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ZELL, TRIBUNE AND S ESOP2009]II. WHAT IS AN ESOP?Broadly speaking, an ESOP is a type of defined contribution employeebenefit plan. As with other defined contribution plans-such as 401(k),403(a), and 403(b) plans-the employer makes contributions on behalf of itsemployees. 26 Employees sometimes also contribute. In contrast with definedbenefit plans, employees with a defined contribution plan are not provided27with a guaranteed benefit, such as a pension for the rest of their lives.Instead, they are entitled to receive either the actual securities they have in28their accounts or the market value of those securities.With an ESOP, the sponsoring company sets up a trust for the principalpurpose of acquiring and holding the sponsor's securities for the benefit of itsemployees. The ESOP thus provides participants with an ownership interestin their employer. Proponents of employee ownership emphasize theincentive and team-building advantages of paying employees in part withemployer stock.29 Critics argue that concentrating employees' financialresources in their employer's securities increases their exposure to theiremployer's fortunes. 30 That debate, between the advantages of more closelyaligned incentives and the disadvantages of increased concentration ofinvestments, 31 has been the central issue in the debate over ESOPs in32particular, and employee ownership in general, for many years.ESOPs can be used to achieve a range of purposes. The most commonuse of an ESOP is to purchase the shares of a closely held company from adeparting owner. 33 In such circumstances, an ESOP is a way for thedeparting owner to cash out, maintain control of the company for a period of26 BNA TAX MGMT. PORTFOLIOS, No. 814 § I(A)(2)(b)(5) (2008).27 BNA TAX MGMT. PORTFOLIOS, No. 814 § I(A)(2) (2008).28 Corey Rosen, How ESOPs Work, in S CORPORATION ESOPs 7-8 (Scott Rodricked., 2d ed. 2005).29 See, e.g., Freeman, supra note 6, at 7.301d. at9.31 In the language of finance, increased concentration raises the level of unique (ornonsystematic) risk. Unique risk is risk that can be eliminated through diversification. Incontrast, systematic risk is that risk that cannot be eliminated by diversification, but canonly be shifted among owners. Systematic risk is compensated for in the market (througha higher return); unique risk is not compensated. See RICHARD A. BREALEY ET AL.,PRINCIPLES OF CORPORATE FINANCE 162 (8th ed. 2006). It is because the market providesno compensation for bearing unique risk that some commentators argue employee stockownership is a bad idea. Freeman, supra note 6, at 9.32 For a comprehensive and recent survey of the literature on the costs and benefitsof ESOPs, see Freeman, supra note 6.33 Rosen, supranote 28, at 9.

OHIO STATE LA WJOURNAL[Vol. 70:3time, and arrange for succession. 34 ESOPs can also be used to provideemployees with stock-based compensation so as to better align their interestswith those of the stockholders. Other uses include divesting or acquiringsubsidiaries, buying back publicly held shares (especially as a takeover35defense), and restructuring benefit plans.ESOPs are authorized and regulated by the Employee Retirement Incomeand Security Act of 1974 (ERISA). Among the requirements that an ESOP36must satisfy are the following:(i)(ii)(iii)(iv)(v)the ESOP must be designed to invest primarily in securities37of the employer;38contributions cannot exceed statutory maximums;individual beneficiaries must be able to vote the shares thathave been allocated to their individual accounts; 39 shares40not yet allocated can be voted by the ESOP trustee;ESOP participants have the right to diversify their accounts41once they reach certain age and service benchmarks;the ESOP must meet certain distribution and vestingrequirements;4234Jeffrey Tomich, ESOPs Have One-for-All Appeal, ST. Louis POST-DISPATCH, Oct.30, 2005, at El.35 For discussions of the various reasons why companies establish ESOPs, see CoreyRosen, Things To Do With An ESOP Besides Buying Out the Owner, in THE ESOPREADER (Scott Rodrick & Corey Rosen eds., 4th ed. 2005); Jared Kaplan et al., ESOPs,in BNA TAx MGMT. PORTFOLIOS, No. 354 § 1(B) (2008).36 For a comprehensive discussion of the various provisions that regulate ESOPs,see Kaplan et al., supra note 35.37 I.R.C. § 409(1) (2006).38 The limit on tax-deductiblecontributions to defined benefit plans is 25% ofcovered compensation. I.R.C. § 404(a)(3)(A) (Supp. 2008).39 I.R.C. § 409(e) (2006). If directions are not timely received, then the trustee canvote these shares. See Rev. Rul. 95-57, 1995-2 C.B. 62. The employees' right to votetheir shares applies only to certain key issues. See Rosen, How ESOPs Work, supra note28, at 16.40 See Kaplan et al, supra note 35, at § II(B)(2).41 When employees reach age fifty and have ten years of service, the company mustgive them the option of diversifying twenty-five percent of their account balances orwithdrawing that amount. I.R.C. § 401(a)(28)(B) (2006). At age sixty, employees canhave half of their account balances diversified or distributed to them. Id.42 For discussions of these provisions, see, for example, Kaplan et al., supra note 35,at § II(C), and Scott Rodrick, ESOPDistributionand DiversificationRules, in THE ESOPREADER 108, 109-11 (Scott Rodrick & Corey Rosen eds., 3d ed. 2003).

ZELL, TRIBUNE AND S ESOP2009](vi)the trustee is subject to the general fiduciary duties of43ERISA;(vii) if the ESOP borrows money, it is subject to a series of44additional restrictions;(viii) the employee has the right to put the employer's securitiesback to the employer at its fair market price if there is not aliquid market for the securities; 45 and(ix) participation in the ESOP cannot occur on a discriminatory46basis.If the ESOP meets all of the above requirements, then the parties'transactions with the ESOP are taxed according to a specific set of rules thatapply to ESOPs. 4 7 Those rules are widely considered to be very attractivebecause they confer various tax benefits on the sponsoring employer and theparticipants that are not otherwise available. However, before discussing thetax treatment of ESOP transactions, the next Part gives a simple example of aleveraged ESOP.III. How ESOPs WoRKThe typical ESOP is leveraged. That is to say, it uses borrowed money tofinance the purchase of the employer's stock. In a leveraged ESOP, thecompany establishes a trust and the trust borrows money to fund the purchaseof employer stock.48 Over time, the employer makes contributions to the planand the plan uses that money to repay the principal and interest on the ESOPloan. 49 Shares in a leveraged ESOP are initially held in a "suspense43 Employee Retirement Income Security Act § 404(a), 29 U.S.C. § 1104(a) (2006).44 For a discussion of these provisions, see Kaplan et al., supranote 35, at § II(C).45 I.R.C. § 409(h) (2006).46 For a brief summary of the participation rules, see Corey Rosen, Questions andAnswers on Operating an ESOP, in THE ESOP READER 120, 120-21 (Scott Rodrick &Corey Rosen eds., 3d ed. 2003).47 These rules are set forth in I.R.C. § 409 and the accompanying regulations. See 26C.F.R. §§ 1.4 0 9 (p)-I, 1.409-1T (2006).48 Typically, the company borrows the money from a lender and relends the moneyto the ESOP. The proceeds of the loan are used to acquire the employer's stock eitherfrom the company or from other shareholders. If the stock is acquired from the company,the company can use the proceeds in its business for any legitimate purpose. If the stockis acquired from investors, they can use the money as they like. The ESOP Association,What is a Leveraged ESOP?, d.asp(last visited April 22, 2009).49BNA TAx MGMT. PORTFOLIOS, No. 814 § I(A)(2)(b)(5) (2008).

OHIO STATE LAW JOURNAL[Vol. 70:3account."' 50 As the loan is repaid, shares are released into the individual51accounts of plan participants.Consider the following simple example of a leveraged ESOP. E Corp.establishes an ESOP and agrees to sell that ESOP 100 shares of E Corp. at aprice of 10 per share. The ESOP funds the purchase by borrowing 1000 atan interest rate of 10 percent, compounded annually. Upon transfer, the 100shares are held in a suspense account for the benefit of E Corp.'s coveredemployees. The terms of the loan call for the loan to be repaid in ten equalannual installments of 162.75. At the end of the first year, E Corp.contributes 162.75 to the ESOP. The ESOP, in turn, pays that same amountto the lender. Of that 162.75, 100 is payment of accrued interest and 62.75 is repayment of principal. The principal payment of 62.75 reducesthe outstanding balance of the ESOP loan by 6.27 percent. Accordingly, 6.27shares 52 will be released from the suspense account into the accounts ofindividual ESOP participants. 53 The contribution from the company to theESOP, the ESOP's payment of interest and principal, and the number ofshares released from the suspense account each year are given in Table 1.Table 1: A Simple Example of a LeveragedESOPYear12345678910TotalContribution 2.75162.75 1627.45Interest 10093.7386.8279.2370.8861.6951.5940.4728.2514.80 627.45PrincipalShares 47.95 13.4514.80100At the end of year 10, the ESOP loan has been repaid and 100 shares ofE Corp. stock are in the ESOP accounts of the individual employees. If E50Id.51 The release generally must follow one of two formulae. See Rosen, supra note 46,at 122. In either case, because of stock price volatility, the market value of the sharesreleased each year will rarely equal the principal repayment on the loan that year.52 That is 6.27 percent of the 100 shares in the ESOP's suspense account.53 The example assumes immediate vesting.

2009]ZELL, TRIBUNE AND S ESOPCorp. has not paid any dividends over the prior ten years, then the shares willbe the only assets in the ESOP. 54 Obviously, the total value of the ESOPaccounts will depend upon how much each share of E Corp. is worth. If thatstock has appreciated, the accounts, in aggregate, will be worth more than 1000; if it has declined, they will be worth less.IV. A CLOSE LOOK AT THE TAXCONSEQUENCES OF USING ANS ESOPThe ESOP literature frequently extols tax benefits as one of the principaladvantages of and therefore motivations for using an ESOP. 55 In order forthat claim to have merit, the tax benefits of ESOPs on net-after taking outany disadvantages-must be substantially greater than the tax benefits on netthat can be achieved through feasible alternative transactions. The taxconsequences of C ESOPs were examined by Myron Scholes and MarkWolfson in 1990, 56 several years before Congress authorized S ESOPs. 5 7 Inthis Article, I examine the tax consequences of S ESOPs. 58 Accordingly, inthis Part, I take a close look at the tax advantages and disadvantages ofS ESOPs relative to other structures. 59A. Tax Advantages: Claims and ResponsesCommentators and ESOP promoters regularly claim that there aresubstantial tax benefits from using an S ESOP. 60 They generally make twoclaims. First, they claim that the ESOP structure allows the employer todeduct repayment of principal on loans incurred by the ESOP. 6 1 Becausecontributions to an ESOP are deductible, an employer that establishes aleveraged ESOP-an ESOP that borrows funds to purchase employersecurities-can deduct repayment of principal. 62 In contrast, in othersituations-including leveraged buyouts-repayment of loan principal is notdeductible. 63 Second, ESOP proponents regularly claim that the use of anS ESOP allows participants to defer tax on their income received through theESOP. 64 Both claims are usually made in a manner that suggests that suchbenefits are, if not unique to the ESOP structure, sufficiently rare to warrant65attention.1. Deduction of PrincipalSubject to limitations on amount, payments made by an employer to anS ESOP are deductible by the employer. 66 Because those contributionsusually go to pay interest and principal on the ESOP loan, the employer can,in effect, deduct both interest and principal on itS ESOP loans. 67 The ability54 The example assumes no diversification of the individual ESOP accounts.

OHIO STATE LA W JOURNAL[Vol. 70:355 The interested reader should see, e.g., the website of the National Center forEmployee Ownership, http://www.nceo.org.56 Myron S. Scholes & Mark A. Wolfson, Employee Stock Ownership Plans andCorporateRestructuring:Myths and Realities, FIN. MGMT., Spring 1990, at 12.57 Congress authorized S ESOPs in 1996, and the provisions became effective onJanuary 1, 1998. Rosen, supra note 7, at 5.58 The method I use to analyze the tax consequences of the S ESOP structureendeavors to make an "apples-to-apples" comparison across all parties. The taxconsequences of a transaction cannot be understood by just looking at how one party to atransaction is taxed. In order to evaluate the tax consequences of a transaction, it isimportant to employ an all-parties perspective. If a tax benefit to one party is offset by atax detriment to another party, then there is no net benefit to the structure. In such cases,no party will likely be helped or hurt by the tax treatment. Instead, the parties are likely toundo the effect of the tax consequences through the terms of the transaction. It is alsoimportant to separate the tax and non-tax consequences of a transaction by holding thenon-tax consequences equal across transactions so as to avoid confounding tax and nontax consequences. The method for making accurate tax comparisons was developed byMerton H. Miller & Myron S. Scholes, Executive Compensation, Taxes andIncentives, inFINANCIAL ECONOMICS ESSAYS IN HONOR OF PAUL COOTNER 179, 190-201 (1982). Thatmethod was introduced to the legal literature by Michael S. Knoll, The Tax Efficiency ofStock-Based Compensation, 103 TAx NoTES 203 (2004), and David I. Walker, Is EquityCompensation Tax Advantaged?, 84 B.U. L. REv. 695, 699 (2004). That method has beenpicked up by various legal scholars and is now part of the regular discourse. See Eric D.Chason, Deferred Compensation Reform: Taxing the Fruit of the Tree in its ProperSeason, 67 OHIO ST. L.J. 347, 348 (2006); Chris William Sanchirico, The Tax Advantageto Paying PrivateEquity FundManagers with ProfitShares: What Is It? Why Is It Bad?,75 U. CHI. L. REV. 1071, 1077 (2008); Ethan Yale, Investment Risk and the Tax Benefit ofDeferred Compensation, 62 TAx L. REV. (forthcoming 2009), available d l 279455.59 Some proponents of ESOPs argue that the tax benefits to S ESOPs are lessgenerous than those granted to C ESOPs because the seller of shares to an S ESOP cannottake advantage of I.R.C. § 1042. See, e.g., Corey Rosen, ESOPs in S corporations,in THEESOP READER 38, 40-41 (Scott Rodrick & Corey Rosen eds., 3d ed. 2003). Section 1042allows the seller of shares to an ESOP to defer paying tax on the gain from those shares ifall of the following conditions are met: (i) the company is a closely held C corporation;(ii) the seller held her shares for three years or longer; (iii) after the sale, the ESOP holds30 percent or more of the employer's stock; and (iv) the seller's reinvest the funds inqualified replacement securities, essentially stocks and bonds of domestic corporationswithout too much passive income. I.R.C. § 1042(a)-(c) (2006). If the seller satisfies all ofthose conditions, then the seller can defer her capital gain tax until she sells thereplacement securities. By its own terms, Section 1042 does not apply to sales to SESOPs. See I.R.C. § 1042(c)(1)(A) (limiting scope of exclusion to employer securities"issued by a domestic C corporation"). The claim that C ESOP tax benefits are moregenerous than S ESOP benefits has some merit. The ability to defer tax on the sale if theproceeds are invested in qualified securities is valuable. In the extreme, if the qualifiedsecurities are held until death, the seller of shares to the ESOP can permanently avoid theentire tax on the gain from those shares. Moreover, although there are some techniques

ZELL, TRIBUNE AND S ESOP2009]to deduct principal is often described as a major tax benefit available only to68employers who adopt an ESOP.Start with the employer. Returning to the example, the employer deductsthe payment it makes each year to the S ESOP on behalf of its participants.Thus, the employer would deduct the amount contained in the columnlabeled "contribution" each year. That is to say, the employer would deduct 162.75 each year for 10 years. For shareholders in the 35 percent taxbracket, the deduction reduces taxes by 56.96 each year. Thus, over tenyears, the deductions reduce the shareholders' taxes by 569.61.that have traditionally been used to transfer the economic interest from owning an assetwithout triggering immediate taxation, and so would enable sellers to obtain in essencethe tax benefit afforded by Section 1042 without using that provision, such"monetization" techniques have been sharply curtailed by the law. I.R.C. § 1259(constructing sale rules). Thus, the tax benefit afforded sellers to a C ESOP cannotreadily be replicated by sellers who do not meet the requirement of that provision.60 Rosen, supra note 46, at 134.61 Id.62 Rosen, supra note 28, at 7-8; David Ackerman, Legal ConsiderationsforS corporationESOPs, in S CORPORATION ESOPs 27, 33-35 (Scott Rodrick ed., 2d ed.2005); Chandler et al., supra note 3; Ashley M. Heher, Tribune Accepts Buyout OfferFrom Zell, Plans to Sell Cubs, BUFF. NEWS, Apr. 3, 2007, at B7; Mary Lynn F. Jones,Employee Ownership Plans Offer Risks, Rewards, PRESSTIME, May 2007, at 20; TamiLuhby, ESOP Is Key to Making Tribune Deal Work, NEWSDAY, Apr. 3, 2007, at A44;Thomas S. Mulligan, How Zell's Offer for Tribune Might Work, L.A. TIMES, Mar. 29,2007, at Cl.63 A related claim that is sometimes made with respect to S ESOPs is that when theESOP owns 100 percent of the company's stock that no portion of the company's incomeis taxable. See, e.g., Editorial, ESOP Expectation and Reality, CRAIN'S, Apr. 16, 2007, at10.64 Karen D. Ng, ESOP-The Misunderstood Plan, 26 S.F. ATT'Y 17, Oct.-Nov.2000.65 See Rosen, supranote 16 (describing unique tax advantages of S ESOP structure).66 The maximum amount that employers can generally deduct for contributions to anESOP is 25 percent of total employee compensation. I.R.C. § 404(a)(3) (Supp. 2008).67 With a C ESOP, contributions that go to pay principal on an ESOP loan do notcount against the 25 percent limit. I.R.C. § 404(a)(3)(A) (Supp. 2008). Instead, for suchcontributions, there is an additional 25 percent limit for contributions that go to payprincipal. I.R.C. § 404(a)(9)(A) (Supp. 2008). Contributions that go to pay interest on theC corporation's ESOP loan are not limited. I.R.C. § 404(a)(9)(B). For S ESOPs, there areno increased limits. I.R.C. § 404(a)(9)(C). Instead, for S ESOPs, contributions that go topay for principal and/or interest on the ESOP loan count against the general 25 percentlimit. I.R.C.

advantages (and disadvantages) that are not generally available with other transactional structures. I also quantify those advantages (and disadvantages) when they arise. Finally, I apply those insights to the Zell Tribune transaction and estimate the likely tax savings and the increase in bid price that can be