In latest edition of The Wright Toolbox:
- To ESOP or Not to ESOP – read now
To ESOP or Not to ESOP
Your hard work, business savvy, and loyal employees have built a closely-held company into something of considerable value. You are ready to retire and consider alternatives for diversifying investments. You face significant capital gains exposure. What are the options? Sell stock? Sell assets? Merge? Redeem stock or other ownership interest? Spin off some of the business? Alternatively, perhaps you hope to reward and incentivize your employees by giving them an opportunity to become shareholders and therefore have “skin in the game.” The company might use stock options, a profit- sharing plan or bonuses in addition to other employee benefit plans.
For a variety of reasons, prospective purchasers of closely-held businesses frequently prefer purchasing assets as opposed to stock. Unless the business is a pass-through entity such as a limited liability company, partnership or S Corporation, sale of assets could result in two levels of taxation – one at the corporate level and the other at the individual level. They also want control, that is, a super majority. They may not hire the loyal employees that you the business owner desire to protect. Additionally, a merger does not create the opportunity to diversify unless the surviving company stock is publicly traded.
In these scenarios, the business owner should consider an Employee Stock Ownership Plan, commonly known as an ESOP. An ESOP is a popular vehicle if the company is a corporation. ESOPs are only available for corporations. There are a number of potential benefits flowing from an ESOP structure besides creating a market for a departing stockholder. It can be used to supplement existing employee benefit plans. Contributions by the company are tax deductible within certain limits. ESOP’s offer the seller the opportunity to defer capital gains taxes. An ESOP has income tax benefits as well.
What is an ESOP? It is another type of employment benefit plan. ESOPs are subject to ERISA much like other types of employee benefits. The company or stockholder donates or sells stock to a trust set up to benefit its employees. Allocations to employees’ individual accounts are established by a formula such as one that is based on compensation. The employee becomes vested in three to six years depending on the type of vesting schedule. When the employee retires or leaves, the shares allocated and vested are repurchased by the ESOP. The ESOP can borrow money to purchase shares. Debt service may be funded by contributions from the company. The company’s contributions are tax deductible, within certain limits.
To form an ESOP, the company must adopt a plan and a trust approved by the company’s board. The trustee must be independent. Technically, the seller should not be involved in the selection of the trustee. All employees covered by the plan must be employees of the incorporated company, which can be either a C or S Corporation. If stock is to be sold to the trustee, the seller and trustee must engage in arms- length negotiation. The trustee must have the value of the stock appraised by a qualified appraiser. Frequently, sellers engage their own financial advisor for assistance in negotiating price and the structure of the purchase.
There are a variety of options for establishing a qualified ESOP. The ESOP typically acquires stock from the seller or the company in the case of treasury or newly issued securities. The purchase price is financed. Alternatively, the company may contribute stock to the trust.
A leveraged purchase can take several forms:
- The company can contribute cash to the ESOP for it to use to fund the purchase. Contributions are tax deductible within certain limits.
- The ESOP may borrow the funds from a third party. The company will likely be required to guaranty the loan. Contributions by the company to pay principal and interest are tax deductible within certain limits.
- Alternatively, the company may take out a collateralized loan from a third-party and lend the proceeds to the ESOP, secured by the stock that is purchased from those loan proceeds. However, this may be problematic if other debt obligations of the company have covenants or restrictions that might be violated by taking on additional debt.
- The company may lend the purchase price to the ESOP. In that case, the company sells the stock to the ESOP in return for a note collateralized by the stock being purchased. The note cannot charge interest, whether fixed or variable, greater than a fair rate. To be safe, the Applicable Federal Rate is frequently used. There is no maximum term for the loan. Terms of twenty or thirty years are not uncommon. The loans must be non-recourse, that is, limited to the stock purchased by the loan and its proceeds. In other words, the individual employees cannot be at risk for repayment.
- The company can donate new or treasury stock to the ESOP and take a tax deduction up to certain limits.
An ESOP may also be an effective vehicle for deferring capital gains taxes on stock with a low basis by using the proceeds to purchase a replacement investment within twelve months. As always, there are limitations. The employer company must be a C Corporation. The seller cannot be a corporation. Certain sellers will not qualify for the deferral such as a seller that is also an employee participating in the ESOP or has close family members that participate, as well as a seller that owns 25% or more of the stock of the company. In calculating that percentage, certain family member holdings must be included as well as shares of stock the seller retains outside of the ESOP. The seller must have owned the stock being sold for at least three years and not have acquired the stock as part of compensation such as bonus, stock option or bargain sale. In addition, the ESOP must own at least thirty percent of the company after the sale. Should the ESOP dispose of the stock within three years, it may be liable for a 10% excise tax. To qualify for the deferral, the replacement investment must be securities in a company operated within the United States. It cannot be a mutual fund or governmental securities. Sellers frequently replace the stock sold to an ESOP with highly rated corporate bonds that historically trade at par – that is, not volatile. Such investments are attractive collateral to support loans that can be used to buy other securities.
Whether or not an ESOP is a beneficial alternative requires thorough analysis. What are the owner’s goals, needs, and estate planning? Is an ESOP financially feasible? Are there tax advantages, existing employee benefits? Does it fit within the company’s governing documents, shareholder agreements, and other company loan obligations? This usually requires a financial advisor, a qualified appraiser, and legal services. It is not inexpensive. There is also a cost to maintaining the ESOP – trustee fees, fiduciary insurance, life insurance if required, an annual appraisal, audit fees if more than one hundred employees, accounting fees, and fiduciary bond cost. One must always weigh the benefits against the burdens.