Quiz 7: Employee Stock Ownership Plans Esops

Business

ESOP i.e. Employee Stock Ownership Plan is a method of employee retirement plan under defined contribution approach qualified under the conditions of Employee Retirement Income Security Act (ERISA) where the contribution made is primarily invested in the employer's stock. ESOP can be leveraged or non leveraged. Leveraged ESOP refers to the plan where the investment is made through debt financing. The trust created by employer takes the loan and the contribution made by the employer is used to repay the loans in instalment. As per the provisions, the leverage ESOP is exempted from the prohibited transaction provision of ERISA. Apart from this, it is also exempted from the diversity requirements of contribution stated under ERISA. Though, leveraged ESOP are subject to fulfil the prudency requirements under any circumstances. The rational for providing such exemption in the fiduciary requirements depends solely upon the factor that the loan has been taken with the primary purpose of employees and their beneficiaries benefit and no other reason. In order to confirm the same, special scrutiny is made by Department of Labour (DOL) Internal Revenue Service (IRS) to fulfil the purpose of employees benefit. Thus, under leverage ESOP the above stated exemptions are available but on the fulfilment of the conditions.

Employee Stock Ownership Plan (ESOP) is referred to as one of the method of defined contribution plan under which a part or whole of the asset is invested in employers securities through a trust that manages such share holdings of the beneficiary employees. Leveraged ESOP refers to an ESOP where the large part of the plan contribution is based upon debt financing. An arrangement of debt financing in leveraged ESOP involves  back-to-back loan/arrangement  where a loan is taken from bank directly by the trust where guarantee is provided by the employer for repayment and the amount as because trust does not generate any income or otherwise employer directly takes loan from the bank and deposit it in a suspense account with the trust who purchase shares from it. As the employer goes on paying the contribution amount to the trust, the trust repays it to the bank and when all the dues are cleared, the shares in the suspense account are allocated to the employees according to their eligibility. This method involves use of borrowed fund or debt financing to purchase employer securities directly from the employer.

Employee Stock Ownership Plans i.e. ESOPs is a method of investment of contribution under defined contribution retirement plan where the major investment is made primarily in the employer's securities. This process serves both advantageous and disadvantageous to the employer and the employees. ESOPs can be leveraged which means that an the financing made in the purchase of security is primarily made from debts. In this method, the employer establishes a trust that takes bank loan and employer act as a guarantor holding only the contingent liability. The contribution made by the employer for the ESOP is used to repay the loan taken from the bank. Advocates often claims that a leveraged ESOP allows employer to retire the debt with pre-tax dollars however the reason behind it is that the loan is actually incurred by the trust who repays it with the employer's contribution money which is paid pre-tax. This result in debt pay off through pre-tax dollars however it causes a charge to the earnings leading to reduction in the net income and earnings per share. Also the share value decreases and the cash flow of the company gets effected. Thus, the one side of the coin that the debt is paid off from pre-tax money is quite oversimplification of the larger side of the financial aspects that are included in a leverage ESOP.

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