Page 333 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 6. Employee Benefits and Perquisites 319

by plan formula. The amount of benefit the plan participant receives will be based on contri-
bution (employer and/or employee, depending on the plan) as well as investment gains and
losses. However, qualified plans are limited by Section 415(c) of the IRC, which requires the
annual addition to the individual’s account be the lesser of $40,000 or 100 percent of the
participant’s compensation. Defined-contribution plans can also be integrated with social
security; however, the maximum spread cannot exceed the lesser of 5.7 percent or two times
the lowest rate.
Forfeitures of nonvested benefits by terminating employees may, by plan design, also be
allocated among plan participants. This is a key difference from defined-benefit plans where
forfeitures must be used to reduce employer contributions; they cannot be used to increase
benefits of plan participants. Thus, an employee in a plan that is experiencing high employee
turnover may receive significantly more than the amount of the company match. This is not
a required feature, and some plans take the same approach required of defined-benefit plans,
namely, to use the value of the forfeitures to offset the company contribution.
Employee contributions may be prohibited or permitted and, if permitted, either volun-
tary or mandatory, and from pretax and/or after-tax pay. The advantage to employees is that,
even if their contribution is made in after-tax dollars, the tax on company contribution plus
any appreciation on investments is deferred until the time of retirement. Under some condi-
tions, it may be possible to defer tax liabilities on unrealized capital gains even further if at
the time of with-drawal the amount is taken in company stock.
Unlike defined-benefit plans, defined-contribution plans are not restricted as to the
amount of plan assets that can be held in company stock. By design, some defined-contribu-
tion plans are 100 percent company stock; others have varying amounts. Not atypical is that
the company contribution to defined-contribution plans is in company stock while employees
can usually choose what portion, if any, of their contributions will be in company stock ver-
sus alternative investment options. When individual contributions are accepted, many plans
provide half a dozen or more choices, each with different reward and risk characteristics. This
provides sufficient investment flexibility to participants, avoiding company liability for
investment losses. The objective is to fall under the safe-harbor provision of ERISA.
This section reviews a number of variations of defined-contribution plans. They include
employee stock ownership plans (ESOPs), profit-sharing plans, employee stock purchase
plans, employee stock option plans, savings plans (a.k.a. thrift plans), cash or deferred
arrangements (CODAs), individual retirement account plans (IRAs), and Keogh plans. We
begin with ESOPs.
Employee Stock Ownership Plans. An employee stock ownership plan (ESOP) can be
viewed as a broad-based, deferred stock award plan that meets the defined-contribution plans
requirement of Section 401 of the IRC. They were developed in the 1950s by investment
banker and lawyer Louis Kelso and were known as Kelso plans. ESOPs are either leveraged
or nonleveraged. With either form, accounts for each employee are established and annually
credited with the number of shares prescribed by formula.
The leveraged ESOP is one way to obtain financing for the company and pass on a por-
tion of company ownership to employees. The company makes a contribution of company
stock to an employee stock ownership trust (ESOT). The trust, in turn, uses the stock to
obtain a loan, the proceeds of which it gives to the corporation. The corporation then pays
off the loan through the trust and gains a tax deduction on the principal (as an employee