The Risks and Rewards of ESOPs

(The first of three feature articles about ESOP Plans. We are available to answer all inquirees - just click below )

by David Binns, Beyster Institute

Note: Mr. Binns, a former Executive Director of the ESOP Association, is one of the leading experts on ESOP Plans.

If you are one of the estimated 10 million Americans who participate in an employee stock ownership plan (ESOP), you are part of a growing number of workers who receive a significant part of their overall compensation in the form of stock in the company where they work. ESOPs can be found in virtually every industry, in small companies and large, both publicly-traded and privately-held. Some of the country's most successful companies have implmented ESOPs and millions of employees have realized handsome rewards from the appreciation of the stock in their ESOP accounts. However, the employee-shareholders at Enron, United Airlines, Worldcom and other companies who gained virtually nothing from their stock ownership, provide ample evidence that employee ownership includes both risks and rewards.

So are ESOPs a good thing? The evidence suggests that, despite the risks, there are a number of ways that ESOPs can be a net benefit for employees – and in successful companies ESOPs can provide financial returns that far exceed those provided through other types of employee benefit plans. Perhaps most importantly, a broad range of studies have shown that ESOPs, when combined with participatory management practices that actively engage employees in helping to improve business operations, consistently out-perform non-ESOP companies. Other research suggests that employees like being owners and that, the more shares they own, the more committed they are to their company, and are more likely to not only work harder, but also to intervene with employees who aren't pulling their weight. In other words, broad-based ownership such as provided by ESOPs can be a significant factor in improving company performance, which will help to enhance the value of the company's stock which, of course, improves the financial returns for the employee-shareholders in the ESOP.

How Do ESOPs Work?

Like deferred profit sharing plans, ESOPs are structured as a trust fund in which each employee has an individual account. In most cases, ESOPs are an employee benefit plan – employees rarely invest their own money in an ESOP. The company makes regular contributions to the plan in the form of cash and/or company stock and the contributions are allocated to individual employee accounts according to a pre-determined formula (typically an equal percentage of pay). Company contributions are tax deductible and employees pay no taxes on the assets in their account until such time as they receive a distribution from the plan. Like all tax-qualified plans, ESOPs are subject to the oversight of the Department of Labor and the IRS.

What makes ESOPs distinct from other employee benefit plans is there use as a means of promoting employee ownership and there ability to be used as a technique of corporate finance. Whereas the assets of most defined contribution plans are invested in a diversified portfolio of stocks and bonds, ESOPs are intended to be invested primarily in the stock of the sponsoring corporation. In addition, unlike other qualified benefit plans, ESOPs can borrow money from the sponsoring corporation or a third party lender to purchase the sponsoring corporation's stock. This ability to “leverage” the ESOP makes it a compelling corporate finance technique that permits employees to obtain a large equity stake through a single transaction. A great many ESOPs are established by closely-held companies that use the ESOP as the vehicle to purchase shares from retiring owners, thereby transferring ownership of the company to its employees.

ESOPs benefit from certain tax advantages that encourage companies to use them. These include corporate tax deductions for both principal and interest payments on ESOP loans, a deferral or total avoidance of capital gains taxes for stock sold to an ESOP by owners of privately-held companies, and tax deductions for dividends paid on ESOP stock.

To qualify for the tax benefits ESOPs provide, companies must abide by certain rules governing the responsibilities of ESOP fiduciaries to operate the ESOP for the exclusive benefit of ESOP participants and regulations governing who can participate in the ESOP, how the assets are allocated, and how and when employees receive their benefits. ESOP participants also have a variety of rights to help ensure that the fiduciaries live up to their obligations and that they receive basic information about the plan.

To protect ESOP participants approaching retirement age from undue investment risk, the law requires that ESOP participants be entitled to diversify their holdings in the ESOP. TheseESOP diversification rules permit employees who have attained the age of 55-59 and who have10 years of participation in the plan, an annual opportunity to diversify up to 25 percent of the shares in their ESOP account. When the employees reach age 60, they must be given a one-time option to diversify up to 50 percent of the stock in their accounts. To meet the ESOP diversification requirement, employers must provide at least three alternative investment options within the ESOP or another qualified employee benefit plan or the employer can choose to distribute the diversified amount to the employee in cash. If such a cash distribution is rolled over into an IRA, it is not considered to be an early distribution from the plan and is therefore exempt from early withdrawal penalties.

ESOPs can also be combined with 401(k) plans whereby the ESOP contribution is used as the company match to an employee's elective deferral in the 401(k). Many employers allow employees to transfer funds from excercising the ESOP diversification option referenced above to their 401(k) account. Some publicly-traded companies also allow employees to invest their 401(k) deferrals in company stock though, in the post-Enron environment, many companies attempt to limit employees' exposure to just the company's stock.

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