Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
What Is An Employee Stock Ownership Plan
(ESOP)?
• An ESOP is a type of qualified retirement plan that must
invest its assets primarily in the employer’s securities
• With an ESOP the employer may lend funds or use of its
credit facilities to the ESOP to facilitate the purchase of
employer securities
• A trust must be established and a formal designation
must be made to set up an ESOP
– The trust may qualify as a tax-exempt employee trust
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
What Is An Employee Stock Ownership Plan
(ESOP)? (cont’d)
• An ESOP may be a shareholder of an S corporation
• AN ESOP can offer favorable tax treatment and an exit
strategy for business owners
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
When Is Use Of An ESOP Appropriate?
• When a shareholder who is a substantial owner of a
closely-held business would like to shift his
investment, on a tax-deferred basis, into publicly
traded securities
– Tax free rollover of proceeds received from the sale of a
business to an ESOP may be available if the proceeds are
invested in another business
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
When Is Use Of An ESOP Appropriate?
• When an employer would like to obtain an income tax
deduction with little or no cash outlay
– A current deduction is allowed within limits for both employer
contributions of cash and contributions of stock or other
property
– Contribution of an employer’s stock generates a deduction
equal to its FMV and may be carried back, potentially
generating a tax refund for the corporation
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
When Is Use Of An ESOP Appropriate?
• When an employer wants to create a market for its
stock
– Note: Participating employees must be entitled to exercise
voting rights (on major corporate issues) of stock allocated to
their accounts, where employer stock is not readily tradable
and constitutes more than 10% of a defined contribution plan
• When a corporation faces an accumulated earnings
threat
– An ESOP can be used to take cash out of a corporation
• When an employer wants to motivate and compensate
long service employees
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
When Is Use Of An ESOP Appropriate?
• When shareholders with large amounts of corporate
stock in their estate want liquidity
– Stock may be sold to the ESOP in exchange for cash, thus
providing liquidity to pay taxes and other debts
• When a corporation desires to make payments of
premiums for life insurance on key employees from
deductible contributions
– The insurance policy is an investment of the ESOP and may
be a source of liquidity to buy the shareholder’s stock at death
Copyright 2011, The National Underwriter Company
6
Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
When Is Use Of An ESOP Appropriate?
• When an employer is seeking a means for financing
corporate growth through the use of untaxed dollars
– By selling rather than contributing stock to the ESOP, an
employer can obtain a large amount of cash
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
What Are The Requirements?
• ESOPs meeting certain requirements may distribute
benefits in the form of employer stock or cash
– Participants must be given the right to receive employer
stock if they so desire, unless the employer’s charter or bylaws restrict the ownership of outstanding shares to
employees and/or the ESOP
– If employer stock is distributed, participants must be given a
“put” option for a limited time, which allows them to purchase
the stock from the employer at FMV
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
What Are The Requirements?
• Plan must meet the same requirements as apply to
other qualified plans, with respect to
–
–
–
–
–
–
Coverage
Nondiscrimination in contributions
Nonforfeitability or termination
Rules regarding forfeitures
Rules relative to the source of contributions
Integration with Social Security (none for ESOPs unless
grandfathered)
– ESOP must be in writing
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
What Are The Requirements?
• The trust must be for the exclusive benefit of the
employees and their beneficiaries
• The trust must be a United States trust and not a
foreign trust
• The cost of employer stock purchased by the trustee
must not exceed its FMV (may require an independent
appraisal)
• Participants must be entitled to vote employer stock
that has been allocated to their accounts if the stock is
registered under the Securities Exchange Act of 1934
or falls into the more than 10% of plan assets rule
Copyright 2011, The National Underwriter Company
10
Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
What Are The Requirements?
• Participants who have completed 10 years of
participation in an ESOP must be given the opportunity
to diversify 25% of their account balances beginning at
age 55 and an additional 25% at age 60
• Generally, the plan must provide that if the participant
elects, the distribution of a participant’s account balance
will commence within one year after the plan year
– in which participant separates from service by reason of normal
retirement age, disability, or death, or
– which is the fifth plan year following the plan year in which he
otherwise separates from service
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
What Are The Requirements?
• Plan must insure that in the case of “qualified sales”
of employer securities by participant to the ESOP, no
portion of the assets of the plan attributable to the
securities purchased by the plan may accrue or be
allocated during the nonallocation period for the
benefit of
(1) the taxpayer who made the election under former IRC
Section 2057, or
(2) any individual who is a member of the family (brother,
sister, ancestor, lineal descendant) of the taxpayer or
decedent, or
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
What Are The Requirements? (cont’d)
• Plan must insure that in the case of “qualified sales”
of employer securities by participant to the ESOP, no
portion of the assets of the plan attributable to the
securities purchased by the plan may accrue or be
allocated during the nonallocation period for the
benefit of ...
(3) any person who owns, or is considered as owning under the
attribution rules of Section 318(a), more than 25% of any class
of outstanding stock of the employer or any corporation which is
a member of the same control group of corporations as is the
employer.
Copyright 2011, The National Underwriter Company
13
Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
What Are The Requirements?
• An ESOP can own stock in an S corporation, so long
as the plan provides that no portion of the assets of
the plan attributable to the employer securities accrue
to the benefit of a “disqualified person” in a
“nonallocation year”
• A “disqualified person” includes
– an officer or director,
– a person who owns more than 10% or more of stock in the
employer’s S corporation, and
– a highly compensated employee earning 10% or more of the
yearly wages of an employer
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
How Is It Done?
Example 1:
– Corporate client earns $200,000 per year
– Corporation has no pension or profit-sharing plan
– Employees would like to see some type of deferred comp.
plan instituted
– Due to expansion, periodically the corporation is cash poor
– Establishing an ESOP gives the greatest increase in
working capital
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
How Is It Done?
Example 1 Comparison:
No Plan
Earnings Before Tax
Contributions (15% x $600,000 of compensation eligible for coverage)
Taxable Income
Tax (assume combined 40%)
Net Earnings After Taxes
Profit
Sharing
ESOP
$200,000
$200,000
$200,000
0
90,000
90,000
$200,000
$110,000
$110,000
80,000
44,000
44,000
$120,000
$66,000
$66,000
$120,000
$66,000
$66,000
0
0
90,000
$120,000
$66,000
$156,000
Net Worth Increase:
Net Earnings After Taxes
Cash from Sale of Capital Stock to ESOP
Increase in Working Capital
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
How Is It Done?
Example 2:
– Corporate client earns $200,000 per year
– Corporation needs a new building that will cost
approximately $250,000
– A loan would require amortization at a rate of $50,000 over
five years
• Interest paid to the bank would be deductible
• Principal would have to be repaid with expensive
(nondeductible) dollars
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
How Is It Done?
Example 2 (cont’d):
– An ESOP could borrow the $250,000 from the bank and use
the proceeds to immediately purchase $250,000 of capital
stock from the corporation
– The corporation’s net working capital would be increased by
$250,000
– The corporation would then make annual contributions to
the ESOP on an annual basis and the ESOP would repay
the bank
• Corporation receives a deduction for the dollars it contributes
to the ESOP
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
How Is It Done?
Additional Examples:
– An ESOP could also be used to purchase all or any portion of
the stock owned by an estate and not create dividend
consequences to the estate
• Where the majority of the stock of a closely-held corporation is
owned by one individual, and her spouse and/or children own
the balance of the stock
– In lieu of a buy-sell funded with life insurance, an ESOP can
be directed by its investment committee to purchase key
individual insurance on lives of all stockholders to provide the
ESOP with liquid funds to purchase shares from their estate,
at the then-FMV on the date of the shareholder’s death
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Tax Implications
• Corporation is allowed a deduction (within limits) for
contributions made to the ESOP
– An excess deduction may generate a net operating loss
carryback with a resulting tax refund
• An employer can generally deduct a contribution to a
single ESOP of up to 25% of the total compensation
paid to all participants in the plan, with carry forward
for unused deductions
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Tax Implications
• Special deduction rules apply to C corporation plans
that have incurred debt to purchase employer stock
(Leveraged ESOP)
– Employer may contribute as much as 25% of covered
compensation to a single ESOP where the contributions are
applied to make principal payments on the loan
– Additional unlimited deductions are allowed for employer
contributions used to pay interest on the loan (except for S
corp. ESOPs)
– Limitations on allocations to employee accounts may limit
the availability of these special deduction limits in some
circumstances
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Tax Implications
• The employer does not have to make the contribution to
the ESOP in stock of the employer, but may use cash or
any other property
– A contribution of property may result in a prohibited transaction
– Any forms of contribution will generate a deduction to the
corporation equal to the FMV of the assets being transferred
• If the corporation transfers assets to the ESOP that have
appreciated in value (except for cash or employer stock),
the gain will constitute income to the corporation
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Tax Implications
• Corporation is allowed a special deduction for cash
dividends paid with respect to stock held on the dividend
record date by an ESOP, provided the dividends
– Are paid directly in cash to participants or their beneficiaries, or
– Are paid indirectly to them through the plan within 90 days after the
close of the plan year, or
– Are used to make payments on a loan incurred to purchase
qualifying employer securities
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Tax Implications
• Corporation is also generally permitted a deduction
for dividends paid to the plan (or paid out to
participants or beneficiaries) and reinvested in
qualifying employer securities, if so elected by
participants or their beneficiaries
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Tax Implications
• Individual may defer gain on the sale of closely-held
stock to an ESOP under Section 1042 if
– The sale would qualify for long-term capital gain treatment
– After the sale, the ESOP owns at least 30% of the total value
of the employer securities
– Within a 15 month period “qualified replacement securities”
are purchased, and
– The taxpayer held the shares for three years or longer
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Tax Implications
• “Qualified Replacement Securities” are generally stock or
bonds of a domestic corporation which does not have
passive income of more than 25% of gross receipts
• Beware of the 50% penalty tax that will be levied against
the employer sponsoring the plan if any portion of the
assets of the plan attributable to the sale accrue to certain
persons during the “nonallocation period” discussed above
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Tax Implications
• If an ESOP has made an investment in an S corporation,
allocations to a person who directly owns 10% or more of
the S corp. stock (or owns 20% or more indirectly with
members of his family) may result in significant penalties
• Employer contributions are generally not currently taxable
to the employees
• ESOP trust assets grow tax free
• An employee pays no tax until distribution is made to him
or her
Copyright 2011, The National Underwriter Company
27
Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Issues In Community Property States
• Benefits from ESOPs are generally held to be
community property to the extent contributions are
made by or on behalf of a married employee residing
in a community property state
• Death and divorce of an employee are not as clear,
but it is generally accepted that a non-participant
spouse personally retains a valid community property
interest in qualified plan benefits
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Issues In Community Property States
• A spouse’s community interest in his spouse’s
qualified plan benefits is included in his gross estate if
he predeceases his spouse with the qualified benefits
– Estate taxes apply even though the surviving spouse may
have no immediate access to the benefit to provide funds to
pay the tax
• If an employee with a qualified plan predeceases his
spouse and benefits are paid to a beneficiary other
than the surviving spouse, the surviving spouse may
be treated as making a gift of 50% of the benefits
payable to the beneficiaries
Copyright 2011, The National Underwriter Company
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Issues In Community Property States
• Care must be taken to minimize the possibility that
the IRS will claim that a spouse’s community share of
plan benefits remaining in the trust is subject to
federal estate tax at the spouse’s death
• Different states vary on their position with regard to
community property and valuing the qualified plan
benefits for the purposes of division in divorce,
especially where the employee’s interest has not yet
vested
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
Purchase of Life Insurance by ESOP
• ESOP may purchase key person life insurance on
important employees of corporation, within limits
• ESOP may purchase life insurance for participants as
long as amount of insurance is deemed “incidental”
(generally premiums not over 25% of amount
allocated to ESOP account)
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31
Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
S Corporation ESOPs
• Not required to grant participants the right to receive
distributions in the form of stock, so long as
distributions made in cash equivalent to FMV
• Allocations to person owning 10% directly or 20%
indirectly of S corp may trigger 50% excise tax and
income taxation of allocation
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32
Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
S Corporation ESOPs: Anti-Abuse Rules
• If “deemed owned” shares of S corporations that are
attributable to “disqualified persons” result in a “nonallocation year,” significant penalties are triggered in
the form of a 50% excise tax.
• A “non-allocation year” results when “disqualified
persons” are deemed to own more than 50% of the
equity of the entity that sponsors the ESOP.
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Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
S Corporation ESOPs: Anti-Abuse Rules (cont’d)
• The calculations that determine “deemed owned”
shares include not only direct equity interests but also
“synthetic equity,” which includes various other ways
of funneling benefits to highly paid executives
• The purpose of the anti-abuse rules is to ensure that
ESOPs result in broad based employee ownership
and meaningful benefits to rank & file employees
Copyright 2011, The National Underwriter Company
34
Employee Stock Ownership
Plan
Chapter 49
Tools & Techniques of
Estate Planning
S Corporation ESOPs: Anti-Abuse Rules (cont’d)
• “Synthetic equity” includes NQDC plans (whether
stock based or not), allocated ESOP shares,
unallocated ESOP shares, restricted stock, phantom
stock, stock appreciation rights, qualified stock
options, non-qualified stock options, warrants and
other rights to acquire stock in the S corporation that
sponsors the ESOP or any related entity to that S
corporation.
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