Employee Stock Ownership Plan Design and Compliance

Lexis Practice Advisor® Employee Stock Ownership Plan Design and Compliance A Lexis Practice Advisor® Practice Note by Gregory K. Brown, Polsinelli P.C. For annotated ESOP form documents, see Employee Stock Ownership Plan (Private Company) and Employee Stock Ownership Plan (Public Company). For discussion of ESOPs in the M&A context, see Employee Stock Ownership Plans in Corporate Transactions. For material relating to plans Gregory K. Brown offering employer securities generally, see Employer Stock in Polsinelli P.C. Retirement Plans Resource Kit. For an additional discussion regarding ESOPS, see ALI-ABA Course of Study Materials This practice note addresses the issues related to employee “ESOPS: Current Twists and Turns” (Jul. 2004). stock ownership plan (ESOP) design and administration. An employer considering adoption of an ESOP, whether as a supplemental employee benefit plan or as a means of General Mechanics of an corporate financing in a tax-advantaged manner, should ESOP first conduct a feasibility analysis to determine whether an ESOP would be financially and culturally appropriate for Whatever the primary reason that an ESOP is established, all the company. After making the decision to adopt an ESOP, ESOPs generally will operate, as follows: there still is substantial work to be done, including designing the ESOP before adoption and administering the plan after • Obtaining loan from outside lender. The ESOP commonly adoption. will often, but not always, obtain a loan from an outside lender, such as a bank. The ESOP signs a promissory This practice note addresses the following topics related to note for the money. In a back-to-back loan, the employer the design and administration of an ESOP: receives the loan and lends the proceeds to the ESOP to acquire employer securities. • General Mechanics of an ESOP • Written guarantee to the bank. The employer provides a • Designing an ESOP written guarantee to the bank promising that the ESOP will • Distinctive Provisions of an ESOP repay the loan. Each year the employer will pay the ESOP enough money to permit the ESOP to make its annual loan • ESOP Operation and Administration repayment. • Distribution of ESOP Shares and Diversification • Stock acquisition. The ESOP uses the money from the • Valuation of ESOP Shares and “Adequate Consideration” loan to buy stock from the employer or a shareholder. • Pass-Through of ESOP Voting Rights Thus, the employer has received new capital. The loan is secured by the pledge of the stock acquired by the ESOP. • Fiduciary Duties in ESOPs • ESOP suspense account. The stock is held in an ESOP • Reducing Risk Associated with Holding Employer Securities suspense account. The stock is released annually for • ESOP Document Precedents allocation to participant accounts as the loan is repaid with funds contributed to the ESOP by the employer and/or by Design issues will vary from company-to-company. A factor the use of dividends on employer securities in the ESOP. considered merely routine for one company may be pivotal to the ESOP at another company. Thus, you should perform • Tax-deductible payment to the ESOP. Each year, the a design study. employer makes a tax-deductible payment to the ESOP sufficient to enable the ESOP to make its annual debt repayment. As the debt is repaid, employer securities in Aspects of the ESOP Design Study the ESOP suspense account are released and allocated to participants’ accounts. The employer can repay the Options to Address in ESOP Design acquisition indebtedness of the ESOP out of the earnings Various options that you should address in an ESOP design from its new capital. study include, but are not limited to: • Loan repayments deductible. Since the employer’s contributions to the ESOP used to repay the loan are • Eligibility deductible within the I.R.C. § 404(a)(9) limits, a leveraged • Payroll systems ESOP allows the company to repay the entire loan on a tax- • Compensation favored basis. See Internal Revenue Manual Section 4.72.4. • Vesting schedules Designing an ESOP • Timing and form of benefit distributions Designing an ESOP takes great care and thought with respect • Forfeitures to the delivery of appropriate benefit levels to participants • Contribution levels over time and doing so in a vehicle which can be administered • Allocation formula effectively and efficiently. Thus, the two functions are closely related. Designing an ESOP that presents too many • Post-service credit administrative challenges may present significant problems • Early retirement policies –and– in delivering benefits to participants. Similarly, designing an • Charter or bylaw provisions that may restrict stock ESOP that provides for substantial administration must still ownership to employees allow for efficient and effective benefit delivery to ESOP participants. Questions to Answer When Designing an ESOP The ESOP’s design flexibility allows it to accomplish a variety Consider the following additional key questions: of corporate and/or shareholder objectives. These objectives • Who will participate in the ESOP? may vary to include: • How much should the ESOP borrow? • Providing employees with a supplemental employee benefit • Will I need an independent appraiser to determine the plan and employer ownership value of the employer securities? • Providing a means of corporate financing • Must the ESOP distribute stock to employees at • Establishing an anti-takeover devise –or– retirement or other required distribution dates? • For a private company, like an S corporation, providing a • Which divisions or subsidiaries should be included or tax-efficient vehicle for the purchase of the shares of a excluded? departing owner • Who will vote the ESOP stock and under what Finding the design that best achieves these objectives is circumstances? central to the decision to adopt the ESOP. This flexibility is • Should the ESOP be combined with a 401(k) plan? the rationale for the ESOP. Utilizing this advantage enhances its value. • Who will act as trustee(s)? • For a public company, will I need a Form S-8 to register An ESOP which merely meets the IRS requirements for tax additional shares for the plan or will the offering qualify for qualification may fail to meet corporate objectives. In addition an exemption? to designing the ESOP to meet legal requirements and satisfy corporate objectives, you should adapt plan design to simplify ESOP administration. ESOP Design Requirements Allocation of Contributions Based on Compensation At a minimum, the ESOP must be designed to satisfy the Allocation of contributions to an ESOP based on relative following specific requirements: compensation is typical, although what is included in the definition of compensation is quite variable. Compensation- • The plan must be formally designated as an employee stock based allocations are used for ESOPs because the “safe ownership plan harbors” for qualified plan discrimination testing are not • The plan must be designed to invest primarily in employer available for ESOPs. Treas. Reg. § 1.401(a)(4)-1(b)(ii)(A). Thus, securities (see “Invested Primarily in Employer Securities” allocations that use a factor other than compensation, such as in Distinctive Provisions of an ESOP below) length of service, are rarely used for ESOPs. Very few ESOPs allocate contributions on a per capita basis. • The plan must meet the requirements of I.R.C. § 409(e) if it has a registration-type security (see “Voting Rights” in The challenge here is defining “compensation.” Some ESOP Distinctive Provisions of an ESOP below) sponsors limit or exclude non-basic compensation (such • The plan must meet the requirements of I.R.C. § 409(h), as bonuses, commissions or overtime) from compensation regarding the right to demand that benefits be distributed for allocation purposes. However, most ESOPs use W-2 in the form of employer securities, or purchased by the compensation (including 401(k) deferrals) in the allocation employer, where the securities are not readily tradeable base. The plan sponsor should be careful to test for (see Distribution of ESOP Shares and Diversification) discrimination for any exclusions from compensation which –and– may have a bigger impact on non-highly compensated employees than highly-compensated employees (such as • The plan must meet the requirements of I.R.C. § 409(o), overtime, production bonuses, etc.). addressing when distributions must commence (see “ESOP Distributions” in Distinctive Provisions of an ESOP, below) For more information on plan definitions of compensation, I.R.C. § 4975(e)(7); Treas. Reg. § 54.4975-11. see Compensation Definition Rules for Qualified Retirement Plans. Design Choices Vesting Schedules Eligibility The optimal choice for vesting schedules is different for most ESOPs. Most defined contribution plans (such as 401(k) plans Eligibility service may be as short as one hour of service but that are not safe harbor plans) use a six-year “graded” vesting cannot exceed two years. A plan may also require that an schedule requiring 20%-per–year vesting beginning with employee must be at least age 21 years to participate. I.R.C. the participant’s completion of three years of service. Some § 410(a). use a three-year “cliff” vesting schedule vesting 100% after If eligibility service exceeds one year, vesting must be full and completing at least three years of service. Most ESOPs use immediate upon entry into the plan. I.R.C. § 410(a)(1)(B). One the graded schedule. I.R.C. § 411(a)(2). year of service and age 21 are very typical with entry into the Some ESOPs, however, use the three-year cliff schedule ESOP retroactively for an entire plan year or prospectively because participants do not vest at all until they have from the date the service and age requirements are met. three years of vesting service, at which time they become Some plans have very liberal eligibility requirements in the fully vested. That schedule typically favors longer-service first year of the plan (i.e., one hour of service in that year to employees at an ESOP employer.

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