How ESOPs Became Part of the Internal Revenue Code

If you’re launching a startup, you may be considering an ESOP — employee stock ownership plan. As I wrote in a previous post, more than half of Fortune Magazine’s 100 Best Companies to Work For is made up of companies that offer ESOPs. Therefore, it bears consideration.

To understand more about the fundamental purpose of an ESOP, let’s delve a bit deeper into its history.

History of ESOPs

Today, ESOPs are an accepted business practice, but that wasn’t always the case. The person credited with developing the concept is Louis Kelso, an attorney and economist who perceived a basic problem of capitalism. According to Kelso, capitalism places both capital and the benefits of capital ownership into the hands of a very small minority. At the same time, the United States is a consumer-based economy. If capital is concentrated only among a small minority, the consumer economy cannot flourish. Kelso sought to find a way to expand the ownership of capital without taking property from others.

Gil Smolinski — Louis Kelso invented the ESOP
Louis Kelso in 1964

Your first reaction upon reading this might be that more people simply need to work hard and thereby earn capital. According to Kelso, however, working hard isn’t enough. Often, you need money to make money. If someone isn’t born into that luxury, they need a loan. To get a loan, you need to offer some sort of collateral. Where is a hard-working, lower or middle-class person supposed to get that collateral?

Many people can end up working very hard, sometimes at multiple jobs, but all the capital they earn goes toward paying bills for necessities, like food, rent, clothes, etc. Since all their hard-earned money gets spent on necessities, they aren’t able to save up any substantial amount of capital or put up anything toward collateral.

Make no mistake — Kelso did not champion socialism. Rather, he sought to find a way to democratize access to the credit necessary to earn private capital. It was this way of thinking that led him to develop the concept of a vehicle that would allow employees to acquire stock via credit, and they would pay back the debt from the earnings of the company. That concept has become the modern ESOP.

The First ESOP

Kelso created the first ESOP in 1956 for Pennsylvania Newspapers, Inc. (though the term ESOP wasn’t coined until the late 1970s). He used the plan as a way to transition the ownership of its two founders, both in their 80s, to the company’s managers and employees.

The founders had wanted their employees to inherit ownership of the company — they felt it would be in the best interests of both the company and employees. Of course, the employees didn’t have enough money to buy the company, even if they pooled all their money, took out loans, and remortgaged their homes.

Kelso, sympathetic to the situation, noted that the company had been making annual contributions to a traditional IRS tax-qualified profit-sharing plan, which had then reached a total that could make up 30% of the down payment. While using these funds meant that employees would risk losing part of their retirement funds, they decided it was better than selling the company to an outside buyer. The owners and employees agreed to use these funds toward the down payment. The rest would need to be covered by a bank loan.

And where would the money come from to pay back the loan? This issue dogged the company until Kelso came up with a unique idea. Instead of having the company take out the loan, which it would have to pay back with after-tax dollars, the profit-sharing plan itself would borrow the money. It could repay interest and principal from the annual contributions the company was making anyway, and these contributions would be tax-deductible.

All the pieces of the puzzle seemed to fit into place, except for the last one — the IRS. At that point, this was all unheard of, and the IRS didn’t authorize such a plan. The company would need to file for an exemption in order for this to work. Fortunately, Kelso was an attorney, and he was able to secure the exemption for the company.

ESOP Legislation

Kelso was able to make the ESOP idea work for Pennsylvania Newspapers, but it was a one-off exemption. It solved the company’s particular issue, but the broader issue of a small minority holding most of the country’s capital still remained. Therefore, Kelso pushed hard to make the idea of ESOPs accepted by Congress and the IRS. He shared his ideas with Barry Goldwater — the Republican presidential candidate in 1964; with Milton Friedman — his advisor; with Gerald Ford — a congressman at the time, and with Richard Nixon. Eventually, in the early 1970s, he gained the ear of Russell Long, an influential Louisiana senator, who became the driving force behind Kelso’s ideas in Washington, D.C.

In 1974, Congress passed the Employee Retirement Income Security Act (ERISA), the first law to include a provision for ESOPs as part of the Internal Revenue Code (IRC). Over the next decade, Long helped pass numerous ESOP-related pieces of legislation and tax code amendments.

ESOPs Today

As of 2018, there were nearly 6,500 ESOPs in the U.S. that covered some 14 million participants. It is interesting that ESOPs are being used today in the same way that Kelso created the original one — both as a tool for business succession and as a way of giving employees ownership of a company. In addition to the actual purpose of the ESOP, many additional benefits are being recognized, including increased employee loyalty as well as company tax benefits.

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