ESOP: A Tax Free Marketplace for Stock of Your Corporation.

Employee Stock Ownership Plans (ESOPs) are gaining in popularity with owners of privately held corporations as a way to sell part or all of their company stock tax free and still effectively control the company. In this way they can start diversifying their assets.

ESOPs are somewhat similar to profit sharing or pension plans in that the sponsoring corporation can make tax deductible contributions to the employee trust and the funds are invested. The employees receive cash when they retire. There the similarity ends. Those plans must invest away from the company. They don't invest in the stock of the sponsoring company. The ESOP is mandated by law to invest primarily in the stock of the employer. An ESOP is the only tax qualified plan that can borrow to purchase stock from the stockholders or buy authorized but unissued stock from the company itself, the latter being a way to infuse capital into the company.

CONTROL

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.

HOW THE OWNER CAN SELL STOCK TAX FREE

If the stockholder of a private corporation sells stock to the 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 three or more years and must reinvest the proceeds in qualified replacement property within twelve months. These are stocks or bonds of domestic operating public or private corporations. If one retains these securities until death, there is a step up in basis and there is never a capital gains tax. There are other creative strategies which offer great flexibility that can be considered as well. The shareholder will then receive a supplemental income from the replacement securities.

LEVERAGING THE ESOP

The stock would be appraised by an independent valuation firm so as to establish fair market value of the stock being sold. A lender then lends funds to the ESOP to enable it to purchase the stock. Alternatively, the bank typically lends to the corporation and the corporation lends to the ESOP which then buys the stock.

The corporation, out of future earnings, enables the ESOP to repay the loan by making tax deductible contributions to the ESOP in an amount that equals principal and interest. The ESOP passes this on to the bank. Only in this way can a company deduct principal payments.

INCENTIVE TO THE EMPLOYEES

The stock is allocated to the accounts of the ESOP participants, the employees, in accordance with 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 their ESOP accounts are subject to a gradual vesting schedule, generally becoming full vested over a five or a seven-year period. If an employee terminates before becoming fully vested, he or she forfeit the non-vested portion of their account and it is reallocated to the loyal employees who stay with the company.

If an employee terminates for other than retirement or death, distributions of cash to the employee are usually deferred until the loan has been fully paid. Even then, the distributions can be made gradually over the subsequent five years. This avoids the possibility that some employees might be tempted to leave for the wrong reason. The ESOP is a long term employee benefit plan rather than a short term savings plan.

The more their stock grows in value, the greater the amount of cash the employees receive at retirement. Studies have shown that ESOPs tend to improve productivity. They indicate that ESOP companies are 8% to 11% more profitable than their peer companies that do not have ESOPs.

HOW ESOPS HELP YOU MAKE ACQUISITIONS

Let's assume you would like to acquire your competitor or supplier. Normally, your company would not be able to deduct the purchase and the seller would pay tax on the sale of his or her stock. An ESOP would let your company deduct the cost of the acquisition and let the seller avoid being taxed on the sale. This can make it easier to negotiate a lower price and do the deal with pretax dollars rather than with after-tax dollars.

HOW TO DEDUCT LOAN REPAYMENTS WITH AN ESOP

Interest repayments on loans are tax deductible but principal payments are not deductible - except through an ESOP. For example, suppose your 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 the company $700,000 of future earnings. The government chips in 41 cents on the dollar to help the company expand.

ESOPS FOR PUBLIC COMPANIES

It is commonplace for public corporations to have ESOPs. They are used to put stock into the hands of the employees at no cost to the employees. The company can thereby increase its friendly stockholder base while simultansously getting tax deductions. ESOPs are sometimes used to thwart takeovers. ESOPs can also provide a means of acquiring large blocks of stock while without having an adverse effect upon the stock price.

ESOP, AN ALTERNATIVE TO SELLING THE COMPANY

Owners of successful private corporations are often besieged by tempting offers to sell their company. If they accept the offer, they will be taxed down to their basis in the company. They will also give up their "toy" in life, their business - a stimulating place to go. Hardly anyone wants to buy 49% of a private company. They want all or nothing. An ESOP lets the stockholder sell part of the company at a fair price and tax free, while still effectively voting the stock that was sold.

In this way, the owner can diversify his or her holdings and receive a supplementary income from the replacement securities in which he or she invested. This avoids the dislocations and trauma to the employee that generally results from a sale to outside investors as well as the feeling of guilt on the part of the selling founder.

SUCCESSION PLANNING 

Wall Street Would classify a private company in the vernacular of a "junk bond". Owners of private corporations frequently have the preponderance of their assets in the form of company stock. Founders often like the idea of selling the company to their management group. Employees seldom have sufficient capital to purchase the stock. A management buyout (MBO) in connection with an ESOP is often feasible because of the tax advantage to the selling stockholders and to the corporation.

IMPLEMENTING THE ESOP

An ESOP is an instrument of corporate finance, not merely an employee benefit plan. The ESOP should be implemented by a firm whose primary activity is the implementation and administration of ESOPs, preferably all under one roof rather than fragmented. Very often, CEOs and CFOs do not know what questions to ask in connection with the possible adoption of an ESOP. A specialist who devotes full time to ESOPs can bring up all the questions that should be discussed. A preliminary feasibility study should be done to determine how an ESOP might help the owner and the company achieve their objectives. The stock of a private corporation must be valued by an independent appraiser to determine fair market value. This does not involve an appraisal of assets. Financing sources should be investigated. Perhaps some internal financing might be considered. The ESOP specialist can help in this regard as well.

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

Robert A. Frisch is Chairman of The ESOT Group, Inc. in Los Angeles and is the author of six books on ESOPs and Succession Planning. He can be reached at (800) 422-ESOP (3767) for more information.