WHAT IS AN ESOP?
An Employee Stock Ownership Plan, an ESOP, can be an extraordinary
financial tool to accomplish corporate goals and generate tremendous
tax savings for both the corporation and its shareholders. An
ESOP is a tax qualified retirement plan sanctioned by the Employee
Retirement Income Security Act of 1974 (ERISA) and more than 20
other pieces of legislation. The ESOP movement is fully supported
by both aisles of Congress. ESOPs are similar to Profit Sharing
and Pension Plans in that they are all subject to ERISA. However,
there are two major distinctions between ESOPs and other tax qualified
plans. An ESOP’s primary purpose and mandate is to acquire
stock of the sponsoring corporation and the ESOP is permitted
to borrow money to accomplish this goal. Other tax qualified plans
are expressly prohibited from this type of transaction. These
two differences between an ESOP and other tax qualified plans
turn the ESOP into a financial tool for the corporation. In fact,
the IRS defines an ESOP as a tool of corporate finance.
WHAT CAN AN ESOP ACCOMPLISH?
In an ESOP company, the ESOP often becomes the centerpiece of
the financial architecture of the company. Listed below are the
traditional uses of ESOPs and there exist numerous non-traditional
uses about which we can provide more information. ESOPs are very
flexible in that they can be used to simultaneously accomplish
any combination of the following:
Creation of a liquid marketplace for closely held stock
which provides a viable tax advantaged exit strategy for shareholders
under Section 1042.
Maximizing the stockholder's cash-out proceeds via Section
1042 rollover that allows the stockholder to eliminate, through
proper planning, federal and state income taxes on the long
term capital gain on the sale of the stock.
Sell some or all of your privately held stock and still maintain
Repay the principal portion of corporate debt with tax deductible
The corporation is provided with the ability to buy out minority
or majority shareholders with tax deductible dollars.
Motivate and reward employees and attract and retain good
Closely associated with the above 1042 transaction is the
ability of an ESOP to help a stockholder diversify his or
her personal net worth. Many of our clients have 90% or more
of their net worth tied up in their business and this method
allows tax-free diversification of shareholder equity.
ESOP purchases of stock are deductible to the corporation.
Corporate redemptions are done with after-tax dollars. In
terms of pre-tax earnings, a profitable corporation will have
to have $1,667,000 of pre-tax earnings to complete a $1,000,000
redemption. An ESOP purchase requires $1,000,000 of pre-tax
earnings to complete a $1,000,000 purchase. In addition, the
selling shareholder must pay taxes on his gain in a redemption
versus the tax free treatment with an ESOP as mentioned earlier.
Transfer the business to a son, daughter or management group
with huge tax advantages and guarantee the perpetuation of
Sell the company to an outside buyer with significant tax
advantages to both buyer and seller.
Cash out investors with pretax dollars and tax free to the
Redirect tax dollars to non-qualified tax advantaged deferred
compensation plans for selected employees.
Corporate acquisitions can be done with deductible dollars.
An ESOP acquisition allows a corporation to acquire a business
entity of a larger size than what would normally be allowed
in a traditional acquisition.
Current long-term debt can be refinanced via ESOP providing
the corporation with tax deductible principal, as well as
interest, for debt repayment.
Dividends, if paid through an ESOP, are deductible to the
corporation. Many ESOP companies replace their bonus programs
with dividend dollars via ESOP because dividends are not subject
to FICA taxes, saving both the company and its employees taxes
on "bonus" income.
Recover C corporation income taxes paid over the prior two
years. This is accomplished by making either a cash or stock
contribution to the ESOP in an amount equal to the taxes to
Reduce or eliminate estate taxes with ESOP planning techniques.
Increase employee productivity. The Department of Labor
has statistics that indicate for every 1% improvement in productivity
in ESOP companies, there is a 20% increase in gross profits.
This benefit should not be underestimated as many ESOP transactions
can be funded exclusively through productivity increase.
Takeover defense tool. Having stock in the "hands"
of "friendlies" such as employees makes hostile
Eliminating a current union or discouraging a unionization
Some of these areas need to be reviewed in more detail:
THE CAPITAL GAINS TAX DEFERRED SALE OF STOCK TO THE ESOP
Section 1042 allows the owners of privately held C corporation
companies to sell some or all of the stock to the ESOP and defer
or possibly eliminate the capital gains tax on the transaction.
To qualify for the deferment, three basic criteria must be met:
1. The selling shareholder must have owned the stock for three
years prior to the sale to the ESOP.
2. After the transaction the ESOP must own a minimum of 30% of
all the outstanding classes of stock.
3. Within 12 months of the transaction the sale proceeds must
be reinvested in Qualified Replacement Property which is generally
defined as the debt or equity of any U.S. operating company such
as IBM, General Motors, Xerox, etc.
On a sale of $1,000,000 of stock, assuming an effective zero
basis, the selling shareholder in the 25% combined federal and
state tax bracket will save $250,000 of taxes and have the full
$1,000,000 to invest rather than only $750,000 to invest as in
a traditional sale.
Investment of the sales proceeds within 12 months of the transaction
into Qualified Replacement Property (QRP) will defer the capital
gains tax on the sale. If the QRP is held until death the property
receives a stepped up basis and the gains tax is eliminated. A
frequently used QRP is the Floating Rate Note (FRN). This note
pays an interest rate akin to a money market instrument. However,
up to 95% of the value of the note can be borrowed and, if used
for investment purposes, the after tax cost of borrowing may nearly
approximate a wash. The loan proceeds of the note can then be
given to, say, an investment manager, who can trade them as frequently
as desired to achieve the maximum possible gains in the market.
The selling stockholder could also invest the sale proceeds into
another privately held company, either existing or new, and this
company would qualify as QRP as long as the company does not generate
its income from passive investments.
TAX DEDUCTIBLE PRINCIPAL & INTEREST ON LONG TERM
The interest on traditional debt service is tax deductible, but
the principal portion of the payment to the bank is not deductible.
Contributions made by the corporation to the ESOP are tax deductible
by the company. With proper structuring, these contributions can
be used for debt service, which makes both the interest and the
principal payments deductible.
The corporation seeks a loan from a lender. The lender loans
the money to the corporation which in turn makes an identical
mirror loan to the ESOP. As the ESOP has no funds to repay the
company, the corporation makes tax deductible contributions to
the ESOP in the amount of the debt service, making both the interest
and the principal portions of the debt service deductible. The
ESOP uses the contribution to service its debt to the company
and the company, in turn, uses the payments from the ESOP to service
the debt to the bank. Using this technique, a company in the combined
federal and state tax bracket of 40% can borrow money and the
after tax cost of the interest and principal payments may be less
than the amount of funds originally borrowed.
CONTROL OF THE ESOP STOCK
A properly designed ESOP will "pass through" the voting
rights of shares held by the ESOP to one of the fiduciaries, either
the ESOP Trustee or Administrative Committee. In some cases, an
ESOP company would want to employ a bank trust company as Trustee
with no discretionary authority. The Administrative Committee
makes strategic decisions and votes the shares held by the ESOP
and the Trustee simply executes financial transactions and instructions
provided by the Administrative Committee.
Employees who participate in the ESOP have no minority shareholder
rights. In a properly designed ESOP, the employees never see,
feel, touch or own a single share of stock. The employees have
no access to confidential financial information. Their interest
in the ESOP essentially begins and ends with their account balance
being based on the underlying value of the company's stock. The
only time an employee can vote allocated shares is on issues of
merger, acquisition, divestiture, recapitalization or a sale of
substantially all of the assets of the corporation.
The company's Board of Directors, elected by the outside shareholders,
has the authority to appoint and remove members of the Administrative
Committee of the ESOP. The Committee could be comprised of Board
members or officers of the company. In some cases the outside
shareholders, having elected themselves to the Board, may appoint
themselves as the Administrative Committee just as they might
elect themselves as the President or the Chairman of the company
- a change in fiduciary hats or responsibilities.
REWARDING EMPLOYEES WITH A "PIECE OF THE ACTION"
Many company owners want to reward their loyal employees who
have worked hard over the years to make the company what it is
today. What better way to reward them than to make them employee-owners
of the company through an ESOP. The ESOP can be used as a method
to get company equity into the hands of the employees through
tax deductible stock contributions to the ESOP and no current
taxable income to the employees. Employees, through the communications
process are educated to understand that they are no longer just
employees, they are now employees owners and an ownership culture
is developed throughout the company. Employee owners begin to
think and act like owners. They are taught that for each dollar
of extra profit they can generate through sales or, for each extra
dollar of savings they can generate through efficiency in the
specific area of their job, this extra productivity will increase
the profitability of the company. In turn, the increased profitability
will increase the value of company stock and this is the same
stock that they have in their individual ESOP accounts.
IMPROVING EMPLOYEE PRODUCTIVITY
In today's business environment, employees will seek an employer
who will provide some form of welfare and/or retirement program.
Employees view these programs as a demonstration by the employer
of the intent to provide permanent employment, offer opportunity
for advancement within the company and ultimately to retire comfortably.
Employers who provide no plans will find difficulty in retaining
not only line employees but middle and upper level management
as well. Pension plans have lost their appeal to employers as
tax laws have changed. Profit sharing plan contributions are often
only a token amount. An ESOP can not only replace the basic function
of a pension or profit sharing plan, but additionally, can reap
a tremendous change in attitude by the employee which benefits
ESOP participants perceive themselves as company owners. This
perception, this change in attitude, this feeling the employee
develops has direct financial rewards for the corporation. Employees
are quickly taught that if they waste company money by inefficiency,
carelessness, lack of incentive or irresponsibility, it directly
impacts their own personal financial status. Lower corporate profits
due to the "it's only a job" attitude will tend to reduce
or retard the growth of company stock. Employees who are ESOP
participants recognize that their own individual improvement on
the job will increase corporate profits which, in turn, will increase
the potential allocation to their accounts, which will increase
the value of the stock in their accounts.
The change in attitude by employees in ESOP companies, from the
bottom all the way to the top, has been repeatedly demonstrated
in studies by the Department of Labor. The studies have consistently
shown that a 1% increase in employee productivity can directly
translate in up to a 20% increase in profitability for the employer.
Given a choice, nearly everyone would choose to be an "owner"
rather than just an employee.
ESOP Corporate Resources, Inc. can guide you through
the ESOP process from A to Z to maximize the effectiveness of
your ESOP. For additional information or a personal free initial
consultation, contact ECR.