Chapter 6 - Stock Bonus Plans & Employee Stock Ownership Plans

Question 1

Define Adequate Consideration Standard

Answer 1

Fair market value determined in good faith.

Question 2

Define Dilution

Answer 2

The reduction in the monetary value or voting power of an owner’s stock as a result of contributions to stock bonus plans and ESOPs.

Question 3

Define Discretionary

Answer 3

The choice for a plan sponsor of a profit sharing plan as to the amount and frequency of a contribution

Question 4

Define Disqualified Persons

Answer 4

Any person who owns with other family members 20% of more of the stock of the company, or in the case of someone without other family ownership, owns 10% or more of the stock of the company.

Question 5

Define Diversified Investment Portfolio

Answer 5

An investment portfolio invested in a broad range of investment classes to reduce investment risk.

Question 6

Define Employee Stock Ownership Plan (ESOP)

Answer 6

A qualified profit sharing plan that utilizes employer contributions to the plan to purchase the stock of the employer’s company and allocates the ownership to the plan participants.

Question 7

Define Fair Market Value

Answer 7

The price that a willing buyer would pay to a willing seller, both having reasonable knowledge of the pertinent facts and neither under duress.

Question 8

Define Leveraged ESOP

Answer 8

An ESOP that borrows the funds necessary to purchase the employer’s stock. The interest and principal repayments on the loan are tax deductible for the employer.

Question 9

Define Net Utilized Appreciation (NUA)

Answer 9

The appreciation in value of employer stock after the date of contribution to the plan until the date of distribution.

Question 10

Define Nonallocation Year

Answer 10

Any plan year of an employee stock ownership plan that holds employer securities consisting in an S corporation, and disqualified persons own at least 50% of the number of shares of stock in the S corporation.

Question 11

Define Nonrecognition of Gain Treatment

Answer 11

A delay in the recognition of gain available to owners of a company that sell company stock to an ESOP. The transaction must meet the stated requirements of the IRC and the owner must reinvest the proceeds from the sale within 12 months of the sale into qualified domestic replacement securities.

Question 12

Define Pas Through Voting Rights

Answer 12

The voting rights of the stock pass through from the ESOP or stock bonus plan to the participants.

Question 13

Define Qualified Replacement Securities

Answer 13

Securities in a domestic corporation, including stocks, bonds, debentures, or warrants, which receive no more of their income from passive investments.

Question 14

Define Rank-and-File Employees

Answer 14

The non-key, non-highly compensated employees.

Question 15

Define Repurchase Option (Put Option)

Answer 15

An option that allows a terminating employee to receive in cash the FMV of the employer’s stock with a stock bonus plan or ESOP if the employer stock is not readily tradable on an established market. An option to sell to the employer.

Question 16

Define S Corporations

Answer 16

Small corporations taxes as pass-through entities that cannot have more than 100 individual shareholders and have only one class of stock.

Question 17

Define Stock Bonus Plan

Answer 17

A qualified profit sharing plan funded solely with employer stock.

Question 18

Define Substantial and Recurring

Answer 18

IRC standard defining the frequency requirement of contributions by employers to profit sharing plans.

Question 19

Why would an employer establish a stock bonus plan instead of a profit sharing plan?

Answer 19

Because they don’t want to take away from their cash flow to provide their employees benefits. With a stock bonus they can use shares of stock instead of cash that may or not be best used to fund an employee’s account.

Question 20

What is in ESOP?

Answer 20

An employee stock ownership plan is a qualified plan that invests primarily in “qualifying employer securities,” typically shares of stock in the corporation creating the plan.

Question 21

What requirements must stock bonus plans satisfy?

Answer 21

• Unlike PSPs, stock bonus participant’s must have pass through voting rights on employer stock held in the plan.
• Participants must have the right to demand employer securities on plan distributions.
• Participants must have the right to demand that the employer repurchase the employer’s securities if they are not publicly traded (the put option).
• Distributions must begin with one year of normal retirement age, death, or disability, or within five years for other modes of employment termination.
• Distributions must be fully paid within five years of commencement of distributions.

Question 22

What are the advantages of a stock bonus plan?

Answer 22

• The FMV of the contributions of employer stock are tax deductible to the employer.
• Contributions are not required to be fixed in amount, which allows the corporation flexibility in funding.
• They promote productivity within the corporation because participants, as shareholders, have a vested financial interest in the growth and success of the corporation.

Question 23

What are the disadvantages of a stock bonus plan for the employees?

Answer 23

• For employee, risk associated with non-diversified portfolio
• If corporation were to fail, entire value of employee retirement accounts may be lost as well as job and source of income.

Question 24

What are the disadvantages of a stock bonus plan for the employers?

Answer 24

• Ownership and control of corporation are diluted.

- Required put option could deplete cash of the corporation.

Question 25

What are the diversification requirements for stock bonus plans?

Answer 25

To the extent that a stock bonus plan is funded with publicly traded stock, it is required of the plan to allow plan participants to diversify their pre-tax deferrals, after-tax contributions, and employer contributions that have been invested in employer securities. All plan participants must be allowed to diversify the investment of their elective deferrals and after-tax contributions. In addition, plan participants with more than three years or service must be allowed to diversify the investment of other contributions made on their behalf.

Question 26

What is the difference between PSP and stock bonus plans when it comes to voting rights?

Answer 26

If a PSP consists of employer stock, the plan participant generally does not having voting rights in the stock held by the plan. However, participants in a stock bonus plan must have pass through voting rights on employer stock that is held by the plan on their behalf.

Question 27

What is a benefit for taking a distribution from a stock bonus plan of shares instead of cash?

Answer 27

The participant gets to defer income tax on the stock’s appreciation until the stock is actually sold.

Question 28

What is the taxation consequence of taking a lump sum distribution in the form of the employer’s stock?

Answer 28

The employee will be subject to ordinary income tax in the year of the distribution based on the fair market value of the employer stock at the time of the original contribution.

Question 29

What is the taxation consequence of taking a partial distribution in the form of the employer’s stock?

Answer 29

The FMV of all employer securities distributed in the installment distribution attributable to employer contributions will be taxed as ordinary income.

Question 30

What is the tax benefits of NUA?

Answer 30

The NUA of the stock is not taxed as ordinary income at the time of the distribution, but rather is taxed as long-term capital gain when the stock is sold. There are no holding period requirements to qualify this gain for the preferential long-term capital gains tax treatment. The cost basis of the stock (as provided by the employer) at the date of contribution is taxable as ordinary income at the date of distribution.

Question 31

What are the requirements in order to qualify for nonrecognition of gain treatment?

Answer 31

1. The ESOP must own at least 30% of the corporations stock immediately after the sale (notice that the controlling interest may remain owned elsewhere, but if this occurs the ESOP share should have been valued using a minority share discount).
2. The seller or sellers must reinvest the proceeds from the sale into qualified replacement securities withing 12 months after the sale and hold such securities three years.
3. The corporation that establishes the ESOP must have no class of stock outstanding that is tradable on an established securities market.
4. The seller or sellers, relatives of the seller or sellers, and 25% shareholders in the corporation are precluded from receiving allocations of stock acquired by the EDOP through the rollover.
5. The ESOP may not sell the stock acquired through the rollover transaction for three years. The requirement, however, will not apply if the corporation is sold. The three-year period is called a “holding” period, which prevents unnecessary, duplicative rollovers by the corporation.
6. The stock sold to the ESOP must be common or convertible preferred stock and must have been owned by the seller for at least three years prior to the sale.

Question 32

What are the advantages of ESOP plans to the employers?

Answer 32

• Creates a market for stock in a private/closely held corporation
• Helps retain employees
• Improves employee loyalty
• Employee-owners may create a diversified portfolio without recognition of capital gain.
• Corporation can borrow against stock
• Corporation can improve the current cash flow of the corporation by taking a tax deduction on stock contributions

Question 33

What are the disadvantages of ESOP plans to the employers?

Answer 33

• Dilutes ownership
• Administrative costs
• May strain employer cash flow to meet payout requirements to departing employees at uncertain times
• Periodic appraisal costs are expensive
• Personal liability concerns for officers or management who also serve as trustees to ESOPs
• Creates cash flow uncertainty in the future
• Social Security integration is not permitted.

Question 34

What are the advantages of ESOP plans to the employees?

Answer 34

• Acquires ownership in employer corporation
• Employees have better perception of or attitude towards employer corporation
• Favorable tax treatment on stock distribution (NUA)
• Can force employer to repurchase stock at end of employment (put option)
• Receives stock as form of compensation

Question 35

What are the disadvantages of ESOP plans to the employees?

Answer 35

• Employee bears risk of employer’s insolvency (non diversification)
• Value of stock subject to appraiser
• Stock value subject to fluctuation
• Stock not liquid

Question 36

Why are valuations necessary for employer stock in ESOPs?

Answer 36

• When contributions are made to an employee’s account, the employer must know the value of the contribution for the corporation’s tax deduction purposes.
• When contributions are made to an employee’s account, the employee must know the value of the contribution for future NUA calculations.
• If a lender lends money to leverage the ESOP, the lender must know the value of the stock to determine if and how much money to lend to the corporation.
• If an employee exercises the put or repurchase option, the value of the stock must be determined.
• Valuations are needed for financial statements and reports.

Question 37

What are the fiduciary duties related to the handling of an ESOP under ERISA?

Answer 37

• The duty of loyalty, which requires the fiduciary to make all decisions regarding the ERISA plan “with an eye single to the interests of the participants and beneficiaries”
• The “prudent man” obligation, which requires the fiduciary to act as a prudent person would act in a similar situation or under similar circumstances; and
• The exclusive purpose obligation, which requires the fiduciary to act for the exclusive purpose of providing benefits to plan beneficiaries.

Question 38

How are participants in an ESOP treated in regards to an S Corp running the ESOP?

Answer 38

To maintain being an S corp there is no more than 100 shareholders allowed, so to make ESOPs feasible the ESOP itself counts as 1 shareholder instead of counting each participant as a shareholder.