Chapter 1
Employee Stock Ownership Plan History and Background
Overview of Employee Ownership and Employee Stock Ownership Plans
There is general agreement that the one person instrumental in developing the concept of the employee stock ownership plan (ESOP) is Mr. Louis O. Kelso. Mr. Kelso was an attorney and economist who studied what he perceived to be a fundamental problem with capitalism. The problem, as he defined it, is capitalism's propensity to concentrate both capital and the benefits of capital ownership into the hands of a small minority.
According to a 1986 report by the Government Accountability Office, except for the corporate stock held in pension plans, 90 percent of equities are owned by just 10 percent of households. What is more alarming for our consumer-based economy is the fact that almost 60 percent of all stock is owned by just 1 percent of households. The majority of households do not own any equities.
Underlying Philosophy of ESOPs
Mr. Kelso notes that although the United States is a capitalistic country, we are, first, a consumer-based economy. The concentration of wealth into the hands of a few does very little to support a consumer-driven economy. The great challenge, from his perspective, is to fashion a practical approach to broaden the ownership of capital in this country without taking property from others.
One great barrier to broad equity ownership in our economy is that it most frequently takes existing capital resources to earn more capital. Virtually all financial institutions require collateral before you can borrow money, or capital. Most people are effectively shut out from amassing capital because they currently have no capital, and they cannot obtain the credit to acquire capital assets.
Our Puritan heritage suggests that the individual must work hard to save and that those savings are the wellspring of capital formation. The problem, according to Mr. Kelso, is that most people working for a salary are just barely able to purchase life's necessities. They are often unable to save and thereby build capital resources.
The way to broaden equity participation is to enhance the individual's access to credit markets for the purpose of acquiring private capital resources. Mr. Kelso was sensitive to allowing market forces to work in favor of the individual. He did not propose to socialize private capital; rather, he championed democratizing access to the credit needed to acquire private capital.
The solution to the barriers in our economy preventing broader equity participation is the ESOP. The ESOP was envisioned as a vehicle whereby employees in a company could acquire the company's stock using credit and could repay the debt from the earnings of the company. Widespread application of the ESOP principal would promote broader ownership of capital. This would be accomplished through the use of free enterprise incentives.
The full reasoning of Mr. Kelso is far more intricate and complex than this brief overview. His philosophy is more clearly outlined in several books he has written or coauthored with Mr. Mortimer J. Adler, including
The Capitalist Manifesto (1958)—Kelso and Adler
The New Capitalists: A Proposal to Free Economic Growth from the Slavery of Savings (1961)—Kelso and Adler
Democracy and Economic Power: Extending the ESOP Revolution through Binary Economics (1990)—Kelso and Kelso
Legislative History
Mr. Kelso was particularly influential in gaining Congressional interest in his ideas for employee ownership. A critical early Congressional supporter was Senator Russell Long from Louisiana. Senator Long was the chairman of the United States Senate Committee on Finance in the early 1970s, and he witnessed firsthand some very difficult problems in capitalistic countries.
Some of those problems included the Penn Central Transportation Company bankruptcy, banks rationing credit, high interest rates, and scarce venture capital. Senator Long was one of the first political leaders to grasp the significant benefits of employee ownership, and he personally campaigned for its formal existence.
ESOPs were first specifically mentioned in the Regional Rail Reorganization Act of 1973. This bill required the feasibility study for using an ESOP in the reorganization of the Northeast rail system. The rail system was being reorganized into the government-owned Conrail, and Conrail eventually included an ESOP.
The following legislation indicates major ESOP enactments that are generally still in effect. We have omitted a number of relatively minor acts and legislation that is no longer applicable.
Employee Retirement Income Security Act of 1974
The ESOP came into the forefront with the passage of the Employee Retirement Income Security Act of 1974 (ERISA). This law is the first specific statutory provision for the framework of ESOPs.
ERISA included ESOPs in the definition of a qualified employee benefit plan under the Internal Revenue Code (IRC). ERISA generally standardized the rules governing pension and retirement plans, but it permitted certain exceptions to ESOPs in recognition of their special mission.
ERISA permitted the ESOP to borrow money in the interest of acquiring employer securities, and ESOPs had to be primarily invested in employer securities. These provisions are significant because most other qualified retirement plans contain specific restrictions against the inclusion of more than 10 percent in employer securities.
Revenue Act of 1978
This act required stock that was not publicly traded and in a leveraged ESOP to offer participating employees a put option back to the employer.
Full pass-through voting rights on allocated shares in publicly traded securities was required. Closely held companies were required to extend voting rights to plan participants on major issues.
The Chrysler Loan Guarantee Act of 1979
This act required Chrysler to establish an ESOP and ensure the employees a significant stake in the company by 1984. With this legislation and the Regional Rail Reorganization Act of 1973, the federal government officially encouraged employee ownership.
The Economic Recovery Tax Act of 1981
This legislation contained two significant ESOP provisions. First, the act increased the covered payroll contribution limit from 15 percent to 25 percent in leveraged ESOPs for principal payments, and it allowed unlimited interest.
Second, it permitted companies substantially owned by the employees to require that departing employees accept cash for the fair market value of their stock, rather than the stock.
Deficit Reduction Act of 1984
Tremendous financial incentives were extended to ESOPs in the Deficit Reduction Act of 1984. The legislation is noteworthy because it occurred at a time when the federal government was concerned about reducing the spending deficits, and yet, ESOPs were further encouraged by extending tax-oriented incentives to them.
Those incentives included a deferral of taxes on the gains of a selling owner to an ESOP if the ESOP owns at least 30 percent of the company, and the proceeds are reinvested in domestically qualifying securities within 12 months (this is generally referred to as the IRC Section 1042 rollover). There is also a tax deduction for cash dividends paid to ESOP participants.
Tax Reform Act of 1986
This legislation revised many rules for qualified employee pension and retirement plans in such areas as contribution limits, employee benefit distributions, vesting, and coverage requirements.
Several additional revisions were made to ESOPs. The significant provisions provide for the following: expansion of the deduction for dividends for the repayment of an ESOP loan, modification of the put option so that employees would be paid entirely in cash over a period not to exceed five years, imposition of new rules on the payments to ESOP participants following a break in service, and clarification of pass-through voting rights in closely held companies.
Significantly, this legislation requires the use of an independent appraiser for the valuation of closely held securities.
Small Business Job Protection Act of 1996
This act allows ESOPs, as well as other tax-exempt trusts, to hold the stock of an S corporation, which means that for the first time, an S corporation may sponsor an ESOP beginning after January 1, 1998. Certain provisions of the act required clarification before ESOPs would likely appear in any quantities. Many of the technical issues were addressed the following year.
The ESOP lender's interest rate exclusion applying to loans made after August 20, 1996, was repealed.
Taxpayer Relief Act of 1997
The legislation contains expanded provisions that permit an S corporation to establish and operate an ESOP.
An S corporation may distribute a participant's account in cash, not stock. The S Corporation sponsoring an ESOP has exemptions from ERISA-prohibited transaction rules, similar to those for a C corporation sponsoring an ESOP.
Taxable income of an S corporation sponsoring an ESOP is prorated to the ESOP's share of ownership. The ESOP's proportionate share of income is not subject to federal income tax, and the income may be retained in the company. Eventually, the retained income will be paid to plan participants in the future.
In an S corporation arrangement, some of the special tax incentives for ESOPs are not available, such as the tax-deferred rollover for certain sales of stock to an ESOP (the IRC Section 1042 rollover), the deductibility of dividends paid on ESOP stock in certain circumstances, and the deductibility level of 25 percent of payroll plus interest on the ESOP loan for annual contributions to the ESOP.
The Economic Growth and Tax Relief Reconciliation Act of 2001
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) generally increases a broad array of benefit and contribution limits applicable to qualified plans. The increases include the cap on both the contribution limit to a qualified plan in the percentage of compensation and the actual dollar amount. Increases generally take effect beginning in 2002. Significantly, many of the increases are indexed to inflation thereafter.
The limit on deductible contributions to a qualified plan is increased to 25 percent of qualifying payroll. This is a significant increase from prior years.
Reasonable dividend deductions in a C corporation are permitted when the dividends are reinvested in the plan.
Complicated compliance measures have been enacted for S corporation ESOPs. The general intent of the complex testing is to help ensure that the financial benefits of the ESOP legislation are shared by a larger percentage of the plan sponsor employees and to not have the benefits skewed to only a few key individuals. This provision of the EGTRRA is intended to eliminate perceived abusive ESOPs when the plan was installed in an S corporation with only a few employees.
Jobs and Growth Tax Relief Reconciliation Act of 2003
Key provisions include lowering the capital gain tax rate to essentially 15 percent, and personal income tax rates were adjusted to lower amounts.
Impact on ESOPs
Since 1973, the first time ESOPs were mentioned in federal legislation, there has generally been a significant increase in the financial incentives officially extended to encourage employee ownership of their companies. Those incentives have become substantial, ranging from the deferral of taxes on a properly structured ESOP transaction in a C corporation (the IRC Section 1042 rollover) to the full deductibility of the purchase price of stock purchased by the ESOP. Most of the incentives relating to ESOPs are virtually exclusive to only this type of qualified plan.
Only a few incentives have ever been withdrawn; the most notable is the interest rate exclusion previously extended to financial institutions to encourage them to make ESOP loans. This legislation withdrawing the interest income incentive was passed in 1996. It is estimated that today over 10,000 ESOPs exist, and the greatest percentage of them are installed in closely held companies.
ESOPs have been officially created to both provide a means for employees to gain an equity investment in their employer and serve as a vehicle for retirement. ESOPs are included in ERISA as a qualified plan subject to the protections and incentives extended to all qualified retirement plans, including pensions, profit sharing plans, and 401(k) savings plans.
ESOPs Today
Increasingly, ESOPs are installed in S corporations, and many if not most of the new ESOPs have a goal of becoming a 100 percent employee-owned company. This trend is a direct result of S Corporation tax attributes generally combined with the tax incentives of ESOPs. Chapter 5, "Employee Stock Ownership Plan Transaction and S Corporation," discusses S corporation ESOPs in greater detail and illustrates the power of combining S corporation attributes with ESOP incentives.
The major tax cuts of the Bush administration, including the EGTRRA and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (which lowered the capital gain tax rates and many personal income tax rates) are set to expire on January 1, 2013. Tax rates will reset to the rates in effect just before the legislation was passed. In essence, sharp tax increases appear as a near certainty in the near future. Due to the tax incentive nature of ESOPs, the higher tax rates will likely fuel an increased interest in employee ownership. Indeed, if capital gain rates increase due to a combination of the preceding Bush tax cuts' sunset provision and the impact of a capital gain surtax as part of the Patient Protection and Affordable Care Act of 2010 (nationalized healthcare), there will certainly be more interest in the C corporation-specific application of the IRC Section 1042 tax deferral provisions discussed at length in chapter 3, "Employee Stock Ownership Plan Transaction Mechanics."
Since 2007 and the beginning of what is now being referred to as the Great Recession, the nation has been incurring significant and unsustainable spending deficits. The national debt has increased by over $5 trillion is just a few years. These unsustainable deficits will have to be addressed by the federal government. Assuming there is a mixture of tax increases and spending cuts in the future, such developments bode well for ESOPs.
Certainly, a legitimate question could be asked: With all the deficit spending, are the ESOP tax incentives at risk? The correct answer is that no one knows for sure what Congress will do, given the fiscal pressure coming to bear on the budget. Because of a lengthy history of ESOPs accomplishing precisely what Congress intended, it seems unlikely that the program to encourage employee ownership will be assailed. ESOPs provide a wide range of economic and societal benefits, such as a fairer allocation of corporate profitability, converting more people into active participants in our market-based capitalistic economy, and employee owned companies financially outperforming their nonemployee owned counterparts (increasing job growth and compensation packages).
Summary
Today, it is possible to have an ESOP in both a C corporation and an S corporation. A number of significant differences between the tax incentives for C corporations and S corporations will be considered. Encouraging employee ownership and participation in a market-based capitalistic society are truly goals of our government.