Companies Cash In on Tax Breaks From Employee Retirement Plans

Rosel Patton, a 49-year-old switch engineer in Marlboro, Mass., doesn't realize it, but when she saves for retirement by contributing to her 401(k), she's also helping her company save money.

That's because her employer, Verizon Communications Inc., matches Ms. Patton's savings with Verizon stock. Thanks to little-known tax rules, any of a company's own stock in its retirement plans -- whether contributed by employees or by the company -- can trigger special tax breaks. For Verizon, that means tax breaks valued at as much as $30.5 million a year.

Verizon isn't alone. Company stock in retirement plans is generating billions of dollars in tax deductions each year for thousands of companies, including Sears, Roebuck & Co., Lockheed Martin Corp., McDonald's Corp., Bank of America Corp., Ford Motor Co., and Procter & Gamble Co.These big, but little-noticed tax benefits are a reason that companies use their own stock in retirement plans and, in many cases, lock employees into them until age 50 or later. But the potential financial risk to workers of having too much company stock in such plans has become a political issue in the wake of the collapse of Enron Corp. Many of its employees have seen retirement savings evaporate because much of it was invested in Enron stock.

Congress will hold hearings next week to consider whether there should be limits on the amount of employer stock in 401(k)s and to what extent companies ought to be allowed to restrict employees from selling shares the company contributes.

If employees are allowed more flexibility in diversifying the holdings in their retirement plans, it would probably lead to fewer company shares in many plans, cutting the tax deductions that employers enjoy. Especially in light of Enron, many workers undoubtedly would diversify because it would reduce the risk they face.

"I'm trying to be as diversified as I can possibly be," says Ms. Patton, the Verizon employee, who now has about 20% of her retirement-savings plans in Verizon stock. "This Enron thing has really gotten people nervous." A Verizon spokeswoman says the structure of its retirement-savings plan provides financial benefits for the company but also provides a good benefit for its employees.

Employer groups are lobbying against any major changes in laws governing retirement-savings plans. "If providing stock to an employee no longer has any value to the employer, then of course the employer is going to stop doing it," says Mark Ugoretz, president of the ERISA Industry Committee, which represents major employers.

It is well-known that companies prefer contributing shares to savings plans because it is cheaper than contributing cash and keeps the stock in friendly hands. But there has been little public focus on the tax benefits for companies, which helps to explain why so much company stock is in employee-retirement plans. In 1995, 33% of the value of the total assets in 401(k)s, Employee Stock Ownership Plans or ESOPs, and profit-sharing plans was in employers' stock. This rose to 44% as of mid-1999, according to the Institute of Management and Administration, which bases its figures on a survey of 219 large companies. As the stock market slumped, the percentage fell back to 34% in late 2001.

Ordinarily, companies aren't allowed to deduct dividends they pay, but they may if the stock is held by an ESOP or a certain type of hybrid 401(k), called a KSOP.

KSOPs are created when a company marries its 401(k) to its ESOP; this makes the company stock in the 401(k) eligible for the dividend deduction, too. "Savings from additional tax deduction can be substantial," noted an August 2001 newsletter that Towers Perrin, a benefits consulting firm, sent to clients.

An analysis of Internal Revenue Service filings reveals KSOPs have become widespread. By 1998, the latest year for which comprehensive data are available, more than 900 large companies had grafted their 401(k)s onto their ESOPs, creating KSOPs. In addition to the companies getting this tax break mentioned above, these include SBC Communications Inc., Anheuser-Busch Cos., United Technologies Corp., Target Corp., and Marsh & McLennan Cos.

And more companies are likely to follow suit, even though the concentration of company stock in 401(k)s has become controversial. A little-noticed tax-law change in May 2000 made it easier for companies to capture the dividend deduction. "For most companies which have a significant amount of company stock in their 401(k) plan, this is a no-brainer," says Joseph Hessenthaler, a consultant in Philadelphia with Towers Perrin. "A lot of people have done it, and a lot of people are looking at it."

Abbott Laboratories Inc. on Oct. 1 transformed its 401(k) plan into a KSOP. The company was already contributing stock to the 401(k) plan, which owns nearly 6% of the company's shares outstanding. But now all $5.1 billion of its shares in its retirement-savings plan -- some 82% of the plan's $6.2 billion in total assets -- generate dividend deductions.

The tax savings are substantial. In 2001, Abbott paid $72 million in dividends to the retirement plans; at a 39% corporate tax rate, this could produce $28 million in deductions. To put this into perspective, Abbott reported that its cost of contributing to its retirement plans was $86 million in 2000, meaning the potential deductions could cover one-third of its contribution.

Abbott won't comment on the tax-deduction estimate, but spokesman Chris Bona acknowledges that tax advantages figured into the pharmaceutical company's decision to change the plan. "Everyone stands to benefit," he says, noting that employees have fewer restrictions on selling the shares. In the past, Abbott required employees to hold onto shares contributed by the company until they turned 50 years old. Now, they can sell the shares immediately and put the money into other investments.

Pfizer Inc., a drug maker, is also converting its 401(k) plan to a KSOP. Pfizer paid some $60 million in dividends to its retirement plans in 2000, which could bring Pfizer a tax deduction of $23.4 million. The plans last year held $6.3 billion of company shares contributed by employees and Pfizer. A spokeswoman says it is too soon to discuss details about the new plan.

To enhance the value of the ESOP dividend deduction, companies often create special preferred shares, paying higher dividends, for the ESOPs and 401(k)s. P&G has shares used exclusively for its retirement plan that pay annual dividends of as much as $2.06 a share, compared to a dividend of $1.40 a year on common shares. The plan's $10.8 billion in P&G stock, accounting for 12.6% of the company's shares outstanding, would garner $346 million in dividends -- or a tax deduction of some $127 million, using the company's tax rate of 36.7%.

P&G didn't respond to specific questions about the tax deductions from its retirement plan. But spokeswoman Martha Depenbrock notes that P&G contributes an average of 15% of employees' base salary each year to the retirement plan. "One of the reasons we are able to be so generous to employees is because of the way [the plan] is structured," she says.

Most companies contacted confirmed that tax breaks were one reason they contribute shares to employee 401(k) accounts. But many note that they also offer traditional pensions and that they have additional reasons for contributing company shares. W. Randolph Baker, Anheuser-Busch's chief financial officer, says that providing company stock is "consistent with the objective of increasing employee ownership of the company and further aligning employees with shareholder goals." With an annual dividend yield of 1.6%, the $2.3 billion in Anheuser-Busch stock in the ESOP and 401(k), which accounts for 83% of the plans' total combined assets, generates a dividend deduction valued at an estimated $14.5 million annually.

Similarly, Marsh & McLennan says it sees its 401(k) plan as a way for employees to hold a stake in the firm, says spokeswoman Barbara Perlmutter. "We don't think of [the 401(k) plan] as a retirement plan," she says. The plan has almost $2 billion in assets, 61% of which is invested in the company's stock; the dividend would provide some $10 million in tax savings each year under current rules.

In addition to the tax break that companies get for dividends on the stock in employee retirement accounts, there is another potential tax advantage. The genesis of these other tax breaks came largely in the late 1980s, when many publicly traded companies set up ESOPs at least in part because they enabled them to borrow money cheaply. ESOPs are the only kind of retirement plan allowed to take on debt, and a company can deduct not just interest payments on ESOP loans, but principal payments as well.

By funneling a loan through these leveraged ESOPs, companies could take a deduction on the full amount and reduce the cost of financing by some 40%. Leveraged ESOPs provide companies with a large source of cash for capital expenditures and leave the plan with a large amount of the company's own shares in giant unallocated pools.

Finally, studies have shown that when employers contribute stock, employees are more likely to put their own contributions into the employer's shares. Further reducing the cost for employers: Employer contributions to retirement plans, whether in cash or company stock, are exempt from the 7.65% FICA taxes (though employees are not exempt from the tax on the salary they defer).