Reinvigorating aging ESOPs.

What can a plan sponsor do to cope old age?

Many employee stock ownership plans (ESOPs) created over the past 20 years are experiencing the pains of old age as tax and other projections diverge from the original plan designs. To solve these problems, ESOP sponsors must carefully consider possible corrective action--including reloads, refinancings, grantor trusts (and even possible plan terminations) as well as tax and accounting changes--to arrive at a solution that best serves the company and participants, all while complying with ERISA and the IRC.

Companies created leveraged ESOPs in the late 1980s and early 1990s, borrowing funds to purchase company stock. In the intervening years, the plans repaid the stock acquisition loans and released shares to participant accounts. As these loans near the end of their terms, employers face new problems if these plans are to continue in the future. This article focuses primarily on issues of interest to large employers, many of which are public companies. Other concerns that confront private company ESOPs exclusively--S corporation ESOPs, IRC section 1042 transactions and valuations issues among them--are not addressed because much has been written about them elsewhere.

THE STATE OF ESOPs TODAY

For most people, hostile takeovers, junk bonds and ESOP leveraged buyouts (see the sidebar on page 53) seem largely a relic of another age. When LBOs and hostile takeover activity slowed in the early 1990s, the creation of new large ESOPs by companies trying to block or facilitate takeovers slowed as well. Since then, family-owned businesses have used ESOPs as devices to sell the businesses through tax-advantaged section 1042 sales. More recently, small businesses have employed them to reduce taxes through the use of ESOP-owned S corporations.

Many older ESOPs are drawing attention again as the loans the plans used to acquire stock come due. Much of the debt had a term of 10 to 20 years. For example, for exempt securities acquisition loans relying on the 50% interest exclusion under IRC section 133, loans made after July 10, 1989, were limited to 15 years (subject to certain grandfather rules). Loans using the "principal only" method of allocating shares to participants were subject to a 10-year maximum term under Treasury regulations section 54.4975-7 (b) (8)(ii).

As ESOPs move forward to meet the needs of a new generation of employees, plan sponsors, and the CPAs and financial managers who advise them must consider the accounting and tax changes that have an impact on plan operations. Those companies that decide they want to continue to use ESOPs to promote employee ownership must then decide what techniques they will use to finance and acquire shares as they make the transition to the future.

NEW RULES TO FOLLOW

The AICPA changed the accounting for ESOPs by issuing Statement of Position 93-6, Employers' Accounting for Employee Stock Ownership Plans, in 1993. Previously, a company charged the amount of an ESOP contribution to expense without regard to whether it used the contribution to pay down an exempt loan to release shares. SOP 93-6, however, generally provides that when a company allocates shares to participants' ESOP accounts, a compensation expense results that is measured by the fair market value of the stock on the allocation date.

Under SOP 93-6, a company treats dividends on stock held in an ESOP the same as dividends on non-ESOP shares if the stock is allocated to participant accounts, reducing retained earnings. If the dividends are paid on unallocated shares, the company treats them as

* A reduction of the principal or interest on the exempt loan if it uses them to repay the exempt loan.

* Compensation expense if the company allocates the dividends to participants' accounts or if it pays them to participants out of a suspense account.

Previously, under SOP 76-3, Accounting Practices for Certain Employee Stock Ownership Plans, a company treated dividends paid on ESOP shares the same as those paid on non-ESOP shares.

There is another significant difference between SOP 93-6 and the prior rule. Under SOP 76-3, a company considered all ESOP shares outstanding when calculating earnings per share. Under SOP 93-6, the company treats only allocated shares, or shares committed to be allocated (released from the suspense account but not yet allocated within the plan year), as outstanding for this purpose.

SOP 93-6 was effective for all shares ESOPs acquired after December 31, 1992, for periods beginning after December 15, 1992. Employers may elect to apply it to shares acquired before 1993.

The impact. While the effects of these accounting changes depend on a particular company's situation, most CPAs and financial managers view them as making leveraged ESOPs somewhat less attractive than under the prior rules because of the potential that a company will incur higher compensation costs. The principal reason costs may be higher is because the expense amount a company records for new shares will be based on the fair market value of the shares the plan allocates to participant accounts--measured at the time of allocation--rather than on the amount of the cash contribution the company makes to the ESOP to repay the loan.

THE REPEAL OF SECTION 133

The section 133 interest exclusion for qualified ESOP lenders was first restricted by the Revenue Reconciliation Act of 1989 (RRA). It limited loans to 15 years and generally required that for loans made after July 10, 1989, the ESOP own more than 50% of each class and of the total value of all of the corporation's outstanding stock. The exclusion was finally repealed by section 1602(a) of the Small Business Job Protection Act of 1996. Loans in existence on August 10, 1996, were grandfathered, subject to certain binding commitment and refinancing rules found in section 1602(c) of the act.

Deductibility of dividends. Under the 1989 NRA, a company can deduct dividends on shares held in an ESOP (allocated and unallocated) acquired on or after August 4, 1989, and used to pay principal or interest on an exempt loan--if the loan the dividends repay was used to acquire the shares, subject to certain other rules under IRC section 404(k). Shares acquired before that date, subject to certain binding commitment grandfather rules, are not restricted. The IRS never has indicated clearly that dividends on shares acquired before August 4, 1989, may be deductible if the company uses them to repay an exempt loan taken out to acquire additional shares after that date. However, a private letter ruling (PLR 8921101) and a technical advice memorandum (TAM 9435001) suggest this is the case, illustrating the importance of having a recordkeeper that can separately account for which shares the plan acquired before August 4, 1989. In the event of a reload in particular, the ability to account separately for grandfathered shares can be important.

Dividend pass-through. Under section 404(k), dividends are deductible without regard to the acquisition date of the shares on which they were paid. However, the plan must distribute the dividends in cash to participants no later than 90 days after the close of the plan year in which they are paid. While this does not appear to be a common practice, a company can combine it with a 401(k) plan to permit reinvestment in company shares at an employee's election. To secure the dividend deduction, some employers have designated not only the employer matching account as an ESOP but also the company stock account for participant-directed investment of elective contributions as well. Stock accounts designated as ESOPs must meet all ESOP requirements, and the recordkeeping can be complex.

Dividend reinvestment plans. A plan sponsor that does not use the dividends on ESOP shares to repay an exempt loan alternatively can obtain a deduction by distributing the dividends to participants in cash within 90 days of the close of the plan year. Letter rulings have allowed such distributions to be reinvested in employer stock--at the participant's election--as additional pretax contributions. The recontributed amount is subject to the IRC section 402(g) limit (currently $10,000 per year per participant) as well as to the IRC section 415 limit on annual additions. (See PLRs 9619078, 9619066, 9530006, 9526023 and 9518018.)

Legislative proposals would have loosened the limits on reinvestment elections. (See HR 2488, the Taxpayer Refund and Relief Act of 1999, which President Clinton vetoed on September 23, 1999.) Congress reintroduced similar relief as part of a proposal--still pending at the time of this writing--to increase the minimum wage. (See HR 3081, the Wage and Employment Growth Act of 1999.) Employers are expected to continue to press for such a provision, if not as part of the minimum wage bill, then in some other legislation.

FIDUCIARY ISSUES

Despite their unique combination of retirement benefit and corporate financing objectives, ESOPs are covered under basic ERISA fiduciary prudence and loyalty provisions. Accordingly, ESOP fiduciaries, who are company insiders, face the often contrary task of determining whether holding employer stock is prudent and solely in the interest of plan participants and beneficiaries.

Generally, ESOPs of publicly traded companies are perceived as having fewer fiduciary concerns than ESOPs of nonpublic companies because the market provides the fiduciary (often a committee of company executives appointed by the employer) with daily information on whether the stock remains a good investment. It's important for fiduciaries not to become complacent, however. In-house fiduciaries must be sensitive to company-related events that can cause their fiduciary duties to conflict with their role in the company. Also, any downturn following a bull market can cause problems. It may be advisable for fiduciaries to consider in advance what their responses would be to such contingencies.

RELOADING FOR THE FUTURE

For the most part, the leveraged ESOPs companies created in the mid- to late 1980s are, or will soon be, making their final loan payments and releasing the last shares to participant accounts. Given employee expectations that their employers will contribute stock to their ESOP accounts each year, companies may be reluctant to eliminate this benefit and terminate the plans. To ensure that stock will continue to be available to distribute to employees, employers may want to "reload" the plans with new loans and more employer stock.

For most companies, a reload involves many of the same considerations that went into the original ESOP loans, including

* Determining how many shares they project the plans will need.

* Designing the loans to release shares and to allocate them to participants in a way that coordinates with the plans' need for shares.

* The desirability of obtaining the loans directly from the companies rather than from third parties.

* The need to comply with fiduciary considerations in purchasing the stock and obtaining the loans.

However, companies now also must take into consideration the accounting changes brought about by SOP 93-6. These rules may lead an employer to consider purchasing and holding shares in a more flexible grantor trust, which would contribute the shares to the ESOP later, as described below. The grantor trust advantage may be offset by the deduction companies can take for dividends paid to ESOPs that use those dividends to repay exempt loans. Because of the uncertainties companies face in refinancing exempt loans, it's important to build flexibility into the terms of the new loan so the company can avoid having to refinance the loan in the near future.

EMPLOYER STOCK GRANTOR TRUSTS

Under a traditional ESOP, an ESOP trust borrows money to buy stock, holds the stock as collateral in a suspense account and allocates it over the term of the loan according to one of the formulas Treasury regulations permit. Some companies, however, use an alternative method to create a grantor trust of the corporate plan sponsor, which invests in shares of company stock. A number of letter rulings address this situation. (For example, see PLRs 9609010, 9404008 and 9235006.)

The trust is not an ESOP; if properly structured, it is also not an employee benefit plan subject to ERISA. Thus, creating a grantor trust gives companies flexibility because the trust's purchase of stock, creation of loans to purchase stock and use of shares to fund employee benefits are not limited by restrictive DOL and IRS rules. The shares, while subject to the claims of the employer's creditors, otherwise are dedicated to be used for employee benefits--frequently health care as well as pension benefits.

As the employer needs shares to fund welfare benefits or to make annual contributions to an ESOP or other profit-sharing or stock bonus plan, the trustee distributes the shares from the grantor trust to the health or qualified plan. The employer can deduct the shares' value when it contributes them to the qualified plan, resulting in an accounting treatment similar to that found in SOP 93-6. Dividends paid on the shares held in the grantor trust, however, are not deductible.

REFINANCING EXEMPT LOANS

When the exempt loan regulations under IRC section 4975 were made final in 1977, there was little question that exempt loans could be refinanced. Such refinancings were subject, however, to a requirement that a new loan be primarily for the benefit of ESOP participants and their beneficiaries. (See IRC section 4975(d)(3), ERISA section 408(b)(3) and Treasury regulations section 54.4975-7(b)(3).) The IRS issued several letter rulings in the past few years (PLRs 9704030, 9704021, 9649050 and 9610028) holding that specific facts and circumstances satisfied the primary benefit requirement. However, in many cases workforce reductions, divestitures and spin-offs, together with increased stock values--all common in the 1990s--have made the value of the shares released more than originally intended or needed, for example, to provide a 50% match with employee contributions. The result is that plan sponsors increasingly are interested in refinancing loans to reduce share releases to the amounts originally intended.

Recently, however, the Department of Labor has begun examining exempt loan refinancings and, particularly when loan terms are extended, has indicated informally its concern whether such refinancings comply with ERISA. The DOL reportedly has made the area an enforcement priority and has asked a number of institutional ESOP trustees for documents about such transactions. More than one refinancing is apparently under audit. Because schedule E of form 5500, the annual information return, specifically asks whether any securities acquisition loans have been refinanced, a transaction is easily detectable. Thus far, the DOL has declined to shed light on its specific concerns, which creates confusion for ESOPs contemplating loan refinancing. DOL guidance would be welcome.

The IRS, in turn, formally added ESOP refinancings under the primary benefit requirement to its no-ruling list. This apparently was due to concerns about dual jurisdiction with the DOL. The IRS continues to issue rulings on the impact of refinancings on the 50% interest exclusion for section 133 loans, although it no longer expresses any opinion about the primary benefit requirement. (Compare prior PLRs 9530023 and 9443039 with more recent PLRs 9847005 and 9811050.)

The consequences of an exempt loan failing to satisfy the primary benefit requirement theoretically may include the plan having to both unwind the refinancing and pay significant prohibited transaction excise taxes. As a result, plan sponsors, trustees and fiduciaries considering refinancing exempt loans should proceed with caution. Use of an independent fiduciary to determine that the refinanced loan satisfies the primary benefit requirement may be advisable. All parties should review carefully the reasons for the refinancing; the terms of the current and proposed exempt loans; the plan and trust provisions; the roles of the sponsor, administrator, trustee and fiduciary; and past employee communications.

TO TERMINATE OR NOT?.

If a company decides not to continue its ESOP after the acquisition loan is repaid and shares are allocated to participants, it can terminate the plan. The tax consequences of terminating an ESOP also have evolved in the last decade. The principal question is how to treat the gain on the sale of unallocated shares in excess of the amount necessary to repay the loan. Until recently, the long-standing but informal IRS position was that the allocation of gain to participants' accounts was an annual addition subject to the section 415 limit. (See PLRs 9507031, 9417033, 9417032 and 9416043.)

The IRS apparently modified this position subsequently in PLR 9648054 to indicate that the gain was subject to the section 415 limit only in proportion to the basis of the shares used to satisfy the loan. In a still unpublished TAM issued to the taxpayer in October 1997, the IRS treated all such gain as earnings to participant accounts and none as subject to the section 415 limit. Although not technically precedent for any other taxpayer, this TAM appears to represent the current IRS view.

Another issue that may not arise unless--and until--a company terminates an ESOP while part of the exempt loan remains outstanding is the question of whether the fiduciary is required to sell or transfer the unallocated shares to satisfy the loan. This may come up, for example, when the lender does not have an enforceable security interest in the shares as collateral for the loan under local law. (See DOL Advisory Opinion 93-35A, December 23, 1993.)

HERE TO STAY

While a company may find it useful to tinker with the design of an ESOP after it has been around for a few years, it seems clear ESOPs are here to stay. CPAs and financial managers must help each company evaluate its ESOP in light of the company's financial situation and goals. To date, the issues ESOPs face are manageable. Few healthy employers are opting for plan terminations. Employees continue to expect to receive company stock in their 401(k) and profit-sharing plans, and employers find ESOPs a financially and tax-effective way to provide it. In addition, companies today are looking at proposed legislation that would loosen the rules a company must follow to deduct dividends paid to ESOPs. If and when it passes, it may contribute to the overall health of ESOPs in the twenty-first century.

ESOP Statistics

* There are approximately 10,000 ESOPs in the United States with 10 million employee--owners. This represents 10% of the

* About 1,000 ESOPs are in publicly traded companies that employ more than 50% of the nation's employee-owners.

* In 1994 U.S. ESOPs owned $222 billion in corporate assets.

Source: The ESOP Association, Washington, D.C. www.the-esop-emplowner.org/.

EXECUTIVE SUMMARY

* WITH MANY OF THE ESOPs CREATED OVER the past 20 years suffering the pains of old age, ESOP sponsors must carefully consider some of the possible courses of action available to them, including reloads, refinancings, grantor trusts and even possible plan terminations.

* ACCOUNTING FOR ESOPs CHANGED WHEN THE AICPA issued SOP 93-6. It requires that a company allocating shares acquired after 1992 to participants' ESOP accounts record a compensation expense that is measured by the stock's fair market value on the allocation date.

* THE TAX CONSEQUENCES OF TERMINATING an ESOP have evolved over the last 10 years. One major question is how a company treats the gain on the sale of unallocated shares in excess of the amount necessary to repay the ESOP loan. The most recent IRS opinion is that all such gain represents earnings to participant accounts.

* THE LOANS MANY ESOPs TOOK TO BUY stock are starting to mature. As the loans come due and the final shares are released, some employers may wish to reload the plans with new loans and more stock.

* THE DEPARTMENT OF LABOR HAS BEGUN TO SCRUTINIZE the refinancing of exempt ESOP loans, particularly when the loan terms are extended, to make sure the transactions comply with ERISA. Due to concern about dual jurisdiction with the DOL, the IRS has added ESOP refinancings to its no-ruling list.

DAVID W. POWELL, CPA, JD, is a principal with the Groom Law Group, Chartered, in Washington, D.C. His e-mail address is [e-mail]. THOMAS D. TERRY is of counsel with the Groom Law Group, Chartered. He is a former benefits tax counsel for the Department of the Treasury. His e-mail address is [e-mail]. IAN LANOFF is a principal of the Groom Law Group, Chartered, and a former administrator of pension and welfare benefit programs at the Department of Labor. His email address is [e-mail].

A Brief History of ESOP

Employee stock ownership plans (ESOPs) formally date to the enactment of ERISA in 1974, when proponents of increasing employee stock ownership succeeded in having Congress permit the creation of ESOPs. They accomplished this largely through an exception to the diversification requirement for investments by ERISA-covered plans. That exception also imposed certain requirements for the purchase of "qualifying employer securities" (generally, the employer's common stock having the greatest voting power and dividend rights or, in certain cases, noncallable preferred stock convertible into common stock) by ESOPs, as well as by other individual account plans not designated as ESOPs, and on the "exempt loans" an ESOP might enter into to purchase qualifying employer securities.

Many observers, however, date the beginning of the modern era in ESOPs to the mid-1980s. In 1984 Congress added an exclusion from gross income for 50% of the interest a qualified lender receives on a securities acquisition loan; in 1986 Congress made dividends paid on ESOP shares deductible when they were used to repay exempt loans.

Although the employee ownership benefits of ESOPs had been apparent for some time, the increased tax advantages, a rising stock market, hostile takeover activity and the availability of high-yield debt to .purchase companies (most notably through the temporary success of Drexel Burnham Lambert and its chief bond trader, Michael Milken) combined to encourage new and larger ESOPs. One purpose of many new plans was to finance a leveraged buyout (known as an ESOP LBO). Another was to serve as an antitakeover device.

In an ESOP LBO, an ESOP was created to purchase part of a company being taken private. The ESOP issued debt to third parties to enable it to purchase a substantial portion of the shares. The company could deduct dividends on ESOP shares used to repay the exempt loan, and a qualified lender could exclude from gross income 50% of the interest it received on certain loans. As the loan was repaid, the purchased shares were allocated to participating employees, giving them a stake in the company's future.

The combination of these factors, plus an increasing market for high-risk debt made such deals economic and profitable to all parties. Examples of ESOP LBOs from this period, some involving mergers and others involving tender otters, include Raymond International, Blue Bell, Parsons Corp., U.S. Sugar and Amsted. In other cases, companies used ESOPs to sell a subsidiary, such as with Healthtrust and Avis.

ESOPs never lost their purpose as a mechanism to give employees company ownership, which, in turn, led to loyalty and increased productivity. As hostile takeovers became common in the mid- to late 1980s, due in part to the ease of obtaining financing, companies began to understand that ESOPs had a collateral benefit: a large number of shares in presumably friendly hands. Even if the plan passed the voting or tender decisions through to participants, employee shareholders could largely be expected to vote against a hostile takeover that might mean a loss of jobs for a large number of employees.

Delaware amended its laws in 1988 to generally require that a hostile acquirer could not combine with a target within three years of becoming a 15% shareholder unless the acquirer obtained 85% or more of the target's outstanding stock in the same transaction in which it became a 15% holder. Thus, for a company concerned about a hostile takeover, it became very useful to have close to 15% of company stock in friendly hands. Companies viewed the employee pension plan as friendly hands. The Shamrock' Holdings, Inc. v. Polaroid decision (559 A. 2d 257 [Del. Ch. 1989]), which upheld such a transaction, accelerated this trend. As a result of this ruling, many employers enlarged or added an ESOP feature to their qualified plans, often adding it to an existing 401 (k) plan by matching part of employee contributions in employer stock.

Employee Ownership Index

The employee ownership index (EOI) was created in 1992 by three professors. The index tracks the average percentage increase in stock price of the approximately 350 publicly traded companies having broad-based employee ownership of 10% or more and more than $50 million in market value. American Capital Strategies (www.american-capital.com), an investment bank based in Bethesda, Maryland, now maintains the EOI.

From 1992 through 1997 the EOI grew 193%. Over the same period, the Dow Jones industrial average was tip 145% and the S&P 500 index, only 140%. Over the past five years, the EOI outperformed the S&P 500 by 80%.

The index is published quarterly in the Journal of Employee Ownership Law and Finance (www.nceo.org/ nceo.journal.html), a publication of the National Center of Employee Ownership.