Employee Stock Ownership Plans (ESOPs)

Ownership is largely determined by who has access to capital credit. Just as society can structure its laws and institutions to concentrate ownership, society can reform its laws and institutions to decentralize ownership. Similarly, future corporate credit can be used to build more ownership into the same tiny group of present shareholders. Or it can be used to create new owners, with a new social contract based on private property for workers in the bargain.

One powerful ownership-expanding technique, known as the Employee Stock Ownership Plan (ESOP) provides widespread access to capital credit to each employee in a company on a systematic basis. Technically, the ESOP uses a legal trust that is “qualified” under specific U.S. tax laws encouraging employee ownership. (In some countries, an Employee Shareholders’ Association is used instead of a trust.) Fortunately, these laws are extremely flexible, so that each plan can be tailored to fit the circumstances and needs of each enterprise, and deficiencies in the design of an ESOP can easily be corrected.

Over twenty U.S. laws have passed Congress since late 1973 to make ESOPs more attractive to workers and owners. More are on their way. While less than a dozen ESOPs existed in the United States in 1965, today over 10,000 companies, mostly highly profitable small and medium-size firms, have already adopted the ESOP in one form or another, creating over 11 million employee-owners. In 1500 companies, employees hold the majority of stock. A number of Fortune 500 companies have adopted ESOPs, including Proctor & Gamble, Texaco, General Mills, Hallmark Cards, and American Standard, thus planting the seed for significant expansion of worker ownership within the giant multinationals.

A number of other countries are taking steps to implement ESOPs. In 1989, the United Kingdom passed laws similar to U.S. laws to encourage the formation of ESOPs. Several outstanding demonstrations of ESOPs involve employee buyouts of formerly state-owned enterprises, including National Freight Lines and People’s Provincial Bus Company. In May 1989, Egypt launched the first ESOP in the developing world with the formation of the Alexandria Tire Company, a $150 million joint venture with Pirelli Tire Company of Italy and other investors.

Overcoming the initial skepticism of organized labor toward employee ownership, the United Steelworkers, the Air Line Pilots Association and the Amalgamated Clothing Workers have strongly endorsed the ESOP concept, and have initiated several model ESOP buyouts.

An ESOP combines many elements into a single package. It is an employee benefit program. It is an incentive and productivity program for all employees. It is a retirement program. It is a reward system, working best when a modest base salary is supplemented with cash bonuses and equity shares, linked to the proceeds of the operation. It is a two-way accountability and communications system between management and non-management employees. It is a means for workers to participate both as workers and as stockholders in corporate direction. It is an in-house tax-exempt stock exchange, for both new equity issuances and repurchase of outstanding shares. It is a tax-deferred means for workers to accumulate equity. It can offer workers a source of current dividend incomes. An ESOP is all of these and more; but one of its most unique features is that it is a basic innovation in corporate finance.

An ESOP is the only tool in the world of investment finance that can generate new sources of capital credit for corporate growth or transfers of ownership, insulate its eventual owners from direct personal risk in the event of default, and allow repayment of its entire debt in pre-tax corporate dollars.

How the ESOP Works

The leveraged ESOP operates in this way: it channels capital credit through a trust representing employees, from the same sources and subject to the same feasibility standards and corporate guarantees as direct loans to the corporation. The loan funds are used to buy stock for the workers, either from present owners or for financing expansion or modernization of the corporation. The ESOP can be used to purchase existing shares from present owners using credit which is wholly secured by and repaid from future profits.

Normally, the workers make no cash outlay from payroll deductions or their savings, and none of their present savings is at risk. Shares of stock are allocated to the individual accounts of workers only as blocks of shares are “earned”, i.e., the company contributes cash out of future pre-tax profits to the trust. The cash, which is treated as a tax-deductible employee benefit, is used to repay the stock acquisition loan. Whereas traditional uses of leveraged corporate credit work only for present owners, the ESOP uses corporate credit to convert its workers into stockholders. Thus, the magic of self-liquidating capital credit can be used to lift more individuals into an expanding ownership system.

A well-designed ESOP clarifies subtle distinctions between “ownership,” “management,” and “worker participation.” Operationally under an ESOP, day-to-day control would remain in the hands of professional managers who, under a carefully designed system of checks and balances, would simply become accountable to a broader shareholder base, including other workers, and a more broadly representative board of directors. Employee stock ownership, therefore, would involve balancing continuity and efficiency of the firm with justice and accountability for the workers.

ESOP Incentives in the United States

Employer tax deduction. Up to 25% of participants’ payroll may be deducted from the gross income of an employer to make principal payments on an ESOP loan used to acquire employer securities. Deductible contributions in excess of 25% are permitted to the extent the excess is used to pay interest expense on an ESOP loan.

Employee tax deferral. The annual addition that may be allocated to each participant’s account in the plan cannot exceed the lesser of 25% of pay or $30,000. Stock acquired for employees’ accounts is not taxed until distributed. Distributions are taxed at original cost utilizing 5-year averaging rates if received in a lump sum after age 59-1/2, on account of separation from service or due to death or disability.

Rollover of gain. If, after a sale of stock to an ESOP, at least 30% of the stock of a closely-held company is held by the plan, tax is deferred on any gain realized by selling shareholders to the extent that proceeds are “rolled over” (reinvested) within a 15 month period beginning three months prior to the sale in securities of other operating companies.

Dividend deductions. Companies may claim a deduction for dividends paid on ESOP-held stock, provided the dividends are either applied to repay an ESOP loan or paid out to employees on a current basis.