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11.3 Types of ESOPs
Publication date: 30 Nov 2022
us Stock-based compensation guide
11.3.1 Nonleveraged ESOPs
In a nonleveraged employee stock ownership plan, the employer contributes cash to the ESOP, which is used by the ESOP to purchase the employer's stock, or the employer contributes its stock directly to the ESOP. This type of ESOP is essentially a defined contribution plan, or part of a defined contribution plan. An employer’s accounting for contributions to a defined contribution plan and the related compensation cost to be recognized are specified in ASC 715-70. ASC 718-40, Employee Stock Ownership Plans, also contains guidance for nonleveraged ESOPs (see SC 11.4.1).
Many employers have established nonleveraged ESOPs within their 401(k) plans when employer stock is offered as an investment option to participants or there is or was a company contribution of employer stock. The funds in these 401(k) plans held in company stock can be converted to nonleveraged ESOPs within the plan to take advantage of the dividend deduction opportunity, as described in SC 11.2.
11.3.2 Leveraged ESOPs
In a leveraged employee stock ownership plan, the ESOP borrows funds from a bank or other lender. The employer that sponsors the ESOP generally guarantees the loan or otherwise commits, directly or indirectly, to make contributions, pay dividends, or both to the ESOP. Alternatively, the employer may make a loan to the ESOP without any external financing. Employer contributions to the ESOP and, in most instances, dividends on the employer’s stock held by the ESOP, are used by the ESOP to service the debt, whether with a third party or with the sponsor. In cases when there is a third-party lender, it is common for the third-party lender to provide a loan to the employer, and for the employer to make a loan to the ESOP.
11.3.2.1 Debt terms and share allocation of a leveraged ESOP
Some leveraged employee stock ownership plan borrowings have terms that require level repayment of the debt over a period of years. Alternatively, the repayment schedule for the ESOP loan could depend on the employer’s expected cash flow or expected compensation costs. Loans may be structured to require only interest payments for a number of years or may permit negative amortization of the principal amount. Debt agreements may also require prepayments of debt if the employer’s cash flow exceeds certain thresholds or may permit voluntary prepayments by the employer. Shares issued to the ESOP may be allocated to participants (employees) based on principal payments or principal and interest payments, depending on the particular ESOP plan and IRS regulations. In cases when there is a loan from a third party to the employer with a corresponding loan from the employer to the ESOP, the outside loan from the third party is frequently repaid more rapidly than the loan from the employer to the ESOP. The repayment of the loan to the ESOP (from the employer in these cases) triggers the release and allocation of shares to participants in the ESOP.
11.3.2.2 Dividends paid on shares held in a leveraged ESOP
Some leveraged employee stock ownership plans are structured so that much of the amount necessary to service the debt comes from dividends paid on the shares of stock held by the ESOP. Dividends on allocated shares—i.e., essentially shares that are deemed to be owned by the employees—are not treated as compensation expense but are charged by the employer directly to retained earnings. For this reason, some preferred stocks issued to leveraged ESOPs pay dividends at rates that may be higher than the dividend rates for similar securities.
ASC 718-40-25-16 requires employers to account for dividends on unallocated shares as a payment of debt or accrued interest (if the dividends are used to pay debt service) or as compensation cost (if the dividends are paid to participants or added to their accounts) (see SC 11.4.2).
Pursuant to ASC 718-740-45-8, the tax benefit of tax-deductible dividends on allocated and unallocated employee stock ownership plan shares should be recognized as a component of income tax expense. See TX 17.
11.3.2.3 Cash flow impact of payments on leveraged ESOP debt
Payments made on principal balances of outstanding employee stock ownership plan loans obtained from outside lenders that are funded through contributions (either cash or as dividends) from the employer should be reflected as financing cash outflows. Under ASC 718-40, the employer that sponsors the ESOP effectively consolidates the ESOP, reflecting both the loan and the cost basis of the shares held by the ESOP on the employer's balance sheet. ASC 718-40-25-9 indicates that employers should accrue interest cost on the debt, and should report cash payments to the ESOP that are used by the ESOP to service debt (regardless of whether the source of cash is employer contributions or dividends) as reductions of the debt and accrued interest payable when the ESOP makes payments to the outside lender. As the contributions are reflected as reductions of the debt and accrued interest balances, the cash flows associated with paying down the principal balance of the debt should be reported by the employer as financing cash outflows (FSP 6.7.2). The payments associated with interest should be reflected as operating cash outflows.
11.3.3 Convertible preferred stock with a put option in an ESOP
Some companies have issued a class of convertible preferred stock (rather than common stock) to an employee stock ownership plan due to, among other things, the additional flexibility this allows with respect to dividends and the potential for mitigating the earnings per share dilution impact from ESOP shares.
An ESOP may purchase employer securities in the form of convertible preferred stock that is not readily tradeable on an established market. Under federal income tax regulations, employer securities held by ESOP participants that are not readily tradeable must include a put option. The put option gives participants the right to demand that the employer redeem shares of employer stock held by the participant for which there is no market at a price determined by a fair valuation formula. The employer may have the option to issue other of its marketable debt or equity securities for all or a portion of the put option rather than pay cash. In some cases, the provisions of the ESOP may permit the ESOP to buy the employer’s stock under the put option instead of the employer buying it back; however, in no case can the employer require the ESOP to assume the obligation for the put option.
In ESOPs when the employee has the option to put the preferred stock to the ESOP trustee for cash or employer common stock, the ESOP trustee would have the right to put the preferred stock back to the employer. In certain plans, the employer may be required to satisfy the put with common stock only, and the ESOP would then sell the common stock in the open market for cash, which it would use to satisfy the employee request for cash.
ASC 480, Distinguishing Liabilities from Equity, establishes standards for how an issuer should classify and measure certain financial instruments with characteristics of both liabilities and equity. The guidance in ASC 480 is required to be followed for freestanding financial instruments (as defined in the standard) issued in connection with an ESOP only if they are no longer subject to ASC 718-40 or related guidance. Until that occurs, the instruments would be outside the scope of ASC 480. ASC 480-10-15-8 states that ESOP shares or freestanding agreements to repurchase these shares are not within the scope of ASC 480 because those shares are accounted for under ASC 718-40 or its related guidance through the point of redemption.
Thus, these hybrid securities must be analyzed to determine whether any of the embedded derivative features need to be bifurcated under ASC 815, Derivatives and Hedging. ASC 815-15-25 requires that the terms of a convertible preferred stock, excluding the conversion option, be assessed to determine if the host is more debt-like or equity-like. A conclusion that the host is more debt-like would require further evaluation of the security to determine whether the embedded derivative should be bifurcated. If the security contains any options (whether they are puts, calls, or conversion options, and whether they are contingent or not), the options should be evaluated under ASC 815. Refer to FG 1.6 for additional information.
11.3.4 Convertible preferred stock with guaranteed redemption
An employer may issue a convertible preferred stock to an employee stock ownership plan that is redeemable by the employer at a redemption price equal to the initial value established for the preferred stock. Redemption may be satisfied in common stock, cash, or a combination of both. Alternatively, each share of the preferred stock could be convertible into a fixed number of shares of common stock.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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