These “short and sweet” Questions and Answers are extracted from those typically asked by a CEO and/or a CFO of a closely-held company exploring the ESOP concept.
– Ronald J. Gilbert, President, ESOP Services, Inc.
The Author gratefully acknowledges the assistance of Ronald L. Ludwig in the preparation of this article.
1. Does sale to an ESOP of 30% or more of stock actually mean the seller would get 20% more then for regular cash sale? What impact does the lower capital gains tax have?
In an Internal Revenue Code Section 1042 “tax-free” rollover transaction, the seller pays no capital gains tax to the extent that the proceeds are reinvested, within twelve months of the transaction date, in qualified replacement property. Thus, if the basis in the stock is very low, the tax savings, depending on the state tax rate, is approximately 20%. To the extent you sell any of the rollover portfolio securities in the future, you will trigger a capital gains tax at the rate in effect at the time of the sale of the replacement securities.
A lower capital gains tax rate may reduce the attractiveness of the ESOP “tax-free” rollover to some sellers, but makes an unrestricted sale of stock to the ESOP possibly more attractive. If you wish to liquidate a portion of your 1042 portfolio in the future, you will pay capital gains tax on the liquidated portion only.
2. What are the investment options under Section 1042?
In order to quality for the “tax-free” rollover, the proceeds from the sale of stock to the ESOP must be invested in securities (stocks or bonds) of domestic operating companies. Mutual funds and government securities are excluded. Securities of public or private companies, provided that the investor does not already have a controlling interest in the company, are eligible. It is permissible to margin the securities that have been acquired from the rollover proceeds. For those individuals wishing to be aggressive in this area, some investment banking firms offer Floating Rate Notes (“FRNs”), which are designed to be margined up to 90% or higher.
3. Would the lender for the ESOP loan require the selling shareholder to pledge the Section 1042 portfolio as collateral?
An ESOP lender may or may not require some portion of the “tax-free” rollover portfolio as collateral for the ESOP loan. If they did require some portion of the “tax-free” rollover portfolio as collateral, they should agree to negotiate an early release.
4. Will an increasing repurchase obligation create problems for the company?
The corporation sponsoring the ESOP must commit to repurchase stock from the accounts of participants who are eligible for an ESOP distribution due to retirement, death, disability, or termination of service. These distributions can be made in annual installments over a period of approximately six years for retirement, death, and disability. For individuals who quit or get fired, there can be a six-year waiting period before the installments begin. Distributions of financed shares can be deferred until the acquiring ESOP loan has been repaid. Projected repurchase liability should be carefully considered, as part of a comprehensive ESOP feasibility study, before any decision is made to install an ESOP. The magnitude of the repurchase liability may dictate scaling back the amount of the initial ESOP purchase. Companies also need to clearly understand the various strategies that are available to manage repurchase liability.
5. What is the balance sheet impact of the continuing (and escalating) obligation to repurchase employees’ stock?
There is little or no balance sheet impact due to the ESOP repurchase obligation (the corporation obligation to buy back stock from employees who are entitled to a distribution under the ESOP). However, it is strongly recommended that companies carefully consider the projected repurchase obligation of any intended ESOP transaction prior to implementing the ESOP, and then carefully monitor the repurchase obligations on a going forward basis. If a company does not properly plan for handling its repurchase obligations, growth may be constrained, or it may be forced to sell or go public to solve the problem.
6. What option do employees over 55 have that want to start selling their stock?
Participants who have reached the age of 55 and have 10 or more years of participation in the ESOP are entitled to elect up to 25% of their stock account balance be diversified into other investments. Having an election of three (3) investment options within the ESOP, or a 401(k) plan, or a distribution from the ESOP satisfies this requirement. At age 60 the individual, with 10 or more years of participation in the ESOP, can elect to have up to 50% of their stock account balance diversified. As part of the feasibility study, a repurchase liability study should be done to measure the impact of the diversification election. We normally recommend that companies assume between approximately 80% and 100% of their employees elect to diversify their account balances, although the actual number can be substantially lower. In other words, we recommend assuming a “worst case scenario” from the beginning for the diversification option.
7. How would minority shareholders be affected by adopting an ESOP?
When a majority shareholder decides to sell stock to an ESOP, minority shareholders must be treated “fairly”. Under state corporate law (not ESOP rules and regulations) this may mean that minority shareholders need to be given the right to sell the same proportion of their stock to the ESOP that the majority shareholder is selling. If minority shareholders do not wish to sell stock at the present time or agree not to sell, they could be given a guarantee by the company that the stock would be redeemed at some future date.
8. What is the valuation impact on present shareholders that do not sell stock?
Once the ESOP has acquired stock, and assuming a leveraged transaction has occurred, the post-transaction fair market value of the company may be less than the pre-transaction value, due to the debt that the company has undertaken to finance the ESOP’s purchase of stock. Shareholders who elect not to sell in the initial ESOP transaction must understand that in the early years of the ESOP debt repayment period, their stock value may decline.
9. How much previously confidential information must be given employees, such as management salaries and bonuses; capital expenditures, etc.?
ESOP participants are entitled to the same information under ERISA as participants in any other retirement plan. That is, they are entitled to a summary plan description, to an annual statement regarding the status of their account, a summary annual report, and to other plan information, such as plan and trust documents, if they request it. Unless the ESOP vote pass through (explained below) is triggered, ESOP participants are entitled to no other information. They are not entitled to corporate financial statements, information regarding compensation, the valuation report, etc.
The ESOP vote pass through is triggered if one of seven defined events occur. They are merger, liquidation, recapitalization, sale of substantially all of the assets of the corporation, dissolution, reclassification, and consolidation. If one of these events occurs, then participants must be given the right to confidentially vote the shares allocated to their ESOP account, and given adequate disclosure, under state law, regarding the matter to be voted on by shareholders.
10. What effect does an ESOP have on any future sale negotiations?
If an ESOP acquires stock in a C Corporation “tax-free” rollover transaction, and then sells that stock within three years, a 10% excise tax based on the value of the stock sold by the ESOP is payable.
After three years have expired, the ESOP is normally treated like any other shareholder in a transaction, that is, the ESOP is bought out. When the sale is a stock sale, there is normally no requirement to have ESOP participants vote their stock on the sale. The ESOP trustee votes the shares when it is sale of substantially all, or all, of the assets of the company, then the vote pass through is required.
11. How can an ESOP resemble a defined benefit plan?
The ESOP can be written with a number of defined benefit plan characteristics;
a. Participants can be given the option to take their retirement distribution the form of an annuity.
b. A contribution formula reflecting length of service and/or age can be used to allocate contributions, provided that the formula is not discriminatory in favor of highly compensated employees.
c. A “floor price” can be guaranteed by the company for the stock distributed by the ESOP.
From the standpoint of company contributions, leveraged ESOPs and defined benefit plans both have contribution obligations. In the case of the leveraged ESOP, it is the amount required to repay ESOP debt, which could be spread over many years. Because of the size of the blocks of stock acquired by ESOPs, contribution levels to leveraged ESOPs are usually greater than contributions to defined benefit plans. As a result, the value of the stock in the ESOP could decline and still provide a benefit greater than that provided under a defined benefit plan.
12. How are shares allocated each year?
As ESOP debt is repaid, stock is released from the suspense account in the ESOP using one of two formulas selected at the time of the ESOP transaction by the ESOP trustee. For example, if the principal and interest release method were selected, and it were a level payment loan, then an equal number of shares would be released annually.
Shares are normally allocated based solely on W2 compensation. However, it is possible to construct a formula that includes length of service, provided that it does not violate IRS anti-discrimination rules.
13. Is majority shareholder liquidity a fair reason to put in an ESOP? Doesn’t this leave a company with a substantial amount of debt?
The principal reason that ESOPs are established is to provide shareholder liquidity, possibly on a “tax-free” basis, and simultaneously perpetuate a business. For those goals to be achieved, a capable management team must be in place to run the company after the departure of the majority shareholders. (Note: The sale of a block of stock to the ESOP does not in any way require that the selling shareholder reduce his involvement with the operations of the company.) The ESOP transaction does mean that the sponsoring company will incur debt, and so it is incumbent upon the management team, and the selling shareholder, to feel confident that the debt can be managed.
The alternative is the sale of the company to an inside or outside buyer. Even if the company is not sold initially, the ESOP can be a candidate to be sold to an inside or outside buyer in the future. An example of this is Avis.
14. If the ESOP owns over 50%, do employees have to be on the Board?
There is no requirement to have non management, or any other employees on the board of directors of the company, regardless of the percentage owned by the ESOP. The trustees of the ESOP (which can include senior managers) are appointed by the board of directors of the company, and they vote all the stock in the ESOP for the election of the board of directors.
Research by the National Center for Employee Ownership has shown that the principal concern of ESOP participants is involvement at the work level, not the board level. It is an excellent idea to have at least 1 or 2 outside Board members if the ESOP is a majoirty owner. There are numerous variations as to what ESOP companies actually do. At ComSonics Inc., for example, there is a 10 person board, with 6 of the members being outsiders. The Chairman of the ESOP Employee Committee automatically becomes a board member. ComSonics’ employees are also allowed to vote their vested shares for the election of the Board of Directors.
15. What is the vesting requirement?
The maximum period for vesting is either three or six years, as outlined below.
|Years||Three-Year “Cliff”||Six-Year Graduated|
The vesting schedule may be more liberal than those outlined above, and partial or full past service credit may be granted at the beginning of the ESOP.
16. Can management buy stock directly?
Management can be a “buying partner” with the ESOP, and some transactions are structured so as to allow management to acquire a different class of securities with greater appreciation potential and greater risk, stock options, etc.
17. What about fiduciary liability?
An ESOP is designed to be invested primarily in the stock of the sponsoring company, and can be invested exclusively in the stock of the sponsoring corporation. The trustees of the ESOP have fiduciary responsibility under ERISA in that it is their duty to operate the ESOP for the exclusive benefit of plan participants and their beneficiaries. ESOP trustees (frequently the senior officers and/or shareholders of the sponsoring company) must take great care that the ESOP does not pay more than fair market value for the stock that is being acquired. ESOP trustees are advised to retain an experienced ESOP financial advisor/independent appraiser that has significant experience in their particular industry. The corporation can indemnify the trustees, and fiduciary liability insurance can be purchased for the trustees. An independent trustee or independent fiduciary can be appointed by the Board of Directors.
Note: This advisory memorandum is not intended to provide legal advice. Attorneys or other professional advisors should be consulted prior to making any final decision.