The Tax Reform Act Favors Esops
| Publication year | 1984 |
| Pages | 1981 |
1984, November, Pg. 1981. The Tax Reform Act Favors ESOPs
The Tax Reform Act of 1984 ("1984 Act")(fn1) includes provisions that make employee stock ownership plans ("ESOPs") a more attractive tool for buying out principal shareholders of closely held corporations. The Act also makes it easier to pay estate taxes when much of the decedent's estate consists of a corporation's stock, to provide employees with an interest in a corporation's performance or to finance corporate activity. An awareness of these alternatives, particularly for closely held corporations, gives attorneys an additional tool for corporate planning. This article reviews the types of tax-qualified retirement plans permitted to hold employer stock, the special characteristics of ESOPs, and comments upon the new provisions added by the 1984 Act.
In general, tax-qualified retirement plans permit an employer to make a tax deductible contribution on behalf of an employee. The employee pays tax on the contribution and any accumulated earnings only when he receives distributions from his plan account, usually upon termination of employment. Qualified plans may not discriminate in favor of officers, shareholders or highly compensated employees for purposes of eligibility to participate, vesting of accounts, or contributions or benefits. However, minimum service requirements for participation are permissible (one year if a vesting schedule is used; three years if accounts are 100 percent vested), as are vesting schedules (e.g., 10 percent vesting a year over ten years). Plans that primarily benefit officers, shareholders, or highly compensated employees ("top heavy plans") are subject to more rapid vesting and minimum contribution or benefit requirements.(fn2)
ESOPs are a type of defined contribution plan. In most defined contribution plans, the employee is allocated a contribution each year based on a percentage of his compensation, without reference to the employee's age or years of service. Most defined contribution plans also may be integrated with Social Security, so that more highly compensated employees receive greater plan benefits (as a percentage of compensation) than employees with lower compensation. However, the ESOPs to which the new provisions added by the 1984 Act apply may not be integrated.(fn3)
Under current law, the contribution limitation to a defined contribution plan is $30,000 or 25 percent of compensation, whichever is less. However, only 15 percent of compensation may be deducted by the employer for contributions to profit-sharing plans and stock bonus plans. Because of the deduction limitation, these plans generally do not provide for more than a 15 percent contribution.(fn4) Contributions to such plans may be a fixed or discretionary percentage of a participant's compensation.
Any qualified retirement plan, not prohibited by its language from doing so, may acquire qualifying employer securities with a value of up to 10 percent of the total plan assets.(fn5) A defined contribution plan (except a money purchase plan) may invest up to 100 percent of its assets in qualifying employer securities, if the plan provides for such investment. An "employer security" is a security issued by an employer of the employees covered by a plan or by an affiliate of the employer. The phrase "qualifying employer security" means an employer security which is stock or a marketable obligation.(fn6) Contributions to stock bonus plans are not dependent upon profits, and benefits are distributable in employer stock if the participant demands stock.(fn7) It should be noted that there is no requirement that stock bonus plans must invest in employer stock.
Since a stock bonus plan is designed to invest up to 100 percent of plan assets in employer securities, the fiduciary requirements imposed on plan trustees under ERISA for diversification of assets and prudence in management of assets (to the extent prudence would
Stock bonus plans allow employers to provide benefits for employees without a cash outlay. If contributions are made directly in stock, the fair market value of that stock is deductible. Thus, the corporation need not be deprived of working capital by large cash contributions to qualified plans. Stock bonus plans give employees an additional incentive to contribute to the corporation's success, since they profit directly from increases in the value of its stock. The plan also can create a ready market for minority interests, including those of retiring employees, who will ordinarily wish to convert their stock into cash.
In addition to these advantages of stock bonus plans, employees who take distributions in employer stock can avoid some taxation at the time of distribution. If he employer stock is part of a lump sum distribution, the entire net unrealized appreciation with respect to such securities escapes taxation at the time of distribution and is taxed when the participant sells his stock. Net unrealized appreciation is the excess of the market value of the securities at the time of distribution over the cost (basis) of the securities to the trust. Thus, the only amount taxed at the time of a lump sum distribution of employer securities is the value of the stock when originally contributed to or purchased by the trust. This amount can be subject to favorable lump sum distribution (ten-year averaging) tax treatment.
If employer securities are distributed other than in a lump sum, in the year of distribution the net unrealized appreciation attributable to employer contributions and the basis will be taxed as ordinary income.(fn9) Nevertheless, if such a distribution is made over a long term (e.g., ten or more years), a higher after-tax distribution may result, since the tax is deferred over a number of years.(fn10)
Stock bonus plans have some disadvantages. They are not the best type of employer sponsored retirement plan for providing employees with retirement security. If the plan invests mainly in employer stock, the value of employees' accounts can be lost when the company performs poorly. If this occurs, employees who have counted on their stock to provide for retirement may be bitter and alienated, and may seek recourse against plan fiduciaries.
Even if the fiduciaries have managed the plan well after it acquired employer securities, two other fiduciary issues may be raised. First, stock in a closely held business can be very difficult to value, and its value may change rapidly if key personnel leave the company. If a plan buys out a principal and the price paid is not adjusted for the possible decrease in the stock's value because of the principal's leaving or because the stock the plan holds is a minority interest, the plan fiduciaries may become embroiled in a dispute over whether the price paid was excessive.(fn11) Payment of more than adequate consideration, defined as fair market value determined in good faith, is a prohibited transaction.(fn12)
Second, conversion of a defined contribution plan with a diversified portfolio of investments into a stock bonus plan may not be a prudent fiduciary decision.(fn13) While the fiduciaries of a plan that permits up to 100 percent of the plan's assets to be invested in employer securities are exempt from ERISA's diversification requirements, the decision to convert a diversified plan to a stock bonus plan investing mainly in employer securities still must satisfy the prudence requirement.(fn14)
Another potential drawback to stock bonus plans is the possible dilution of stock ownership. However, this problem may not be significant if the shares transferred to the plan are a small portion of outstanding shares. Also, the added incentive effect of employee stock ownership could benefit both existing and new shareholders.
The phrase "employee stock ownership plan" has been used to describe several different types of...
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