Page 334 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

320 The Complete Guide to Executive Compensation

benefit) and the interest (as a normal business expense). The amount credited to each
employee’s account would be in relation to his or her portion of the total payroll. For
example, a person earning $100,000 would receive 1 percent of the total stock award if the
total payroll were $10,000,000.
ESOPs can be very attractive to individuals who own a large portion of company stock,
especially in privately held businesses. Death, disability, and retirement often create signifi-
cant problems with liquidity and keeping control of the business in friendly hands. By selling
stock to an ESOP, owners can get needed cash and their companies can take a tax deduction
for the employee benefit. In addition, by taking out key employee insurance on majority
shareholders, the trust can use the proceeds of the policy to purchase the deceased’s stock
from the estate. The ESOP provides liquidity and keeps control of the business in friendly
hands. However, these attributes are more important for smaller organizations (than their
larger counterparts) due to problems associated with determining the value of the stock and
obtaining a buyer both willing to purchase at fair market value and acceptable to the other
owners. These plans are also known as LESOPs (leveraged employee stock ownership plans),
although the Technical Corrections Act of 1979 officially identifies them as ESOPs. A non-
leveraged ESOP has no borrowings; it simply makes annual contributions to the trust that
are then allocated by the above-described earnings formula to individual accounts.
For a period of time, larger companies adopted ESOPs in the form of a TRAESOP (Tax
Reduction Act form of employee stock ownership plan) because of the tax credit. As the name
implies, this is an ESOP provided by a tax reform act (more specifically, the Tax Reform Act
of 1975). The Technical Corrections Act of 1979 officially identified such plans as tax credit
employee stock ownership plans. Compensation and benefit expenses usually qualify for a tax
deduction, which simply means the government will underwrite a portion of the expense (i.e.,
the applicable tax rate). Under a tax credit, the government underwrites the full cost of the
plan since the deduction is applied to taxes due rather than to company income! Needless to
say, this is a more attractive form of benefit “expense” to the company—especially since it
increases corporate cash flow by the amount of the expense. Unfortunately for executives,
the allowable TRAESOP amounts were very meager on a per-employee basis. While all
employees were to share proportionately in the amount of the credit, there was a $100,000
earnings ceiling. In other words, anyone earning above $100,000 would receive the same
dollar benefit as a person earning $100,000. Furthermore, while contributions were immedi-
ately 100 percent vested, they could not be distributed before seven years, except in cases of
separation from service (including disability, retirement, and death). Some companies chose
to make payments only under such conditions, barring distribution to active employees.
In any event, these were likely to be small accumulations except in cases of long service at
high earnings for a capital-intensive company (which has a high credit and a small employee
population).
The 1981 Economic Recovery Act modified and extended TRAESOPs briefly but then
legislated them out of existence. The capital investment formula was replaced with a payroll-
based credit of 0.5 percent for 1983 and 1984, increased to 0.75 percent for 1985 through
1987, after which TRAESOPs expired.
Profit-Sharing Plans. The typical profit-sharing plan will set aside a portion of profits for
distribution to the company’s employees. Profits can be defined as either before or after
taxes. It may apply to the first dollar of profit or after exceeding a prescribed threshold or
minimum level. Alternatively, it can be paid even if there are no profits! Although called