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Beyond The Numbers July - August 2010

 

Employee Stock Ownership Plans

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Many business owners are reaching their 50s and 60s without exit or succession plans for their companies. An Employee Stock Ownership Plan (ESOP) may be a way to help them accomplish their goals and much more. An ESOP is a tax-qualified plan governed by ERISA. Contributions are deductible (within limits), earnings on the assets in the trust do not generate any current taxation, and distributions from the plan are taxed at ordinary income tax rates. However, ESOPs have two significant features that distinguish them from other qualified plans like profit sharing and 401(k) plans:

  1. They are required to invest primarily in the stock of the sponsoring employer. Other plans are required to diversify their asset holdings.
  2. ESOPs are the only employee benefit plan that may use corporate credit to finance the purchase of company stock from a shareholder. For other plans, this would be a prohibited transaction.

How Does an ESOP Work?

Most ESOPs are leveraged; that is, the ESOP uses borrowed money to buy stock from a selling shareholder, typically structured in two steps: 1) a bank will lend money to the sponsoring corporation; and 2) the corporation will re-lend the money to the ESOP. The loan proceeds are paid to the selling shareholder in exchange for stock. The price paid is fair market value as determined by an independent business appraiser, so there is no haggling over the sales price.

To repay the debt, the corporation will make tax-deductible cash contributions to the ESOP, and the ESOP will use the contributions to make payments on its debt to the corporation. Such a structure allows the company to deduct both the interest and the principal payments on the debt.

Since an ESOP is governed by ERISA, the company does not have discretion to pick and choose which employees will participate in the ESOP. In addition, like other qualified plans, individuals are limited in the amount of annual allocation of benefits that they receive in an ESOP. Therefore, nonqualified plans are commonly combined with ESOPs to help companies reward, retain and recruit key people. ESOP eligibility and vesting requirements are generally the same as 401(k) and profit sharing plans.

Tax-Free Rollover

In addition to tax-deductible principal payments on ESOP debt, the government bestows another significant tax advantage. IRC 1042 allows a shareholder to defer the capital gains tax on the sale of stock to an ESOP when the following provisions are met:

  1. The sponsoring corporation must be a C corporation when the stock is sold to the ESOP;
  2. Immediately after the sale, the ESOP must hold either 30 percent of each class of outstanding stock of the corporation or 30 percent of the total value of all classes of outstanding stock issued by the corporation; and
  3. Within 12 months after the sale (or 3 months prior to the sale), the seller must purchase “Qualified Replacement Property.” If the cost of the replacement property is less than the amount received from the sale of stock to the ESOP, the difference is taxable.

"Qualified Replacement Property (QRP)" includes securities that the selling shareholders(s) will be buying with the cash proceeds from the sale of stock to the ESOP. QRP includes stocks, bonds or other debt instruments issued by US domestic operating companies. Certain securities that do not qualify as replacement property include: mutual funds, foreign securities, CDs, REITs, and government bonds. The QRP will “inherit” the cost basis of the shares that were sold to ESOP. Since most business owners have a low cost basis in the companies they own, a significant federal and possible state capital gains tax will be due if the QRP is ever sold or redeemed for cash.

Corporate Governance

An ESOP does not require a company to change the management of the operations of the business. The following summarizes the corporate governance in an ESOP company:


  • The Board of Directors will appoint the ESOP trustee.
  • The ESOP trust, not individual employee participants, owns the stock in the ESOP; the employees only have beneficial ownership through the ESOP trust.
  • The ESOP trustee votes the ESOP stock for all issues except for certain unique circumstances like merging, selling, or liquidating the company or most of its assets.
  • The ESOP trustee can be an individual inside or outside the company or it can be a financial institution.

Since the Board appoints the ESOP trustee, the Board can indirectly control the company even if the ESOP owns a majority of the outstanding shares. It’s important to note that the individuals who are responsible for the maintenance and control of the ESOP are fiduciaries under ERISA.

Other Planning Opportunities

Multiple planning opportunities are associated with ESOPs. For example, a privately owned company with an ESOP has a regulatory obligation to repurchase the stock of anyone in the ESOP who receives a distribution due to retirement death, disability or termination. This requirement to “make a market” in the stock in the ESOP is called the repurchase liability. Like other corporate benefit plan liabilities, the ESOP repurchase liability can be funded with life insurance. Nonqualified plans and buy-sell agreements are commonly combined with ESOPs. In addition, since an ESOP creates liquidity for a company’s owners, estate planning strategies are often implemented or modified after an ESOP transaction.

Who is a Typical ESOP Candidate?

Following are characteristics of typical ESOP candidates:

  • A closely-held C or S corporation generally worth $5M+
  • History of profitability ($500,000 of after-tax net income); the key is to have positive operating earnings to ensure a good enterprise valuation.
  • A stable base of employees over which to allocate the ESOP stock. A good guideline is 30 or more employees. S corporations generally need a larger base to avoid anti-abuse rules.
  • Since the annual ESOP contributions are limited to a percentage of payroll, good ESOP candidates have a total payroll of at least $500,000 to $1,000,000.
  • Owner comfort with the concept of employee ownership
  • Successor management in place or in the wings
  • Available corporate credit

Summary

ESOPs provide a tax-advantaged means for business owners to sell interests in their companies while still maintaining control. Business owners considering a sale of all or a portion of their businesses should at least consider an ESOP.

If you have any questions pertaining to this article, please contact Don Cooper at 914-251-1707 or by e-mail at Cooper.Don@Principal.com.

 
 
 
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