ESOP – The “Down-Side”

Special Limitations and Requirements–ESOPs are subject to special limitations and requirements that may appear to present unsolvable problems, but in actuality, rarely do.

The Right to Demand Distribution of Company Stock—First, ERISA provides that ESOP participants have the right to demand that ESOP distributions be in company stock.  Few closely-held companies would be pleased with such a requirement since having stock “floating around” among passive minority stockholders, especially former employees, could present problems.  Fortunately, however, this same law makes this problem either disappear when the ESOP is an S corporation, or avoidable when that corporation’s charter or by-laws restrict  ownership of “substantially all” (i.e., 80% or more) of its stock to “active employees” (which includes owner-employees) and qualified plans (which, of course, includes ESOPs).  This, in turn, entitles the company, and, through it, its ESOP, to either distribute cash rather than stock, or distribute stock subject to the requirement that it be immediately sold back to either the corporation or its ESOP (which is frequently done in order to entitle departing employees to realize LTCG, rather than ordinary income, to the extent that the stock involved has NUA (i.e., value in excess of the ESOP’s basis in that stock)).

The Right to a Pass Through Vote—ERISA provides that when the ESOP company is publicly traded, or when the matter to be voted on involves major actions such as mergers, consolidations, recapitalizations, reclassifications, liquidations, dissolutions, or sales of substantially all of the corporation’s operating assets, the vote on all allocated ESOP stock must be passed through to the plan participants.  Note, however, that this requirement only applies to allocated stock—the ESOP trustee votes the unallocated stock (and stock as to which the plan participants have declined to exercise their right to vote), and, more often than not, matters such as mergers and acquisitions are accomplished through subsidiaries where the stock to be voted is owned by parent corporations rather than the ESOP itself.  And, by its terms, the law does not extend to “tender offers.”

Annual Appraisal —The law requires that the company stock held by the ESOP be appraised annually by a qualified independent appraiser, and that the appraised value of the stock allocated to participant accounts be communicated in writing to them each year.  Jurisdiction over this requirement has been relegated to the Department of Labor (DOL) which, in 1988, issued proposed regulations which, although never finalized, should be followed.  Transactions involving an ESOP purchase or sale of company stock must take place at “fair market value.”  And, the IRS also has long-standing guidelines as to factors that should be taken into account during the course of these appraisals.  This requirement is arduous and expensive, but it would have to be adhered to in any event. Peoples’ rights are involved.  All of the parties — the company, the ESOP and its participants must be treated fairly.  And appraisals such as those here required are standard and appropriate in any event.  They should not be viewed as a negative but, instead, as being inherently necessary under the circumstances inherent in the whole ESOP process.

Complexity—ESOPs are complex and understood by few.  Here, however, complexity is the corollary of the exceptional benefits they can provide. Congress favors ESOPs, but only when they are not abused and the interests of employees are safeguarded.  Moreover, ESOPs are entwined into the Internal Revenue Code where almost everything is complicated.  Nevertheless, they are understandable and manageable when implemented and overseen by people who understand them and know how they work.  Accordingly, where the aggregation of ESOP-generated benefits is adequately enticing, as it frequently is, the complexity that accompanies them should not present anything like an impenetrable barrier.

Cost—Complexity, coupled with many and varied benefits, generates cost.  ESOPs are not cheap.  Fees in the forty to sixty thousand dollar range are common and, depending upon alternatives being utilized (e.g., lateral transfers) can go well above that.  But those costs must be far offset by the benefits to be derived in order to justify moving forward with implementation.  For this reason, as empathized above, I almost always recommend that a “feasibility study” be undertaken before an ESOP is implemented.  Then an ESOP should only be implemented when the feasibility study supports that course of action.

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