Everything You Never Wanted to Know About ESOPs
ESOPs (employee stock ownership plans) have been around for over 30 years, with S corporation ESOPs since 1998. Many of us have heard of them, yawned, and changed the channel. So, in a couple of paragraphs, here is everything you need to know to sound intelligent at parties populated by tax geeks.
According to the National Center for Employee Ownership, ESOPs hold almost $1 trillion of assets and cover one out of every twelve employees in the U.S. S corporation ESOPs account for approximately 40% of all ESOPs. Last year Sam Zell bought the Tribune company using an S corporation ESOP. Many believe that the favorable treatment he obtained and provided to Tribune shareholders using the S ESOP allowed him to bid under market.
An ESOP is an ERISA-qualified defined contribution plan (similar to a 401(k) or a 403(a)). Unlike other retirement plans, ESOPs are structured specifically to hold the stock of the employer sponsoring the plan. ESOPs are used primarily to provide employees with stock-based compensation and to buy-out interests of retiring shareholders.
Typically, an ESOP is leveraged. It borrows money to purchase the stock of the employer, and as the employer makes contributions to the plan and the loan is paid off, employees vest in the employer's stock held by the plan. If the ESOP is not leveraged, the employer can contribute the stock directly. But that defers the date of the transfer of the stock into the plan, and by then the stock can increase in value and fewer shares will be held in this tax deferred structure.
Proponents of ESOPs claim two major benefits: (i) employers can deduct repayments of principal and interest, and (ii) employees get a tax deferral on the income received through the ESOP.
The fact that the employer gets to deduct the principal and interest paid on the leveraged ESOP loan (or any other contribution made to the ESOP) is true, but irrelevant. Any contribution to an ERISA-qualified plan (within the ERISA contribution limitations) will be deductible by the employer. An ESOP, within an S or a C corporation will offer nothing new or unique in this regard.
The second claim made by ESOP proponents is also true, and also irrelevant. All income earned within a qualified plan is deferred until the distribution stage.
Another claimed benefit is the diversion of taxable income to the ESOP. Whether the ESOP is sponsored by a C or an S corporation, any income it earns is not taxable. With a C corporation, the ESOPs only source of income will be corporate dividends, which will be non-taxable to the ESOP and deductible by the C corporation. With an S corporation there is no corporate level tax, and any income allocable the shares held by the ESOP will escape current income taxation. The S corporation will receive no dividend deduction. The fact that dividends paid to an ESOP or income allocable to an ESOP are not taxable is, again, a true statement, but ignores the fact that any dividends paid on account of the ESOP shares will have to be paid to the ESOP, and not to the individual owners of the company directly.
There are a couple of possible advantages to ESOPs. When an S corporation generates taxable income but little or no distributable cash flow, an ESOP will be a good way to shelter that taxable income. That of course is only good up to the point when the corporation starts generating cash flow, unless that cash flow can be paid out to shareholders in salaries or loans.
Another possible advantage of an ESOP (not found in other qualified plans) is the deferral of capital gain under Section 1042 (sale of stock to the ESOP by the shareholders), available for C corporation ESOPs.
Where ESOPs really do get interesting is when derivative instruments are used in conjunction with the ESOP. This would include the issuance of options, warrants or similar derivatives to the management or ownership of the employer to allow them to derive economic benefits from the employer's stock without the ownership of such stock. This allows the ownership of the employer not to be currently taxed on the income of the employer, and to eventually dispose of the derivative at a capital gain tax rate, as opposed to the ordinary income tax rate imposed on ERISA plan distributions.