Employee Stock Ownership Plans (“ESOPs”) promote employee ownership, facilitate business succession plans, and provide a retirement tool for owners of closely-held businesses. In 2014, approximately 22.9 million Americans owned shares of their company under a 401(k) plan, an ESOP, stock grants, or other similar plans.^[1] As a direct result of employee ownership, ESOP companies are said to grow between 2.3% to 2.4% quicker than nonemployee-owned companies.^[2] Moreover, ESOP participants generate 5% to 12% more in wages than other workers not involved in an ESOP and accumulate more than three times the amount of retirement assets.^[3] Although there is an argument that ESOPs are risky for retirement planning due to the lack of diversification by investing solely in company stock, a number of factors offer countervailing evidence that establishes the benefits of ESOP’s for retirement, as will be shown below.^[4] ESOP contributions are usually larger than 401(k) accounts, ESOPs usually offer an ancillary retirement plan, such as defined benefit pensions, profit sharing plans, and 401(k) plans (sometimes combined, known at “KSOPS”). ESOPs generally offer coverage to a greater number of employees. Because the employer primarily funds the ESOP, employee money is generally not used, mature ESOPs tend to diversify over time, ESOPs are less volatile and usually have a greater return on investment than 401(k)s, and finally ESOP companies generally create stronger job-security.^[5] One of the major criticisms of ESOPs is the complexity of their operation.

EMPLOYEE STOCK OWNERSHIP PLAN OVERVIEW

An employee stock ownership plan (“ESOP”) is a tax-qualified defined contribution retirement plan designed to satisfy the applicable requirements under Internal Revenue Code (“Code”) section 401(a) and the additional requirements under Code section 4975(e)(7). The Employee Retirement Income Security Act (“ERISA”) imposes further requirements regarding ESOPS. An ESOP is a retirement plan tool that allows sponsoring employers to invest primarily in employer securities. Utilizing an ESOP can create an advantageous retirement arrangement for a closely-held company, specifically for an S corporation, which is the focus of this article, among many other transactions. The creation of this retirement arrangement essentially creates a market for the securities of closely-held companies. The primary benefits of an ESOP, which will be discussed later in the article, are the tax benefits that inure to ESOPs, specifically wholly-owned ESOP S corporations. When an ESOP owns 100% of an S corporation, the company will earn money and under the subchapter S taxing regime the profits will pass through to the owner, or the ESOP. An ESOP is a tax-exempt entity. Thus, a wholly-owned ESOP S corporation as a tax-exempt entity and will generally pay no tax income tax.    

The ESOP is required to purchase the employer’s securities. In order to acquire the employer’s securities, the ESOP may borrow funds from a lender, such as a bank. The ESOP will then remit the proceeds to the company. The company will in turn make a “mirror loan” or a “back-to-back loan” to the ESOP. The employer could also borrow capital and loan the money to the ESOP. As a result, the ESOP will service the lender’s debt. This transaction results in a “leveraged ESOP.” Because the ESOP is a distinct entity from the employer’s entity, the employer contributes tax-deductible contributions to the ESOP so that the ESOP can service its loan debt, such a deduction can occcur only when the company is a C corporation.^[6] If the sponsoring company is a S corporation, the entity can deduct contributions to the ESOP, which are used to service the debt of the leveraged ESOP, in an amount up to the twenty-five percent of the compensation paid to the beneficiaries participating in the plan.^[7] Generally, the lending institution will collateralize the debt with the employer’s securities. The employer’s securities are held in a suspense account. As the ESOP pays down its debt the employer’s stock is released from the suspense account and is allocated to the employees.

An ESOP is considered a defined contribution plan, “which is a stock bonus plan which is qualified, or a stock bonus and money purchase plan both of which are qualified under section 401(a), and which are designed to invest primarily in qualifying employer securities . . . . ”^[8] Generally, qualified plans cannot hold employer securities that hold a fair market value in excess of 10% of plan assets.^[9] However, ESOPs are considered eligible individual account plans.^[10] Eligible individual account plans are exempted from the 10% limitation and the diversification requirements under the Code.^[11] Thus, ESOPs can invest in employer securities in excess of the 10% limitation and diversification requirements.

ESOPs are further subject to the prohibited transaction provisions applicable to qualified plans under the Code. A “‘prohibited transaction’ means any direct or indirect . . . lending of money to or other extension of credit between a plan and a disqualified person . . . . ”^[12] An ESOP is considered a plan and a disqualified person includes “an employer any of whose employees are covered by the plan.”^[13] An employer’s guarantee to a lending institution that the ESOP will service the debt is considered an extension of credit to the ESOP.^[14] Thus, a leveraged ESOP would be a prohibited transaction under the Code. However, the Code contains an exemption; the loan to the ESOP is not a prohibited transaction if (1) the loan is for the benefit of the plan participants and (2) the loan bears a reasonable interest rate and the collateral consists of qualifying employer securities.^[15] 

ERISA also imposes prohibited transaction restrictions, specifically, and for purposes of this article, upon leveraged ESOPs. ERISA section 406 states that a fiduciary shall not direct the plan to engage in a transaction “if he knows or should know” the transaction is a “direct or indirect” loan or extension of credit between the plan and a party in interest.^[16] ERISA section 407 states that the plan may not hold employer securities if the holding constitutes more than ten percent of total plan assets.^[17] However, ERISA contains a specific exemption for ESOPs; the prohibited transaction rules do not apply to an individual account plan, which includes an ESOP.^[18]

The coverage requirements under Code section 410(b) and the nondiscrimination requirements under Code section 401(a)(4) apply to ESOPs.^[19] Generally, an ESOP trust will not be considered a qualified trust under Code section 401(a) unless one of three coverage tests are satisfied: 1) the ESOP benefits at least seventy percent of employees who are not highly compensated, 2) the ESOP benefits employees who are not highly compensated which amounts to at least seventy percent of highly compensated employees benefiting under the plan, or 3) the ESOP satisfies the average benefit percentage test; to satisfy the average benefit percentage test the average benefit for each non-highly compensated employee participating in the ESOP is at least seventy percent of the average benefit that each highly compensated employee receives under the ESOP.^[20] Also, the contributions or benefits received under the plan cannot discriminate in favor of highly compensated employees pursuant to Code section 414(q).^[21]  

Vesting requirements in the Code also apply to ESOPs, which are found at Code section 411. An employee cannot be denied benefits under the ESOP upon reaching normal retirement age. The employee’s rights to the accrued benefit under the plan must be nonforfeitable. Further, either of the vesting schedule requirements must be satisfied: 1) if the plan imposes a three year vesting schedule, the employee must be entitled to 100 percent of the accrued benefit, or 2) under a two to six year graded vesting schedule, the nonforfeitable percentage of accrued benefit must amount to twenty percent after two years, forty percent after three years, sixty percent after four years, eighty percent after five years, and 100 percent after six or more years.^[22] The vesting requirements also impose restrictions on certain mandatory distributions.^[23]

Participants in an S corporation ESOP generally have the right to demand distributions from the ESOP and if the securities are readily tradable on an established market, then the participant has the right to demand the employer purchase the shares.^[24] A plan can preclude the distribution of employer securities to participants if the plan provides that the employer will repurchase the employer securities. The exception to the general is applicable if the employer is organized as an S corporation. A participant in an ESOP who is eligible for a distribution can elect to have the distributions commence prior to the required time under Code sections 401(a)(14) and 401(a)(9). A participant can elect to receive distributions not later than one year after the close of the plan year (i) in which the participant separates from service based on reaching normal retirement age, death, or disability, or (ii) the fifth year following the plan year in which the participant otherwise separates from service, provided the former employee is not re-employed before the distribution is required to begin.^[25] Unless the participant elects otherwise, the distribution must occur in substantial equal periodic payments, at least annually, over a period that is not longer than (i) five years or (ii) for an account in excess of $800,000, then over five years plus one additional year, but not more than five additional years, for every $160,000 that exceeds $800,000, whichever is greater.

ESOPs are also subject to strict scrutiny regarding valuation because closely-held S corporation businesses are not traded on a public market and enforcement agencies see this type of arrangement as ripe for abuse. For ESOPs that hold securities that are not traded on an established securities trading platform, an independent appraiser must value the employer’s securities that the ESOP holds.^[26] Two instances arise that necessitate obtaining an independent appraiser to determine the value of employer securities not readily tradable on a securities exchange.^[27] When a transaction occurs between an ESOP and a disqualified person the value of the stock must be determined as of the date of the transaction. Second, a valuation must be assigned to employer securities at least annually, notwithstanding a transaction between a disqualified person and the ESOP. Under ERISA, trustees are also required to make a good faith determination of the fair market value of the plan assets annually.^[28] 

ESOPs that hold employer securities must also satisfy the voting rights requirements under Code section 409(e). For non-registered employer securities, each participant or beneficiary in the plan must be entitled to one vote for every security allocable to each participant’s account. The voting applies to any corporate matter requiring the approval or disapproval of any “corporate merger or consolidation, recapitalization, reclassification, liquidation, dissolution, sale of substantially all assets of a trade or business, or such similar transaction as the Secretary may prescribe in regulations.”^[29] Thus, state corporate law must be analyzed to determine if a vote is required on a certain corporate action. Also, if the ESOP holds shares that are not yet allocated the trustee can vote those shares; in addition the plan trustee can vote the shares of any stock for which the trustee does not receive a voting directive regarding employer stocks held in participants’ account.^[30]

ESOPs are also subject to certain fiduciary requirements under ERISA. Broadly speaking, the fiduciary provisions of ERISA state that a fiduciary shall discharge his duties solely in the interest of plan participants, (ii) for the exclusive purpose of providing to benefits to the participants and beneficiaries and defraying reasonable administrative expenses, (iii) “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character with like aims, (iv) to diversity investments to mitigate large losses, unless it is prudent to not diversify, and (v) according to the plan documents.^[31] An ESOP contravenes the diversification requirement. As a result, ERISA permits an exception to the diversification requirement and prudence requirement, as it relates to diversification, for an individual account plan under ERISA section 407(d)(3). An individual account plan under ERISA section 407(d)(3) explicitly includes an employee stock ownership plan.^[32]

CONSEQUENCES OF A WHOLLY-OWNED ESOP S CORPORATION

1. Benefits

As previously noted, the primary benefit of a wholly-owned employee stock ownership plan S corporation is the tax-exempt status the entity enjoys.^[33] However, the earnings of the S corporation are taxed indirectly once the participants receive the taxable benefit distributions from the Employee Stock Ownership Plan (“ESOP”) trust.^[34] So it is more accurate to describe the taxing regime under a wholly-owned ESOP S corporation as a deferral of taxes rather than a tax exemption. 

As a corollary to the tax-deferral status of an ESOP, the S corporation will retain more capital within the corporation, which is conducive to organic growth of the company. Usually, under a subchapter S taxing regime the company will distribute property in order to aid the shareholders in satisfying their tax liability. However, when the ESOP owns 100 percent of the S corporation the entity does not have a motivation, or a need, to distribute money to the shareholder ESOP to satisfy the tax ESOP’s tax liability. Thus, beyond the tax-deferral advantage per se, the ability to retain capital that would otherwise be distributed through an S corporation allows to company to avoid siphoning off money while attempting to grow the company’s operations.

Employee ownership is also a driving factor behind the implementation of an ESOP. Employee-owners “gain a great windfall of company equity” and overall average pay of employee-owners is higher than workers in non-employee owned firms.^[35] In fact, company stock is often offered in addition to, not in lieu of, other compensation.^[36] Studies indicate that broad based employee-ownership in company’s results in increased job stability as compared to similar firms.^[37] As a consequence of employee-ownership, workers are reported to have increased satisfaction, commitment, motivation, and participation.^[38]  Finally, the entity itself reaps rewards from implementing employee ownership. Virtually all research on employee ownership demonstrates “robust, positive, firm-level effects . . . [where] employee owned firms are more productive and profitable, survive longer, and result in better shareholder returns.”^[39]

Another prominent benefit of a wholly-owned ESOP S corporation is the creation of a market to buy and sell shares of a closely-held business that would otherwise be absent. Specifically, such a market provides for the viable retirement of company owners, in that the ESOP will eventually repurchase shares to provide the retiree with liquidity. Recent studies by Ernst and Young’s Quantitative Economics and Statistics Practices has shown that ESOPs, specifically ESOP S corporations, vastly outperform Standard and Poors 500 Index.^[40] In fact, many publications and studies underestimate the power of a wholly-owned ESOP S corporation; in such an arrangement, employees do not pay for the ESOP stock, the stock is granted as an employee benefit, thus the cost to the employee is negligible at most, nonexistent at least.^[41] Further, the market that an ESOP establishes can provide a business succession device. A retiring owner can sell his or her shares to the ESOP while transitioning out of the business. This situation allows for the succession of a new generation of owners to step into the shoes of the previous owners, which is ideal in a closely-held family business. These issues are particularly relevant for the aging population of the baby boom generation, which is beginning retirement and will continue retirement in large numbers.^[42]

2. Drawbacks

Generally speaking, from the selling shareholder’s point of view, the shareholder may utilize Code section 1042, which allows for the proceeds of a sale of employer securities to purchase qualified replacement property.^[43] Such a transaction defers tax on the proceeds until the subsequently purchased property is sold. Specifically, the Code provision states that if the taxpayer sells any employer securities and “the taxpayer purchases qualified replacement property . . . then the gain (if any) on such sale which would be recognized as long-term capital gain shall be recognized only to the extent that the amount realized on such sale exceeds the cost to the taxpayer of such qualified replacement property.”^[44] However, this provision only applies to C corporations.^[45]

The fiduciary duties imposed on ESOP trustees are also a primary issue that must be resolved. This area of employee benefits law presents a specific thorny issue practitioners must confront and is as follows: how should the board of directors, overseeing a wholly-owned ESOP S corporation, act after the Fifth Third Bancorp v. Dudenhoeffer decision?^[46] 

The exclusive benefits rule states that a fiduciary shall discharge his duties “for the exclusive purpose of: providing benefits to participants and beneficiaries; and defraying reasonable expenses of administering the plan . . . .”^[47] Essentially, the fiduciary must make decisions based solely on the best interest of the participants and beneficiaries, which includes minimizing expenses and maximizing benefits. The prudence requirement states that a fiduciary must deploy his or her services “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims . . . .”^[48] This duty is referred to as the prudent expert standard. The fiduciary is held to the standard of an ESOP trustee that is an expert in handling all aspects of an ESOP. Sometimes, a prudent decision in a given circumstance is not the course of action that the employee-owners would choose for themselves. Also, disclosure requirements under this rule are important. Communicating incomplete information to the employee-owners of an ESOP creates a risk of finding a breach of a fiduciary duty. Another fiduciary duty in the plan document requirement, whereby the fiduciary must act in accordance to the terms of the plan documents.^[49] These plan documents include the ESOP plan document that governs general plan operation the trust agreement, charter, investment policy statement, among others. The critical sub-issue under the plan document rule is the interpretation of plan terms. Plan terms should be interpreted consistently whenever possible. Further, communications with plan participants and beneficiaries should not misrepresent or mislead the participants or beneficiaries.

The foregoing fiduciary rules are implicated under an ESOP arrangement in the process of holding and valuing company stock. A number of practical considerations regarding fiduciary status and action should be addressed in the creation and operation of an ESOP. First, the fiduciary or fiduciaries should be identified. Who is required to take what action? The plan documents should dictate who is a named fiduciary and those who perform fiduciary functions should be apprised of the responsibility. The necessary individuals should be trained and informed regarding any nominal or functional fiduciary status under ERISA. Importantly, professional advisers should follow up with fiduciaries to ensure proper compliance with all applicable laws.

Because the ESOP holds employer securities, in a closely-held business the stock needs to be valued. The fiduciaries should know who is to make and prepare the valuation. Also, the person who makes the final determination as to the valuation should also be identified. The fiduciaries should strive to understand the valuation method used for the employer’s securities. Although certain individuals can rely on outside expert opinions, if litigation ensues ESOP fiduciaries will more completely insulate themselves from liability if the valuation methodology is understood. The fiduciaries should also make sure that the valuation report contains complete and accurate information.

Specifically, a recent issue that has developed under ESOP arrangements is the question of how should the board of directors, overseeing a wholly-owned ESOP S corporation, act after Fifth Third Bancorp v. Dudenhoeffer? In Fifth Third Bancorp the Supreme Court of the United States held that ESOP fiduciaries are no longer entitled to a presumption of prudence, abrogating the presumption created in Moench v. Robertson,^[50] which was referred to as the Moench presumption of prudence.^[51] Second, the Court further held that fiduciaries can prudently rely on the market price of stock as an assessment of its value in light of all publicly available information.^[52] Finally, the Court in Dudenhoeffer held that “to state a claim for breach of the duty of prudence on the basis of inside information, a plaintiff must plausibly allege an alternative action that the defendant could have taken that would have been consistent with the securities laws and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.”^[53]

Apart from the significant import of abrogating the Moench presumption of prudence, the Court in Dudenhoeffer crafted a standard to determine if holding company stock in an ESOP is prudent in certain circumstances. One of the arguments adduced at trial in Dudenhoeffer was that Fifth Third Bancorp acted imprudently, in violation of the prudent person standard of care, in failing to act on nonpublic information, or inside information. Specifically, the respondents contented that insiders of Fifth Third Bancorp obtained information that the market was overvaluing its stock and that petitioners could have mitigated the losses suffered in using such inside information. The standard created in Dudenhoeffer applies to the assessment of whether ESOP fiduciary action violates ERISA’s prudent person standard of care. First, the duty of prudence does not require the fiduciary to break the law.^[54] To trade on inside information is to violate securities laws. Thus, an ESOP fiduciary does not act imprudently when he or she does not mitigate losses in refraining to trade on inside information. Second, if a complaint faults fiduciaries for failing to decide, with knowledge of relevant insider information, to not make additional stock acquisitions or for failing to disclose such information to the public to correct the stock valuation additional issues arise.^[55] The primary consideration under the second factor is “the extent to which the ERISA-based obligation either to refrain on the basis of inside information from making a planned trade or to disclose information to the public could conflict with the complex insider trading and corporate disclosure requirements imposed by the federal securities laws or with the objectives of those laws.”^[56] Finally, in assessing whether an ESOP fiduciary acted imprudently in holding company stock courts should also consider whether a prudent fiduciary in the defendant’s position could not have concluded that halting the purchases or disclosing negative, nonpublic information would do more harm than good to the fund.^[57]Dudenhoeffer involved a public company ESOP, thus unanswered questions remain as to the applicability of Dudenhoeffer to closely-held companies.    

For example, in Hill v. Hill Bros. Construction Co., Inc.,^[58] the United States District Court for the District of Mississippi concluded, among other things, that the fiduciary duty prudence standard as expressed in Dudenhoeffer is applicable to closely-held companies.^[59] The Hill Brothers Construction Company (“HBC”) established an ESOP for its employees.^[60] The ESOP participants received notice that the value of the participant’s retirement investment was approximately $19.8 million.^[61] Eight months later the participants were informed that the retirement savings were valued at zero dollars.^[62] The participant plaintiffs sued the fiduciaries, for among other things, violating the duty of prudence because the fiduciaries did not disclose the material financial condition of the employer’s securities.^[63] The plaintiffs premised their theory on the fact that Dudenhoeffer, which involved publicly-traded employer stock in the ESOP at issue, did not apply in the current case because HBC was a closely-held company. The fiduciary defendants argued that the plaintiffs failed to state a claim as to the prudence violation allegation pursuant to Dudenhoeffer, which the defendants argued was applicable to closely-held company ESOP fiduciaries.^[64] The district court agreed with the defendants, in stating that the Supreme Court has not “specified that the ‘alternative action’ standard is to be applied to ESOPs of publicly-traded entities only.”^[65]   

Conversely, in Allen v. GreatBanc Trust Co.,^[66] the United States Court of Appeals for the Seventh Circuit stated, for purposes of this article, “In Dudenhoeffer, the Supreme Court held the ERISA fiduciaries conducting ESOP transactions can generally prudently rely on the market value of publicly traded stock, absent special circumstances . . . . [T]he Court’s holding was limited to publicly traded stock . . . .”^[67] In that case GreatBanc was the fiduciary for an ESOP that Personal-Touch, a home health care company, sponsored.^[68] The employer’s shares turned out to be valued at much less than the ESOP paid, which left the ESOP with no valuable assets and left the shareholders on the hook for the interest payments on the loan.^[69] One of the claims the plaintiff shareholders alleged against GreatBanc was a breach of the fiduciary duty of prudence by not conducting an adequate inquiry into the value of GreatBanc’s stock.^[70] The Seventh Circuit sided with the plaintiffs by stating that Dudenhoeffer does not apply to the sale privately-held company stock to an ESOP.^[71] Further, the court stated, “There is no support, however, for such a stringent pleading requirement. All the plaintiff must do is to plead the breach of a fiduciary duty, such as prudence, and to explain how this was accomplished. Plaintiffs here accused GreatBanc of failing to conduct an independent assessment of the value of stock and relying instead on an interested party’s number. This is enough to give notice of the claim and to allow the suit to proceed.”^[72] As a result of the foregoing case law, the post-Dudenhoeffer landscape creates a drawback for fiduciaries in creating an ESOP based on the strict rules that fiduciaries must abide by and which are compounded by the lack uniformity in interpreting the applicable standards insofar as closely-held ESOP fiduciaries are concerned.

Transactional concerns are also an important aspect for ESOP fiduciaries. Decisions must be made as to who will make the final determination to buy the company stock. The experts who will provide professional advice, such as legal, financial, and valuation, should be designated. The fiduciary should always make sure to obtain complete and accurate information. The fiduciary should discuss, extensively, the motivation for purchasing company stock, or in the process of purchasing more company stock, if under an ESOP arrangement. Further discussion includes the process of how and when new additional debt will be incurred, and the impact such debt will have on existing ESOP shares. Although these are initial questions for fiduciaries to discuss in the creation, operation, and maintenance of an ESOP, they do not fully apprise the fiduciary of the extent of the fiduciary requirements.

A final consideration that should be noted are the rules found in Code section 409(p), the anti-abuse rules for S corporations. Code section 409(p) generally states, “an [ESOP] holding employer securities consisting of stock in an S corporation shall provide that no portion of the assets of the plan attributable to (or allocable in lieu of) such employer securities may, during a nonallocation year,^[73] accrue (or be allocated directly or indirectly under any plan of the employer meeting the requirements of section 401(a)) for the benefit of any disqualified person.”^[74] The general rule essentially states that no assets of the wholly-owned ESOP S corporation may be allocated, either directly or indirectly, to any disqualified person(s) if such person(s) own, in the aggregate, at least half of the S corporation. The reasoning behind the ant-abuse rule is clear from the statutory language itself, Congress does not want S corporation ESOPs to benefit a small number of owners, but rather seeks to advantage a broad-based employee population.

Further, 409(p) contains familiar attribution rules, strewn throughout the Code, to inhibit shifting ownership to family members in an effort to circumvent the ownership rules.^[75] Even more discrete are the synthetic equity rules. For purposes of 409(p), synthetic equity is essentially treated as outstanding stock and deemed-owned shares. Synthetic equity refers to “any stock option, warrant, restricted stock, deferred issuance stock right, or similar interest or right that gives the holder the right to acquire or receive stock of the S corporation in the future,” and “also includes any stock appreciation right, phantom stock unit, or similar right to a future cash payment based on the value of such stock or appreciation in such value.”^[76]

CONCLUSION

Although Employee Stock Ownership Plan (“ESOP”) S corporations are highly complex, making their operational intricacies somewhat of a drawback, the benefits outweigh the burdens. The tax-deferral benefits that an ESOP creates, in conjunction with the retirement and business succession devices that an ESOP facilitates can be extremely appealing to a small, closely-held business that is operating as an S corporation. Moreover, the idea that employee owned businesses consistently create greater employee motivation, productivity, and job security is widely accepted as accurate in current research on the topic. Even though the assessment, and eventual creation, of deciding whether to adopt an ESOP arrangement is complicated, with the proper guidance and advice such a tool can be advantageous to a company, and its, its owners, in the short- and long-term.