Employee Stock Ownership Plan

Ashgrove Metals sponsors a qualified retirement plan that invests primarily in Ashgrove's own common stock and allocates shares to participant accounts each year. Nolan Reyes participates and watches his account balance rise and fall with Ashgrove's share price. This arrangement is BEST described as:

1. A.A nonqualified deferred compensation arrangement, since it is funded with the employer's own shares.Wrong. Nonqualified deferred compensation is a selective, unfunded promise to a small group. An ESOP is a broad-based qualified plan with real assets held in trust.
2. B.A defined benefit pension plan, because the employer bears responsibility for the retirement outcome.Wrong. In a defined benefit plan the employer promises a stated benefit and bears investment risk. Here Nolan's balance rises and falls with the stock, which is defined contribution behavior.
3. C.An employee stock ownership plan - a qualified defined contribution plan whose assets are invested primarily in employer securities.Correct. An ESOP is a defined contribution plan built to hold employer stock, which is why the participant's balance moves with the share price.
4. D.A money purchase pension plan, because the employer must contribute a fixed percentage of pay each year.Wrong. A money purchase plan is defined by its mandatory fixed contribution formula, not by holding employer stock. The facts here point to the asset held, not the funding formula.

Why: This is an employee stock ownership plan (ESOP). An ESOP is a qualified DEFINED CONTRIBUTION plan designed to hold employer securities as its principal asset. Because it is a defined contribution plan, what goes IN is defined - the annual allocation of shares - and the participant bears the investment risk on what comes out. That is exactly why Nolan's balance tracks Ashgrove's stock price. The obvious downside is concentration: an ESOP participant's retirement savings and his paycheck both depend on the same employer.

Halvorsen Machine Works wants a qualified defined contribution plan deliberately designed to invest primarily in the sponsoring employer's own stock, so that participants build an ownership stake and departing employees receive shares or their value. Which arrangement fits?

1. A.An EMPLOYEE STOCK OWNERSHIP PLAN, a defined contribution plan required to invest primarily in qualifying employer securities.Correct. The ESOP is the qualified plan built to hold employer stock, giving participants an ownership stake and giving a closely held sponsor a ready market for its shares.
2. B.A money purchase pension plan.A money purchase plan commits the employer to a fixed annual contribution stated as a percentage of pay. Its assets are ordinarily diversified and it carries no mandate to hold employer stock.
3. C.A defined benefit pension plan.A defined benefit plan promises a formula benefit at retirement and the employer bears the investment risk. Holdings of employer securities in such a plan are tightly restricted.
4. D.A SIMPLE IRA.A SIMPLE IRA is an IRA-based salary reduction arrangement for small employers. The assets sit in individual IRAs and the plan is not a vehicle for holding the sponsor's stock.

Why: An EMPLOYEE STOCK OWNERSHIP PLAN is a qualified defined contribution plan that is required to invest primarily in qualifying employer securities. It gives employees an equity stake, provides a market for the shares of a closely held business, and lets the sponsor deduct contributions made in stock as well as in cash. Its concentration in one security is the trade-off; ordinary fiduciary diversification duties are relaxed for that reason.

Ferrous Halloran owns roughly 80% of a profitable closely held C corporation and wants eventual liquidity for his stake while giving employees an ownership interest. His advisers propose establishing an employee stock ownership plan (ESOP). Which statement about an ESOP is correct?

1. A.An ESOP is a defined benefit plan in which the employer guarantees participants a stated retirement benefit funded with company stock.Incorrect. An ESOP is a defined CONTRIBUTION plan. No stated benefit is promised, and the account value follows the value of the shares.
2. B.An ESOP is a qualified defined contribution plan designed to invest primarily in employer stock; it may borrow to buy shares, participants meeting age and service thresholds must be offered diversification rights, and distributed shares may qualify for net unrealized appreciation treatment.Correct. The statutory permission to concentrate in employer stock, leveraged purchases, diversification rights and NUA are the defining ESOP features.
3. C.Because qualified plans must diversify, an ESOP may hold no more than 10% of its assets in employer securities.Incorrect. The 10% limit constrains other plan types. An ESOP is expressly designed and permitted to invest primarily in employer securities.
4. D.An ESOP may not borrow money, so the owner can sell only as many shares as annual employer contributions can fund.Incorrect. The leveraged ESOP, in which the plan borrows to buy a large block at once, is a principal reason owners use the structure.

Why: An ESOP is a qualified DEFINED CONTRIBUTION plan that is designed by statute to invest primarily in the securities of the sponsoring employer. That single feature drives everything else about it. It is the one qualified plan permitted to concentrate in employer stock rather than diversify, and it is also permitted to borrow money to acquire a block of shares, the leveraged ESOP structure that lets an owner sell a large stake in a single transaction while the company repays the loan with deductible contributions. Because the concentration risk to employees is obvious, the rules require that participants who reach the specified age and service thresholds be offered the right to diversify a portion of their employer stock into other investments. On distribution, a participant who receives employer securities in a qualifying lump sum may use net unrealized appreciation treatment, paying ordinary income tax only on the plan cost basis and deferring the appreciation until the shares are sold, when it is taxed as long-term capital gain.