“ESOP ” . . .  A Four-Letter Word?

Liquidity and Perpetuation Pros and Cons

While the ESOP offers tremendous tax advantages to both selling shareholders and the sponsoring corporation, as well as allowing employees to build significant wealth, it is also very important to understand the potential disadvantages of the ESOP.  First outlining the tax benefits and potential advantages, the authors then discuss potential disadvantages, misconceptions, and cite extensive ESOP research.  Their goal is to create more ESOPs that are used in the right situations for the right reasons, and reduce the number of situations where the ESOP is a “four-letter word” by cautioning against using the ESOP in the wrong circumstance and/or for the wrong reasons.

Introduction

Owners of privately held companies face difficult choices when they seek to liquidate some or all of their ownership interest.  If they also desire to perpetuate the company, the choices become fewer.  For certain companies at certain times in certain industries, selling to an outside buyer for a good price may be a viable option.  Even when the price is right contingencies, holdbacks, or earn outs may make the transaction less than attractive.
Enter the Employee Stock Ownership Plan (“ESOP”).  The vast majority of ESOPs (there are over 10,000) were implemented to address the issues cited above.  Specifically, ESOPs can provide partial or full liquidity for selling stockholders, while simultaneously perpetuating the business and providing the employees of the company with a “piece of the action.”  Even if the sellers desire to maximize the sale price, and perpetuation is not an issue, the ESOP is frequently the best option due to the very substantial tax benefits offered to both selling shareholders and the sponsoring corporation.

In many respects the decision to implement an ESOP may be the most important decision ever made by a business owner next to founding of the business itself.  ESOPs can be, and often are, implemented on a limited basis where a minority block of stock is sold to the ESOP, and the selling shareholders remain active and continue to run the business.  However, many other ESOP transactions involve the sale of a large block of stock and the immediate or eventual retirement of one or more major shareholders from active involvement in the business.  It is this latter set of circumstances that the ESOP is most frequently used in privately held companies as a liquidity and perpetuation planning vehicle.  In selling to an ESOP, owners can maintain partial or complete control of the company, retain equity, and invest the sale proceeds in a diversified portfolio of stocks and bonds without incurring a capital gains tax, all the while rewarding the loyal people who helped build the business.  In making the decision whether or not to use the ESOP as a principal (but not necessarily the only) perpetuation vehicle, the impact on (1) the selling shareholders, (2) the company, (3) other existing shareholders, and (4) the employees (especially key management) must all be considered.

Summary of ESOP Uses

An ESOP is a very flexible financial and equity incentive instrument that uses corporate tax deductible or tax-free dollars to achieve a variety of individual and corporate objectives.  These objectives include raising working capital, facilitating charitable giving and providing for the acquisition or divestiture of a division or subsidiary.  These ESOP applications are beyond the scope of this article, which focuses on providing shareholder liquidity and perpetuation planning.
In this context, the ESOP can provide a market (at fair market value) for the partial or complete sale of stock by existing shareholders, while simultaneously providing a strong equity incentive for employees.

Individual Tax Benefits

Individuals (or partnerships) who own stock in a privately held C Corporation may be eligible for “tax free” rollover treatment provided that the initial ESOP ownership is 30% or greater, and the shareholders otherwise qualify.  These requirements include ownership of the C Corporation stock for at least three years, and reinvestment of the proceeds from the sale of the stock to the ESOP in stocks or bonds of U.S. operating companies within twelve months after the sale of stock to the ESOP. [i] If the sponsoring company is an S Corporation, then it may be able to convert to C Corporation status to provide selling shareholders with the “tax-free” benefit.  This benefit is the equivalent of a “tax-free” stock swap with a publicly traded company.  The capital gains tax (generally 15% federal plus state capital gains tax) is deferred.  Upon death the estate receives a “stepped up” basis, and the capital gains tax is extinguished.  (Note – the current estate tax law substantially changes in 2010).

Selling shareholders may not qualify to elect the “tax-free” rollover for a variety of reasons.  The sponsoring company may be an S Corporation and not wish to convert to C Corporation status, the shareholders may have received their stock through some form of stock option plan or other method that makes it ineligible, the stock may be owned by a corporation, the company may be publicly held, etc.  In these instances, the stock sold to the ESOP would be subject to capital gains tax treatment, provided the normal one-year holding period had been satisfied.

Example.  A publicly traded company wishes to use the ESOP to go private.  Selling shareholders do not qualify for the “tax-free” rollover treatment because the company is not privately held.  The selling shareholders would pay capital gains tax on the difference between their basis in the stock and the sale price.

Shareholders of privately held companies are frequently eligible for “tax-free” rollover treatment when they sell stock to the ESOP.  Even when they are not, the tremendous tax benefits available to the corporation can make the ESOP an ideal liquidity and perpetuation planning vehicle.

Corporate Tax Benefits

A corporation receives tax deductions for making contributions to the ESOP (within the limits discussed below) regardless of whether the ESOP is leveraged or unleveraged.  However, in the context of perpetuation planning, most ESOPs are leveraged, either initially, or several years after adoption.

In a leveraged ESOP, the ESOP receives a loan and uses the proceeds to purchase a block of stock from current shareholders.  (The loan is frequently made to the corporation by a bank, and the bank re-lends the money to the ESOP.  The corporation that sponsors the ESOP must guarantee the ESOP debt and selling shareholders are sometimes required to guarantee a portion of the debt if the company has inadequate collateral.)  The company or selling shareholder can also provide some or all of the financing.  The stock purchased by the ESOP is held in a Trust.  As the company makes tax deductible contributions to the ESOP to repay the debt, shares held in an ESOP suspense account are allocated to employee accounts at a rate corresponding to the debt amortization.  Plan participants vest in the shares allocated to their account under normal ERISA vesting schedules.  See diagram below.

LEVERAGED ESOP
(ESOP Purchases Stock from Shareholders.)

(1) Bank lends to ESOP with company guarantee.
(2) ESOP buys stock from existing shareholders.
(3) Company makes annual tax deductible contributions to ESOP, which, in turn, repays lender.
(4)   Employees receive stock or cash (4) when they retire or leave the company.

All contributions used by the company to repay principal on ESOP debt are tax deductible to the corporation.[ii] Interest is also deductible for C Corporations earning more than $75,000 in pre-tax income.  The combined federal and state tax rate is approximately 40%.  For every $1,000,000 of debt repaid through the ESOP, there is approximately $400,000 of corporate tax savings.

Contribution Limits

The company may generally contribute up to 25% of covered payroll annually to repay ESOP debt.  Interest is normally excluded from this limit in C Corporations.  Reasonable dividends on ESOP-owned C Corporation stock when used to repay ESOP debt (or passed through in cash to ESOP participants) are excluded from the 25% limit, and are tax deductible to the corporation. [iii]  As a result, contributions can frequently be substantially above 25% of covered payroll.

Tax-Free Corporate Income
As advantageous as the above corporate tax benefits are, there are even more substantial tax advantages for an S Corporation.

The income attributable to S Corporation stock owned by an ESOP is not subject to federal income tax.  Most states mirror this provision. [iv]

Example.  If an S Corporation were 40% owned by an ESOP, then 40% of the company’s income would be tax-free.  If the company were 100% ESOP owned, then the company would pay no tax.  This is not a deferral; the tax liability no longer exists.  In most instances companies with at least twenty employees can benefit from tax-free S Corporation income.

The Perfect ESOP

An ideal ESOP candidate is a C Corporation with more than twenty employees, with pre-tax, pre-discretionary bonus income of $1,000,000 or more, whose owners seek liquidity and wish to perpetuate the company.  Assuming the sellers qualify, they sell their stock to the ESOP and pay no capital gains tax (tax savings = approximately 20%).  Corporate contributions to repay ESOP debt, both principal and interest, are tax deducible to the corporation (tax savings = approximately 40%).  If the company converts to S Corporation status, then it receives tax-free income (tax savings = 100%!).  In many instances, it is impossible to achieve the liquidity objectives of shareholders in a privately held company, and perpetuate the company, without the use of an ESOP.

Summary of Potential ESOP Advantages

There are tremendous potential ESOP advantages in many liquidity and perpetuation planning situations for stockholders, for the corporation, and for the employees of the corporation.

Stockholders:

  1. Creates liquidity, possibly “tax-free”, at fair market value.
  2. Control maintained (under certain circumstances).
  3. “Tax-free” rollover treatment available to sellers of privately held C Corporation stock. [v]
  4. Establishes value and provides liquidity for estate planning purposes.
  5. Additional equity incentives still available (stock option, bonus, purchase, phantom stock, etc.).

Company:

  1. Substantial corporate tax savings (40% to 100%).
    Pre-tax dollars repay debt.
    Tax deductible Corporation dividends. [vi] S Corporation stock owned by ESOP is not subject to    federal income tax. [vii]
  2. Cash flow increased.
  3. Corporate perpetuation.
  4. Justifies accumulated retained earnings.

Employees:

  1. Employees share directly in equity growth of company.
  2. Company contributions to the ESOP tend to be larger than 401(k) matching or profit sharing contributions.
  3. Studies conducted over the past 25 years demonstrate that the ESOP is a proven motivator, which builds unity and team spirit and retains key employees.
  4. ESOP accounts accumulate tax-free, and are tax-favored at distribution.[viii]
  5. Employees can realize dividend income.
  6. Buy/sell agreements can ensure future employee ownership through the ESOP.

The Potential Disadvantages of an Employee Stock Ownership Plan

In privately held companies, the corporation has the obligation to repurchase shares from participants who terminate due to death, disability, retirement or “other” reasons. [ix] Funding for this so-called repurchase liability or repurchase obligation requires careful planning.  Also, if selling individuals elect the “tax-free” rollover, they, as well as certain family members, are excluded from participation in the ESOP.

Furthermore, it may be necessary, or at least strongly recommended, to change the corporate governance structure, especially if the ESOP is a majority owner.  More and more ESOP companies have outside board members and the current stockholders may be able to receive a higher price for the sale of the business to an outside buyer if there is a strategic fit.  In this instance a number of loyal long-term employees may lose their jobs, but if the highest price is the only consideration to current shareholders, the ESOP may not be able to compete with an outside buyer.  Also, the ESOP by itself may not provide enough equity incentive for key management, and ESOPs can be complicated.

It should be emphasized that these are potential disadvantages.  However, through proper planning, and corporate and transaction structuring, these disadvantages can frequently be addressed to the satisfaction of all parties involved

Repurchase Obligation

The repurchase obligation normally begins to emerge approximately six or seven years after the ESOP has been established, about the time that the first ESOP loan is typically repaid.  The graphs illustrated below demonstrate a typical trend.

Annual ESOP Repurchase Obligation

Source:  Private Capital Corporation

Annual ESOP Repurchase ObligationCumulative ESOP Repurchase Obligation

Source:  Private Capital Corporation

Cumulative ESOP Repurchase Obligation

While retirements and turnover are somewhat predictable, death and disability is virtually impossible to estimate due to the relatively small number of employees in the ESOP.

Funding for the repurchase obligation frequently is done through the corporation.  This is particularly true when key person life insurance is used to fund the repurchase obligation.  A “split funded” approach is usually best, with the corporation, not the ESOP, being the owner, premium payer, and beneficiary.  Typically the individuals with the largest ESOP account balances, representing approximately 20% of all ESOP participants, would be insured for death and disability.

Failure to properly plan for the repurchase obligation can create a ticking “time bomb” that can emerge suddenly and threaten to sink the company.

Note, while GAAP does not currently require that the repurchase obligation be listed as a liability on the company’s balance sheet, it is possible that this could change in the future.

Exclusion from ESOP Participation

When selling shareholders elect the “tax-free” rollover, no portion of those shares may be allocated to the seller, certain family members (including parents, children, brother and sisters), or any person who holds directly or by attribution more than 25% of any class of outstanding stock. [x] The company must be a C Corporation at the time of the sale for the sellers to be eligible to elect the “tax-free” rollover.  In many situations the excluded individuals can be made whole outside of the ESOP through a non-qualified deferred compensation plan.  The larger the payroll of excluded participants as a proportion of the total payroll, the more difficult it is to accomplish the “make whole” objective.  If the company is operating, or will operate, as an S Corporation, recent IRS regulations limit the amount of deferred compensation.[xi] A frequent solution to this problem is for selling shareholders to pay capital gains tax on their sale of stock to the ESOP.  Selling shareholders, as well as individuals referred to above, would all be included in the ESOP, provided they are employees of the sponsoring corporation.  The stock allocated to their individual ESOP accounts may offset a substantial portion of capital gains tax paid on the sale to the ESOP.

Corporate Governance

ESOP participants in privately held companies generally must be given voting rights on only seven major issues, which do not include voting for the board of directors, or for the sale of stock of the company.  The seven “vote pass-through” issues are merger, consolidation, recapitalization, reclassification, liquidation, dissolution, or sale of substantially all of the assets of a trade or business.  If one of these vote pass-through issues is triggered, then under state law, participants must be given “full disclosure,” and afforded an opportunity to confidentially vote their shares.

In many ESOP companies, a vote-pass through is never triggered because one of the seven issues cited above never arises.  However, in this post-Enron/WorldCom era, there is more focus on proper corporate governance in all corporations, including ESOP companies.  More and more experts recommend that there be at least one outside independent member of the board of directors, especially when the ESOP has a majority ownership stake.

A Higher Price

An ESOP can pay no more than fair market value for the stock it acquires, as determined by an independent appraisal.[xii] Once the ESOP is established, the stock must be appraised at least annually.  Outside buyers may offer to pay a higher price for the company due to strategic fits, or “downsizing” that will occur after the acquisition, or a combination of the two.

If the outside price is higher, the ESOP frequently can be a competitive buyer for several reasons.  If the sellers are eligible for the “tax-free” rollover, then the outside price will normally need to be more than 20% higher to net the selling shareholders the same amount after they have paid their capital gains tax to the outside buyer.  If the buyer is purchasing assets in a C Corporation, then selling shareholders may have to pay substantially more than 20% in tax.  In addition, outside offers normally contain some type of contingency, hold back, earn out, etc.  In many instances, the ESOP can be a very competitive buyer.

Insufficient Management Equity

A stand-alone ESOP may not provide sufficient equity incentives for key management.  The solution is to provide either real (i.e., stock options, stock purchase, or stock bonus plan) or synthetic (phantom stock or stock appreciation rights) equity.  Many planners feel it is essential for key management have “skin in the game” in order to focus them intently on the success of the company going forward

Ownership Culture

Focusing only on the tax benefits of the ESOP, and then expecting employees to jump with joy when told that the company is now “employee owned” may lead to major disappointments.  How does the ESOP benefit compare with retirement benefits provided under the old profit sharing, 401(k) or defined benefit plan?  How will an ownership culture that enables employees to “think like owners” be developed?  Research has demonstrated that the full benefit of the ESOP is realized only when an ownership culture incorporating employee involvement is developed.

Tax Loophole ESOPs

From time to time some misguided planners have attempted to use the ESOP in ways never intended by Congress or the regulatory agencies that oversee ESOPs:  the IRS and the Department of Labor.  After the passage of the Taxpayer Relief Act of 1997, S Corporations were allowed to sponsor ESOPs, generating tax-free income as explained earlier in this article.  Some planners decided they would create “one person” ESOPs that provided benefits to only one or to a very small group of highly compensated individuals.  This resulted in a provision in the Economical Growth and Tax Relief and Reconciliation Act (EGTRRA) of 2001, which contained an anti-abuse amendment to stop arrangements that did not create significant employee ownership. [xiii] The industry’s leading trade organization, The ESOP Association, acted in concert with key members of Congress to shut down the abuses.

The passage of this law spawned the so-called “Management Company” abuse scheme.  The ESOP was established in an S Corporation with more than ten employees, thus creating tax-free corporate income.  Much of the income of the company was “up streamed” to a management company that provided benefits, frequently including non-qualified deferred compensation, for a small number of key employees.  The IRS became aware of this abuse, and under the anti-abuse provisions of EGTRRA issued temporary and proposed regulations, which limit the amount of non-qualified deferred compensation that S Corp ESOPs can have. [xiv]

As evidenced above, when ESOPs are formed in an attempt to exploit real or perceived loopholes in the law, the loopholes are ultimately closed, and the ESOPs that were formed to exploit the loopholes will usually be terminated.  When that occurs, employees may have a lot of questions to ask, and they may not be easily answered.

Lack of Planning

ESOPs are normally formed only after a comprehensive feasibility study has been performed to show the impact of the transaction on the selling shareholders, the corporation, and the employees.  Individual and corporate cash flow, stockholder equity, projected repurchase obligation, etc. is all studied under different ESOP scenarios.  CEO’s or CFO’s of a company attempting to implement an ESOP without such a study are “flying blind without radar.”  In addition to projecting the repurchase obligation, the rate at which the ESOP debt is repaid, the impact of different distribution policies, whether to operate as a C Corporation or an S Corporation in the future, using ESOP stock as a match to a 401(k) plan, and even using a convertible preferred stock in the ESOP instead of common stock, are among the issues addressed in a comprehensive feasibility study.  The feasibility study is designed to be a “decision package,” where current shareholders, management, and the board of directors (which may or may not overlap) determine to what extent an ESOP can meet individual and corporate objectives.

Misconception

Sadly, sometimes the ESOP as an option for liquidity and perpetuation planning is never seriously addressed, due to misconceptions held by major shareholders and/or their key advisors.

Once business owners and their advisors carve out several hours to communicate with an experienced ESOP practitioner, they frequently find that an ESOP is not only a viable option, it may be the best option.

ESOP Research

Numerous studies have been done over the past 25 years demonstrating the productivity and performance of ESOP companies. Several examples are listed below.

Productivity Number of Companies Percent
Strongly Improved 39 17
Somewhat Improved 142 61
No Impact 33 14
Negative Impact 1
Not Sure 19 8
Totals 234 100

SOURCE: The ESOP Association – 2002

Difference in Corporate Performance Post-ESOP vs. Pre-ESOP

Annual Sales Growth +2.4%
Annual Employment Growth +2.3%
Annual Growth in Sales/Employee +2.3%
Average Increase in Productivity +4.5%

Projected over 10 years, an ESOP company with these differentials would be a third larger than a comparable non-ESOP company.

Source:  Rutgers University, Kruse and Blasi 1998

Average Value of All Retirement Accounts

ESOP Accounts $32,213
Non-ESOP Companies $12,735

SOURCE:  1998 Kardas & Keogh, Washington Department of Community Trade & Economic Development and Adria Scharf, University of Washington

ESOP Success Stories

Our greatest pleasure comes from visiting client companies and hearing the employee owners talk glowingly about the size of the average employee account.  When we talk with employees, management and non-management, they express their appreciation for those who share this ownership.  Incidentally, these companies grow much faster and therefore the family that shares ownership might end up with a much smaller percentage of the company – but the company is many times larger than it otherwise would have been.

Summary

ESOPs, when used in the wrong situation or in an effort to exploit some real or imagined tax loophole, will result in the ESOP becoming a four-letter word in the true meaning of that phrase.  However, when used for liquidity and perpetuation planning purposes, ESOPs provide substantial tax benefits to selling shareholders and the corporation, while simultaneously providing employees with the opportunity to create significant tax-deferred wealth.

Biographies

Dickson C. Buxton, CLU, ChFC, is Senior Managing Director of Private Capital Corporation.  He was instrumental in the early development and evolution of employee stock ownership plans.  He founded Private Capital Corporation (1973), and was Chairman of the PCC Kelso subsidiary (1978 to 1981).  Mr. Buxton conducted the first major ESOP productivity study for the Senate Finance Committee (1979) and was one of the founders of The ESOP Association of America, which now represents over 2,000 corporations and millions of employees.

His books, You’ve Built A Successful Business – Now What? and Lessons in Leadership and Life, Secrets of Eleven Wise Men, cover the major issues to be resolved in comprehensive perpetuation or exit strategy planning.

He may be reached at dbuxton@privatecapitalcorp.com.

Ronald J. Gilbert, CLU, ChFC, is President of ESOP Services, Inc., an international ESOP consulting firm.  Mr. Gilbert currently serves on the Board of Directors of four ESOP companies, and on the Board of Directors of the National Center for Employee Ownership.  Mr. Gilbert has spoken in Argentina , Belarus , England , Estonia , Lithuania , Malaysia , Poland , and Russia .  He is co-author of Employee Stock Ownership Plans:  ESOP Planning, Financing, Implementation, Law & Taxation, the most complete work on the subject, published by The Beyster Institute at the Rady School of Management, University of California, San Diego.

Prior to co-founding ESOP Services, Mr. Gilbert was a Vice President with Kelso & Company in San Francisco .

He may be reached at esop@esopservices.com.