The origins of ESOP are rather new. The brain-child was and economist, Louis O. Kelso, who created the first ESOP in 1956 as a means to transition ownership of Peninsula Newspapers, Inc. from its two founders to their chosen successors. Kelso’s unique idea was that instead of having the company borrow the funds and repay with after-tax dollars, the Company’s profit sharing plan would borrow the funds and repay both principal and interest out of the annual contributions the Company was already making to the plan. Kelso originated the strategy of using an IRS tax-qualified plan as a tool for succession, as many such efforts, the idea was far ahead of the times and therefore ahead of the law, for permitting such a “scheme”.
At such time, nothing in the Internal Revenue Code authorized leveraging of an IRS
tax-qualified retirement plan as it was a prohibited transaction. However, there was an exception was that the transaction had to be arms-length and in the best interest of
the plan participants. The exception was subsequently granted by the IRS.
The concept of an ESOP was formally signed into law in 1974 when the Senate passed
its version of the Employee Retirement and Security Act of 1974 (ERISA). However, for a decade, ESOP activity remained dormant pending issuance of IRS regulations defining parameters of the ESOP exemption. This was a fallout of the total complexity of ERISA and the need for comprehensive regulations for the total ERISA Law. Starting in 1979, during the period of extensive plant shutdowns in manufacturing, ESOPs were used to save failing companies. The goal of employers and the boards of directors of various companies was that employees were given stock in exchange for negotiated salary reductions. In particular, they were used in union negotiations for Weirton Steel, Chrysler Corporation and United Airlines.
From the 1970s to 1990s, ESOPs were used for the following purposes. First, it was used to facilitate divestitures, with the objective of moving employee interests to the sidelines. Secondly and conversely, the ESOP was used in defense of hostile takeovers, and by doing so, making it difficult for the hostile party to act because now it would have to deal with the company’s board of directors and then deal with those in the governance of the ESOP; which may be trustees, directors, or both. Lastly, it was a way to deal with “going private” transactions so as to insulate the new owners with another layer of secrecy of their objectives.
The key to ESOP moving forward was the Reform Act of 1984 relating to ESOPs, which allowed the following:
1. Tax-free roll over treatment
2. 50% interest inclusion
3. ESOP estate tax assumption
4. Deductible dividends
The new law was a reaction to Passage of Economic Recovery Act of 1981, which called into play a transition of the American economy from a manufacturing-based to a service-based economy and the resulting erosion of union membership
Now, even though ESOPs have played many roles since 1956 it seems that they have reverted back to their roots; that is ownership by the people who built the enterprise. Yet, the incentive of the company’s management my still be that such efforts will be used to dilute the increase in wages so as to quell moves to raise the minimum wage.