An ESOP is a plan qualified by the Internal Revenue Service as an equity-based deferred compensation plan. As such, it is in the same family as profit sharing plans and stock bonus plans. An ESOP, however, differs from a profit sharing plan in that an ESOP is required to invest primarily in employer securities, while a profit sharing plan is usually prohibited from investing primarily in employer securities. An ESOP also differs from profit sharing plans and from stock bonus plans in that an ESOP is permitted and authorized to engage in leveraged purchases of company stock. As a consequence, an ESOP requires different accounting procedures and a different method of allocating stocks and other investments among the employees than other types of plans. For this reason the plan should be designed by an ESOP specialist in order to avoid IRS difficulties.

If the ESOP is not leveraged, the Code allows the company to make tax deductible contributions of up to 15% of eligible payroll. Contributions can be made in any amounts up to 25% of payroll if the company has unused pre-1987 contribution carryovers or if the plan is combined with a money purchase pension plan which provides for a fixed annual contribution of up to 25% of eligible payroll to the extent necessary to make principal payments on a loan, assuming that the company does not also contribute to another employee benefit plan. If the company makes a full 25% contribution to an ESOP, it would be precluded from making any contributions to another defined contribution plan such as a profit sharing plan or a 401(k) plan. Conversely, if the company makes contributions to a profit sharing plan or a 401(k) plan, the company will not be able to make a full 25% contribution to the ESOP. It should be specifically noted, however, that the interest on an ESOP loan is deductible over and above the 25% limit on contributions to pay principal, provided that not more than one-third of the contribution is allocated to the highly compensated employees.

If the ESOP is leveraged and the company desires to obtain a contribution deduction in excess of 15% of eligible payroll, the loan must be obtained prior to the company's year end, and the contribution amount in excess of 15% of eligible payroll must be used to pay down loan principal prior to the company's year end. If the contribution amount is 15% of eligible payroll or less, the contribution need not be made until the due date for filing the corporate tax return, including extensions.

The ESOP, like a profit sharing plan, must cover all non-union employees who are at least age 21 and have one year of service. An ESOP may either include or exclude union employees. In practical effect, share ownership under the plan is usually proportionate to the relative salaries of the participants in the plan.

Employer contributions must vest under one or the other of the following vesting schedules:

                    Year 1 --   0       Year 1 --   0

                    Year 2 --   0       Year 2 --   0

                    Year 3 --  20       Year 3 --   0

                    Year 4 --  40       Year 4 --  40

                    Year 5 --  60       Year 5 -- 100

                    Year 6 --  80

                    Year 7 -- 100

An employee is entitled to commence receiving his plan benefit once he has incurred a five year break in service. Such distribution may, at the option of the company, be paid in a lump sum or in five equal annual installments. Except in the case of death, disability or retirement, if the plan has incurred a loan, distribution need not commence until the loan has been repaid in full.

Distributions from an ESOP may be rolled over or transferred into an IRA. If the distribution is in company stock, and the stock is "put" to the plan in exchange for a promissory note (payable in 5 equal annual installments of principal), the note can be rolled over into an IRA. If, however, the stock is sold in exchange for a note, the company must post "adequate security" for the note.

Once a participant reaches age 55 he may elect to diversify up to 25% of his plan benefit. Once he reaches age 60 he may elect to diversify an additional 25% of his plan benefit. The plan must offer at least three investment options. In the alternative, the plan may simply distribute the requisite amount and the participant may then roll over this amount into an IRA. If the participant has not attained age 59 and does not roll over his distribution into an IRA, he will be subject to a 10% penalty tax in addition to ordinary income taxation.

Distributions from the plan are normally made in cash, unless the participant specifically requests that the distribution be made in stock. Under certain circumstances, the option to take the distribution in stock may be eliminated entirely. If the participant has received the distribution in stock, he must be given a "put" option to the company and to the trust (which guarantees the marketability of the stock for a period of 15 months) and a "right of first refusal" (which prohibits him from selling the stock or gifting the stock to any third party without first offering to sell the stock to the company or to the ESOP).

The plan is administered by a committee established by the directors of the company. All voting rights are normally exercised by the committee. However, employees are allowed to vote on any matters involving liquidation, dissolution, recapitalization, merger, or sale of all or substantially all of the assets of the corporation. Thus, voting control of the ESOP may be maintained by the initial shareholders, even after they no longer own 51% or more of the company stock. That is, if the original shareholders control the committee, they will be able to control not only the stock they still own, but also the stock owned by the ESOP. So long as the shareholders are careful in appointing the committee members, there need never be a loss of voting control.

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