9bth Congress COMMITTEE PRINT
An Explanation for Employees
Prepared by the Staff of the
COMMITTEE ON FINANCE
UNITED STATES SENATE
RuSSELL B. LONG, Chairman
41-i MARCH 1978
Printed for the use of the Committee on Finance
U.S. GOVERNMENT PRINTING OFFICE
20-257 WASHINGTON : 19-18
For sale by the Superintendent of Documents, U.S. Government Printing Office Washington, D.C. 20402
COMMITTEE ON FINANCE
RUSSELL B. LONG, Louisiana, Chairman HERMAN E. TALMADGE, Georgia CARL T. CURTIS, Nebraska
ABRAHAM RIBICOFF, Connecticut CLIFFORD P. HANSEN, Wyoming
HARRY F. BYRD, JR., Virginia ROBERT DOLE, Kansas
GAYLORD NELSON, Wisconsin BOB PACKWOOD, Oregon
MIKE GRAVEL, Alaska WILLIAM V. ROTH, JR., Delaware
LLOYD BENTSEN, Texas PAUL LAXALT, Nevada
WILLIAM D. HATHAWAY, Maine JOHN C. DANFORTH, Missouri
FLOYD K. HASKELL, Colorado SPARK M. MATSUNAGA, Hawaii DANIEL PATRICK MOYNIHAN, New York
MICHAEL STERN, Staff Director GEORGE W. PRITTS, Jr., Minority Couneol. JOHN E. CURTIS, Jr., Proftssional Staff.Aember (Ii.)
C 0 N T E N T S
Introduction ---------------------------------------------- 1
What is an ESOP? ----------------------------------------- 1
How does an ESOP work? ----------------------------------- 1
What do employees get as part of the ESOP? ----------------- 2
What do I own in the ESOP? ------------------------------ 2
ANlien do I receive what I own from the ESOP? ----------------- j
NAlhat can I do with my shares of employer stock from the ESOP?-- j How does the ESOP help my employer? ---------------------- 4
Summary ------------------------------------------------- 9
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ESOPs-An Explanation for Employees
An Employee Stock Ownership Plan~, or "ESOP" as it is usually cai'ed, is designed to give employees th-,e chance to acquire a stock ownership in their company. More impol tantly, the ESOP usually does this without requiring the employee to spend any of his own money; his investment is the time and effort he puts into his job to make his employer profitable. Although some ESOPs permit or require employees to put money into the ESOP, most provide -that the employer w, ill make all necessary ESO P paymTents.
What Is An ESOP?
An ESOP is an employee benefit plan which is "qualified" under the Internal Revenue Code. That is, it has been wrTitten in such a wax' that it satisfies the requirements of the Inte, nal Revenue Code. As a qualified plan, the ESOP is required to be operated for the '*exclusive benefit" of participating employees (and their beneficiaries)
How Does an ESOP Work?
The ESOP is designed to acquire stock of an employer for the benefit of employees. To do so, the ESOP max' borrow money from a bank or other lender (including the employer. The stock is bought directly from the emplover or from shareholders. When the ESOP borrows money, the employer guarantees to the lender that the ESOP will repay the loan. Employees are never required to assume any obligation for the repayment of the money borrowed by the ESOP. The employer is required to make annual p payments to the ESOP in an amount at least equal to the amount the ESOP must pay on the money it borrowed. These amounts are then paid by the ESOP to the lender each year.
The employer is also permitted to make additional payments of cash or stock to the ESOP each year. The amount of these additional paym ents is usually decided by the board of directors of the employer. Because the ESOP is "qualified," the employer gets a tax deduction for all payments to the ESOP, up to a maximum limitation established by the Internal Rev.enue Code. This tax deduction is available for the required employer payments and any additional payments, and its effect is to reduce the annual cost of the ESOP to the employer. Cash put into the ESOP by the employer will be used primarily to purchase employer stock. In addition, this cash may be invested temporarily in sa,%ings accounts or certain other permitted investments.
What Do Employees Get as Part of the ESOP?
Each year, all amounts of cash and employer stock paid by the employer to the ESOP, and employer stock I-,ought with cash held in the ESOP, are allocated among the accounts of employees who are participating in the ESOP. This allocation is usually done on a formula related to each employee's salary or wages as compared to the salaries or acres of all other participating employees. Take as an example an employee who earns $10,000 per year from a company where the total salaries of all participating employees equal $500,000. That employee's salary or wares is 2 percent of the total, and so his share of allocations of cash and employer stock under the ESOP for that year would be 2 percent. If the employer contributed $100,000 to the ESOP during the year, the employee's share would be $2,000.
A trust will be established (under the ESOP) to hold the cash and employer stock paid to the ESOP for the benefit of employees (and their beneficiaries). It is created by a separate written trust agreement and will be administered by a trustee. This is done to assure that each employee's interest in ESOP assets willbe protected.
What Do I Own in the ESOP?
An ESOP, like most employee benefit plans, is designed to benefit employees who remain with the employer the longest and contribute most to the employer's success. Therefore, an employee's ownership interest in cash and employer stock held in the ESOP is usually based on his number of years of employment with the employer. The employee-s ownership interest in the ESOP is called his "vested interest," and the language in the ESOP which determines his vested interest is called a "vesting schedule." Although there are many vesting schedules which may be used by an ESOP, most vesting schedules are set up so that the longer an employee stays with the employer the greater his vested interest becomes.
If an employee terminates employment with the employer for any reason other than his retirement, or, income cases his death, his vested interest will be determined by looking at the vesting schedule and measuring how many years he has worked for the employer. All cash and employer stock in which he does not have a vested interest because he has not worked for the employer for enough years will be treated as a "forfeiture," to which the former
employee will not be entitled. Forfeitures are usually allocated among the ESOP accounts of the remaining employees on the same basis as employer payments to the ESOP are allocated.
The vesting schedule applies only where an employee does not end his employment because of retirement or, in some cases death. If an employee retires, or, in some cases if he dies, he will immediately have a 100-percent vested interest in all ESOP assets held for him.
When Do I Receive What I Own From the ESOP?
Even though employer stock and cash are usually put into the ESOP for an employee each year, and put into a special account under his name, he will normally not be able to actually get any employer stock and cash from the ESOP until after his employment with the employer terminates and he ceases to be a participant in the ESOP.
After an employee's participation in the ESOP ends, he (or his beneficiary) will be eligible to receive a payment of his vested interest. There are many permissible times and methods for making the payment to him from the ESOP. For example, an ESOP may provide that payment will be made as soon as possible after an employee's termination of employment. On the other hand, the ESOP may require that any payment be deferred until some later time, such as the normal retirement date set forth in the ESOP or the employee's death. However, payment of a former employee's vested benefit under the ESOP must start soon after his death or attainment of age 65. Payment may be made to a former employee (or his beneficiary,; in a lump sum, or it may be made in installments.
Payment of an employee's vested interest from an ESOP must normally be made in as many whole shares of employer stock as possible, with the value of any fractional share being paid in cash. Occasionally, depending upon how the ESOP is set up, the ESOP may pa, a portion of an employee's vested interest in cash. However, this is not the usual case.
What Can I Do With My Shares of Employer Stock From the ESOP?
Once a former employee (or his beneficiary) gets his shares of employer stock from the ESOP, they are his property and he can do what lie wants with them. He can vote the shares of employer stock at shareholders' meetings, receive any dividends paid on the stock by the employer, and he maw keep the stock as long as he wishes.
However, if he wishes to sell or otherwise 'transfer ownership of the stock to a third party, he inay be required by the terms of the ESOP to first offer to sell the stock to the employer and the ESOP. This requirement is called a "right of first refusal" for the employer and the ESOP; they can exercise this right and purchase the ernployer stock at its fair market value. Generally, the price offered by the prospective buyer would establish the fair market value for the stock. However. if' an independent par ty hired by the employer decides that the fair market value is higher than the offermor price, then that would be the fair market value of the stock when it is sold to the employer or the ESOP. The purpose of this right of first refusal is to protect the employees of a closely held employer by preventing the stock from being acquired by outside parties who hax-e no interest in the employer or the ESOP and to protect the employer from violating any Federal law as a result of having its stock sold when it does not no satisfy certain Government rules.
In addition, at the time the former employee (or his beneficiary) receives his employer stock from the ESOP, he may be given a "put option," the right to demand that the employer buy his shares of employer stock at their fair market value. In such a case, the ESOP may provide that the ESOP may buy the employer stock, although the ESOP may not be required to buy the stock under the put option. The purpose for including a put option in the ESOP is to assure that each former employee (or his beneficiary) will have someone available to buy his shares. of employer stock if he wishes to sell.
How Does the ESOP Help My Employer?
The employer benefits primarily from the favorable tax treatment it receives for all payments made to the ESOP. This is very important when the employer uses the ESOP as a means of borrowing money. In order to understand how the use of the ESOP to raise money benefits the employer, a comparison must be made with the usual method of borrowing money.
If an employer w hich does not have an ESOP wishes to borrow money to build a new building expand production, or for any other reason the employer would go to a bank to borrow money. When the employer repays the loan, it will also pay interest on the loan, just like an individual person would do with a charge account. Although the interest payments would be tax deductible, the principal payments on the loan would not. This means that the employer would first figure its taxable income, then pay its income taxes, and then make its payment on the loan.
The use of an ESOP for this purpose orreatly helps the employer because of the effect it has on the employer's taxes.
In this situation, the ESOP borrows the money from a bank, and signs a promissory note for the money: BANK
E S 0 P
As part of the ESOP loan, the employer gives a written guarantee to the bank, promising that the ESOP will repay the loan and that each year the employer will pay to the ESOP enough money to permit the ESOP to make its annual repayment of the loan:
promissory EMPLOYER note
The ESOP then uses the money from the loan to buy stock from the employer: BANK
promissory note EMPLOYER
Each year, the employer makes a tax-deductible payment to the ESOP, sufficient to let the ESOP make its annual debt repayment to the bank:
Xu pyment EMPLO YER nc annualnual payment
The effect of this transaction is to allow the employer to borrow money from a lender and repay the loan with tax-deductible dollars. Since the principal and interest repayments are deducted before the employer's taxable income is determined the taxable income is lower than through regular borrowing and the employer's taxes are reduced.
Since the major portion of the ESOP assets are used to buy employer stock, the value of each employee's ESSOP benefit is directly tied to the financial success of the employer. Also, the employer, as a result of the use of an ESOP, benefits because employees understand that their work performance directly affects the financial success of the employer and the value of ESOP assets. After all, they now own part of the company.
Another benefit to the employer is that the ESOP provides its shareholders with a buyer for their stock if they wish to sell. For stockholders of a small employer, this is a tremendous advantage, and it could also assist the employer in attracting additional investors.
The adoption of an ESOP provides benefits for the employer, its shareholders and its employees. Our tax laws encourage the establishment and use of ESOPs. Congress has passed five laws in the past 5 vears to encouracre employers to consider ESOP. Will it continue? Senator Russell B. Long, chairman of the Senate Finance Committee, has repeatedly stated: "Just as in 1862, when Congress passed a law to allow Americans who had very little money to own and develop up to 160 acres of land, we should now give Americans the opportunity to become owners of our growing frontier of new capital (stock). The way to do this is through laws which encourage the development of programs like ESOP.*'
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