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ESOPs: What They Are and How They WorkAuthor(s): Henry C. Blackiston III, Linda E. Rappaport and Lawrence A. PasiniSource: The Business Lawyer, Vol. 45, No. 1 (November 1989), pp. 85-143Published by: American Bar AssociationStable URL: http://www.jstor.org/stable/40687044Accessed: 12-03-2016 06:18 UTC

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ESOPs: What They Are and How They Work*

By Henry C. Blackiston III, Linda E. Rappaport, and Lawrence A. Pasini**

INTRODUCTION

OVERVIEW

As a tax-favored, congressionally approved "technique of corporate finance,"1

employee stock ownership plans ("ESOPs")2 are currently experiencing a

period of phenomenal growth in corporate America. In 1974, there were

roughly 300 ESOPs in corporate America. This year, there are approximately

10,000 ESOPs in which about 10 million U.S. workers participate, which

represents approximately one-fourth of all corporate employees in America.3

The reasons behind such growth are apparent. First (prior to the most recent

proposals), Congress has consistently enacted legislation that broadens the tax

advantages of ESOPs since the formal approval of such plans in 1974, with the

passage of the Employee Retirement Income Security Act of 1974 ("ERISA").4

Second, ESOPs can provide retirement benefits, and can develop employees'

participation in the ownership of the corporation, which, in turn, should

improve worker morale and productivity by shifting blocks of company equity

from outsiders to the employees. Third, the financial community has become

aware of the varied possibilities of an ESOP as a tool of corporate finance.

ESOPs can provide a market for the company's stock in order to raise capital

through tax deductions, provide an efficient method of selling a division to

employees, enable a company to reduce indebtedness with pre-tax dollars, prove

an effective way to finance an acquisition or leveraged buyout, and aid in the

development of a defensive strategy in change of control situations.

Because ESOPs are tax-qualified employee benefit plans, there is a myriad of

legal requirements which must be satisfied under ERISA and the Internal

Revenue Code of 1986, as amended (the "Code"), in order to retain the tax-

*Note that at the time of this article's submission for publication, Congress is considering proposals

that would eliminate certain of the tax incentives available to ESOPs. For a discussion of these

proposals, see infra notes 63, 80, and 91.

**Mr. Blackiston, Ms. Rappaport, and Mr. Pasini are members of the New York bar and practice

law with Shearman & Sterling in New York.

Editor's note: William E. Mattingly of the Illinois bar served as reviewer of this article.

1. 129 Cong. Rec. S16,629, S16,636 (daily ed. Nov. 17, 1983) (statement of Sen. Lone).

2. ESOPs are defined in § 4975(eX7) of the Internal Revenue Code. I.R.C. § 4975(e)(7) (1986).

3. See Ungeheuer, They Own The Place, Time, Feb. 6, 1989, at 50.

4. 29 U.S.C.A. §§ 1001-1461 (West 1985 & Supp. 1989).

85


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86 The Business Lawyer; Vol. 45, November 1989

qualified status of ESOPs. One overriding requirement is that the primary

purpose of the ESOP must be to benefit plan participants by distributing to such

participants "the corpus and income of the fund accumulated"5 under the

ESOP. This must be considered when implementing and administering any

ESOP. Thus, if the establishment of an ESOP cannot be justified as a valuable

employee benefit (rather than solely as a corporate financial device), a prospec-

tive plan sponsor should not adopt such a plan.

THE CONCEPT EXPLAINED

The term "ESOP" refers to a trusteed tax-qualified employee benefit plan,

which may take the form of a tax-qualified stock bonus plan or a combination

stock bonus and money purchase pension plan. The plan must be designed to

invest primarily in securities of the sponsoring employer. It is exempt from

certain prohibited transaction rules under ERISA that would otherwise prohibit

loans between a plan and a sponsoring corporation and loans to a plan

guaranteed by a sponsoring corporation. Because an ESOP is considered an

"eligible individual account plan" under section 407(d)(3) of ERISA, it is

exempt from the general qualified plan requirements that the assets of such

plans be diversified and that no more than ten percent of the assets of the plan

be held in employer securities.

Unlike other eligible individual account plans, however, an ESOP may invest

in the stock of the sponsoring employer by purchasing the stock with borrowed

funds (leveraging), which may be supplied either by the sponsoring employer or

a lending institution. Congress has adopted numerous tax benefits and incen-

tives for the establishment of ESOPs, which are discussed below. On the other

hand, ESOPs are subject to more stringent regulation and scrutiny than are

standard stock bonus and other eligible individual account plans because Con-

gress felt that the power to borrow may lead to the potential for abuse. Thus, in

order to enjoy favorable tax treatment, the assets of an ESOP must be invested

in so-called "qualifying employer securities," meeting certain specific criteria,

while a stock bonus plan other than an ESOP may invest in any class of

employer stock. In more recent years, however, Congress has extended many of

the requirements originally imposed on ESOPs to stock bonus plans, including

those involving distribution, put options, and voting provisions.

The type of companies that will be likely to find ESOP transactions most

attractive are companies that are labor-intensive and that have stable earnings.

The more labor-intensive the company, the more it will be able to fully utilize

the tax deduction allowances for employer contributions (which are limited by a

certain percentage of the total employee salary base).

What follows is a discussion of (i) the legal requirements for qualification of

ESOPs, (ii) the allocation rules applicable to ESOPs, (iii) the tax benefits and

incentives available to ESOPs, (iv) fiduciary considerations, (v) accounting and

securities law considerations, and (vi) the current use of ESOPs in financial

5. I.R.C. §401(a)(l)(1986).




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transactions, including issues involving leveraged buyouts and securitized ESOP

loans.

LEGAL REQUIREMENTS FOR QUALIFICATION OF

ESOPs

QUALIFIED EMPLOYEE BENEFIT PLAN UNDER

CODE SECTION 401 (a)

Section 4975(e)(7) of the Code defines an "employee stock ownership plan"

as a stock bonus plan (or a stock bonus plan and a money purchase pension

plan) that is qualified under section 401 (a) of the Code. Code section 401 (a)

imposes the basic requirements for qualification purposes, among them, that: (i)

contributions must be made to the ESOP by the employer/sponsor, the employ-

ees, or both; (ii) the ESOP must be established and maintained for the exclusive

benefit of employees and their beneficiaries; (iii) the ESOP must permit

employee participation on a non-discriminatory basis; (iv) a proper vesting

schedule must be included by the terms of the ESOP; and (v) the ESOP may not

provide benefits in excess of certain limits.

Required Contributions

Under the Code, an ESOP, like other qualified employee benefit plans, is

required to be "supported" by contributions from the employer (or the employ-

ees) for the purpose of "distributing to such employees or their beneficiaries the

corpus and income of the fund."6 Further, qualified plans must be intended to

be permanent, and the failure of an employer to make substantial and recurring

contributions to a profit sharing plan, for example, will generally result in the

loss of its qualification.7 Thus, if an ESOP is formed, but neither the employer

nor the employees contribute any funds to the ESOP trust, either to pay down

an ESOP loan or to purchase additional stock, the ESOP will not constitute a

"qualified" plan under section 401 (a) of the Code. Additionally, the ESOP

regulations warn (in the course of discussing the timing of the repayment of

exempt loans and the resulting release of employer securities from the suspense

account) that not only must contributions be made to support the ESOP, but

any "failure on the part of the employer to make substantial and recurring

contributions to the ESOP" may lead to a loss of qualification under section

401 (a).8 It seems, therefore, that de minimis employer contributions would

violate the sponsoring employer's obligation to make "substantial and recurring

contributions," as required in the regulations. It is not clear whether an ESOP

supported solely by employee contributions would satisfy qualification require-

ments under the Code.

6. Id.

7. Treas. Reg. § 1.401-l(b)(2) (as amended in 1976).

8. See Treas. Reg. § 54.4975-7(b)(8)(iii) (1977) (emphasis added).




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Although the regulations governing ESOPs and leveraged transactions make

no distinction between employer and employee contributions (referring instead

generically to "contributions"), practitioners are generally cautious with respect

to using employee contributions to repay an ESOP loan. Not only does the use

of employee contributions raise securities laws issues regarding registration and

disclosure, but, in addition, the Internal Revenue Service (the "1RS") has

informally indicated that it believes that the use of employee contributions to

repay an ESOP loan is inappropriate and inconsistent with the "exclusive

benefit" rule and that it is currently considering taking formal action on this

question.

Exclusive Benefit of Participants

All tax-qualified plans must be "created or organized ... for the exclusive

benefit of ... employees or their beneficiaries."9 However, despite the clear

language embodied in the statute, the degree to which this requirement has

meaning varies in different contexts. It seems obvious that what may be the rule

of "exclusive benefit" in a defined benefit pension plan would differ from the

rule in the context of a leveraged ESOP since, in the latter case, every

structuring of an ESOP transaction benefits others in some way: the sponsoring

corporation enjoys tax deductions, the lenders have tax incentives, and manage-

ment may obtain increased control. Therefore, the fact that "incidental" benefits

are provided to third parties through ESOPs would not result in a violation of

this rule; however, what constitutes more than an incidental benefit remains

undefined. Similarly, the ESOP regulations require only that loans to ESOPs

be for the primary, but not necessarily the exclusive, benefit of the plan. ESOP

fiduciaries are "cautioned," in the ESOP regulations, to "exercise scrupulously

their discretion" in approving these loans, since the 1RS will subject ESOP

loans to "special scrutiny to ensure that they are primarily for the benefit of

participants."10

Non-discrimination

As a qualified employee benefit plan under the Code, an ESOP cannot

discriminate in favor of employees who are "highly compensated."11 One of the

following minimum coverage tests must be met in fact by the ESOP for it to be

considered non-discriminatory in plan years beginning after 1988:

9. I.R.C. § 401 (a) (as amended in 1988). Under section 404(a)(l) of ERISA, fiduciaries of a

qualified plan must act solely in the interests of participants and beneficiaries for the exclusive

purpose of providing benefits to such persons and defraying reasonable expenses. See infra text

following note 100 for a discussion of ERISA's fiduciary responsibility rules.

10. Treas. Reg. § 54.4975-7(b)(2)(iii) (1977) (emphasis added).

11. I.R.C. § 401(a)(4) (1986). See also I.R.C. § 414(g) (as amended in 1988) which defines a

"highly compensated employee" under the Code as an employee who, over the year or the preceding

year, (i) was a 5% (or more) owner of the company at any time, (ii) earned over $75,000 from the

company, (iii) earned over $50,000 and was in the top 20% of company compensation, or (iv) earned

over $45,000 and was an officer of the company.




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(i) Seventy percent of all non-highly compensated employees are partici-

pants in the ESOP; or

(ii) The percentage of non-highly compensated employees covered under

the plan (in relation to the total number of participants) is at least seventy

percent of the percentage of highly compensated employees covered; or

(iii) The ESOP must cover a fair cross section of employees, and the

"average benefit percentage" for non-highly compensated employees is at

least seventy percent of such percentage for highly compensated employ-

ees.12

In applying these tests, generally employees under age twenty-one (if the

ESOP prescribes this minimum age requirement), employees completing less

than the minimum service requirement prescribed by the ESOP, employees in a

unit covered by a collective bargaining agreement (provided there is evidence

that retirement benefits were the subject of good faith negotiation) and nonresi-

dent aliens with no U.S. source income may be excluded from the calculation.13

In general, under the controlled group requirements of the Code, all affiliated

companies under common control (within the meaning of section 1563(a) of the

Code) are aggregated when calculating the above percentages. However, an

ESOP may not be considered with another qualified plan for purposes of

applying these tests, unless the other plan is also an ESOP whose assets are

invested in employer securities in the same proportion as the first ESOP.14

Vesting

The minimum vesting standards which an ESOP must generally provide

after December 31, 1988 are either:15

(i) 100% vesting after five years of service; or

(ii) a vesting schedule no less favorable than:

Years of Service Percentage Vested

3 20%

4 40%

5 60%

6 80%

7 or more 100%

Once a participant's benefit promised under the ESOP "vests," the benefit

becomes nonforfeitable. If a participant's service with the employer subse-

12. I.R.C. §410(b) (as amended in 1988). Under the Code, the "average benefit percentage"

means the average of the employer-provided benefits to an employee under all qualified plans

maintained by the employer, expressed as a percentage of such employee's compensation. See I.R.C.

§410(b)(2)(C)(1986).

13. See I.R.C. § 410(b)(3), (4) (as amended in 1988).

14. Treas. Reg. § 54.4975-1 l(e) (as amended in 1979).

15. I.R.C. §41 l(a)(2) (1986).




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quently terminates, the percentage which is vested will remain nonforfeitable,

and any non-fully vested percentage will be forfeited.

Benefit Limitations

An ESOP may not provide benefits to participants that exceed certain

statutory limits, and it must provide a formula in the plan document that

allocates employer contributions, and which in practice falls within such statu-

tory boundaries. Generally, annual allocations to an employee's account may

not exceed the lesser of: (i) twenty-five percent of the employee's compensation,

or (ii) $30,000 (or, if greater, one-quarter of the defined benefit plan limit

($90,000, subject to cost of living increases)).16 If no more than one-third of all

employer contributions are allocated to "highly compensated" employees, then

this annual allocation limit may be increased to the limit permitted under Code

section 41 5(c)(6).17

DEFINED CONTRIBUTION PLAN REQUIREMENT

An ESOP is a defined contribution plan under the Code and may be

structured as either:

(i) a stock bonus plan, with employer contributions tied to a formula

which may (but need not necessarily) be based upon profits; or

(ii) a combination stock bonus plan and money purchase pension plan,

with employer contributions that are fixed and not dependent upon prof-

its.18

Distinctions Between Stock Bonus And Money Purchase

Plans

One distinction between the two types of plans is that benefits under a stock

bonus plan must be payable in stock, whereas money purchase pension plan

benefits may be payable in either cash or stock. The money purchase pension

plan is also different in that it is funded with fixed contributions not based upon

profits, whereas the stock bonus plan is often designed as an incentive plan, with

contributions and earnings directly based upon profits. Another distinction

between money purchase pension plans and stock bonus plans stems from the

former's status as a "pension" plan: withdrawals are not permitted until normal

retirement or termination of service. A stock bonus plan, in contrast, may

provide for in-service distributions.19

The most important reason for adding a money purchase pension plan to an

ESOP (other than a leveraged ESOP) is to increase the deductible limit for

employer contributions from fifteen percent to twenty-five percent of compensa-

16. I.R.C. §415(c)(l),(d)(l)(1986).

17. I.R.C. § 415(c)(6) (as amended in 1988).

18. I.R.C. | 4975(eX7) (1986).

19. See Treas. Reg. § 1.401-l(b)(l)(i), (ii) (as amended in 1976).




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tion. A similar increase in deductible limits is also available to any ESOP with

respect to the repayment of a so-called "exempt loan."

Participants9 Individual Accounts

All assets of an ESOP must be held in an ESOP trust, established under a

written trust agreement, and administered by a trustee who is responsible for

protecting the interests of the employees and their beneficiaries. Each partici-

pating employee is given an individual account, and over the term of employ-

ment, each employee's account is credited with an appropriate number of shares

of employer stock. The proceeds of an ESOP account are generally not distrib-

uted until an employee dies, retires, suffers a disability, or otherwise terminates

his service with the employer. Upon the closing of a participant's account, an

employee's benefits are calculated by applying the value of the employer stock to

the number of shares held in the account. The account balance must initially be

distributed in shares of stock, unless a participant elects otherwise.

These requirements will affect both the participants and the employer. With

regard to the ESOP participants, as in other defined contribution plans, their

benefits under the ESOP are ultimately contingent upon the underlying value of

the employer stock. With regard to the employer, stock distributions to employ-

ees will increase the total number of shareholders. This may ultimately trans-

form a privately held company into a public company for securities law

purposes if as a result the employer has more than 500 shareholders. The

ESOP trust is considered to be one shareholder for this purpose.

"QUALIFYING EMPLOYER SECURITIES"

INVESTMENT REQUIREMENT

Investment in Other Assets

"A plan constitutes an ESOP only if the plan specifically states that it is

designed to invest primarily in qualifying employer securities."20 Thus, an

ESOP that is designed as a stock bonus plan or money purchase plan may also

invest part of its assets in non-qualifying employer securities (as long as the

ESOP invests "primarily" in qualifying employer stock), and the plan will be

treated as any other stock bonus or money purchase plan with respect to those

investments.21 Although it is not defined in the statute, the "primarily" element

of this phrase had been interpreted to permit a plan provision that required at

least fifty percent of the ESOP assets to be invested in qualifying employer

securities.22 Under the regulations, the proceeds of an ESOP loan must be used

20. Treas. Reg. § 54.4975-1 l(b) (as amended in 1979); see also, Employment Retirement

Income Security Act (hereinafter ERISA) § 407(d)(6), 29 U.S.C.A. § 1107(d)(6) (West 1985).

21. Treas. Reg. § 54.4975-1 l(b).

22. Dep't Labor Op. 83-6A (Jan. 24, 1983). The Department of Labor ("DOL") declined to

establish a fixed, quantitative standard for the "primarily invested" requirement, instead emphasiz-

ing that the applicable requirements were flexible and varied in different factual contexts.




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"within a reasonable time" to acquire qualifying employer securities, or used to

repay such loan or a prior ESOP loan.23

Definition of Employer Securities

Publicly Traded Companies

Common Stock

Section 4975(e)(8) of the Code provides that a "qualifying employer security"

means an employer security within the meaning of section 409(1) of the Code.

Section 409(1) of the Code defines employer securities as, among other things,

common stock issued by an employer (or by a corporation which is a member of

the same controlled group) which is "readily tradable" on an established U.S.

securities market. If the employer has no readily tradable common stock, but

another member of the controlled group does, that "readily tradable" stock (or a

preferred stock meeting the requirements discussed below) must be the "em-

ployer securities" purchased by the ESOP. The 1RS has ruled that American

Depository Receipts ("ADRs") may be deemed to be "common stock," provided

they have the necessary voting and dividend rights, and that they are traded on

an established U.S. securities market.24

Section 409(l)(4)(A) of the Code further provides that for purposes of this

section, a "controlled group of corporations" has the meaning given to such term

by section 1563(a) of the Code (determined without regard to subsections (a)(4)

and (e)(3)(c) of section 1563), which generally requires an eighty percent of

vote or value test to determine controlled group status. Under Code sections

409(1 )(4)(B) and (C), the controlled group definition is expanded to include

situations in which (i) a common parent owns stock possessing at least fifty

percent of the total voting power, and fifty percent of each non-voting class of

stock in a first tier subsidiary, or (ii) the common parent owns the entire voting

power of a first tier subsidiary, and such first tier subsidiary owns at least fifty

percent of the total voting power, and fifty percent of each non-voting class of

stock in the second tier subsidiary.

The 1RS has ruled that common stock of a. foreign parent corporation traded

on a United States securities exchange, where the parent corporation is a

member of the same controlled group of corporations as the employer and where

members of the group have no readily tradable stock, must be regarded as

"readily tradable" common stock and, thus, "qualifying employer securities."25

However, if the foreign parent only has stock trading on a foreign exchange,

such stock will not be deemed "readily tradable" common stock for purposes of

section 409(1) of the Code.26

23. See Treas. Reg. ft 54.4975-7(bX4) (1977).

24. See Priv. Ltr. Rul. 85-46-125 (Aug. 23, 1985).

25. Id.

26. See Priv. Ltr. Rul. 87-27-025 (Apr. 2, 1987).




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ESOPs 93

Preferred Stock

Under section 409(1 )(3) of the Code, preferred stock of the employer can be

qualified as "employer securities" if (i) it is noncallable, (ii) it is convertible at

any time into common stock that is readily tradable (or common stock having

the greatest dividend and voting rights where no readily tradable common

exists), and (iii) the conversion price is "reasonable."

There are no regulations at the present time under section 409 of the Code;

consequently, the available authoritative guidance as to what is a "reasonable"

conversion price is sparse. Former Treasury regulations regarding TRASOPs

(a form of ESOP no longer permitted under the Code) that addressed the issue

of a "reasonable" conversion price in the context of defining "employer securi-

ties" (for purposes of obtaining an investment tax credit for contribution to a

TRASOP), have been applied to an ESOP in a recent private letter ruling. The

TRASOP regulation states that a convertible employer security must be con-

vertible at all times into common stock "at a conversion price which is no

greater than the fair market value of that common stock at the time the plan

acquires the security," and the 1RS relied on this TRASOP regulation in

finding that a conversion price that was no greater than the fair market value of

the common stock at the time the plan acquired the security was a "reasonable"

conversion price under section 409.27 However, the private letter ruling did not

state that this was the only method of determining a "reasonable" conversion

price. Practitioners generally take the position that the former TRASOP

regulation is inapplicable to the qualification of a class of preferred stock as an

"employer security" in the context of an ESOP because the TRASOP regula-

tion now is obsolete and is generally inconsistent with the standard market

terms for convertible preferred shares. Presently, the authors are aware of

transactions that have been undertaken using a conversion premium above

market, with some as large as thirty percent over market.

Non-Publicly Traded Companies

Under section 409(1 )(2) of the Code, if neither the employer nor any other

member of the controlled group has readily tradable common stock, stock which

is part of a class of common stock having the greatest dividend and voting rights

will be considered qualifying employer securities. In the context of leveraged

buyout companies, which typically have complex capital structures, it may often

be difficult to determine which class of common stock would satisfy the section

409(1 )(2) definition.

DISTRIBUTION REQUIREMENTS

Distributions attributable to employer stock acquired by an ESOP after

December 31, 1986 are subject to special distribution requirements. Unless a

participant elects otherwise, distribution of ESOP benefits must commence no

27. See Priv. Ltr. Rul. 87-52-079 (Sept. 30, 1987) (citing Treas. Reg. § 1.46-8(gXi) (1982)).




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later than one year after the last day of the plan year in which retirement,

disability, or death occurs, or the fifth year following the plan year in which

employment terminates for other reasons.28 However, this rule does not apply in

two instances. First, if the participant resumes employment before the distribu-

tion date, distribution is not required. Second, with exceptions relating to death,

disability, and normal retirement, distributions attributable to employer stock

acquired with the proceeds of an ESOP loan generally may be postponed until

the close of the plan year in which the loan is repaid in full.29

Unless a participant elects otherwise, distribution of ESOP benefits ordinar-

ily must be made at least as rapidly as if they had been made in substantially

equal, annual installments over a period not exceeding five years.30 However,

for participants whose benefits exceed $500,000 in value, the distribution period

may be extended by one year for each $100,000 (or fraction thereof) by which

the value of benefits exceeds $500,000, up to an additional five years.31

INVESTMENT DIVERSIFICATION REQUIREMENT

The Code requires an ESOP to provide an investment diversification election

to certain participants. When an ESOP participant reaches age fifty-five or

completes ten years of participation, if later, he may elect to diversify a portion

of his ESOP balance the next plan year and each plan year thereafter for up to

a period of five years.32 For the first four years, a participant's election may

cover up to twenty-five percent of his account balance. In the final year, an

election may cover up to fifty percent of the participant's account balance. The

diversification requirement can be satisfied by offering three investment options

to each electing participant. Alternatively, the diversification requirement may

be satisfied by distributing the portion of the participant's account balance

subject to diversification.33

For purposes of valuations necessitated by the diversification rules and for all

other valuations under an ESOP of employer securities which are not readily

tradable in an established securities market, the Code requires that the plan

employ an independent appraiser meeting requirements similar to those of the

regulations promulgated under section 170(a)(l) of the Code with respect to

valuation of charitable contributions of property.34 The appraiser's name must

be reported to the 1RS.

28. I.R.C. § 409(o)(l)(A) (as amended in 1988).

29. I.R.C. § 409(o)(l)(B) (1986).

30. I.R.C. § 409(o)(l)(C) (1986).

31. Id.

32. See I.R.C. § 401(aX28)(A) (as amended in 1988).

33. I.R.C. § 401(a)(28)(B)(ii) (as amended in 1988).

34. I.R.C. § 401(a)(28)(C) (1986).




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The diversification requirements are effective with respect to ESOPs adopted

after December 31, 1986 and contributions made to an existing ESOP after

December 31, 1986.35

VOTING RIGHTS REQUIREMENT

If an employer has a "registration-type class of securities," that is, a class of

securities registered under the Securities and Exchange Act of 1934, as amended

(the "1934 Act"),36 or is exempt from registration under section 12(g)(2)(H) of

the 1934 Act,37 each participant or beneficiary in the ESOP holding such

securities is entitled to direct the voting of securities allocated to his account.38

If the employer does not have a "registration-type class of securities," each

participant or beneficiary in the ESOP holding such securities is entitled to

direct the voting of allocated shares on corporate matters which involve the

voting of such shares for the approval or disapproval of any corporate merger or

consolidation, recapitalization, re-classification, liquidation, dissolution, sale of

substantially all assets of a trade or business, or such similar transactions as the

Secretary of the Treasury in future regulations may prescribe.39 The employer

may, however, allow greater pass-through voting rights. Section 409(e)(5)

permits the voting requirement described above to be satisfied by granting one

vote to each participant and voting all of the ESOP's shares in proportion to the

participants' vote. Neither the Code nor the ESOP regulations address the issue

of the voting of unallocated shares or shares that are allocated but with respect

to which no directions have been received. Under the former Treasury regula-

tions addressing TRASOPs, the former would be voted by the trustee in its

discretion, while the latter could not be voted at all.40

MISCELLANEOUS RULES

Written Plan Document

To constitute a qualified plan, an ESOP must be embodied in a written

instrument. This instrument must provide for at least one "fiduciary" who has

authority to manage and control the assets of the ESOP.41 All assets of the

35. A recent notice issued by the 1RS clarified these diversification provisions in several respects.

Among other things, the notice provided that the portion of a participant's account that is subject to

the diversification requirement is only that portion representing the securities purchased or contrib-

uted after December 31, 1986 and allocated to his account. I.R.S. Notice 88-56, A-9, 1988-1 C.B.

540, 541. Further, the notice indicated that the diversification requirement may be satisfied by the

ESOP permitting a participant to direct the transfer of the amounts subject to diversification to

another qualified defined contribution plan of the employer that offers at least three investment

options. Id., A- 13, at 541.

36. 15 U.S.C.A. §§ 78a-78kk (West 1981 & Supp. 1989).

37. Id. § 781(g)(2)(H).

38. See I.R.C. § 409(e)(2) (1986).

39. See I.R.C. § 409(e)(3) (1986).

40. Treas. Reg. § 1.46-8(d)(8)(i), (iv) (1979).

41. ERISA § 402, 29 U.S.C.A. § 1102 (West 1985).




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ESOP must be held in a trust held by the named trustees, or appointed by such

named trustee. An ESOP must be formally designated as an employee stock

ownership plan in the written instrument.42

Put Options

Participants must have a right to demand a distribution of benefits in the

form of employer securities. If a plan distributes employer securities that are not

readily tradable on an established market, a participant must be given the right

to require the employer to repurchase the employer securities under a fair

valuation formula (a "put option").43 With respect to stock acquired after

December 31, 1986, if an employer is required to repurchase employer securi-

ties that are distributed to employees as part of a total distribution, the

requirements of the put option will be deemed to be met provided (i) the amount

paid to the employee for the securities is paid in substantially equal periodic

payments, not less frequently than annually, over a period commencing not later

than thirty days after the exercise of the put option and not exceeding five years,

and (ii) reasonable interest is paid on the unpaid amounts.44 The ESOP

document must specifically provide that the put is nonterminable (the put will

survive the repayment of the loan made to the ESOP to acquire the securities),

even if the plan ceases to be an ESOP.45 These put requirements are an

important consideration, particularly in an LBO context, where they represent

a potential cash drain on a highly leveraged employer.

Valuation

All assets held by an ESOP must be valued at least once a year on a date

specified in the plan document, typically the last day of the plan year.46 If

employer securities that are not publicly traded make up any portion of the

ESOP's assets, this annual valuation must be made by an independent ap-

praiser.

Social Security Integration

The ESOP's benefits may not be integrated with Social Security.47

Certain Amendments

Section 411(d)(6)(C) of the Code exempts ESOPs from the general require-

ment under section 411(d)(6) that a qualified plan may not be amended to

reduce the accrued benefit of any participant, including eliminating an early

42. Treas. Reg. § 54.4975-1 l(a)(2) (as amended in 1979).

43. See l.K.U. $ 4Uy(h) (as amended m IWb).

44. I.R.C. § 409(h)(5)(A), (B) (1986).

45. Treas. Reg. § 54.4975-1 l(a)(3)(ii) (as amended in 1979).

46. See Rev. Rul. 80-155, 1980-1 C.B. 84.

47. Treas. Reg. § 54.4975-1 l(a)(7)(ii) (as amended in 1979).




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retirement subsidy or an optional form of benefit with respect to benefits

attributable to service prior to the amendment. Thus, an ESOP may eliminate a

lump sum option or an installment payment option as long as it does so in a

non-discriminatory manner.

EXEMPT LOAN AND ALLOCATION RULES FOR

LEVERAGED ESOPs

EXEMPT LOAN REQUIREMENTS

The following requirements must be met in order for an ESOP to borrow

funds from an employer, or borrow funds from a third party with a guarantee

from the employer, without violating ERISA's prohibited transaction rules

which would otherwise prohibit such a loan:

(i) The purpose of the loan must be "primarily" for the benefit of plan

participants and beneficiaries. The loan must be made to a plan that

qualifies as an ESOP at the time the loan is made.48

(ii) The rate of interest on the loan must be "reasonable," taking into

consideration all relevant factors.49 A variable interest rate may be consid-

ered reasonable.50

(iii) The term of the loan must be specified, the loan must not be payable

on demand, and the timing of payments may not be accelerated upon a

default. If the loan agreement provides that the qualifying employer

securities purchased with the loan will be released from the suspense

account using the "principal only" method of allocation, the term of the

loan may not exceed ten years.51

(iv) The loan proceeds must be used within a reasonable time after

receipt only to purchase qualifying employer securities, or to repay an

outstanding ESOP loan.52

(v) The only assets an ESOP may pledge as collateral for the exempt

loan are qualifying employer securities acquired with the proceeds of the

loan, or qualifying employer securities that were acquired with a previous

exempt loan that was repaid with the proceeds of the current loan.53

(iv) The terms of the loan, whether or not between independent parties,

must be at least as favorable to the ESOP as the terms of a comparable

loan resulting from arm's length negotiations between independent par-

ties.54

(vii) The annual payments made by the ESOP to reduce the loan must

not exceed the sum of contributions and earnings on the securities for all

48. Treas. Reg. § 54.4975-7(b)(14) (1977).

49. I.R.C. § 4975(d)(3)(B) (1986).

50. Treas. Reg. § 54.4975-7(b)(7) (1977).

51. Treas. Reg. § 54.4975-7(b)(8)(ii) (1977).

52. Treas. Reg. § 54.4975-7(b)(4) (1977).

53. Treas. Reg. § 54.4975-7(b)(5) (1977).

54. Treas. Reg. § 54.4975-7(b)(3)(iii) (1977).




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prior years, less the ESOP loan payments made in all prior years.55 Some

ESOP sponsors have read the concept of "earnings" broadly to include the

proceeds received by an ESOP on a sale of the employer securities pledged

as collateral for an exempt loan. Although earlier 1RS private letter rulings

approved of such an interpretation where the sale of collateral occurred in

connection with the termination of the ESOP,56 the 1RS more recently has

indicated that an ongoing ESOP could not provide for regular loan

repayments funded by the sale of pledged securities.57

RELEASE OF QUALIFIED SECURITIES FROM

SUSPENSE ACCOUNT

As indicated above, the only assets that may be pledged as collateral for an

exempt loan are qualifying employer securities.58 These securities must be held

in a suspense account and subsequently released from encumbrance and allo-

cated to individual accounts as the debt is paid. This release from encumbrance

must be accomplished in one of two ways.

The "Proportional" Method

The proportional method, which the regulations call the "general rule" for

releasing encumbered securities, is used when the amount of shares to be

released from the suspense account is based upon the amount of loan principal

and interest paid.59 The number of shares released from encumbrance in each

plan year under this method must equal the number of shares encumbered

immediately prior to the release, multiplied by a fraction, the numerator of

which is the principal and interest paid in the particular year, and the denomi-

nator of which is the total of the loan payment due in such year (that is, the

numerator) plus all future loan payments to become due in subsequent plan

years. The denominator (the total amount) must be determined without the

possibility of extensions or renewals and, for a floating rate loan, must be based

on the rate in effect at the end of the plan year. For example, if an ESOP

suspense account initially holds 150,000 shares of qualifying employer securi-

ties, the amount of principal and interest on the loan paid in a given year equals

$40,000, and the total of all future years' payments plus payment for the

current year equals $400,000, the number of snares released in the current year

under the proportional method will equal:

150,000 χ Γ $40,000 1 = 15,000 shares

shares χ [ $400,000 J = released this year.

55. Treas. Reg. § 54.4975-7(b)(5) (1977).

56. See Priv. Ltr. Rul. 82-31-043 (May 4, 1982); Priv. Ltr. Rul. 80-44-074 (Aug. 11, 1980).

57. Priv. Ltr. Rul. 88-28-009 (Mar. 29, 1988).

58. See Treas. Reg. § 54.4975-7(b)(5) (1977).

59. See Treas. Reg. § 54.4975-7(b)(8)(i) (1977).




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The number of shares released in year two will equal:

135,000 χ [ $40,000 1 = 15,000 shares

shares χ [ $350 000 J = released in year two.

The "Principal Only" Method

The regulations also contemplate a "special rule," which is used when the

number of shares released each year is determined solely with respect to

principal payments.60 Under this method, however, manipulation of the amorti-

zation schedule to release securities more slowly is discouraged, and, conse-

quently, the "principal only" method is available only under limited circum-

stances. The three restrictions placed upon "principal only" releases are:

(i) the loan must provide for annual payments of principal and interest

at a "cumulative rate" that is "not less rapid at any time than level annual

payments of such amounts over ten years";

(ii) interest may be "disregarded" with respect to releasing shares only if

the amount of each loan payment considered to be interest does not exceed

the amount determined under a standard amortization table (i.e., interest

cannot be front-loaded in order to lower the amount of each payment

which is deemed to be "principal"); and

(iii) this method is not available if the duration of the loan period

exceeds ten years (including renewals or extensions).61

Substantial and Recurring Contributions Requirement

In addition, in an indirect reference to the "permanency" requirements of

section 401 (a) of the Code, the regulations state that "releases from encum-

brance in annual varying numbers may reflect a failure on the part of the

employer to make substantial and recurring contributions to the ESOP which

would lead to loss of qualification under section 401 (a)."62 Therefore, a pro-

posal for an employer to contribute to an ESOP only enough each year to pay

interest in the first nine years of a ten-year loan, and contribute enough for one

balloon payment in the tenth year comprised of all principal, with release from

encumbrance dependent solely upon principal payments, would be unaccept-

able. Additionally, a contemplated arrangement that would utilize a three-year

loan, amortized using a ten-year schedule (that is, minimal principal and

maximum interest paid for two years, with a balloon at the end), although

technically falling within the requirements of the regulations, may very well run

afoul of the "substantial and recurring" contribution requirement of the regula-

tions, as well as the annual benefit limitation under section 415 of the Code,

unless the loan is combined with a loan repayable over a longer term which,

60. See Treas. Reg. § 54.4975-7(b)(8)(ii) (1977).

61. Id.

62. Treas. Reg. § 54.4975-7(b)(8)(iii) (1977).




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together with the three-year loan, results in relatively consistent contribution

requirements. Monthly releases of securities from a loan suspense account

should not violate such regulations, if the payments are relatively consistent.63

ALLOCATION TO INDIVIDUAL ACCOUNTS

Under section 54.4975-1 l(d)(2) of the Treasury regulations, the actual

allocations to participants' accounts are based upon assets withdrawn from the

suspense account.64 The size of the employer's contribution to the ESOP

determines the actual amount of securities released. At least as often as at the

end of each plan year, the ESOP must "consistently allocate" to the partici-

pants' accounts the non-monetary units which represent the participants' inter-

ests in the assets withdrawn from the suspense account.65 Income with respect to

securities acquired with the proceeds of an exempt loan must also be allocated to

individuals' accounts, unless the plan provides for the income to be used to repay

the loan.66 The proportion of assets allocated to each participant's account is

generally based upon the ratio of the participant's compensation to the total

compensation of all participating employees, except that, in years after 1988,

only the first $200,000 of any participant's salary may be included in the

qualifying annual payroll.

Code section 415 also places limitations on individual participants' accounts.

Allocations to each such account, combined with other defined contribution plan

benefits provided to the participant, generally may not exceed (i) the lesser of

twenty-five percent of the participant's compensation or $30,000 (unless the

special nondiscrimination test is met) or (ii) if greater, one quarter of the

defined benefit plan limit of $90,000, subject to cost of living increases. Addi-

tional limits apply if the employer is providing benefits to the same employees

under both defined benefit and defined contribution plans. The section 415

limits will further constrain the loan amortization schedule, since the value

(determined at the original purchase price) of shares released and allocated to a

participant's account in a given plan year cannot exceed the section 415 limit.

Accordingly, the design of an ESOP loan, among other things, must be based

upon the projected annual benefit limitation of participants over the term of the

loan.

ACCOUNTING CONSIDERATIONS

The American Institute of Certified Public Accountants ("AICPA") issued a

statement of position67 ("Statement of Position No. 76-3") in 1976 which has

provided a source of guidance for the accounting aspects of ESOPs. Although

63. See Priv. Ltr. Rul. 87-04-067 (Oct. 30, 1986).

64. See Treas. Reg. § 54.4975-7(b)(8)(iii) (1977).

65. Treas. Reg. § 54.4975-1 l(d)(2) (as amended in 1979).

66. Treas. Reg. § 54.4975-1 l(d)(3) (as amended in 1979).

67. American Institute of Certified Public Accountants, Statement of Position on Accounting

Practices for Certain Employee Stock Ownership Plans No. 76-3 (Dec. 1976).




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ESOPs 101

not binding on members of the AICPA, these recommendations present a

preferred accounting standard by which the financial statements of a company

would reflect the existence of a leveraged ESOP. Statement of Position 76-3,

however, was written at a time when ESOPs were used primarily as compensa-

tion vehicles for employees, and not financial vehicles; thus, in sophisticated

corporate transactions including ESOPs, the complexities of the situation will

necessarily involve accounting variances which better reflect the economic sub-

stance of the transaction.

The following are the three AICPA recommendations with respect to ac-

counting for ESOPs.

FINANCIAL STATEMENTS EFFECT

The debt of the ESOP should be recorded as a liability on the balance sheet of

the sponsoring employer when the debt is either guaranteed by the employer, or

backed by a commitment by the employer to make future contributions to the

ESOP to pay down the debt. Since the assets held by the ESOP are assets of the

ESOP, not the employer, these assets should not be reflected on the financial

statements of the employer. The offsetting debit to the liability recorded by the

loan should be accounted for as a reduction to shareholders' equity. Both the

liability and the equity contra account should be adjusted as the debt is repaid;

the employer's liability decreases and shareholders' equity increases.

COMPENSATION AND INTEREST EXPENSE

When amounts contributed to the ESOP are applied to reduce the loan

balance in a given year, the amount contributed by the employer must be

apportioned to determine the amount of principal and interest deemed to

comprise each payment. The amount of the contribution representing principal

will be directly applied to reduce the loan balance, and the equity contra

account should be appropriately amortized and charged to compensation ex-

pense by the employer. The amount of the contribution representing interest

should be separately identified as interest expense. The terms of the loan,

including interest rate, should be disclosed in footnotes to the employer's

financial statements.

EARNINGS PER SHARE AND DIVIDENDS

All shares held by an ESOP should be treated as outstanding shares for

purposes of determining earnings per share. Thus, for example, if new shares or

treasury shares are issued to the ESOP by the employer, a dilution of earnings

per share will occur and, if debt is incurred to purchase outstanding shares,

earnings per share will be reduced. Dividends paid on all shares held by the

ESOP should be charged against retained earnings.




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TAX BENEFITS AND INCENTIVES

As "qualified" plans under the Code, ESOPs generally enjoy all the tax

incentives available to other tax-qualified employee benefit plans, namely de-

ductions for certain contributions to the plan by the employer, employee tax

deferral on earnings in the account, and exemption of the trust from taxation on

earnings. However, ESOPs also enjoy many other tax benefits and incentives

that are not available to other types of tax-qualified employee benefit plans.

FIFTY PERCENT INTEREST EXCLUSION

General Rule

Under section 133 of the Code, banks that are incorporated and doing

business under the laws of the United States, insurance companies to which

subchapter L applies, corporations "actively engaged in the business of lending

money" other than subchapter S corporations, or regulated investment compa-

nies as defined in Code section 851, which lend money to an ESOP to acquire

qualified employer securities or to refinance an earlier such loan, may exclude

from their gross income fifty percent of the interest received with respect to such

"securities acquisition loan."68 Lenders are generally willing to pass some of the

benefits of this interest exclusion through to borrowers thereby reducing bor-

rowing costs.

68. I.R.C. § 133(a), (b)(l), (b)(5) (1986). On June 7, 1989, House Ways and Means Commit-

tee Chairman Dan Rostenkowski (D. 111.) introduced a bill to repeal the § 133 partial interest

exclusion. H.R. 2572 would repeal § 133 effective as of June 7, 1989, thus barring the application

of the partial interest exclusion to loans (including refinancings) that were not subject to a binding

contractual commitment on or prior to June 6, 1989.

On June 14, 1989, Senator Robert Dole (R. Kan.) introduced a companion bill in the Senate that

would liberalize the effective date rules by continuing to permit the § 133 exclusion for ESOP

transactions (i) that have been the subject of a public announcement made on or before June 6,

1989, setting forth the amount or value of the employer securities being acquired by the ESOP, or

(ii) in which the employer reached an agreement in principle with its lenders evidenced by written

confirmation on or before June 6, 1989, setting forth the principal amount, interest rate or spread

and maturity of the loan.

Under the July 11, 1989 Joint Committee Release, infra note 85, the effective date rules were

further modified. The § 1 33 repeal would not apply to refinancings of loans that were made prior to

June 6, 1989, or are otherwise "grandfathered" under certain limited circumstances (e.g., where the

principal amount of the loan is not increased, the original lender was a "qualified lender" under

§ 133, and the total commitment period - the original term and the term of the refinancing - does

not exceed the greater of the original term or seven years).

Finally, Congress had also discussed retaining the § 133 exclusion for loans with a principal

amount below certain dollar thresholds, and loans to an ESOP used to buy more than a specified

percentage of a company's stock.

Whether the elimination of § 1 33 would endanger the role of ESOPs in our economy is a matter

of some uncertainty. Many of the benefits and attractions of ESOPs remain notwithstanding any

elimination of tax-favored financing. ESOP lobbyists will continue to advocate the expansion of

employee ownership and participatory capitalism. Corporations will still have an incentive to follow

the example of Polaroid's successful ESOP-based defense against a hostile takeover attempt by

Shamrock Holdings. See infra note 181.




20/60

The interest exclusion provided under section 133 is also available to an

institutional lender who lends to the sponsoring employer who then re-lends the

borrowed funds to an ESOP to acquire employer securities.69 Such loan is

generally referred to as a "mirror loan." In order to qualify for the interest

exclusion, however, the loan to the ESOP must be qualified as an "exempt

loan" under sections 54.4975-7 and 54.4975-11 of the regulations and must also

meet all other requirements for such loans under section 133(b)(3).70

Notwithstanding the foregoing, a securities acquisition loan does not include

a loan between members of the same controlled group of corporations, or any

loan between an ESOP and the employer or a member of the controlled group

which includes the employer. Such a related party, although prohibited from

originating such a loan and from receiving the partial interest exclusion, may

nevertheless hold a securities acquisition loan without endangering the interest

exclusion for a subsequent holder that is a qualified lender.71 Thus, ESOP debt

securities may be held temporarily by the sponsor of the ESOP or one of its

affiliates as part of the structure of a securitized ESOP financing.

Immediate Allocation Loans

The partial interest exclusion is available for a loan to a sponsoring employer

who transfers qualifying employer securities equal to the proceeds of such loan

(an "immediate allocation loan") to its ESOP, provided that: (i) the employer

transfers these securities within thirty days of the loan, and (ii) the securities

transferred are allocable to accounts of plan participants within one year of the

date of the loan.72 Although section 133(b)(l)(B) speaks only of "transfers" of

employer securities within the prescribed period of the loan, the legislative

history suggests that the transfer must result from an employer contribution.

Thus, a loan to the sponsor of an ESOP, which is followed within thirty days by

a purchase by the ESOP of immediately allocable employer securities, which

purchase is funded through employee contributions, would not be an "immedi-

ate allocation loan" entitled to the partial interest exclusion. In addition,

although section 133 speaks of the securities being "allocable" within one year,

it seems clear from the Conference Report to the 1986 Tax Reform Act that this

should be read as "allocated" and that, accordingly, section 415 of the Code will

limit the size of any immediate allocation loan.

"Mirror" Loans

General Rule

If the initial loan is provided to the sponsoring employer, and the employer

wishes to on-lend the amount to a leveraged ESOP (commonly referred to as a

"mirror loan"), in order to retain the interest exclusion: (i) the loan to the

69. See I.R.C. § 133(b)(3) (as amended in 1988).

70. See Temp. Treas. Reg. § 1.33-1T (1986).

71. I.R.C. §133(b)(2) (1986).

72. I.R.C. § 133(b)(l)(B) (as amended in 1988).




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ESOP must include repayment terms "substantially similar" to the terms of the

loan between the corporation and the institutional lender, or (ii) the ESOP loan

may include repayment terms providing for a more rapid repayment of princi-

pal or interest, but only if allocations under the ESOP attributable to such

repayment do not discriminate in favor of highly compensated employees.73

"Substantially Similar'3 Requirement

Loans are treated as "substantially similar" under the temporary regulations

for Code section 133 only if the timing and rate at which securities would be

released from encumbrance if the initial loan had been the "exempt loan" is

substantially similar to the actual timing and rate of the loan between the

sponsor and the ESOP. The mirror loans may be considered substantially

similar even though one states a variable rate of interest and the other a fixed

rate. In such a case, the determination of whether the two loans are substan-

tially similar will be made at the time the obligations are initially issued.74

Acceleration Upon Default

The credit agreement for the loan between a commercial lender and an

employer may provide for a complete acceleration of payment upon certain

broad events of default. An issue arises regarding the extent to which the

prepayment and acceleration upon default provisions of each of the mirror loans

may differ from one another. The regulations under the Code limit the amount

which can be accelerated with respect to an ESOP to the amount of the payment

deficiency.75 The regulations also severely narrow the permissible events of

default under an ESOP loan to a failure to meet scheduled payments. The

temporary regulations governing the partial interest exclusion also contemplate

a more rapid repayment of the loan between the employer and the ESOP than

the loan between the institutional lender and the employer. Thus, it would

appear that the ESOP regulations impose restrictions on the ability of institu-

tional lenders to include fairly standard acceleration and prepayment terms in

loans to employers which then on-lend to ESOPs. A recent private letter ruling,

however, suggests that the 1RS will treat mirror loans as "substantially similar"

notwithstanding the inclusion of standard acceleration and prepayment provi-

sions in the loan to the employer.76

73. I.R.C. § 133(bX3) (as amended in 1988).

74. See Temp. Treas. Reg. § 1.133-1T, at A-l (1986). As an example, the temporary regula-

tions compare the initial interest rates on mirror loans, consisting of a variable interest rate loan

with a six-month adjustable rate, and fixed rate, ten-year maturity loans by measuring them against

the yields on six-month and ten-year Treasury obligations. Id.

75. See Treas. Reg. § 54.4975-7(b)(6) (1977).

76. See Priv. Ltr. Rul. 88-21-021 (Feb. 24, 1988).




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ESOPs 105

Refinancings

As noted above, the partial interest exclusion is also available for the refi-

nancing of a loan to a corporation or an ESOP that met the requirements of a

"securities acquisition loan."77 In the amendment to section 133 of the Code

under the Technical and Miscellaneous Revenue Act of 1988 ("TAMRA"), the

interest exclusion for refinancings was clarified by adding a separate subsection

in Code section 133 delineating the basis of the exclusion. Under section

133(b)(5), the term "securities acquisition loan" includes any loan that is (or is

part of a series of loans) used to refinance an ESOP loan, immediate acquisition

loan, or "mirror" loan, and generally meets the requirements of sections

133(b)(2) and (3), which regulate loans between related parties, and the terms

applicable to mirror loans.

Refinancings should be distinguished from the syndication of securities acqui-

sition loans, which is expressly permitted by the temporary regulations under

section 133 if the original lender was a "qualified holder."78 In contrast to a

refinancing, a syndication (including the offering and resale of ESOP debt

securities) does not alter the terms of the underlying debt, but instead changes

the identity of the creditors.

Period to Which Interest Exclusion Applies

TAMRA also amended the period to which the interest exclusion under

section 133 applies to securities acquisition loans. Prior to TAMRA, the

unamended Code limited this period by requiring that the commitment period

of immediate allocation loans and mirror loans extend not more than seven

years. There were no commitment period requirements under the prior Code

for loans made directly to ESOPs. Thus, the limitations on the commitment

period of certain loans determined the interest exclusion period. Accordingly,

there was an unlimited time period of exclusion for loans made directly to

ESOPs, but a maximum of seven years for immediate allocation and mirror

loans.

Under the current Code as amended by TAMRA, there are no loan commit-

ment period limitations; in other words, any securities acquisition loan may be

made for any term. However, under section 133(e) as amended by TAMRA,

the interest exclusion will only apply to interest accruing during the "excludable

period," as explained below. With respect to immediate allocation loans, the

period to which the exclusion applies is the seven-year period beginning on the

date of such loan. With respect to ESOP loans made directly to ESOPs, which

use the proceeds to acquire employer securities, and mirror loans in which the

repayment terms of the ESOP loan are "substantially similar" to those between

the corporation and its lender, the interest exclusion period extends for the

greater of seven years or the term of the securities acquisition loan. With respect

to mirror loans that provide for a more rapid repayment of principal or interest

77. I.R.C. §133(b)(5)(1986).

78. Temp. Treas. Reg. § 1.133-1T, at A-3 (1986).




23/60


on the ESOP loan than on the corporate loan, the interest exclusion period is

limited to seven years. With respect to any securities acquisition loan used to

refinance an original securities acquisition loan, the exclusion generally extends

for the greater of seven years or the term of the original securities acquisition

loan. However, if the original term of an immediate allocation loan or a non-

"substantially similar" mirror loan extends for a period longer than seven years

(that is, if a portion of the term of the original loan itself falls outside the

"excludable period"), any refinancing of such loan should have an interest

exclusion period limited to seven years.

The provisions regarding the period to which the interest exclusion applies

with respect to refinancings are particularly significant in the context of ESOP

financings undertaken during a contest for corporate control. In these instances,

time pressures are such that it is often necessary to put bridge financing in place

pending the negotiation of long-term credit arrangements. With respect to a

loan used to refinance the bridge loan, the rules described above make the

partial interest exclusion available for the greater of the first seven years of the

loan or, if the bridge financing was for a longer term, the term of such bridge

loan.

Effects of Interest Exclusion

An obvious effect of the partial exclusion of interest income is that it gives

lenders an incentive to encourage potential borrowers to establish ESOPs in

stock purchase scenarios. This, in turn, has the effect of encouraging lenders to

"share" their tax savings with ESOP borrowers, at rates that may be between

eighty and ninety percent of those available to borrowers who take loans on a

fully taxable basis. In addition, a growing number of ESOP sponsors are

financing their ESOPs with "securitized" loans. These loans are really floating

rate notes sold to institutional investors who qualify for the interest exclusion.

Since such "loans" are liquid and more attractive as an interest-reducing device,

securitized ESOP loans are currently priced at about seventy-five percent of

prime. Creative methods of syndicating a securities acquisition loan are clearly

permitted under the temporary regulations, which provide that such loans "may

be evidenced by any note, bond, debenture or certificate."79

EMPLOYER CONTRIBUTIONS DEDUCTION

Employer contributions to a leveraged ESOP are generally deductible in

accordance with Code section 404(a)(9). Under the Code, employer contribu-

tions applied by an ESOP toward the repayment of the principal of a loan

incurred by the ESOP to finance the purchase of qualifying employer securities

are deductible in an amount up to twenty-five percent of the compensation

otherwise paid or accrued by employees participating in the plan.80 Employer

79. Temp. Treas. Reg. § 1.133-1T, at A-l (1986).

80. I.R.C. § 404(a)(9)(A) (1986).




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ESOPs 107

contributions applied by the ESOP toward the repayment of interest on such a

loan are fully deductible.81 Section 404(a)(9) does not apply to the repayment of

an immediate allocation loan by the ESOP sponsor. In the absence of an exempt

loan, section 404(a)(3)(A) of the Code permits deductible employer contribu-

tions of up to fifteen percent of covered compensation to an ESOP that consists

solely of a stock bonus plan. Under section 404(a)(7), this limit is increased to

an aggregate twenty-five percent in the case of a stock bonus plan ESOP and a

separate pension plan or an ESOP that consists of a money purchase pension

plan and a stock bonus plan.

Regardless of deduction limits, employer contributions to an ESOP are also

limited by the annual addition limitation to individual participants' accounts.

Under Code section 415(c)(l), the limitation is the lesser of $30,000 (or, if

greater, one quarter of the defined benefit plan limit of $90,000, subject to cost

of living increases) or twenty-five percent of compensation. However, as stated

above, if no more than one third of the employer contributions for a year are

allocated to highly-compensated employees, then this annual addition limitation

is increased in accordance with section 415(c)(6).82 Additionally, if the "one-

third" requirement is met, the section 415 limitations will not apply to forfei-

tures of the stock, or to employer contributions representing interest payments

on the loan, and which are charged against the individual's account.83 If the

employer simultaneously maintains a defined benefit pension plan and an

ESOP, the limits applicable to each plan will still apply. However, the Code

will not permit the employer to maintain both plans at maximum benefit levels.

To determine whether the annual allocations are acceptable, the Code provides

a fractional test.84

DIVIDEND PAYMENT DEDUCTION

In addition to the deductions provided for employer contributions as noted

above, section 404(k) of the Code allows a deduction for: (i) dividends on ESOP

stock paid in cash by an employer directly to ESOP participants or their

beneficiaries, (ii) dividends on ESOP stock paid to the ESOP and distributed in

cash to ESOP participants or their beneficiaries within ninety days of the close

of the plan year, or (iii) dividends on ESOP stock (whether or not such stock has

been allocated to participants) used to make payments on an exempt loan as

81. I.R.C. 5 404(a)(9)(A) (1986).

82. See I.R.C. § 415(c)(6)(A) (as amended in 1988). If no more than one-third of the employer

contributions for a year under an ESOP are allocated to highly compensated employees, the $30,000

figure is increased to the sum of (i) $30,000 plus (ii) the lesser of $30,000 or the amount of employer

securities contributed to the ESOP. This potential $60,000 maximum is limited to $50,000,

however, due to Code § 415(c)(l)(B), which limits the maximum contribution for any participant

during a plan year to 25% of that participant's compensation for the year (which under TRA 1986

is limited to $200,000 per year).

83. I.R.C. § 415(c)(6)(C) (1986).

84. I.R.C. § 415(e)(i) (1986). Essentially, the sum of the fractions that the benefits and contribu-

tions actually provided under each type of plan, in relation to the unreduced limit which would

otherwise apply to that type of plan, may not exceed one (1.0).




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described in section 404(a)(9), if the plan provides that employer securities with

a value equal to such dividends are allocated in the year when such dividends

would otherwise have been allocated.86 Since dividends paid to "ordinary"

shareholders are not tax deductible by the corporation, this dividend deduction

is an added congressional incentive for the formation of ESOPs.

Any dividend deductions for loan payments under mirror loans are not

included in calculating the tax deductible contribution limit of twenty-five

percent of compensation for the repayment of principal and are not considered

to be annual additions for section 415 purposes, since the statute clearly

indicates that such deductions are "in addition to" section 404(a) deductions.86

Additionally, since section 404(a)(9) contemplates the repayment of either the

principal or interest on the securities acquisition loan, dividend payments used

solely to pay the interest portion of the loan should be deductible as well,

assuming all applicable requirements of the ESOP are met.87

ESTATE TAX DEDUCTION AND ASSUMPTION OF

LIABILITY

ESTATE TAX DEDUCTION

Under the Code, an estate may sell employer securities of a privately-held

company to an ESOP, and may deduct fifty percent of the proceeds of the sale

generated thereby, if the sale occurs before 1992.88 The securities must not have

been acquired by the decedent through a compensation-type plan.89 In 1987,

Congress added numerous restrictions to the availability of the estate tax

deduction, including a requirement that the securities must be held by the

decedent since October 22, 1986, or, if longer, the five-year period ending on the

date of death.90

ESTATE TAX ASSUMPTION

Under the Code, an ESOP is permitted to assume all or a portion of the estate

tax liability of a decedent.91 To accomplish this, employer securities of a

privately-held corporation equal in value to the liability must be transferred to

the plan, and the sponsoring employer must guarantee payment of the tax

85. I.R.C. §404(k)(2) (1986). On July 11, 1989, JGX 28-89 was released from the Joint

Committee on Ways and Means, which embodied the description of the Revenue Reconciliation

proposal (the "Revenue Proposal"), from Rep. Dan Rostenkowski (D. 111.). Included in the

proposal is a provision that would repeal the § 404(k) dividend deduction for securities held by an

ESOP. The repeal of the dividends paid deduction would apply to dividends paid or stock acquired

after July 10, 1989 (except to the extent dividends are paid on stock acquired with a loan that is

grandfathered from the repeal of § 1 33).

86. See I.R.C. § 404(k) (as amended in 1988).

87. See I.R.C. § 404(kX2)(C) (as amended in 1988).

88. I.R.C. § 2057(a)(l), (g) (as amended in 1987).

89. I.R.C. * 2057(cX2XB) (as amended in 1987).

90. I.R.C. § 2057(d)(lXC) (as amended in 1987).

91. I.R.C. § 2210(a), (b) (1986).




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ESOPs 109

liability assumed by the ESOP.92 The estate tax, which is generally paid at four

percent interest, may, in effect, be paid entirely in employer stock.93

MISCELLANEOUS TAX IMPLICATIONS

Net Operating Loss Carryforward

The Tax Reform Act of 1986 ("TRA 1986") limited the use of net operating

loss carryforwards after an "ownership change," which is defined generally as a

greater than fifty percent change in the ownership of the entity.94 However,

ESOPs present an exception to this limitation. If an ESOP owns at least fifty

percent of the company after the ownership change, if the allocation require-

ments of Code section 409(n) are met, and if immediately after the acquisition,

the number of participants in the ESOP is generally not less than fifty percent

of the number of employees of the company (for acquisitions occurring after

December 31, 1988), then the acquisition of employer securities by the ESOP

"shall not be taken into account" for purposes of the ownership change test.

Thus, net operating losses may be applied against earnings without the restric-

tions of section 382 of the Code.96

Tax Deferred Rollover for Sale of Stock to ESOP

Individual (but not corporate) shareholders in privately-held companies may

defer the recognition of a gain on the sale of employer securities to an ESOP.96

After this sale, if the ESOP owns more than thirty percent of the company, the

shareholder can in effect "rollover" the capital gains by reinvesting the proceeds

within one year in non-passive instruments of a domestic corporation - stock or

bonds.97 The tax basis of the "new" stock or debt is reduced by the unrecognized

gain when the rollover occurred, so that tax is essentially deferred until the time

of the disposition of the new non-passive corporate instrument.98

Exception from Excise Tax on Reversion of Pension Plan

Surplus

If surplus is recovered by an employer from a terminating pension plan, such

amount will normally be taxed at ordinary income tax rates, plus an additional

fifteen percent excise tax imposed on such reversion.99 However, if any portion

92. I.R.C. §2210(d)(1986).

93. See I.R.C. § 2210(c) (1986).

94. See I.R.C. § 382(g) (as amended in 1988).

95. I.R.C. § 382(1 )(3)(c) (1986).

96. See I.R.C. § 1042(a) (1986). Under the Revenue Proposal, this provision would be modified

to provide that the deferral of recognition of gain on the sale of employer securities to an ESOP is

available only if the taxpayer held the securities for three years prior to the sale of the stock to the

ESOP. See supra note 85.

97. I.R.C. δ 1042(b) (1986).

98. I.R.C. §1042(d) (1986).

99. I.R.C. § 4980(a), (b) (as amended in 1988).




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of the reversion was transferred directly to an ESOP before 1989, or after

December 31, 1988 if the plan termination occurred prior to 1989, the excise

tax would not be imposed, t

esops what they are and how they work

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