smaller corporation has been in operation for several years. Each year , around
ID: 2500418 • Letter: S
Question
smaller corporation has been in operation for several years. Each year , around the holidays, smaller gives cash bonus to each of its employees and Records the bonuses as compensation expense. Smaller has reached the point in which it is now making a reasonable return on its shareholders equity. At the end of the current year, the company president is considering establishing a compensatory share option plan for smaller key executives instead of paying cash bonuses to any of its employees. At this time, the market price and the planned option (excerise) price of the company's common stock are the same. The plan would allocate a specified number of options to each executive based on the executive level within the company and meeting smaller's targeted income goals. The service period would be 3 years and the options would have to be excerise within 10 years.
You are the controller for smaller and one of the key executives who would participate in the plan. You also already own a substantial number of shares of smaller common stock. The company president comes to you for advice about this plan and says, " if smaller establishes this plan, it will work out for all of us. It looks like the plan is pretty valuable, since an option pricing model shows a higher fair value for each option. The corporation will be saving cash because it won't have to pay bonuses to either executives or the other employees. But executives will manage ether because their share option pricing model shows a high fair value for each option will depend on meeting the company's targeted income. Because the market price and the option price are the same, there won't be any compensation cost or expense. This will increase its net income and earnings per share compared to last year, as well as it return on shareholders equity. So the stock value will go up. This seems like a win-win situation for everyone. Am I right on this? Do you think smaller should adopt this compensatory share option plan?
Required :
From financial reporting and ethical perspectives, how would you reply to the president? please remember to quote your references
Explanation / Answer
An Employee Stock Ownership Plan ("ESOP") is a tax-qualified defined contribution employee benefit program intended to invest in the stock of the plan sponsor company. To establish an ESOP, the sponsor company creates a trust with the sole purpose of holding shares of the company. To acquire shares for the trust, the company may contribute newly issued shares, purchase shares with cash on-hand, or, as is more frequently the case, borrow funds from an outside lender against future earnings. Once in the trust, ESOP shares are allocated to individual employee accounts according to a pre-determined formula (for example, length of employment). When an employee departs, the company is obligated to purchase the employee's shares at fair market value.
As a tax-qualified employee benefit program, ESOPs can be used to achieve a variety of individual and corporate objectives at significant tax savings. However, ESOPs are not for every company as they can entail significant administrative expenses and can be cumbersome to administer. This article will explore some of most notable benefits and drawbacks of an ESOP.
ESOP BENEFITS
Tax Benefits to Retiring Owners and Large Shareholders
Retiring shareholders frequently have large holdings of low-basis stock that cannot be sold without incurring sizeable capital gains liability. However, under Section 1042 of the Internal Revenue Code (the "Code") a shareholder of a C Corporation may, under certain circumstances, eliminate a large part of his or her capital gains liability. To take advantage of this provision, the shareholder must sell at least 30% of his or her company shares back to the company's ESOP and then use the proceeds from that sale to purchase other qualified investments. The tax savings are realized by deferring the gain or by the shareholder leaving the newly acquired investments to his or her heirs who receive "stepped up basis" tax treatment upon the shareholder's death.
Tax Benefits to the Company
One of the most attractive benefits of an ESOP is that it can be used to cost-effectively finance growth through its tax-privileged status. An ESOP has the ability to borrow money to purchase shares of the company. Once the ESOP purchases the shares, the company has use of the borrowed funds. The tax savings are realized when the borrowed funds are repaid. Because ESOP contributions are tax deductible when the company makes contributions to the ESOP to repay the borrowed funds, the contributions, within certain limits, are tax deductible. As a result, the ultimate cost of borrowing to the company is significantly reduced and a cash flow advantage is gained.
An additional tax benefit available to an S Corporation is that an ESOP presents it the opportunity to reduce its federal (and in some cases state) income taxes significantly. The Code exempts an S Corporation's ESOP from income taxes. Thus, the percentage of a company that is owned by its ESOP is exempted from federal income taxes. For example, if an S Corp's ESOP owns 70% of the shares of the company, the company will only pay federal income tax on the 30% of the shares not owned by the ESOP. These tax savings can be used to finance growth.
Benefits to the Employees
ESOPs can assist in fostering employee morale and attracting and retaining talented employees since employees who participate in an ESOP are likely to have a greater sense of ownership. Beyond this, employees receive a tax benefit from an ESOP in that their accounts grow tax-free. As with most retirement plans, employees in an ESOP may roll-over their contributions into another qualified retirement plan without paying tax on the distribution. However, it should be noted that employees in an ESOP, even if they maintain outside retirement accounts, frequently lack significant diversification among their investments due to the fact that the ESOP only owns stock in the plan sponsor company and, thus bear all the risks associated therewith.
From an employer's perspective, it is important to note that an ESOP cannot be used as a merit-based reward system. Share allocations must be made relative to pay or some other similar formula. Additionally, it is a frequent misconception among employers that creating an ESOP obligates an employer to share sensitive financial information with employees. In fact, employees are only entitled to receive certain ESOP documents.
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