GT Alert

ESOPs: The Private Business Owner's Secret Planning Device

March 2003
By Jeffrey S. Kahn and Brandon G. Feingold, Greenberg Traurig, Boca Raton Office

  View or download the PDF version of this Alert here.

Owners of closely held businesses are often surprised to learn that employee stock ownership plans (ESOPs) are not just for large corporations. In fact, very often there are more compelling reasons for a private company to adopt an ESOP than there are for a large public company. An ESOP is one of the most powerful planning tools available to a business owner, and in the current recessionary economy, ESOPs are an excellent alternative to the traditional ways for businesses to raise liquidity.

This alert will explore (1) What is an ESOP? (2) Who should establish an ESOP? (3) How does an ESOP work? (4) What are the advantages of an ESOP? and (5) How will an ESOP affect the management of the company?

What is an ESOP?

"An ESOP is one of the most powerful planning tools available to a business owner, and in the current recessionary economy, ESOPs are an excellent alternative to the traditional ways for businesses to raise liquidity."

An ESOP is a tax-qualified retirement plan that invests primarily in the stock of the employer. ESOP companies receive significant tax benefits, as do plan participants and the selling shareholders. For businesses that already have profit sharing or 401(k) plans, these other qualified plans operate similar to ESOPs with regard to eligibility, vesting, and non-discrimination rules. An ESOP is managed by a plan administrator and ESOP trustees who are selected by the employer. Employees have individual accounts in the ESOP, but unlike profit sharing or 401(k) plans, these accounts are invested only in the employer’s stock. How and when an employee receives either cash or stock is a plan design issue that will be decided by the company with the assistance of its professional advisors.

It is important to dispel some common myths about ESOPs. Owners of private companies often incorrectly perceive the following with respect to an ESOP:

1. They will not receive fair market value for their stock.
2. Once an ESOP is adopted, their children will not be able to inherit or own the company.
3. Employees will have access to confidential financial information.
4. Employees will be involved with the management of the company.

There are also some very interesting facts about ESOPs that are not widely known:

1. The vast majority of ESOPs are sponsored by closely held corporations.
2. ESOPs are exempt from most of the investment diversification requirements of ERISA.
3. Unlike other qualified plans, ESOPs are permitted to borrow money to acquire plan assets.
4. According to the National Center for Employee Ownership, the number of ESOPs are growing, while the number of participants is shrinking. This is the result of large public corporations terminating ESOPs, while closely held corporations are increasingly adopting them.
5. Various studies have shown that sales, productivity and profitability improve after an ESOP has been installed, and that ESOP companies are also more likely to offer their employees other forms of retirement plans.

Who Should Establish an ESOP?

Establishing an ESOP is often an effective strategy for business owners who want to cash out all or a portion of their equity in the business. This often occurs when there is no other family member capable of running the business or no immediate market for the business. An ESOP is often well-suited for a business owner who wants to create some personal liquidity and personal asset diversification while continuing to run the business. An ESOP can be used by one shareholder to buy out another on a tax-favored basis. By allowing a business owner to sell stock in stages, an ESOP preserves continuity, while a third-party buyer may disrupt operations. ESOPs are also utilized by companies to establish a market value for their securities in anticipation of a later sale or an initial public offering.

How Does an ESOP Work?

When a company adopts an ESOP it creates a trust for the employees, also referred to as the "ESOP Trust." The company could contribute stock to the ESOP; however, if the owner of the company wants to create liquidity, the owner may sell shares of his or her company’s stock to the ESOP Trust. In a leveraged transaction, the ESOP Trust usually obtains its funds through a loan either from a financial institution or from the seller or a combination of institutional and seller financing. The amount of the loan is based on the cash flow and financial strength of the corporation. The ESOP then gives cash to the shareholders in exchange for their stock.

In practice, it is quite common for ESOP financing structures to use two loans. The first loan or "external" loan is from a third party lender to the corporation. The second loan or "internal loan" is from the corporation to the ESOP. There is no requirement that the terms of these two loans be identical. If, for example, the terms of the external loan are longer, the corporation may be accelerating its tax deduction faster than the loan payoff of the principal to the bank. On the other hand, if the terms of the internal loan are longer, stock will be allocated to employees at a slower pace. Generally, lenders prefer to lend to the corporation, thereby avoiding compliance with the exempt loan requirements of ERISA. This is what a leveraged ESOP transaction looks like.

Seller financing has become an increasingly popular method of funding an ESOP. The seller receives a promissory note from the ESOP for all or a portion of his or her stock. Sellers who do not need all the proceeds of the sale at once may want to use this approach because (i) they receive the interest payments rather than a bank; (ii) they retain greater control of the transaction; (iii) transaction costs are reduced, and (iv) if the company has trouble paying the note, it is generally easier to work with the former business owner than a third party lender.

What Are the Tax Advantages to the Corporation?

Each year the corporation will make a tax deductible contribution into the ESOP. Like other defined contribution plans, the corporation is allowed an annual deduction of up to 25% of covered compensation for its payments into the ESOP. C corporations may also deduct interest payments and reasonable dividends that are paid in cash. The ESOP uses the funds it receives to repay the ESOP loan. As the ESOP repays the loan, shares are allocated to employees’ accounts.

If the corporation had gone into the market place to secure a conventional corporate loan instead of entering into an ESOP transaction, it would only be able to deduct the interest on the loan. However, by making payments through an ESOP, the corporation is able to deduct both principal and interest payments.

What Are the Tax Advantages to the Employees?

An employee’s ESOP account is similar to an IRA, profit sharing or 401(k) account. While the stock is in the ESOP, it grows tax deferred. In a closely held corporation or in a public company with thinly traded stock, when an employee leaves the company, the company pays the employee for his or her vested stock. The employee may then continue to defer taxes by either rolling over these funds to an IRA or transferring them to another qualified retirement plan. If the employee takes a distribution in stock, capital gains treatment may be available.

What Are the Tax Advantages to the Shareholder?

If the corporation is a C corporation and the shareholder sells 30% percent or more of his or her stock, the owner can defer indefinitely the taxation of his or her gains on the sale of the stock. The additional liquidity for the shareholder presents vast investment opportunities and increases his or her estate and charitable planning options. Under Section 1042 of the Internal Revenue Code, an owner of a closely held C corporation can defer capital gains tax on the sale to an ESOP if the ESOP owns 30% or more of each a class of outstanding stock or of the total value of all outstanding stock and the seller reinvests the sale proceeds in Qualified Replacement Property (QRP) within fifteen months. The QRP is restricted to investing in stocks or bonds of United States domestic operating companies and may not invest in mutual funds, partnerships or REITS. However, the use of a special funding device known as "floating rate notes" as the QRP can provide the seller with almost total reinvestment flexibility.

Since 1998, S corporations have also been permitted to adopt ESOPs; however, different rules apply. Rollover treatment under Section 1042 is not allowed and dividends are not deductible. It is not uncommon, therefore, for an S corporation to convert to a C corporation prior to an ESOP transaction. On the other hand, if all the stock is sold to an S corporation ESOP, the future earnings of the company will be exempt from income tax.

ESOPs As an Estate Planning Tool

An ESOP is also an effective estate planning device. Utilization of an ESOP can be an integral part of a comprehensive estate plan and a full discussion on this topic is beyond the scope of this Alert. However, there are several estate planning advantages that an ESOP provides that should be mentioned, First, an ESOP can create liquidity, thereby increasing the amount of money available to pay bequests, taxes, debts, and estate administration expenses. Second, an ESOP transaction cannot be completed without an independent stock valuation which must be updated annually. This may greatly reduce the chance of a valuation dispute with the IRS after the death of the shareholder.

How Does an ESOP Affect Management of the Business?

In many instances, a minority stock interest is sold to the ESOP. In that case, the majority shareholder will continue to control the corporation. In addition, the corporation selects the trustees who vote the ESOP stock in all instances except upon a liquidation or sale of the business. Thus, for most practical purposes, there is no management change.

Conclusion

An ESOP can be an integral part of a business owner’s business and estate planning. It is a versatile financial tool that can offer substantial tax benefits. If a sale or restructuring of a closely held business is contemplated, ESOPs should be explored as a planning alternative.

© 2003 Greenberg Traurig

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