ESOPs: The Private Business Owner's Secret Planning Device
By Jeffrey S. Kahn and
Brandon G. Feingold, Greenberg
Traurig, Boca Raton Office
View or download the PDF version of this Alert
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:
- They will not receive fair market value for their stock.
- Once an ESOP is adopted, their children will not be able to inherit
or own the company.
- Employees will have access to confidential financial information.
- Employees will be involved with the management of the company.
There are also some very interesting facts about ESOPs that are
not widely known:
- The vast majority of ESOPs are sponsored by closely held corporations.
- ESOPs are exempt from most of the investment diversification requirements
- Unlike other qualified plans, ESOPs are permitted to borrow money
to acquire plan assets.
- 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.
- 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
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
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.
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
For more information, please review our Tax Practice or Executive Compensation
& Employee Benefits Group description, or feel free to contact one of our
This GT ALERT is issued for general purposes only and is not intended
to be construed or used as legal advice. Greenberg Traurig attorneys provide
practical, result-oriented strategies and solutions tailored to meet our
clients’ individual legal needs. The Firm’s responsive approach to client
service often cuts across legal subject matter, applying the right experience
and resources to provide cost-effective solutions.