ESOPs and Perpetuity

by Christopher Michael

What if the ESOP is sold? How do I know my legacy will last? Is there a way to “lock in” the ESOP so that the trustee and the employees can’t sell the ESOP shares? How can I establish an employee ownership program that will survive as long as the company does?

These are important questions for the founder of any employee-owned business. Related questions exist for employee-owners when considering how much of the annual profits to retain and reinvest in the firm. Some founders and employee-owners aim to protect the “employee-owned” nature of the company through heightened voting requirements in the corporate documents. But those protections can always be changed by a shareholder vote. A more advanced tool might involve a shareholders’ agreement––but, again, the shareholders can always modify or cancel the agreement. And, for ESOP companies, the trustee is legally bound to sell when presented with a sufficiently attractive offer.

Evolving Trust Law

When ESOP legislation was first passed in 1974, the rule against perpetuities (RAP) was still in effect in all states––with the exception of Louisiana. For those unfamiliar, RAP is a complex set of common law rules governing the longevity of trusts. However, beginning in 1983 with South Dakota, a majority of states have either eliminated or substantially modified RAP. In so doing, they opened up the possibility of perpetual (or dynasty) trusts. These changes did not effect ESOP regulations, notwithstanding the desire of many ESOP founders to create a lasting benefit for company employees. In the current day, a provision mandating that an ESOP trustee act so as to maintain the plan would conflict with Treasury regulations and rulings that interpret the “exclusive benefit of the employees” rule under the Internal Revenue Code.

Assuming IRS adoption of a broader interpretation of the “exclusive benefit” rule, founders could establish perpetuity as a valid purpose of the ESOP trust––where trustees must act in the long-term interest of current and future employees––and locate the trust in a dynasty trust state. But what if employee-beneficiaries attempt to “bust the trust”? Generally, trust law allows beneficiaries to dissolve a trust by unanimous consent––which threatens the perpetuity of any trust.

Thankfully, an even more recent development in trust law eliminates the requirement of a beneficiary––and entitles grantors to establish a higher purpose for the trust than distributing cash to one or more legal beneficiaries. Of course, trust law has long permitted trusts dedicated to charitable purposes––but purpose trusts are new. Originally authorized in foreign territories such as Jersey and Bermuda, U.S. states witnessed a wave of non-charitable purpose (NCP) trust legislation in the last decade. Purpose trusts are now also included in the uniform trust code, model legislation recommended for adoption by all U.S. states. In light of late twentieth century and twenty-first century developments in trust law, a moderate improvement to ESOP regulations would allow founders to leverage dynasty and purpose trust law to establish perpetuity as a higher purpose of the ESOP trust.

However, another obstacle arises in the context of minority ESOP-owned businesses. A company may refrain from selling or contributing new shares to the ESOP upon the retirement or exit of plan participants. This is not often a real-world problem. However, in theory, a minority ESOP might terminate after exit of all the participants. This issue could be viewed as fundamental to the value-based approach to employee ownership developed in the twentieth century by Louis Kelso––which prioritizes the gain realized by employees through an increase in the value of their shares.

Traditional Principles

In contrast, traditional employee ownership emphasizes profit sharing and employees’ control of the company. Based on these principles, an employee ownership trust (EOT)––as it is known in the United Kingdom––does not involve assigning and repurchasing shares for individual employees. Shares are transferred to the EOT and held in perpetuity on behalf of all present and future employees. Note the company has no repurchase obligation. Rather, in fulfillment of traditional employee ownership, the EOT passes profits and voting rights through to employees. The profits formula might involve only hours worked, or include some additional factors, such as seniority or salary level. Voting rights might pass through on a one person, one vote basis for all tenured employees, e.g., with 2000 hours of employment. Moreover, federal law specifically excludes trusts that do not systematically defer income until retirement. As such, perpetual employee ownership can be achieved today––without any regulatory or legislative changes––by means of establishing an EOT in a non-RAP and NCP jurisdiction, e.g., South Dakota, Delaware, New Hampshire, and Wyoming. This is possible in the context of both minority and majority EOT ownership of a firm––and nothing precludes the combination of a majority EOT (to “lock in” perpetuity) and a minority ESOP (for tax benefits).

Of course, no business lasts forever. EOTs should have an independent co-trustee or trust protector that can approve the liquidation or sale of the company when the close of the business is unavoidable. In such a case, the trust principal might be distributed to an organization that supports employee ownership. An additional benefit of the EOT is that certain “constitutional protections” can be locked into the structure. For example, the EOT might require the company to retain a certain percentage of annual net income as permanent reserves; join a lobbying association for employee-owned businesses, e.g., the ESOP Association; and make annual contributions to a charity in support of employee ownership, e.g., NCEO.

As a final note, it is worthwhile to point out that the United Kingdom passed EOT legislation in 2014. U.K. business owners are entitled to a 100% capital gains exemption for shares sold to an EOT in the year that the trust achieves majority ownership of the target company. The law requires that the trust manage the shares for the benefit of employees––as employees, not shareholders. If business conditions require that the target company be liquidated or sold, the trust principal may be donated to charity. An EOT is not restricted to majority ownership or a charitable “remainder holder”––however, the capital gains exemption is only accorded in the case of majority ownership.

Serious attention should be dedicated to amending Treasury regulations and rulings that interpret the “exclusive benefit of the employees” rule as referring to the immediate, financial interests of current employees––as opposed to the long-term, financial and non-financial employment-related interests of current and future employees. In so doing, allowing for the perpetuity of ESOP trusts should be a foremost concern––granted that some ESOP founders will avail themselves of the option, and others will not. That said, as the employee ownership community works to expand tax benefits and loan guarantee programs for ESOPs, these programs should be strengthened to include employee ownership trusts and other substantial all-employee ownership plans.