stock
formance. Moreover, an ESOP can con- Reduction Act of 1984, and the Tax being purchased (or contributed) from either
vert a retirement program that drains cash Reform Act of 1986, additional tax bene- the company or the selling shareholder.
into a program that generates it. fits became available to ESOPs, making The ESOP can then buy new and existing

54 APRIL 2013 / THE CPA JOURNAL

shares for a variety of purposes. ESOPs are requirements under IRC section 4975(e)(7); n The loan is at a reasonable rate of
almost never used to save troubled compa- otherwise, it is considered a stock bonus plan. interest, and any collateral given to a dis-
nies (“How an Employee Stock Ownership These kinds of loans are prohibited transac- qualified person by the plan consists only
Plan Works,” The National Center for tions under IRC section 4975(c)(1)(B), but of qualifying employer securities (as
Employee Ownership, http://www.nceo. IRC section 4975(d)(3) provides an exemp- defined in IRC section 4975[e][8]).
org/articles/esop-employee-stock-ownership- tion from excise tax if the plan meets both In a leveraged ESOP, the loan is referred
plan); instead, they are most commonly used of the following criteria: to as a “back-to-back loan.” The company
for the following purposes: n The loan is primarily for the benefit of borrows money, which is loaned to a tax-
n A company can acquire businesses or participants and beneficiaries of the plan. favored ESOP trust. The trust then uses the
buy back shares from the market.
n A business can create an additional
employee benefit; to do this, the company
can issue new or treasury shares to an
ESOP, deducting their value (for up to 25%
of participants compensation) from taxable
income, or can contribute cash to the plan
by buying shares from existing public or
private owners. In public companies, which
account for approximately 5% of ESOPs
and 40% of plan participants, ESOPs are
often used in conjunction with employee
savings plans; rather than match employ-
ee savings with cash, the company
matches contributions with stock from an
ESOP, often at a higher matching level (see
Glenn James, “Advice for Companies
Planning to Issue Stock Options,” Tax
Adviser, February 1999; “Employee
Stock Options and Ownership,” Reference
forBusiness.com, http://www.referencefor-
business.com/encyclopedia/Eco-Ent/
Employee-Stock-Options-and-Ownership-
ESOP.html#ixzz11aaILRjH).
n An employer can buy newly issued
shares in the company and use the proceeds
to buy new productive capital, such as
buildings or equipment. The company can,
in effect, finance growth or acquisitions
with pretax dollars, while using those same
funds to create an employee benefit plan.
n A company can buy the shares of a
departing owner of a closely held compa-
ny. Under certain conditions, owners can
defer tax on the gain from the sale to an
ESOP (an IRC section 1042 tax-free
rollover); moreover, the purchase can be
made with pretax corporate dollars.

Leveraging an ESOP
The most favorable aspect of an ESOP
is that it can be either leveraged or non-
leveraged; what distinguishes the two is the
availability of an exempt loan. A leveraged
ESOP must have all of the necessary lan-
guage for an exempt loan in its plan docu-
ment, as required by Treasury Regulations
section 54.4975-7(b), along with all other

APRIL 2013 / THE CPA JOURNAL 55

proceeds of the loan (i.e., a “securities acqui- shares released, however, is the amount order to cover the principal portion of the
sition loan”) to buy newly issued company used on the income statement, where it is loan, and they can deduct all of the inter-
shares; thus, the company is able to gener- reflected as a compensation cost. Proper est. Company contribution plans, such as
ate capital for acquisitions, share buy-back, valuation of securities is important; if the stock bonus, 401(k), or profit-sharing plans
expansion, and other business needs. must be included in the payroll calculation.
Exempt loans must be made without On the other hand, “reasonable” dividends
recourse against the ESOP, meaning that paid on shares acquired by the ESOP loan
the ESOP is absent of any liability. Thus, ESOPs can become a can be used to repay the loan; these are not
the plan is not liable for repayment of the included in the payroll calculation.
loan beyond the unallocated securities in
the suspense account. The company must financing vehicle and can Taxation of ESOP Contributions
make cash contributions sufficient for the A company can, within certain limits,
ESOP to meet its loan obligations. The deduct the entire loan contribution it makes
repayment of the loans must come solely be used as a planning to an ESOP—that is, the company can
from employer contributions, dividends on deduct both the interest and the principal
shares in the plan, or earnings from other on the loan. This is a significant tax incen-
investments in the trust contributed by the tool for employers that tive because debt principal payments are gen-
employer. Although there is no statutory erally not deductible for income tax purposes.
limit on the term of an ESOP loan, lenders Under certain circumstances, the company
usually expect repayment in five to ten want to generate capital can also deduct dividends paid on shares
years. Many ESOP loans also require a acquired by the trust (James Lardner, “OK,
guarantee from the selling shareholder or Here Are Your Options: Employee Stock
the plan sponsor. through the plan’s ability Plans Are Spreading Fast—and Not Just at
As the loan is repaid, these shares are High-Tech Firms,” U.S. News & World
released from a suspense account into the Report, Feb. 21, 1999). Companies may take
accounts of plan participants, according to
to borrow funds. a tax deduction when using reasonable div-
specific formulas that comply with regu- idend payments to repay the ESOP loan;
lations and ensure fairness. The value of these payments are not counted against
the shares released each year is rarely the valuation is overstated, it could result in contribution limits. Companies can also
same as the amount contributed to repay the corporation losing the deduction or deduct dividends that are “passed through”
the principal on the loan. If the price of the the ESOP being disqualified. Nonpublicly directly to employees, as well as dividends
shares goes up, the amount released will traded stock must be valued by an inde- that are voluntarily reinvested by employees
be higher than the amount contributed; if pendent appraiser, as required by IRC sec- back into company stock in the ESOP; how-
it goes down, the amount released will be tion 401(a)(28)(C). ever, it is impossible to make this reinvest-
lower. The amount contributed to repay the Employer contributions are tax deductible ment on a pretax basis when combined with
principal on the loan is determined as if to the employer within the limitations a 401(k) plan (Edward O. Welles,
the company is within the limits for con- imposed by IRC section 404. Companies “Motherhood, Apple Pie Stock Options,”
tributions allowed each year in calculat- can generally deduct up to 25% of the Inc.com, Feb. 1, 1998, http://www.inc.com/
ing the tax deduction. The value of the total eligible payroll of plan participants in magzine/19980201/80.html).
The rules for ESOPs are similar to those
for other tax-qualified plans in terms of
participation, allocation, vesting, and distri-
FOR FURTHER READING bution, but special considerations might
apply. Shares are generally allocated to indi-
n “How an Employee Stock Ownership Plan (ESOP) Works,” The National Center for vidual employee accounts based on their
Employee Ownership, http://www.nceo.org/main/article.php/id/8/ compensation, but a formula can be used that
puts a cap on compensation or gives limit-
n “ERISA in the United States Code,” BenefitsLink.com, ed recognition for years of service. The
Economic Growth Tax Relief Recon-
http://benefitslink.com/erisa/crossreference_short.html
ciliation Act of 2001 (EGTRRA) accelerat-
ed the vesting schedule. ESOPs are required
n “Employee Plans Technical Guidelines,” Manual Transmittal, Department of the to follow one of two vesting schedules:
Treasury, IRM 4.72.4, Apr. 1, 2006, http://www.irs.gov/pub/irs-tege/esops.pdf n Cliff vesting. Employees are entitled to
100% vesting no later than the comple-
n “Meeting Your Fiduciary Responsibilities,” U.S. Department of Labor, tion of three years of employment.
http://www.dol.gov/ebsa/publications/fiduciaryresponsibility.html n Graded vesting. Employees are entitled
to 20% vesting after the second year of

56 APRIL 2013 / THE CPA JOURNAL

employment and an additional 20% per
year for the next four years, totaling
100% vesting after six years.
EGTRRA had a sunset provision with
a 10-year lifespan that created instability
for plan sponsors and participants; how-
ever, in 2006, the Pension Protection Act
made the EGTRRA changes permanent.
Different rules will come into play if the
ESOP is combined with a 401(k) plan.
Moreover, there are specific rules govern-
ing the distribution of shares to retiring and
terminated employees and to families or
beneficiaries of deceased employees.
When an employee receives a distribution
from the plan, it is taxable unless it is rolled
over into an individual retirement account
(IRA) or other qualified plan. Otherwise, the
amount contributed by the employer is tax-
able as ordinary income and appreciation on
the shares is taxable as capital gains. In addi-
tion, if an employee receives the distribution
before normal retirement age and does not
roll over the funds, a 10% excise tax is
levied. While the stock is in the plan, any
income or gain is not taxable to employees.
When employees choose to leave the com-
pany, they receive their stock, which the
company must buy back from them at its
fair market value (unless there is a public
market for the shares). The proceeds of the
stock sale can be rolled over into another
tax-sheltered retirement plan, such as an IRA.
As with other retirement plans, an individ-
ual’s ESOP account grows tax free until dis-
tributed (Steve Kaufman, Nation’s Business,
vol. 85, no. 6, June 1997, p. 43).
Additional Uses
An ESOP can also provide an exit strate-
gy for shareholders who might have concerns
about selling their business. The plan allows
shareholders to sell all or just a part of their
interest in the company; in addition, they
can do this gradually or all at once (“Tax
Advantages of ESOPs: C and S,” The
ESOP Association, http://www.esopassocia-
tion.org/explore/how-esops-work/learn-about-
esops/tax-advantages). Selling smaller
blocks of stock in a “piecemeal approach” is
a popular strategy, because the transaction can
be structured so that control remains with
the shareholders until the controlling block
of stock is sold to the ESOP (Scott D.
Miller, “The ESOP Exit Strategy: Explore the
Advantage of this Popular Tool for Succession
Planning,” Journal of Accountancy, March
APRIL 2013 / THE CPA JOURNAL
2010, http://www.journalofaccountancy.
com/issues/2010/mar/20092046.htm).
Furthermore, selling smaller blocks of stock
is easier to finance because it avoids exces-
ESOPs are a unique financial
tool for the continuation
of a successful business
that can provide the
employees of that business
with an ownership stake.
sive leverage and reduces the company’s
risk of default.
Prior to 1997, ESOPs were prohibited
from holding shares of an S corporation,
because the S corporation would lose its
status upon funding of the ESOP.
Generally, the trust pays no taxes, and
therefore a portion of the S corporation
earnings would go untaxed; this is why S
corporations could not have an ESOP
obtain its own shares of stock. Effective
for tax years after December 31, 1997, IRC
section 1361(c) was changed to allow
various trusts, including ESOPs, to own
stock of an S corporation. The Taxpayer
Relief Act of 1997 (TRA) rendered ESOPs
even more appealing to S corporations by
exempting the plans from the unrelated
business income tax; essentially, this made
all of the income attributable to an S cor-
poration stock tax free.
But TRA did not allow an S corporation
to deduct ESOP interest payments (under
IRC section 404[a][9]); thus, interest can-
not be disregarded as an annual addition.
IRC section 1042, which allows the
deferral of gain on the sale of qualified
securities to an ESOP, is not available to
an ESOP maintained by an S corporation
because IRC section 1042(c)(1)(A) limits
the definition of qualified securities for pur-
poses of the nonrecognition of gain treat-
ment to C corporations.
After the passage of TRA, a few abu-
sive S corporation ESOPs, designed to ben-
efit only a few highly compensated
employees, were reported. As a result,
Congress added IRC section 409(p) to
close the loopholes that allowed an S cor-
poration’s ESOP to benefit just a few
shareholders.
EGTRRA, which also included provi-
sions intended to prevent a few share-
holders from reaping the majority of ben-
efits while diluting the value of ESOP
stock, made a number of changes to retire-
ment plans. In the case of C corporations,
EGTRRA section 662 allows a plan to pay
a dividend and offer a participant the
right to have the dividend reinvested in
qualifying employer securities in the 401(k)
portion of an ESOP. These dividends are
now fully deductible by the corporation,
even if they are not used to service the
ESOP loan. EGTRRA permits both
employer and employee to avoid tax on the
dividends; however, in the case of an S
corporation, ESOPs can only use dividends
paid for unallocated shares as repayment
for an ESOP loan.
Productivity and Profitability
ESOPs are a unique financial tool for the
continuation of a successful business that can
provide the employees of that business
with an ownership stake. (For more infor-
mation on ESOPs, see the sidebar, For
Further Reading.) Surveys and research stud-
ies show that ESOP companies are more
productive and more profitable; they also
have a higher survival rate. With the lever-
aged provision in the plan agreement, ESOPs
provide tax-favored liquidity for the selling
shareholders and provide retirement plan
benefits for employees. ❑
Warren M. Bergstein, CPA, AEP, is a part-
ner at Adelman Katz & Mond LLP and an
adjunct professor of accounting and taxation
at Long Island University, Brookville, N.Y.
Wanda Williams, CPA, is the founder and
owner of Williams Consulting Group, based
in New York, N.Y., and Silver Spring, Md.
57
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