By: Robert C. Hackney
Way back in 1956, two partners had a dilemma. They were both in their 80s and were looking to retire. The problem causing the dilemma was what to do about their company. They could sell it, but it was their baby, and they had seen similar companies in their industry being sold to larger companies, and disappearing into the black hole of a corporate giant. What they really wanted was to sell the company to its employees, because they knew that the employees had taken them where they were, would be good stewards of the future of the company, and loved it as much as they did and did not want to see the major changes that would come with a sale to an outsider. But how could that happen, when they knew the employees did not have the money for the purchase?
The partners hired accountants and tried to see if there was a way that the employees could afford the purchase. The answer was that even if the employees mortgaged their homes, there would not be enough capital to make it work. There must be another way, they thought.
Fortunately, they came upon Louis O. Kelso, a lawyer in San Francisco, and asked him to help them find a way to make this work. Kelso determined that the company had a profit-sharing plan that was IRS qualified and that the company had been making annual contributions into the plan. Kelso came up with a plan to use most of the profit sharing money to make a down payment of about 30% of the purchase price, and to have the profit sharing plan borrow the balance from a bank. The profit sharing plan would then continue to receive annual contributions and use those contributions to repay the bank debt. The contributions were tax deductible, and therefore both the principal and interest would be repaid with pre-tax dollars. The alternative was to have the company borrow the money and repay the loan with after-tax dollars. They could not afford the after-tax dollar plan, but the projections confirmed that the pre-tax repayment plan would fly.
Kelso then tackled the next problem. The IRS rules said that a related party transaction like this was a “prohibited transaction.” Kelso did not let this stop him, since he found out that it might be possible for him to obtain an exemption from the IRS, which could be granted on a case-by-case basis if he could show the IRS that the plan was beneficial to the plan participants and was deemed to be “arms-length.” Kelso successfully obtained the exemption from the IRS, and Peninsula Newspapers, Inc. of Palo Alto became wholly owned by its employees.
Employee ownership was nothing new in 1956. In 1921, stock bonus plans were permitted by the IRS to help motivate and incentivize employees. Large companies of the day like J.C. Penny, Pillsbury and Sears Roebuck instituted such plans, but until Kelso came along stock plans were not used as a methodology to create an exit plan for company owners, and the use of such plans by smaller companies was unheard of.
In 1958 Kelso and Mortimer Adler co-authored a book called “The Capitalist Manifesto.” The book’s focus was on employee ownership of businesses and set forth the argument for expanded use of tax approved plans to accomplish this goal. The authors argued that most employees had no way to acquire capital for investment and that the resulting wealth disparity was a negative force in society. Their most compelling argument is one that resonates with today’s reality, that with technological advances, capital will become more productive and labor will be even more disadvantaged, which results in an increase in inequality. Kelso’s arguments would seem to be even more pertinent in today’s world than in the 1950s and 60s, since the technological advances of today make those years look like the stone age. In 1960 Kelso and Adler published their follow up book, “The New Capitalists.”
According to David A. Spitzley, in Democratic Capitalism Made Simple, Kelso’s Principles of Economic Justice can be summarized by the following three rules:
1. The Principle of Distribution: Each participant in the production of wealth should receive a share proportionate to the market value(s) of the labor and capital they contribute to the enterprise.
2. The Principle of Participation: Each household must have the opportunity to earn a decent standard of living through effective participation in the production of wealth, whether by property in labor, capital, or both.
3. The Principle of Limitation: No one may exclude others from effective participation in the production of wealth through excessive concentration of ownership, whether in capital, labor, or both.
As the concept of Kelso’s plan spread, the IRS adjusted some of their procedures to accommodate these types of plans, and Determination Letters approving them became somewhat easier to obtain. The process hit a wall, however, in 1974 when Congress was working on the Employee Retirement Security Act of 1974 (ERISA) because early versions of this legislation did not provide for any mechanism to obtain an approval for such a plan. Critics believe that this was initially because Congress was completely unaware of this trend and unfamiliar with this type of employee stock plan. The law of unintended consequences was at work, and it appeared that this trend would end before it had even gotten fully started.
1974 was one of those watershed years. The economy in the United States was in the dumps, sitting at its lowest level since 1929. Tax rates were the highest they had ever been, interest rates were high and unemployment was over 10%. The economy needed a shot in the arm. Fortunately, Senator Russell Long, the chairman of the Senate Finance Committee, heard about Louis O. Kelso, and after meeting Kelso, decided that these so called “Kelso plans” were just what the doctor ordered for a sick economy. Senator Long championed changes to be proposed law which solidified the tax advantaged aspects of these plans.
As Kelso and others continued to use these plans, it became clear that the flexibility that could be built into a plan made them even more valuable. For example, if there are owners of different ages, it is not necessary to buy out everyone at the same time. An older owner who wants to retire could sell his or her shares to the plan and the remaining original owners could stay in place. Many owners also set up plans and then sell their shares over a period of years, without using any bank loans at all, just by making their annual contributions to the plan and having the plan purchase a certain percentage of the stock each year.
Based on what is happening in the world today, the name Louis O. Kelso may once again become a household word.
What Kelso dubbed the “second income plan” and others called the “Kelso plan” was primarily a concept designed to assist owners of businesses in selling their company to their employees. Kelso also advocated the use of such plans to finance corporate growth through the sale of newly issued stock to employees.
As these plans developed and adapted, one of the most vocal supporters of the corporate finance approach to the use of these plans emerged and added his voice to Kelso’s.
Enter Walter P. Reuther
Today few people recognize the name Walter P. Reuther, but throughout the 1940s to the 1960s he was one of the best known labor leaders in America.
Walter Reuther would seem to be an unlikely champion and hero of capitalism, since he spent many years of his adult life as the President of one of the most powerful labor unions in history. Reuther was born and raised in West Virginia, the son of a labor unionist and a socialist. He dropped out of high school at 16 and learned the tool and die trade. He later finished his high school education and attended Detroit City College. Reuther worked for the Ford Motor Company in the 1920s. Although early in his life he supported the socialist party, was raised by an avowed socialist, and went on an extended visit to the Soviet Union with his brother, later in life he became a fierce anti-Communist.
Walter secured various leadership positions in his local chapter of the United Automobile Workers union, and eventually in 1946 became the President of the UAW, and remained in that position until his untimely death in an airplane accident in 1970. He also became the President of the Congress of Industrial Organizations (CIO), and engineered the re-merger of the CIO with the American Federation of labor (AFL) in 1955.
Reuther’s focus in life was social equality and justice. In the 1960s he was an ardent civil right activist and referred to by some as “the white Martin Luther King.” He was an advocate of the working man and believed firmly in the idea that employees ought to have an ownership opportunity in their workplace.
While Kelso was an advocate of employee ownership and believed that employees should participate in the benefits of being a stockholder, his focus to get them there was primarily through acquiring stock in a buyout of the owners. Reuther‘s focus was a shift in that thinking.
What if, instead of buying stock that had already been issued to an owner, the employee plan bought new issue stock directly from the company? The plan would borrow the money to buy the stock, and the money it borrowed would be used to expand and grow the company, instead of going to the former owner. This form of corporate finance would be the best of all worlds, the company could deduct the full amount of both the principal and interest of the loan, the employees would own some stock, and the company would get working capital. The concept of the employee plan as a corporate finance tool was born.
Not Coconut Grove, but Bohemian Grove
Bohemian Grove is a 2,700-acre redwood luxury “campground” located in Monte Rio, California, and it belongs to a private San Francisco-based club known as the Bohemian Club. The Bohemian Club’s all-male membership and guest list includes artists, musicians, prominent business leaders, and government officials. It has been said that every Republican President since 1923 has attended their activities, along with various Democratic Presidents, and many cabinet officials. The industries represented by these people include military contractors, oil companies, banks (including the Federal Reserve), utilities, and national media. Some familiar names who have either been members or guests are Henry Kissinger, Thomas Watson Jr. (IBM), William Casey (CIA), George Bush, Walter Cronkite, and William F. Buckley.
In mid-July each year, Bohemian Grove hosts a two-week, three-weekend retreat for its members and guests. This retreat has sometimes been called an “informational clearing house for the elite.” During the retreat, along with networking, there are speeches, known as “Lakeside Talks”, where information and ideas are shared with the group.
In July of 1974, then California Governor Ronald Reagan addressed the Bohemian Grove Encampment, in a talk he called “Expanded Capital Ownership: The Only Answer to Creeping Socialism.“ The following is an excerpt from that address:
“…In our resistance to what some of us see as a creeping socialism, we have just theorized about the superiority of capitalism. Have we really made capitalism work to prove those benefits can do everything for everybody better than the promises of the socialists? All they can offer with their system, if you analyze it, is to take from the ‘have’ and give to the ‘have-nots’. That doesn’t eliminate have-nots – it just changes them around.
But capitalism can work to make everybody a “have”. Some years ago, a top Ford official was showing the late Walter Reuther through the very automated plant in Cleveland, Ohio, and he said to them jokingly, “Walter, you’ll have a hard time collecting union dues from these machines,” and Walter said, “You are going to have more trouble trying to sell them automobiles.” Both of them let it stop right there. But there was a logical answer to that. The logical answer was that the owners of the machines could buy automobiles, and if you increase the number of owners, you increase the number of consumers.
Over one hundred years ago, Abraham Lincoln signed the Homestead Acts. There was a wide distribution of land and they didn’t confiscate anyone’s already privately-owned land. They did not take from those who owned to give to others who did not own. It set the pattern for the American capitalistic system. We need an Industrial Homestead Act. . . I know that plans have been suggested in the past that all had one flaw. They were based on making the present owners give up some of their ownership to the non-owners. Now this isn’t true of the ideas that are being talked about today.
Very simply, these business leaders have come to the realization that it is time to formulate a plan to accelerate economic growth and production at the same time we broaden the ownership of productive capital. The American dream has always been to have a piece of the action.
Income, you know, results from only two things. It can result from capital or it can result from labor. If the worker begins getting his income from both sources at once, he has a real stake in increasing production and increasing output. One such plan is based on financing future expansion in such a way as to create stock ownership for employees. It does not reduce the holdings of the present owners, nor does it require the employees to divert their own savings into stock purchases.
This one plan, and undoubtedly there are alternatives, utilizes an Employee Stock Ownership Trust to purchase newly issued stock when a corporation needs new capital for expansion. The trust acquires its funds by borrowing with a guarantee from the corporation, from a commercial bank, or other lending institution. Over a ten-year period, it is possible for 500 billion of newly-formed capital to be owned by individuals and families who today have little or no hope of acquiring a vested interested in our capitalist system . . . What a better answer could we have to socialism? What an export item on the World market! What argument could a foreign land have against a corporation which made its “have-not” citizens into “haves”?
In short, I am suggesting that we face a choice between government that has grown desperate, embarking on a course that leads to confiscation and redistribution, or using the great talent and expertise of the private sector to spread legitimate capital participation in free enterprise to those who now are only property-less employees….”
Ronald Reagan recognized that the answer to increasing dedication and opportunity for employees was not a give away, but an but a plan that showed them that if they invested their heart and not just their time, that they could earn the benefits of ownership along with a salary.
Walter Reuther testified before the Joint Economic Committee of Congress in 1967. At the time he was concerned about the loss of manufacturing jobs in America, and the fact that Japan seemed to be beating American companies in head to head competition. His solution? Profit sharing for employees in the form of employee stock ownership was his conclusion. Before Mr. Reuther could see implementation of this approach, he died in an airplane crash, and labor and America lost its employee shareholders’ champion.
Governor Reagan picked up where Reuther left off, and supported the concept of employee ownership. While the concept grew to where we now have millions of participants, it still remains one of the most underutilized corporate finance tools, and certainly the most beneficial, from the viewpoint of employee benefits and tax advantage.
The Nuts and Bolts of Employee Stock Ownership Plans
Bring on those tired, labor-plagued, competition-weary companies and ESOP will breathe new life into them. They will find ESOP better than Geritol. It will revitalize what is wrong with capitalism. It will increase productivity. It will improve labor relations. It will promote economic justice. It will save the economic system. It will make our form of government and our concept of freedom prevail over those who don’t agree with us.
Russell B. Long
In 2013, Frey and Osborne published a study known as “The Future of Employment.” This study, which has been widely recognized, predicted that there was a greater than 70% possibility that approximately 47 percent of all jobs in the United States are at high risk of being automated over the next few decades. This estimate is based on advances in artificial intelligence and the continuing explosion in computer robotics. The predictions by economists Frey and Osborne that almost 50% of all occupations are threatened by AI automation technologies may just be another example of the overblown predictions discussed earlier, or they may be accurate. Knowing what we know about the resilience of the American entrepreneur, we believe that solutions will be found to use the new technology to the advantage of the overall society.
The President’s Report, referenced previously, contains an excerpt from a speech by White House Council of Economic Advisers Chair Jason Furman, in New York, July 7, 2016:
“Fears of mass job displacement as a result of automation and AI, among other motivations, have led some to propose deep changes to the structure of government assistance. One of the more common proposals has been to replace some or all of the current social safety net with a universal basic income (UBI): providing a regular, unconditional cash grant to every man, woman, and child in the United States, instead of, say, Temporary Assistance to Needy Families (TANF), the Supplemental Nutrition Assistance Program (SNAP), or Medicaid. While the exact contours of various UBI proposals differ, the idea has been put forward from the right by Charles Murray (2006), the left by Andy Stern and Lee Kravitz (2016), and has been a staple of some technologists’ policy vision for the future (Rhodes, Krisiloff, and Altman 2016). The different proposals have different motivations, including real and perceived deficiencies in the current social safety net, the belief in a simpler and more efficient system, and also the premise that we need to change our policies to deal with the changes that will be unleashed by AI and automation more broadly. The issue is not that automation will render the vast majority of the population unemployable. Instead, it is that workers will either lack the skills or the ability to successfully match with the good, high paying jobs created by automation. While a market economy will do much of the work to match workers with new job opportunities, it does not always do so successfully, as we have seen in the past half-century. We should not advance a policy that is premised on giving up on the possibility of workers’ remaining employed. Instead, our goal should be first and foremost to foster the skills, training, job search assistance, and other labor market institutions to make sure people can get into jobs, which would much more directly address the employment issues raised by AI than would UBI.”
We agree with Mr. Furman that the creation of a UBI is a step in the wrong direction, and will tend to create more problems than it would solve.
We believe that one of the ways to embrace the technology and simultaneously benefit workers is to turn them into capitalists who own a stake in the new automated companies. An underutilized tool that was created many years ago may be the perfect vehicle for this concept.
The Kelso plan, or the second income plan, has come to be known as the Employee Stock Ownership Plan (ESOP). The Employee Stock Ownership Plan is nothing new, but could provide a resurgence in popularity as the right tool to incorporate workers into the new technologies. What exactly is an ESOP?
An ESOP is simply a defined contribution employee benefit plan. The avowed purpose of an ESOP is to involve employees in the ownership aspects of the company. The ESOP is a very different concept from most defined contribution employee benefit plans, such as 401k plans, because the ESOP is required by law to invest primarily in the stock of the employer. As we all know, a 401k generally prohibits the purchase of the employers’ stock.
What really makes an ESOP unique is that, unlike 401k plans and other benefits, it can be used as a corporate finance strategy. This is where it gets interesting, and where it could be employed as a way to help a company expand and incorporate AI automation, which simultaneously getting employees involved in ownership.
While ESOPs are most commonly used to provide an exit strategy for departing owners of successful privately-held companies, they can also be used to obtain financing for expansion and acquisition of equipment, like AI automation. ESOPs have the ability to take advantage of incentives to borrow money for acquiring new assets, such as AI automation, in pretax dollars.
When it borrows money, the ESOP becomes a “leveraged ESOPs” which can be used to not only reward and motivate employees, but reduce the sponsoring company’s taxable income by the interest and principal borrowed to buy shares owned by the ESOP.
To begin with, a company that wants to start an ESOP needs to create a trust and appoint a trustee, which is typically the owner of other executive of the employer. Shares of stock of the employer company are then sold to the trust, for the benefit of the employee participants. Employees that meet the minimum requirements set for in the ESOP plan document can participate in ownership, which typically means full time employees over the age of 21 years. The stock is allocated within the trust to each participant employee’s account. As is done in many stock option plans, when shares are added to employee accounts, they may not “vest” immediately. Under the law, employees must be 100% vested within three to six years. The time frame involved in vesting depends upon whether the shares are set to vest all at one time, or over a period of time. The details of this are set forth in each individual ESOP plan.
While we have discussed the fact that the trust is buying stock in the employer company for the benefit of the employees, we have not described how that happens, or where the money comes from to buy the shares.
In one scenario, after an independent appraisal is made of the value of the stock, the ESOP Trustee would obtain an agreement from the company to buy newly issued shares on behalf of the ESOP. The employer company would then borrow money from a lender, in what is sometimes called the “outside loan.” The company would then immediately lend the loan proceeds to the ESOP in what is known as an “inside loan” so that the ESOP could purchase the stock.
How does the ESOP repay the “inside loan”? The company is required to make tax-deductible contributions to the ESOP (like making contributions to a profit sharing plan). The ESOP Trustee can then use the contributions to repay the inside loan, and in addition, the company may pay tax deductible dividends on the stock, which dividends can also be used to repay the inside loan.
The shares that have been purchased by the ESOP are held in a suspense account while the loan is outstanding, and as the loan is paid down, shares are released from suspense and allocated to the employee participants accounts.
The money paid for the shares to the company is used to purchase new AI automation equipment or for other expansion purposes. The end result of all of this is that the company, in essence, pays back the loan will all of the principal and interest on the loan being deductible. Why more companies are not doing this right now is beyond our comprehension.
There are different ways that dividends on ESOP stock can be deducted by the company. We just discussed the first way, which is to apply the dividends to loan payments in a leveraged ESOP transaction. If they are not applied to the loan payments, or the loan has been paid off, dividends may be paid in cash to ESOP employee participants, either directly or as payments to the ESOP that are distributed to participants within 90 days after the close of the plan year, or dividends many be voluntarily reinvested in company stock in the ESOP by employees.
When dividends are directly paid to plan participants on the stock allocated to their ESOP accounts, while such dividends are fully taxable, they are exempt from income tax withholding and are not subject to the 10% excise tax that applies to early distributions.
What companies should consider an ESOP? Although it can work for smaller companies, a safe place would be a value of at least $5 million, and a net income of at least $500,000 would be best. The company should have around 50 employees, but it could work with as little as 30, and the ESOP should consider purchasing at least 30% of the company. Does your company have steady cash flow? Is it increasing in value? Is it growing? Is expansion or AI automation viable?
ESOPs were created with the goal in mind that ownership opportunities and retirement assets would be available to employees of successful companies, and also to provide a method for owners of privately held companies to have tax incentives to sell their companies to employees. Most ESOPs have been created to provide a method for owners to sell out over a period of years to their employees who will carry the company into the future. The scenario above is purely an expansion plan using an ESOP, but it could be a combination of both an owner buyout and an expansion.
Don’t miss Part 2 of this Blog Post!