Is An ESOP Right For Your Company?
Originally published: 08.01.07 by Mike Coyne
An employee stock ownership plan can provide cash to the owner and a futureto the business.
Tom, age 49,owns an hvacr business with 30 employees. Tom's personal financial adviser isconcerned that most of his net worth is tied up in the business and hassuggested that Tom begin to diversify. Likewise, the company's attorney isconcerned with the company's succession plan. Tom knows of several employeeswho could succeed him, given more time to learn the business and work together.He doubts, however, that these employees could raise the money necessary to buyhim out. Tom needs to consider an employee stock ownership plan, known as anESOP.
An ESOP is anemployee benefit plan that primarily invests in employer stock, thereby makingthe employees of a company the beneficial owners of the stock in that company.Because the ESOP is an employee benefit plan, it is subject to certain rulescontained in the Internal Revenue Code and Employee Retirement Income SecurityAct (ERISA).
One of themost common uses of an ESOP is to buy the stock of an owner in a closely heldcompany. An ESOP can provide a market for the equity of a shareholder of aclosely held company while providing benefits and job security for employees.The owner may be retiring or may be staying in the business but selling hisshares to the ESOP to diversify his personal assets (e.g., have some personalliquidity rather than maintaining most of his net worth in the closely heldbusiness).
ESOPs arebeneficial for both the selling shareholders and the employees if done right.Education and communication are vital to the ESOP's success. ESOPs work bestfor companies with 20 or more employees, with revenues sufficient to warrantthe added ESOP expense and for companies that desire to foster an ownershipculture.
Selling sharesto an ESOP does not happen overnight. It requires careful, thoughtful planningand analysis. The process is very similar to selling the business to a thirdparty, except the third party in this transaction is the ESOP.
FeasibilityStudy and Fiduciary
The firststep in selling shares to an ESOP is to conduct a feasibility study todetermine whether the company can afford the ESOP loan payments anddistribution payments to the participants. The feasibility study requires anin-depth analysis of the company's financial health and prospects for growth aswell as consideration of the stability of the company's workforce.
Once thefeasibility study is completed and reviewed, the company must hire anindependent or transactional fiduciary, or trustee, to represent the ESOP. Thisis to assure that the ESOP is treated fairly in the stock purchase transaction.The fiduciary will conduct due diligence and negotiate the terms and price ofthe purchase of stock. The ESOP may only purchase the shares for "adequate consideration"as defined by the Department of Labor (DOL) and Internal Revenue Service (IRS).Adequate consideration is determined, in part, by (1) an independent appraisalprepared by a qualified ESOP appraiser hired by the fiduciary and (2) thefiduciary reviewing the independent appraisal to ensure that reasonableassumptions were made by the appraiser and that the independent appraisal isaccurate, complete, reasonable, and complies with the DOL and IRS rules.
The sale ofthe shares can be structured in various ways. The selling shareholders cansimply sell the shares and obtain capital gains tax treatment on the sale.Alternatively, Section 1042 of the Internal Revenue Code permits owners ofclosely held companies (which are taxed as C corporations) to incur no taxablegain on the sale of stock to an ESOP. However, there are numerous restrictions andconditions that apply in order to obtain this favorable tax treatment. Forexample, if the selling shareholder elects Section 1042 treatment, he cannot bea participant in the ESOP. It is not necessary for an owner to sell all of hisstock to the ESOP, although a complete sale is not uncommon.
The sale ofthe stock to an ESOP may be leveraged or non-leveraged. In a leveraged ESOP,the ESOP or its corporate sponsor borrows money from a bank or other qualifiedlender. The company usually gives the lender a guarantee that it will makecontributions to the trust, which will enable the trust to pay off the loan;or, if the lender prefers, the company may borrow directly and make a loan backto the ESOP. The leveraging will be used to buy out the stock of the formerowners, and the ESOP will acquire those shares.
Two taxincentives make borrowing through an ESOP extremely attractive to companies.First, because ESOP contributions are tax deductible, the corporation is ableto deduct principal payments as well as interest payments from taxes. This cancut the cost of financing to the company significantly. Second, dividends paidon ESOP stock of a C corporation whether passed through to employees,reinvested by employees for more company stock, or used to repay the ESOP loanalso are tax deductible. This provision of federal tax law may increase theamount of cash available to a company compared with one utilizing conventionalfinancing. See the schematic of a leveraged ESOP on page 12.
In aleveraged ESOP, the cash would flow as follows:
1.The company would make plan contributions to the ESOPSOP.
2. The ESOPSOP pays onthe promissory note to company. When the shares are paid, they are allocated inthe ESOPSOP to the plan participants.
3. The company pays onthe promissory note to the bank.
Let's go backto Tom's situation, described in the beginning of this article. The companyhired an independent fiduciary to negotiate the sale of Tom's shares to theESOP. Because Tom is continuing in the business and has an interest in itsfuture success, Tom decides against the 1042 treatment. Tom will pay capitalgains tax but also will participate in the ESOP. Tom believes his participationin the ESOP is meaningful to the employees and sends the employees the messagethat they are all in this together. Because Tom did not take 1042 treatment, healso agreed to seller-finance the sale to give the ESOP a longer term to payoffthe debt than the proposed bank financing (10 years vs. 7 years) and a lowerinterest rate than the bank financing (7.5% vs. 8%). Because Tom was being paidover 10 years, he agreed to sell all his shares to the ESOP.
The company,now 100% owned by the ESOP, elects to become a subchapter S corporation. Thismeans that there no longer will be any tax at the corporate level — all of thecompany profits pass through to the owner. Because the owner is an ESOP, whichis tax exempt, no income tax is paid on any of the company's profits! Throughthis process Tom has increased the company's cash flow by 35% (the amount thatwould otherwise be paid out in federal taxes).
The successof an ESOP depends, in part, on company philosophy and employee involvement.Considerations in adopting an ESOP should include: How will the employees viewthe sale? Employee communication and involvement early in the process is key.Many organizations assist businesses with employee communications. Among themare: The ESOP Association, NCEO (NationalCenter for Employee Ownership), andthe Ohio EmployeeOwnership Centerat Kent State University.
Tom involvedthose key employees identified early on in the entire process so that thetransaction was a group effort and group success. The company used servicesfrom some of the organizations mentioned above to assist with employeecommunication and education. The company's key employees continue to serve onthe trustee and administration committees and attend annual ESOP workshops andseminars. These actions further the goal of developing Tom's successors withinthe business.
Once an ESOPis established, it is important to maintain successful management. Therefore,many ESOP companies will implement a management incentive program. Frequently,nonqualified deferred compensation plans are implemented to maintain keymanagement (golden handcuffs) and/or to cover those individuals that are notreceiving comparable benefits provided in a pre-ESOP retirement plan. Theexistence of the ESOP does not prevent the company from continuing existingnonqualified plans or implementing new ones.
Whenconsidering an ESOP, it is never too early to consider the ESOP repurchaseobligation. Since the participants cannot sell their closely held stock on anopen market, the ESOP/company must provide the market and repurchase the shares.The cost for repurchasing the shares must be factored into whether an ESOP willwork in a particular company. Consideration must be given to the repurchaseobligation projections for death, disability, retirement, diversification, andother termination for the next 10 to 15 years. What is the company's workforcecomposition? Is there high or low turnover? Can the company handle theobligation and still maintain desired growth? Too large a repurchase obligationin proportion to available cash flow can stifle a company's ability tomodernize and compete in the long term. The corporation can adopt a fundingplan within the ESOP or outside the ESOP — such as accumulating cash inside theESOP, the company purchasing life insurance on participants with high accountbalances, pay-as-you-go, or establish a sinking fund (a cash reserve in thecorporation for purposes of paying down the debt).
Considerationshould also be given to the impact on the company's other retirement plans.Will the company continue providing benefits in the other retirement plans?This will depend on company philosophy, cash flow, and IRS deduction limits.Most companies discontinue company contributions in other retirement plans andtreat the ESOP as the replacement. However, the companies do maintain the401(k) plan, permitting deferrals but scaling back matches.
Finally,there are special S corporation ESOP considerations. Analysis has shown thatthe long-term tax savings generated by S corporation ESOP companies can besignificantly greater than for some C corporations. Due to the tax-free natureof the S corporation ESOP, there are complicated calculations that must beperformed each year to ensure that the ESOP benefits a broad range of employeesand that the ownership is not concentrated in the hands of a few employees.
MikeCoyne is a founding partner of the law firm Waldheger Coyne, Cleveland,Ohio, and isa regular contributor to HVACR Business. Talk to Mike online at www.hvacrbusiness.com/forums.
1. Qualifiedsecurities are defined as common stock of a C corporation with voting anddividend rights equal to the classes of common stock having the greatest votingand dividend rights. The securities must have been owned by the seller for atleast three years and cannot have been received by the seller in a distributionfrom a qualified retirement plan or a transfer under a stock option granted bythe company.
2. Qualifiedreplacement property is defined as any security issued by a domestic operatingcorporation that is not the corporation that issued the qualified securitiesthat were sold to the ESOP (or a member of the same controlled group ofcorporations), and which does not receive more than 25% of its gross receiptsduring the taxable year in which it is purchased from passive investment (thisrequirement disqualifies mutual funds). Government securities and securitiesacquired by an underwriter do not qualify. An operating corporation is onewhose assets are used in the active conduct of a trade or business. Passiveincome has the same meaning as under the S corporation rules.
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