ESOP Information

ESOPs provide a company’s workforce with an ownership interest in the company.

In this article:

ESOP Plan Rules

ESOP Rules were put in place to oversee employee stock ownership plans (ESOPs). ESOPs provide a company’s workforce with an ownership interest in the company. Rules state that to be an ESOP, the plan must be specifically designated as an ESOP in the plan document, and must comply with employee stock ownership plan rules of the Internal Revenue Service (IRS).

ESOP plan rules are established under the Employee Retirement Income Security Act (ERISA), a federal law that sets minimum standards for investment plans in private industry. Additional ESOP rules can be found under Internal Revenue Code section 404(a)(3). These ESOP rules provide for an annual limit on the amount of deductible contributions an employer can make to a tax-qualified stock bonus or profit-sharing plan of 25 percent of the compensation otherwise paid or accrued during the year to the employees who benefit under the plan.

ESOP plan rules do not require the IRS to approve the plan prior to setting up the ESOP or having the ESOP acquire company stock. Nor is it necessary to file plan the with any governmental agency. However, ESOP companies usually submit their employee stock ownership plan to the IRS with a request for a determination letter which confirms that the form of the ESOP satisfies the requirements of the Internal Revenue Code.

ESOP Rules governing employee eligibility

In order to satisfy IRS nondiscrimination guidelines, ESOP rules state ESOPs must cover a substantial percentage of non-highly compensated employees who have attained age 21 and completed a year of service. For this reason, ESOPs established by smaller companies usually cover all employees who have satisfied these minimum age and service requirements.

ESOP Rules governing participant allocations

ESOP rules have established a ceiling on the amount of annual compensation that can be recognized for determining participant allocations in ESOPs. The ESOP ceiling is set at $255,000 for plan years beginning in 2013, with future adjustments based on cost of living increases. For calendar 2013, an employee who is compensated at an annual rate of $350,000 will receive the same allocation within the ESOP as an employee who earns $255,000.

ESOP rules also impose limits on the maximum annual additions to a participant’s ESOP account. Annual additions consist of a participant’s allocated share of the company’s ESOP contribution and any forfeitures. The maximum annual additions amount includes contributions to other plans such as a 401(k) plan.

ESOP Rules governing leveraged ESOPs

For leveraged ESOPs which satisfy a special nondiscrimination test, interest paid on the ESOP loan and forfeitures do not count as an annual addition (only C corporations).

Another ESOP rule allows certain leveraged ESOPs to determine the maximum annual additions by using the fair market value of the company stock released from the suspense account, if this value is less.

ESOP Rules governing valuation

Valuations of company stock in the ESOP must be made by an independent appraiser annually or any time the ESOP purchases company stock from the company or an employee, officer, director, or 10 percent or greater shareholder. The Department of Labor (DOL) and IRS require that an independent appraiser value company stock in the ESOP. ESOP rules state an independent appraiser must (i) hold himself/herself out to the public as an appraiser or perform appraisals on a regular basis, and be qualified to make appraisals of the type of property being appraised; and (ii) be independent of the company and other parties to the ESOP transaction.

Under ERISA ESOP rules, the legal responsibility for valuing the stock rests with the ESOP trustee or other named fiduciary designated in the ESOP plan document as responsible for valuation. The named fiduciary must carefully select and monitor the performance of the ESOP appraiser.

ESOP rules provide participants in all qualified plans with legal rights, and impose penalties on fiduciaries who violate those rights. In addition, ESOPs are subject to the prohibited transactions rules of ERISA and the Code. The prohibited transactions rules apply to purchases of company stock by an ESOP for more than fair market value, and sales of company stock for less than fair market value. Substantial tax penalties are imposed on persons connected with the company or the ESOP who participate in a prohibited transaction.

ESOP Rules governing plan termination

ESOP rules state that termination of an ESOP must result in all participants becoming 100 percent vested, and their accounts in the plan must be distributed within a reasonable time. Benefit distributions from the ESOP are eligible to be rolled over into an IRA; ESOP distributions not rolled over are taxable, but may be eligible for special favorable tax treatment.

SES ESOP Strategies’ team of ESOP experts stay up on all the latest ESOP plan rules so you don’t have to. Get the most out of your employee stock ownership plan with SES ESOP Strategies.

Can I Use the ESOP to Refinance Existing Corporate Debt?

Yes. Refinancing existing corporate debt through an ESOP should improve after-tax cash flow. The refinance is accomplished through a loan to the ESOP which uses the borrowed money to purchase newly issued stock from the company. The company uses the cash to pay off the existing debt, which is thus replaced with ESOP debt. After the refinancing, the company’s contributions used to pay the principal portion of the ESOP debt will be tax deductible, whereas principal payments on the prior corporate debt were not.

Can an ESOP Be Terminated?

Yes. Just as a company can terminate a profit sharing plan, it can also terminate an ESOP. At that point, all participants must become 100 percent vested. Benefit distributions from the ESOP are eligible to be rolled over into an IRA; ESOP distributions not rolled over are taxable, but may be eligible for special favorable tax treatment.

Are ESOP Accounts Required to Be Fully Invested in Company Stocks?

ESOPs are not required to invest exclusively in company stock; many ESOPs have substantial investments in cash or other securities. However, ESOPs normally have more than half their assets invested in company stock.

In addition, ESOP participants who are approaching retirement age must be given an opportunity to diversify their ESOP accounts. For shares acquired by an ESOP after December 31, 1986, the ESOP must provide any participant who has attained age 55 and completed 10 or more years of service of participation in the ESOP with an annual option to diversify 25 percent of his or her ESOP account into investments other than company stock for five years. In the sixth year, the participant must be given a one-time option to diversify up to 50 percent of his or her account.

At least three investment options must be offered within the ESOP to meet the diversification requirements. Alternatively, the ESOP may transfer assets to another qualified plan, or make a distribution directly to the participant to satisfy the diversification requirements.

SES ESOP Strategies’ ESOP  services can help ensure that your ESOP addresses reporting and compliance requirements.

Are Annual Contributions to the ESOP Mandatory?

Although annual contributions are not mandatory for each year, the IRS does require that recurring contributions be made to a tax-qualified retirement plan to maintain its qualified status. However, in a leveraged ESOP, employer corporations need to commit to contribute enough cash each year to service the ESOP loan debt. If the ESOP has sufficient cash to pay the ESOP debt, additional contributions are not required. In some instances, it may be wise to make contributions in excess of the required ESOP debt payments to accumulate cash in the ESOP for years in which cash flow may be restricted.

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