A Deep Dive into ESOP Plan Design: Part 3
Four-Part Series by Vantage Point Advisors, Inc. | Jason M. Bolt, CFA, ASA & Rich Barth
Table of Contents
The objective of this four-part series is to discuss some of the aspects of plan design management may consider when establishing an ESOP.
Part I: ESOP Considerations
- ESOP Plan Considerations
Part II: ESOP Considerations, Continued
- Alternative Equity Compensation Plans
- Preexisting Retirement Benefit Plan Considerations
Part III: The Specifics of ESOP Design
- Basis of Allocation of Contributions
- Release of Shares from Suspense Account
- Dividends and How Dividends Will Be Applied
- Put Options
Part IV: Leveraged ESOPs
- Leveraged ESOPS
- Vesting and Forfeiture
Part III: The Specifics of ESOP Design
When establishing an ESOP, one of the first issues a sponsor company is confronted with is deciding who can participate in a particular plan. There are no automatic eligibility criteria that often leave a company with many options with various pros and cons depending on how loose or strict the eligibility requirements are.
One benefit of more relaxed eligibility thresholds is an ESOP being able to maximize the number of employees eligible to participate in a plan. A downside effect is low thresholds increase the risk that part-time or seasonal employees may increase the administrative burden (and cost) of a plan.
Alternatively, a sponsor company may set a high threshold to lower administrative burdens—for example, it’s common to see requirements that include a minimum of one year of service, 1,000 hours of annual service, and continued employment at plan year-end. Of course, the higher threshold will lower the number of employees eligible to participate in an ESOP which may blunt the overall impact on a sponsor company’s workforce. Additionally, a stricter eligibility threshold may lead to other requirements for an ESOP.
Under current law, eligibility periods can be as long as two years. Establishing an ESOP with this two-year plan would require full and immediate vesting, making the administration of a plan relatively simple. It can also be risky for a company to set high thresholds that employees may perceive as unfair, which is another reason to have employee representation in the early steps of an ESOP design process. In all, employees may be excluded from participation of an ESOP based on any of the following grounds:
- Minimum age;
- Minimum years of service;
- Entry date into the ESOP;
- A break in service; and
- Failure to make mandatory employee contributions.
Finding the right balance of maximizing the number of employees without overextending the administrative capabilities of a sponsor company is important and will depend on the mix of employees.
Basis of Allocation of Contributions
Typically, the basis for allocation contributions is compensation, although definitions of “compensation” can vary.
Furthermore, if another qualified plan is in place alongside an ESOP, pretax deferrals may be included in the eligible payroll used to determine the basis of allocation of contributions.
A sponsor company may use a basis of allocation other than compensation as long as it is non-discriminatory. The non-discriminatory classification test, according to IRC 410, is: “The average benefit percentage for employees who are not highly compensated employees is at least 70% of the average benefit percentage for highly compensated employees.” It is important to be aware that compensation in the context of the IRC is determined by the statute, and it may include or exclude items such as extraordinary or nontaxable compensation regardless of the definition of compensation provided in a plan document.
Release of Shares from Suspense Account
When an ESOP is funded by an exempt loan and it uses that loan to purchase company stock, the shares are put into an ESOP suspense account. The shares in the suspense account serve as collateral to a loan.
A loan provides a predetermined share allocation to ESOP participants over the term of an ESOP loan. For example, as a certain percentage of a loan is repaid, an equivalent percentage of shares in a suspense account is released. For a 10-year loan, for example, with equal principal payments each year, 10 percent of shares are released annually.
Because of this ESOP loan design, a recommended practice is to structure an ESOP loan to assist a company in obtaining its desired benefit level allocated to ESOP participants. Too short of an ESOP loan repayment schedule may result in early plan participants having a much larger portion of allocated shares compared to participants entering a plan after a loan is repaid. Alternatively, a loan with a very long repayment time period (and a correspondingly long timeframe for shares to be released from a suspense account) may result in benefits being too small to provide meaningful enough impacts on the financial futures of ESOP participants.
According to ESOP regulations, the release formula—the method for determining how much stock will be allocated each year—can be based on either the (1) General Rule or a (2) Special Rule. The General Rule is based on the principal and interest method, with even payment or self-amortizing loans, which provides for an even release of shares over the term of the loan.
The Special Rule is based only on principal payments, and a company must satisfy other regulatory requirements in order to use it. This formula is:
SRY = Number of Shares Released in Year
PPY = Principal Paid for Year
PTBP = Principal to be Paid for all Future Years
SIS = Shares in Suspense Account
If the release is determined with reference to principal payments only, three additional rules must be followed:
- The loan must provide for annual payments of principal and interest at a cumulative rate that is not less rapid at any time than level annual payments of such amounts for 10 years.
- Interest included in any payment is disregarded only to the extent that it would be determined to be interest under standard loan amortization tables.
- The term of the loan cannot exceed 10 years (including any renewal, extension, or refinancing).
Dividends and how Dividends will be Applied
Dividends provide a direct benefit to employees. In ESOPs, dividends can provide unique tax benefits. For instance, dividends are tax-deductible if they are used to repay ESOP loans in a C corporation or if they are paid out directly to employees. As a general rule, dividends do not count toward limits on how much stock can be allocated to employees.
A 2012 article from The National Center for Employee Ownership (NCEO) describes the special rules for repaying loans with dividends:
Dividends on both allocated and unallocated shares can be used to repay a loan. Dividends paid on allocated shares must release shares to employee accounts at least equal in value to those dividends. Dividends paid on unallocated shares can be distributed to employee accounts based on the allocation formula for other contributions or on the prior account balance and can also be passed through to employees. Dividends paid on shares NOT acquired by an ESOP loan (such as shares the ESOP owned before) cannot be used to repay that loan.
Dividends must be “reasonable.” The IRS has not defined what reasonable means, however. In the one private letter ruling on this issue, a 70% dividend was ruled unreasonable. Dividends that are within a range of those paid by other companies with similar earnings clearly would be reasonable, but beyond that, there is no guidance
Accounting treatment for dividends paid on ESOP loans is complex. Previous rules indicated dividends used to repay a loan would be charged to retained earnings. New rules will require them to be charged to compensation expense, with the charge measured by the value of the shares released. The application of these rules requires detailed guidance from a specialist.
According to IRC 409(h), participants or beneficiaries receiving a distribution of company stock from an ESOP generally must be given a put option for the stock if the employer securities are not readily tradable on an established market. This means that all participants in the plan have the right to require the employer to repurchase those employer securities at their fair market value.
According to the Revenue Act of 1978, the put option must give the following benefits:
- The trustee of the participant’s individual retirement account must be able to exercise the same option,
- The participant must have at least 60 days after receipt of the stock to require that the employer repurchase the stock at its fair market value and make payment within 30 days if the shares were distributed as part of an installment distribution,
- The ESOP may be permitted to take the employer’s role and repurchase the stock in lieu of the employer,
- The participant must have an additional 60-day period in which to exercise the put option in the following plan year after he has been advised of the updated fair market value,
- If the shares were distributed as part of a lump-sum distribution, payment for the shares must begin within 30 days after the exercise of the put option on a schedule at least as rapid as substantially equal annual payments over a period not exceeding five years, at the option of the party buying back the stock. Under IRC 409 (h)(5), the seller must be given a promissory note providing for a reasonable rate of interest together with adequate security (e.g., a secured interest in specific assets, a letter of credit, a surety bond, a secured escrow account, but not employer securities).
 Robert W. Smiley, Jr, Ronald J. Gilbert, David M. Binns, Ronald L. Ludwig, Corey M. Rosen, Employee Stock Ownership Plans (La Jolla, CA: the Beyster Institute at the Rady School of Management, University of California, San Diego, 2007) 13-63.
 Scott Rodrick and Corey Rosen (Eds), The ESOP Reader (3rd edition) (Oakland, CA: The National Center for Employee Ownership, 2003) 15-17, 88-89.
 IRC 410(b) (2) (A); Treas. Reg. 1.410(b)-4.
 Treasury Regulation 54.4975-7.
 “Dividends and Employee Ownership,” National Center for Employee Ownership, April 5, 2012, https://www.nceo.org/articles/dividends-employee-ownership.
 Robert W. Smiley, Jr, Ronald J. Gilbert, David M. Binns, Ronald L. Ludwig, Corey M. Rosen, Employee Stock Ownership Plans (La Jolla, CA: the Beyster Institute at the Rady School of Management, University of California, San Diego, 2007) 13.4[d].
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Jason Bolt is a Manager at Vantage Point Advisors, Inc. Portland office. During his tenure in the valuation profession, Jason has performed valuations of business entities for purchase price allocations (ASC 805), goodwill impairment testing (ASC 350), board advisory, tax reporting, and share-based compensation (IRC 409A and ASC 718).
Rich Barth is Managing Director at Vantage Point Advisors, Inc. He has compiled over 20 years of international investment banking and valuation experience at firms including Goldman Sachs, HSBC Securities and Houlihan Lokey.