Diversify Your Assets With The Power of ESOPs.

A fantastic tool exists that enables owners of privately held corporations to diversify their assets, while maintaining effective control of their companies, eliminating their capital gains taxes and creating incentive for their employees -- Employee Stock Ownership Plans (ESOPs).

ESOPs are somewhat similar to profit sharing or pension plans in that the sponsoring corporation makes tax deductible contributions to an employee trust that invests the funds, and the employees receive cash when they retire. There, the similarity ends.

Profit sharing and pension plans must invest the contributions outside of the sponsoring company, thereby reducing the company's working capital (cash). Alternatively, ESOPs are mandated by law to invest primarily in the stock of the employer, thereby remaining growth capital for the business. Another major advantage of an ESOP is that it is the only tax qualified plan that can borrow money to purchase stock from selling shareholders or to buy authorized but unissued stock from the company itself.

Loss of control should not be a concern since the owner can be a part of or the sole member of the administrative committee that effectively controls the ESOP.

Diversification While Minimizing Taxes

Owners of successful, private corporations face challenges with respect to estate tax planning, succession planning and asset diversification. An obvious option is an outright sale of the company. However, there are both financial and emotional costs for the seller associated with the sale avenue, such as:

* A large capital gain tax burden.

* Premature loss of their 'toy' or 'passion' in life -- a stimulating place to go.

* No surety of continued employment for valued employees.

If the stockholder of a private corporation sells stock to an ESOP and the transaction brings the ESOP's ownership up to 30 percent or more of the outstanding stock, the selling shareholder can defer or possibly avoid capital gains taxes on the sale. To achieve this favorable tax treatment, the selling shareholder must have held the stock for three or more years and must reinvest the proceeds in qualified replacement property -- stocks or bonds of domestic operating public or private corporations -- within twelve months. These replacement securities provide the selling shareholder with a diverse source of supplemental income.

If the seller retains the replacement property until death, then his/her heirs will get a step up in basis in the property, pursuant to estate tax laws. This effectively eliminates all capital gains from the sale of the stock to the ESOP!

Leveraging the ESOP

Owners of private corporations often like the idea of selling the company to their management group, but employees seldom have sufficient capital to purchase the stock. A management buyout (MBO) in connection with an ESOP is often feasible due to two unique tax benefits:

1. a lower price is demanded due to the tax advantages to the selling stockholders and to the corporation; and

2. both the principal and interest paid on a loan to an ESOP are deductible.

The process of leveraging an ESOP involves a few steps, starting with an appraisal by an independent valuation firm to establish the fair market value (FMV) of the stock being sold. Based upon the FMV, we make a loan to the ESOP to enable it to purchase the stock from the selling shareholder. Alternatively, we may lend directly to the corporation, which lends to the ESOP to enable it to buy the stock.

The company makes tax deductible contributions in amounts equal to the loan's principal and interest payments to the ESOP to enable it to repay the loan to the bank. Through this process, the corporation can deduct the principal payments, in addition to the interest payments.

For example, suppose a corporation, in the 41% state and federal tax bracket; borrows $1 million. The company must, over the term of the loan, earn $1.7 million to repay $1 million of loan principal, ignoring interest.

By contrast, the corporation with an ESOP can deduct both principal and interest payments. This allows the company to repay $1 million loan principal with only $1 million of future earnings, saving $700,000.

Employee Incentives

ESOPs are a highly motivating method of compensation for employees. Technically, each participant has an ESOP account to which contributions in stock are made by the company in accordance with each employee s compensation. The employee that is paid $50,000 annually gets twice as much allocated to his or her account than the one who earns $25,000.

The values in the employees' ESOP accounts are subject to a gradual vesting schedule, generally becoming fully vested over a five or a seven-year period. The more the stock grows in value, the greater the amount of cash the employees receive at retirement. Studies have shown that ESOPs tend to improve productivity, indicating that ESOP companies are 8% to 11% more profitable than their peer companies without ESOPs.

ESOPs and Acquisitions

The tax incentives provided by ESOPs also provide a great method for acquisitions. Normally, an acquirer would not be able to deduct the purchase price, and the seller would pay taxes on any gain on sale of stock. Through a leveraged ESOP, a company can deduct the cost of the acquisition while the seller avoids being taxed on the sale. As a result, a lower purchase price can be negotiated since it is based on pretax, not after-tax, dollars.

Implementing an ESOP

An ESOP is an instrument of corporate finance, not merely an employee benefit plan. The ESOP should be implemented by a full-service firm whose primary activity is the cohesive implementation and administration of ESOPs. A specialist who devotes full time to ESOPs can help CEOs and CFOs with the unique issues connected with the possible adoption of an ESOP.

Consider this: Assume that we provide the owner a 100% nonrecourse loan on the value of the company. He or she pays no tax. The company pays no tax thereafter.

With proper advice by a firm that specializes in ESOPs, the implementation process can go smoothly and expeditiously.

Robert A. Frisch, Chairman, The ESOT Group, Inc., Los Angeles, a firm that implements ESOPs nationally, is the author of seven books on ESOPs and succession planning.