ESOP fables.

ESOP FABLES

As noted last month (see J of A, Jan. 90, page 10), employee stock ownership plans may be an effective planning tool in the corporate setting. ESOPs also have become one of the more popular types of employee benefit plans, largely because of the deductions afforded employers and the deferral of taxation on benefits provided for participating employees.

Definition. An ESOP is a defined contribution plan designed to invest primarily in the stock of the company sponsoring the plan (or one of its affiliates). It can provide benefits to both the sponsoring corporation and the participating employees.

CORPORATE BENEFITS

Exemption from prohibited transaction rules. Generally, transactions (such as loans or sales) are prohibited between qualified employee benefit plans and an employer. Separating business assets from retirement plan assets protects the plan assets from the employer's creditors and the risks of the employer's business.

Companies, however, may make loans to ESOPs. Such a loan must be primarily for the benefit of plan participants, must bear a reasonable rate of interest and must be collateralized only by employer securities. In addition, it must be a term loan and be used within a reasonable period of time to acquire the securities or repay the loan.

While an employee benefit plan may not normally acquire or sell employer securities, ESOPs are not so bound. Provided the sale is for adequate consideration and no commission is charged, an ESOP may (and usually does) deal in the stock of the employer.

Interest exclusion. ESOP sponsors are able to borrow money at lower interest rates than are normally available. Since 50% of the interest received by a bank on loans to an ESOP will not be included in income (as long as the ESOP owns more than 50% of the sponsoring company's stock), these plans are usually able to negotiate a lower lending rate.

Deductions. A sponsoring employer's contributions and dividends to an ESOP are deductible (within limits). Contributions to ESOPs used to repay the principal portion of an exempt loan are deductible to the extent of 25% of compensation, while contributions to repay interest on an exempt loan are fully deductible. To the extent dividends are used to make payments on the principal portion of an exempt loan or are paid in cash to participants, dividends paid to an ESOP are deductible.

Corporate control. A sale of stock to an ESOP can avoid some of the adverse consequences normally associated with the sale of a portion of a company's stock. Since legal title and voting rights in ESOP stock are centered in the plan's trustees, the loss of control normally associated with the sale of stock can be limited.

SHAREHOLDER BENEFITS

Nonrecognition. As long as the proceeds are reinvested in qualified replacement property, no gain will be recognized by shareholders on the sale of stock to an ESOP. The shareholder must make the proper election on his return, and must reinvest the full amount realized in qualified replacement property within a 15-month period beginning 3 months before the sale and ending one year after the sale. Qualified replacement property is basically stock in any domestic operating company that uses more than half its assets in the active conduct of a trade or business. When the selling shareholder disposes of the replacement property, the prior unrecognized gain has to be recaptured. However, dispositions by reason of death, gift or tax-free reorganizations in which the ESOP sale proceeds are reinvested are exempt.

Note: After the sale of securities to an ESOP, the plan must hold at least 30% of each class of stock or of the stock's total value. In addition, this stock must be held by the ESOP for at least three years after the sale.

Practical applications. ESOPs may be used in a number of situations.

* Raising capital. A corporation can undertake a new issue of stock or sell unissued shares of stock to the ESOP. The ESOP borrows the necessary funds to pay for the stock and the corporation then can use the proceeds for whatever purpose it desires.

* Estate planning. Shareholders of closely held corporations can diversify their assets. By selling his or her stock to an ESOP and reinvesting the proceeds in other qualified securities, a shareholder can shift his holdings from the closely held corporation to other businesses. In addition, these qualified securities may be income producing and may provide needed liquidity after the shareholder's death.

* Buyout of principal shareholder. Other shareholders can use ESOPs to buy out a majority shareholder if they do not have the needed capital.

Ed. note: The material discussed provides general information. Before taking any action in this area, the appropriate code selections, regulations, cases and rulings should be examined.

Nicholas J. Fiore, editor The Tax Adviser