ESOP’s Lawyers and accountants can’t make hay from this. Everyone can have skin in the game. United Airlines and The Chicago Tribune. Avoiding taxes. The 80-20 rule reveals itself again. How can you determine the value of anything? Lose your job and your retirement plan tanks. Bad day.

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Ed: Welcome, I’m Ed.

Chuck: I’m Chuck.

Ed: Today’s topic will be a specialized individual account plan called an ESOP, but more specifically, an employer stock ownership plan and associated trust. Having said that, bearing in mind that one of our last sessions we talked about two types of defined contribution, retirement arrangements. Specifically, the simple, which is, as the name might suggest, a very simple savings plan with employee or match expressed on a very simple government forum, called forum 5304-simple. You can pull that up on irs.gov documents. You will have a tax-qualified arrangement permitting deductions and employer matching or non-matching contributions. First, reductions of about $13,000 employer match/adds up to 5%. Then we have a SEP IRA form 5305-SEP, which permits employer contributions to IRAs set up by each individual who’s been with the company organization at least three years and has a compensation of at least $600. The drawbacks in both these arrangements is their simplicity. There’s no opportunity for lawyers and accountants to really make hay on the arrangement, but the positive is, there’s no fiduciary responsibility. I’m sorry, no impact on the employer other than having established that contributions are made by the employer to IRAs and end of story. We also talked about a defined contribution plan in the form of a profit-sharing plan. We also talked about the 401K plan. The ESOP, Chuck, any observations about it?

Chuck: Yes, this is actually pretty, I think, just heuristically, the best way to think about this as a form of the profit-sharing plan or the employer-sponsored plan, such as a 401K. In the sense that it’s an employer-sponsored plan that involves having a trust. So that the individual participant rather than having their own IRA holding their separate assets, they’re actually a participant in this omnibus account. This omnibus trust account with the particular characterization of the ESOP. What makes it different is the fact that as the name implies, it’s holding company stock. This is a way of getting employees to have some ownership in their employer company stock. There’s a limitation or it’s just necessary by the design of the thing that there is not choice on behalf of the employees to choose various investments. If they’re in this, they’re going to be invested in employer stock. I suppose some people would think that that’s the downside. Of course, if the employer is not a successful employer, then that would genuinely be a very serious downside, but the upside is that, as we’ll be getting into here, there are some really particular tax benefits that go above and beyond the benefits. That apply to any other employer-sponsored plan that would that apply specifically to this type of plan. Also, that this is just a great way of having employers incorporate ownership by their employees into the business so that everybody has your favorite term here. Everybody has skin in the game, or at least the employees who are participating in the plan, all have skin in the game, in the sense that they are cognizant of how the stock is performing. They’re interested in it performing well. They’re financially invested in the business doing well. These plans are subject to eligibility requirements, vesting requirements and so on, but the idea is to have the vast majority of the workforce as shareholders of the company.

Ed: Yes. We get to the definition of an ESOP and that’s an arrangement, our plan and trust, which is designed primarily, to invest primarily qualified employer securities. I mean, there can be other investments and there’s some diversification options with respect to each participant after securing several years of service. It isn’t necessarily 100% in employer style, but it’s for the most part, in employer stock. The downside is the performance of the organization, and the upside is the performance of the organization. A way of illustrations in United Airlines, when it went belly up, over half of the employee benefits were held in the ESOP which went to nothing. More recently, the Tribune company was the subject of a court leveraged buyout with an ESOP, and it’s fell on very hard times. The very best types of employers that should be adapting or at least considering an ESOP would be those that are very capital intensive. For example, a bank, an insurance company, large manufacturing facilities that have a fixed source of capital and a return on invested capital in the form of cash. This suggests that a small organization, a startup or for that matter, some of the, wish to call these non-capital companies out in the West Coast, are not really good opportunities for ESOPs. One of the primary issues we have is the value. How do you determine value for ESOP purposes?

Chuck: Yes. I think that’s actually one of the most difficult things for plan sponsors and employers and ESOP trustees where they can really get into trouble is on the question of value when the company in question is not a publicly traded company. If it’s a publicly traded company, then it’s very easy to answer this question. You can simply refer to what the market is placing on the value of the stock. A quite of few of these ESOP plans are introduced by companies where their stock is not publicly traded, and then it is necessary for the trust that’s holding the stock to periodically have a formal appraisal done on the value of the business in order to place a value on the stock. There have been many, many cases. It’s actually– I don’t want to go quite as far as to say it’s a cottage industry, but this is a– it’s a serious problem, I think. Where sometimes the people who are coming up with those values, on behalf of the employer and the end the trust are not going about that in a completely independent way. They end up coming up with values that later get challenged, bringing court cases and resulting in fiduciary liability. The short answer to the question, how do you determine the value, actually it’s pretty easy. You just simply have an appraisal done of the value. You make sure that appraisal is someone who is well qualified and understands the industry and is going to act independently. I guess the longer answer is that there– I think it’s really important to make sure that the appraiser is doing that in the best faith possible, since there are a number of instances where this particular function has caused a lot of problems.

Ed: In other words, there’s really a relationship between the employer, the major shareholder, and the trustee. That trustee must be independent and is a fiduciary. In the sense, he’s going to act in the best interest of the beneficiaries, his participants. In the critical issue is yes, we can come over the value. Down the road when a participant retires, where is the sufficient cash to cash out the individual to buy the shares back? While the benefits, and we’ll get into fantastic benefit in the form of conversion of ordinary income, capital gain and reinvestment opportunities in deferring gain– the real issue is, do we have an organization that evaluation issues don’t apply, that is, the marketable securities traded on New York Stock Exchange? Second, do we have one, even if it is soul traded that can generate sufficient cash to pay off the liabilities associated with the distribution of employer’s securities to the participant when that participant no longer is employed? Check the tax benefit, especially when the net unrealized appreciation. This is my favorite turning ordinary income to a capital gain. Can you address that?

Chuck: Exactly. This is the golden opportunity that is really unique with respect to employer securities in a retirement plan. The idea here is that again we covered this in previous episodes of the podcast. When employee participates in an ESOP plan, bear in mind that what’s happening is that the money that is going into the plan is money that otherwise would be realized too that employee in the form of salary. It would be subject to payroll taxes. That’s both social security and Medicare taxes. Then on top of that it would be subject to ordinary income tax, which is the type of income tax that will typically have the highest possible rate. What you’re doing is by putting money into what would otherwise be wages into an ESOP plan. You’re avoiding, FICA you’re avoiding FUTA, you’re avoiding ordinary income. You’re deferring all of that by putting the money into the plan. Of course, state income taxes to are avoided or deferred depending on the state. Then the money is allowed to grow inside the plan without incurring any income tax on the dividends that are generated inside the plan or any growth in the value of the stock. Now normally with any other type of retirement plan, that’s what happens when the money goes in. When it comes out, you pay ordinary income tax on that. That does get stripped of any obligation to pay social security tax, but it still is taxed as ordinary income. With employer stock, this is the one exception. It’s the only exception I know of. What will happen is that you can have the stock itself not cash distributed to you, but the participant can have the stock itself distributed to the participant. The tax is imposed only on the basis of the stock that comes out to the employee.

Ed: Let’s talk about an example. Let’s assume a trustee of NEWCO, ESOP, and paid $10 a share bought on the open market. At the data’s distribution is worth $110. In other words, there’s $100 of unrealized untaxed appreciation. As they ESOP trustee, I distribute those shares to Pete. In one lump sum in one year, it’s all ESOP shares. The tax consequences then. That $10 a share is taxed as–

Chuck: That’s taxed as ordinary income.

Ed: Though $100.

Chuck: Is that that point unrealized gain, so you can continue to hold the stock after it’s been distributed out of the plan and have it continue to accumulate further value and not pay any tax on that until you sell the stock. Then when you sell the stock then you incur the capital gain.

Ed: On 100.

Chuck: On 100.

Ed: Those issues about tax step-up in the like. Of course, if you were to send it to an IRA you lose that benefit. You want to keep that stock in your own name and of course, you can margin it and that thing to get the cash out of it. The point is it’s the only place that I know of in the Internal Revenue code where you convert ordinary income, $100 per share to capital gain as to the unrealized appreciation of $100 tax basis of 10.

Chuck: It’s easy to imagine two people both of whom buy a particular stock at the same price at the same time and do so inside an employer-sponsored plan. One of those people and we’ll just for the sake of our argument refer to him as Ed, happens to be an employee of that company. He gets this advantage of the net unrealized appreciation treatment of that when it comes out. Let’s say the other one, hypothetically, will call him Chuck, works for a different company. He’s buying this just in an ordinary plan. If they both retire at the same time, if that stock is worth $110 per share and it gets distributed out in kind to Chuck. Chuck has to report $110 dollars per share as ordinary income versus Ed who only pays $10 a share. Economically, they’ve both done the exact same thing. It’s just that Ed gets an enormous tax advantage.

Ed: Let’s talk about leverage. We visited about the 80/20 rule but more specifically one of the problems with these ESOPs because people think it is. It sounds like the greatest thing since sliced bread. In fact, with leverage, it can be the worst possible activity. Specifically, what occurs is that a bank will loan the ESOP trustee some money to buy shares. ESOP buys the shares from the co-organization. Then the company makes contributions to the ESOP and it used to pay off the loan ending up with those shares only. A debt free and the appreciation is very substantial at really no cost to the employee. However, they go south. That leverage works as we’ve discussed before. Any insights on leverage, Chuck on this transaction?

Chuck: In general, we like leverage, but I think where these things go south is in the fact that the– What’s happening here with these plans is that they’re typically in the transaction like you just described. They’re highly leveraged. I mean, they’re not following the 80/20 rule. They may be borrowing all of the money or almost all of the money that’s required in order to make that initial purchase of stock. Here is where we back into that discussion, we had a few minutes ago about the evaluation. Which is, who are they buying that stock from? Typically, what’s happening there is that when you’re talking about a small company and they first form that ESOP. Who is the ESOP buying that stock from? Usually, the person who started the company or either directly or indirectly. That person is benefiting by having the value set on that purchase according on the date of that purchase. That person who’s selling to the ESOP wants the value to be high because someone is cashing out of their stock in this plan or in this company or they’re selling some stock to the ESOP. They want a high value on that stock. Of course, it’s in the best interest of the employees who are going to benefit under this ESOP plan for the value to be set low. That’s where you end up with– Who’s hiring the appraiser? Well, ultimately, it’s the employer who ends up with some degree of control over who’s going to appraise it. Again, that’s where you see this combination of things that are on the startup of these where someone who is inclined to be a little bit unscrupulous. If they can also find partners in the transaction who are willing to do a wink-wink-nudge-nudge type of transaction with them, where everybody pretends to be independent, but they’re really not. You can get that combination of having a highly leveraged purchase at a price that might be artificially inflated for the benefit of the person who is setting up the ESOP plan. Ultimately to the detriment of the next generation of people who will be running that company. That’s really not a good way for a plan to start out.

Ed: The issue seems to be getting back to value. We have loved politics, religion and value. All very qualitative even though you can apply mathematical formula to determine what value is. Value is nothing more nothing less than what you can get for the property when you sell it. You can have a real estate appraiser appraise your residents that are million dollars. No one will give you more than $200,000 or it’s no guarantee. The real value is when the subject asset is sold. Moreover, an appraisal can say it’s worth a million dollars, but because of its location. It’s really worth three million dollars because they’re going to rip it down and put up a story office building. Aside from the situation, we have a publicly listed organization is very difficult to contend with. It’s with extreme caution that you go into an employee stock ownership plan and Trust unless you’re confident. The value is sustainable by way the cash flow from the employer over a long period of time. That fourth, five, six years as the organization been around for a long time, consistently generating return on invested capital cash. Watch out for airlines, watch out for the areas that are going down rather than up, for example, the Tribune. What’s happening to newspapers in today’s world? Could you foresee that when the ESOP was set up? But when it’s leverage and value, watch out. One other interesting opportunity for tax savings and the ESOP situation is something akin to the like kind exchange rules for real estate. We refer to that as Code Section 1031, almost everyone hears about 1031. Well, there’s a comparable provision in the internal revenue code related in ESOP’s and that’s 1042. That relates to the sale of stock to an ESOP by individuals. So long as the resulting ownership in the ESOP is at least 30%, and the proceeds I reinvested with a period of time expressed interest code, that’s three months before the date of the sale, and 12 months afterwards, the gain associated with that stock is deferred. Like you would have in the course of real estate. As we’ve talked about before with real estate, you’re married to two people, or you’re married to your spouse and you’re married to the real estate investment. That’s not two people, but a person in an asset. In the same situation with a business organization that qualifies as a corporation and that can take advantage of the special 1042 treatment. The opportunities are enormous. Be careful though, of value and be careful of the fact that you’re married to these shares until such time as you become a ghost. Any observations about any abuses, any further abuses in this area Chuck?

Chuck: Well, yes. There again, of course, you do have to have qualified securities in terms of the securities that are coming out. The other thing is there again, it all depends on the value that’s been placed on the employer stock that’s going into this plan. Yes, it’s another area that’s very ripe for that. It’s interesting, because this particular code section refers specifically to employee stock ownership plans, by name. Clearly, Congress intended to create a very special benefit, just for this type of plan. Any idea and why that was deemed to be in the public interest?

Ed: No, it’s upside down as far as I’m concerned. The ESOP Association and his progeny were successful getting this information into the Internal Revenue Code. It’s really not a retirement program and that’s the thing that concerns me. We have talked about the simple the SEP-IRA, the profit-sharing plan, 401Kplan. Those suggested investments off balance sheet, more likely or not. Now that you’re investing your account balance and in the recent account balance and readily marketable securities, for example, the S&P 500 total return index fund, little no friction costs, but you’re not putting all your eggs in one basket. I think the ESOP is an excellent vehicle to get everyone with skin in the game, but it should not constitute more than 20% of your total investment portfolio, using that at 20% rule. To speak, you’re going to spend 80% of your time on 20% of your issues. Well, and I’m not sure there’s any logic associated with this. I would never suggest to an individual participant of having more than 20% of your total assets in employer securities.

Chuck: Well, I agree with that completely. One thing that I’ve noticed is how frequently that advice is disregarded or really not understood by people. It seems like quite often people who are working for an employer that has employer securities either as an option or as the only option in a retirement plan, the employees tend to very heavily load there, balance, their account with those employer securities. That really is a very genuine concern, because of course, this almost goes without saying except that, apparently, you do have to say it, which is that if that employer hits rough times, two things can happen simultaneously. First of all, you can lose your job and at the same time the value of your retirement plan can go dramatically down or disappear completely if you’ve gone all way. This is literally the case, well, not literally, but this is figuratively what the phrase putting your eggs all in one basket is referring to. People should be extremely cautious. Overall of these ESOP plans are an interesting mixed bag because when they’re working well, they are just fantastic.

Ed: There is nothing like it.

Chuck: Almost the best thing since the sliced bread. I think we’ve used that phrase several times, not today, but in previous episodes, referring to them. On the other hand, people who have an opportunity to participate when they really do need to be fairly cautious. I would say, be a little hesitant if the ESOP plan is first being created, as opposed to one that’s already been in place for quite a while. It’s up and running and it’s running well. You can see whether the cash flow is working the right way with it. You can have a sense of whether the company is producing enough dividends to be able to fund distributions that come out of that plan. Also, if the ESOP has been in place for a while, or the company has also been in place for a while, you have some sense of the stability of the company itself. I would feel a lot more comfortable as an employee participating in a plan that has been around a while. Assuming, of course, that the stock is in the company is performing well and you have every other reason to believe that you can have confidence in the company. Even there, you need to be cautious not to participate too much in the plan. It really should be no more than 20% I would say. If that even of your total portfolio.

Ed: Having said that, my favorite guidepost, guideline is looking at the direct ownership of the shares of the business organization. It seems to me if you have an economic interest in the way of ownership, you’re going to pay a little more attention to what’s going on. My rule of thumb with respect to a listed organization, before I invest in that organization, generally speaking, or I would look at the director ownership outright. I don’t mean restricted stock and non-qualified arrangement, stock options, or any other. I’ll call them gimmicky, but not gimmicky, but they are a situation options in particular, where the director can only win. The employee can only win. Goes up exercises, if it goes down, nothing happens, versus restricted stock, we actually own stock. But most importantly, the case of directors, they should have in after-tax dollars in their portfolio, at least twice their annual retainer in employer securities. If you’re getting $120,000 a year as a director, guess what? $240,000 in cash in stock, and let’s assume it goes to 2,000,000, 4 or five, fine, but you have to have economic skin in the game. The real test and ESOP’s is, who are the directors, that the real one test and all kinds of them. One test is these employers, how much dollars do they have in the organization? After-tax cash in the organization? All these issues can be resolved by simply how much cash you have invested of your own cash after-tax cash.

Chuck: I really couldn’t agree with that more. What’s actually really surprising to me is how many public companies, you find where that’s not the case. To someone who’s just an ordinary person, the thought of having $240,000 of stock in one particular company might seem a little bit daunting. If you’re talking about the person who’s been appointed to the board of directors of a publicly traded company, this is not a heavy lift to say, why not invest at least twice what your retainer is going to be for sitting on that board. It’s astonishing to me, how, how infrequently you see that to be the case. The place where you really should be seeing maybe lower participation at that rate is in the management of the corporation. Even there, I would say, when you’re talking about the CEO, the President, the Vice Presidents, the people who are in the top tier of management, the CFO, and so forth, I would expect them to have heavy participation in terms of stock ownership in any publicly traded company. Yet there, again, quite often what you see instead are stock options.

Ed: Yes. We’ll be discussing this in a subsequent podcast, but executive compensation as contrasted with what does an NFL athlete make and how those things compare. That’s whole different game. You must understand that the measure of conservatism is how much of your cash is in the organization. If you have no cash, you let nothing to lose. If you’re a political maven you’re spending someone else’s money, you have no cash in the game. Whatever the test is, how much cash does the individual have in the game? If you’re on the city council of Chicago, you don’t own part of the city and so you’re going to spend taxpayers’ dollars without regard to the benefit or detriment long-term to the city. I know people would like to run me over with, run over me with a John Deere whatever, or a D nine cat. The bottom line to this is successful wealth accumulation based upon my experience of over five decades messing around this area is that if you have money in the transaction, in the ownership, in whatever you’re doing, you are going to be more cautious, less willing to take gambles and result in a long-term investment that benefits you, your family and in the case of a corporation, it’s employees.

Chuck: I think the takeaway lesson here is for people who have an opportunity to invest in an ESOP, that first of all they should be very excited about having that opportunity. There’s a number of things that they should look at prior to jumping in with both feet. Number one, limit their exposure. Number two, look at the health of the company itself and whether the ESOP has in fact been around long enough and you can assess whether it’s likely to be successful. Then number three, look to the management and the directors of your company and ask yourself, are these people invested in the company to a degree where I know that they really are having skin in the game? I think the worst case scenario we had is when you have somebody where the ESOP is as buying stock from the person who’s running the company who is in fact using it as a way of cashing out that’s an ESOP you don’t want to participate in.

Ed: It’s very difficult course. You can have employer securities in a defined contribution plan and you’ll still get the benefits of this, that unrealized appreciation. But be careful. Don’t run to the bank with the benefits associated with ESOP and think about your long-term goals, your risk tolerance ratios, skin in the game, very complex set of circumstances, but tested against what would you do if it were your money in the game. Going forward we’ll talk about defined benefit plans and in particular some fancy specialized version called a cash balance plan. Chuck, any closing observations?

Chuck: No, but I actually, I have one closing observation of something we haven’t really discussed today in detail because we’ve been talking about this from the employee’s standpoint, but from the employee, your standpoint, I just want to mention one other tax benefit of these things that is not embedded in the code as specifically as section 10, 42. But if the corporation is an S Corp, this is just a fantastic opportunity for an S Corp to have an ESOP plan and avoid income tax on the income that is attributable to that S corp stock that’s held by the ESOP and owners of corporations are people who control corporations that are s corps. They really should be looking at that opportunity as well.

Ed: Unfortunately, you can’t use 10 42 on that. Then the last, they’re putting another way. This labyrinth of all of these alphabet approaches to retirement plans is getting larger, more imaginative combinations and it’s really what’s best for you. Remember, the second question that someone asks is, where do you work? What do you do? If you are investing in an ESOP company and you lose your job, what are you going to say you do?

Chuck: You’re right.

Ed: Okay. That’s it for today.

Chuck: See you next time.

Thank you for listening to Money Talk. Please join us again and do check out our previous Money Talk topics.