Past, Present and Future
Introduction
Historical Perspective
Philosophical Foundation
Summary
INTRODUCTION
Clarification of the two terms ESOP and ESOT must first be addressed, as the two
terms are somewhat interchangeable. ESOP refers to an Employee Stock Ownership
Plan and ESOT refers to an Employee Stock Ownership Trust. If a corporation has
an ESOP it must also have an ESOT. The trust is the legal entity and the plan is
the document that sets guidelines for operation of the trust. The plan also has
the power to borrow money to purchase company stock.
ESOPs are recognized as a benefit that employers may provide to their employees under the Employee Retirement Income Security Act (ERISA) of 1974, the Tax Reduction Act of 1975 and later legislation. They are defined as stock bonus or combined stock bonus/money purchase pension plan trusts. Employers contribute company stock, cash or other assets to the plan trust. The trust generally allocates these contributions to the accounts of the employees who are participants in the plan. Employees receive partial or full distribution of the assets in their accounts when they retire, terminate employment or when other events occur that must be specified in the plan document.
Unlike other types of qualified retirement plans, such as pension and profit sharing plans, ESOPs must be invested primarily in the securities of the sponsoring employer rather than in a diversified portfolio. An ESOP must be qualified by the Internal Revenue Service and must conform to Internal Revenue Code 401(a) and the exempt loan provisions of 4975(e)(7). Unlike profit sharing or pension plans an ESOP is exempt from the fiduciary requirements of prudence, diversification and fair rate of return relating to investments in employer securities.
The past, present and future play crucial roles in the evolution of the ESOP. Its humble beginning is no indication of its current or future state. It is, and always will be, simple in principle but inherently complex in application.
The earliest sign of anything remotely similar to an ESOP was in 1926. The stock bonus plan was authorized in the same Internal Revenue Code that authorized the profit sharing plan. Some of the more famous stock bonus plans include the Sears Plan, which was adopted in the late 1920s, the J. C. Penney Plan and the Proctor and Gamble Plan. In fact, stock bonus plans were not very popular until the 1950s and 1960s and were used primarily by public companies that already had a ready-made public market for their stock.
The first significant date for ESOP purposes was 1956. At this time, a revenue ruling was made that authorized stock bonus plans to borrow money to purchase company stock. Previously, the critical difference between a stock bonus plan and an ESOP had been that an ESOP had the power to leverage; that is, to borrow money to purchase company stock. A stock bonus plan, on the other hand, did not have the authority or the power to borrow money; it could only purchase stock on an annual basis. In 1956, for the first time, an Internal Revenue Service Ruling allowed stock bonus plans to borrow funds to purchase company stock. With this ruling the first ESOP was adopted and operated in the form known today.
The first recognizable case was Peninsula Newspapers. In this case, two owners wanted to sell their company to the employees rather than see their company bought by a large newspaper chain. They approached Louis Kelso, a San Francisco attorney, to assist the employees in obtaining loans since the bank had refused their loan request. In reviewing the matter with the company, Kelso discovered that the company had several profit sharing plans with $250,000 worth of trust assets. He realized that this could be the down payment toward the purchase. The employees again approached the bank. This time the bank approved a loan, but instead of letting the employees borrow the money, the bank let the trust borrow the money. The trust then purchased the company stock from the two owners. All the employees who were also participants in the plan were now the owners of the company.
Each year following, the company made tax-deductible contributions to the plan, which were used to repay the loan. The loan was originally designed as a 20-year loan. However, since the repayment was made with tax-deductible dollars, the company paid off the loan in only eight and one-half years.
This was the first IRS qualified ESOP. Again, the qualification of the ESOP rested entirely upon one revenue ruling. There was no statutory authority for ESOPs then and each ESOP designed between 1956 and 1974 had to be “hand-carried” through the IRS.
Because of this lack of statutory authorization, there were very few ESOPs installed between 1956 and 1968. In 1968, there were less than two dozen ESOPs installed throughout the country. From 1968 to 1971, the interest in ESOPs began to grow, primarily because of new interest generated by the publication of Kelso’s book, Two Factor Economics. By 1971, there was sufficient interest and Kelso established a separate firm to specialize exclusively in ESOPs. His firm was established as an investment banking firm and contributed to the increased public awareness of ESOPs. Between 1971 and 1974, approximately 50 plans per year were installed throughout the United States.
In 1974, Congress was considering the Employee Retirement Income Security Act (ERISA). The Act originated as an attempt to regulate the Central States Teamsters’ Pension Plan that had been subject to abuse. However, in its final form, the Act regulated everything from savings plans to profit sharing and pension plans.
In the same year, significant actions regarding ESOPs came to the Senate. The Senate, at that time, had two bills: the Senate Labor Committee Bill and the Finance Committee Bill. Both bills were based upon the provisions in the 1969 Charitable Foundation Act and the 1969 Tax Reform Act. That is, there was a series of prohibited transactions and a series of exemptions from prohibited transactions. Accordingly, there was an exemption for loans to purchase company stock. There was also a prohibition against purchasing or borrowing stock from a party-in-interest. However, an exemption existed in the private foundation provisions and in ERISA for borrowing money from a party-in-interest. No one in the Senate realized that this inadvertently protected ESOPs.
After considering both bills, they were assigned to a Conference Committee composed of members of the Senate Finance Committee and the Senate Labor Committee. Since only one or two senators were even aware of ESOPs, the Conference Committee saw no need for the exemption and deleted the exemption that protected ESOPs. The Senate passed the bill 90 to 2 and sent the bill to the House Ways and Means Committee. As a result, the House, making ESOPs prohibited transactions, passed the bill.
Consequently, Kelso began immediate work in rewriting the exemption and redefining the ESOP. He, in turn, hand filed a memorandum with the House Ways and Means Committee that addressed these considerations. Most members of the House did not realize that ESOPs even existed, let alone realize that legislation would be needed to protect them. Once they understood the problem, most of them readily endorsed the ESOP concept.
In the Senate, the ESOP concept was expressly endorsed and wholeheartedly supported by Senator Russell Long, D-La. Senator Long, chairman of the Senate Finance Committee, was in a unique position to appreciate the many aspects of ESOPs. At the time of this legislation, 1974, Senator Long was grappling with several problems. He was in charge of the Penn Central Railroad Reorganization and he also commissioned a study to determine the capital needs of the nation. During 1974, there was high inflation; high interest rates and banks were rationing credit. As a result, the Dow Jones Industrial Average was in the 500s, there was no venture capital and there were no mergers or acquisitions. Small businesses could not even borrow money from their banks. The Penn Central was in bankruptcy and was asking Congress for a $15 billion subsidy. Added to this, the British economy was in a depression, and the entire work force in Britain was on a three-day workweek due to the presence of various union strikes. Because of these circumstances, Senator Long immediately endorsed the ESOP for the following reasons:
ESOPs...
* Reduce the tax burden for smaller companies.
* Reduce inflation by encouraging employees to take less pay in return for more equity.
* Are an incentive for employees to become more productive.
* Generate capital.
* Reduce unionization and the frequency of strikes.
Accordingly, he sponsored the legislation that became law on September 2, 1974 (ERISA). He also sponsored ESOP legislation in the Railroad Reorganization Act. This legislation proves that, to the maximum extent possible, should Congress give federal subsidy to private industry, — i.e., Penn Central Railroad, this financing should be provided through an ESOP, to the maximum extent possible. By doing so, a broader ownership of capital would be created, the employees would be less likely to engage in striking and featherbedding, and the probability of having the money repaid would be enhanced.
In 1976, 1978 and 1982, there was additional ESOP legislation. These bills made technical corrections that improved and enhanced the abilities and the advantages of ESOPs. The Retirement Equity Act of 1984, signed into law by President Reagan on August 24, 1984, contains the most dramatic tax benefits for ESOPs ever enacted. It is evident by this Act that Congress intended to encourage and promote the ESOP concept by providing special tax incentives for companies that adopt them. The most dramatic provision of the 1984 law is the tax-free rollover provision contained in Section 1042 of the IRS Code. Under this provision, a taxpayer may defer paying the capital gains tax of certain securities sold to an ESOP if he reinvests the proceeds in qualified securities within 12 months of the date of sale. Further enhancements included an interest exclusion, a dividend deduction and an estate tax assumption. Together, these strengthened and encouraged the implementation of ESOPs.
However, in the Tax Reform Act of 1986, Congress unexpectedly questioned the practicality of all ESOPs. Their future existence was at stake. After much debate, but little action, ESOPs remained basically unchanged. Since then, the popularity of ESOPs has grown, and it is now unlikely that Congress will drastically change or eliminate ESOPs in the future.
The philosophical foundation of the ESOP is based upon increasing incentives for employee productivity, broadened ownership of capital, providing retirement benefits, unlocking capital and, to a certain extent, decreasing unionization.
When ESOPs were authorized in 1974, one of the reasons Congress enthusiastically supported them was its concern with the productivity rate in this country, which had been declining for the past several years. With an ESOP, employees have a direct interest in the success of their company. If properly communicated, this can have great impact on their productivity. In certain companies, it has been found that a 1% increase in productivity will translate into a 25% increase in profitability. Most companies and most employees do not realize that they possess this tremendous leverage. On the other hand, it is difficult to persuade employees to increase productivity if they do not have some share in the increased profits. Consequently, an ESOP is a very fair method of rewarding increased productivity, since employees automatically share in any increased profitability of the company.
The second reason for Congress’ support of the ESOP was its influence in creating a broadened ownership of capital. Various studies have shown that in the last two decades, ownership of capital outside pension plans has become more concentrated. Approximately 85% of all stock and bonds held outside pension plans are held by 5% of the population. By broadening ownership of capital, ESOPs help reverse this trend. As a company grows, its employees become part owners. This can have tremendous social and political consequence. For instance, when the U.S. was an agrarian economy, the Homestead Act was created. This, in turn, created millions of individual landowners who became, not only financially, but socially and politically independent. As the country changed to an industrial economy, the U.S. lost some of that independence and the laborers became disenfranchised from ownership of capital. The ESOP is an effective way of reversing this trend.
ESOPs also provide retirement benefits. A United States Senate study shows that the average person over the age of 65 has a substandard level of income. If this is to be reversed, workers have to be given a chance to earn equity in order to make investments that will generate additional retirement benefits. One of the best investments for employees is the stock of their company. Here, they have some degree of influence and effect with respect to the growth and value of their investment.
The fourth basic principle of the ESOP is that it serves to unlock capital. Before ESOPs, capital was essentially locked in many, if not most, privately held companies. An owner could not withdraw his capital in the company without either selling the company entirely or having to pay exorbitant dividend rates of taxation. With an ESOP, the owner can withdraw (sell) capital from his private corporation at capital gains rates, just the same as if he were a shareholder in a publicly held corporation. The pretax market, provided by an ESOP to owners of private companies, provides the very foundation of all ESOP structures and tax advantages. It is very simple in application but misunderstood by over 90% of the non-ESOP consulting specialists. Consequently, owners of private business are also confused about the establishment and operation of an ESOP.
In conclusion, ESOPs encourage ownership of equity, as opposed to ownership of labor. Unfortunately in the past, labor unions focused upon increasing the wages of labor. This has resulted in higher wages, in turn, decreasing competitiveness among some of our major industries. Since higher wages have to be passed on in the form of higher prices, the United States is less competitive. Along with ESOPs comes the hope that employees will realize the benefit of owning equity in a profitable company over that of receiving short-term wage gains at the expense of the company’s profitability.
Between 1974 and 2001, twenty-four different laws were passed that strengthened ESOPs. The Taxpayer Relief Act of 1997 reduced the capital gains tax from 28% to 20% for sales of stock to a company’s ESOP. The reduced capital gains rate provides added flexibility in structuring sales of stock by individuals, estates and trusts. The Tax Relief Reconciliation Act of 2001 made numerous changes beneficial to ESOPs and qualified retirement plans. Those changes will be discussed in the appropriate sections of this booklet and designated as “The Act.”