Feasibility studies help avoid ESOP foibles.

Companies consider employee stock ownership plans (ESOPs) for a variety of reasons, which often includes purchasing shares from retiring owners, owners without heirs or owners with estate-planning concerns. Companies also use ESOPs to boost employee morale and reduce turnover. No matter the reason for considering an ESOP, companies must address a range of issues: Can the company afford to purchase the stock from selling shareholders? How significant will the ESOP contributions be each year? Will the ESOP provide adequate benefits to employees? If the ESOP is the primary benefit plan, how does it compare to other available benefit plans?

There are many complex issues that determine whether an ESOP is feasible. Companies and owners considering an ESOP often commission an ESOP feasibility study to give them the insight they need to make an appropriate decision. Such a study combines input from shareholders, company management, legal counsel, accountants, valuation professionals, trustees and benefits consultants, to give all parties involved a detailed understanding of the pros and cons of their ESOP options.

The first step in determining an ESOP'S feasibility is to develop a clear understanding of the goals of the major parties in the ESOP transaction. The parties might include the management team, employees, shareholders selling and not selling, and even lenders providing capital for the transaction. To accurately define these goals, parties to the transaction should determine the amount of stock to be purchased, the number of plan participants, the company's debt-carrying capacity for a leveraged ESOP, plan provisions, voting rights and the trustee selection process.

Maintaining Management Continuity

Long-term corporate plans and the potential effect of shareholders' departures and sales of their interests are key issues. Many companies are dependent on the skills, contacts and reputations of their principals. A feasibility analysis should consider how much stock shareholders wish to sell and over what period of time. It should determine if selling shareholders plan to remain with the company. If not, the company should plan for future managers to develop their own independent authority before the principals leave completely.

A basic estimate of the value of the owners' shares is fundamental to any ESOP feasibility discussion. Share value determines whether the ESOP transaction will be attractive to potential sellers and whether the company can afford to fund a stock purchase.

The Code requires that an ESOP purchase stock at its fair market value, as determined by an independent appraiser using standards of "adequate consideration" and "fairness." Therefore, an independent appraiser's preliminary valuation is a key first step in any feasibility study. This valuation is not intended to satisfy all of the requirements necessary to defend it before the IRS or the Department of Labor (DOL). Instead, it is a cost-efficient method of determining the underlying economics of the proposed ESOP and the company's value. Should the ESOP prove feasible, the valuation firm would provide a formal valuation opinion for the stock transaction between the ESOP and the selling shareholders; often, this opinion is an update of the preliminary study. The final valuation would complete the necessary due diligence work to satisfy the "adequate consideration" and "fairness standards" that the Service and the DOL require.

Capitalizing on Capital Issues

A company's corporate form and capital structure can affect how attractive an ESOP will be and how effectively it will operate. Therefore, a feasibility analysis should also consider certain ownership and capitalization issues.

Effective Jan. 1, 1998, the Small Business Job Protection Act of 1996 (SBJPA) permitted an S corporation to sponsor an ESOP. However, the SBJPA prohibits S corporations from using the tax-free rollover available under Sec. 1042 (which permits the deferral of the gain when a shareholder sells stock to the ESOP if certain requirements are met). S corporations considering ESOPs should weigh these limitations.

A company's capital structure should also be reviewed. Companies with an insufficient number of issued and authorized shares necessary to establish an ESOP may need to recapitalize. Further, companies also may wish to recapitalize to eliminate fractional shares and attendant value concerns. Recapitalization prior to adopting an ESOP could eliminate passthrough voting requirements later.

Payroll Adequacy

Under certain circumstances, companies with leveraged ESOPs are permitted to contribute and deduct a higher percentage of payroll if those costs are used to make principal payments on an ESOP loan. The deduction, however, may be limited because of S status, payroll size and interaction with other benefit programs. Therefore, companies considering leveraged plans should examine these issues as part of their feasibility study.

The maximum deduction that an employer can take in any year for a leveraged ESOP is 25% of participants' covered payroll, if this amount is used to make principal payments on an ESOP loan. (This tax incentive is not available for S corporation ESOP. arrangements.) Covered payroll is not the same as total payroll; not everyone is likely to be included under an ESOP New employees who have not met the eligibility requirements or employees covered under a collective-bargaining agreement may not be eligible to participate.

If a plan includes highly compensated employees (HCEs), covered payroll may be further reduced. HCEs' salaries could be excluded to the extent they exceed the maximum amount permitted. That amount was $160,000 in 1999, adjusted for inflation in future years.

The 25% limit on covered payroll can be reduced by other factors. If a company maintains other defined contribution plans (such as a profit-sharing or Sec. 401(k) plan), amounts that the company and its employees contribute to those plans reduce the maximum amount that can be contributed to an ESOP, dollar for dollar. If a company maintains a defined benefit pension plan, a complicated formula determines the reduction in an ESOP deduction. If a company has a cafeteria or Sec. 125 plan or its employees contribute to a Sec. 401(k) plan on a before-tax basis, the company's payroll base is reduced by those amounts.

To maximize covered payroll (and the 25% deduction), companies may consider reducing contributions to other plans until they repay the ESOP loan, freezing benefits or even terminating existing plans. Companies can also increase the 25% limit by using dividends to help repay a loan. Dividends may be used as long as they are "reasonable"; however, the IRS has yet to define reasonable. Dividends do not count toward the 25%-of-covered-payroll limit and are often used when a payroll base is inadequate. Generally, dividends are allocated on the basis of participant account balances.

Shareholders Selling

For shareholders, an ESOP's potential benefits are a vital feasibility issue. Therefore, a feasibility study should also include an examination of these benefits. As mentioned previously, Sec. 1042 permits shareholders selling in an ESOP transaction (other than an S corporation ESOP) to defer gain recognition on the sale of their stock in certain circumstances. These shareholders should realize that, if they choose this option, they are precluded from receiving a stock allocation under the ESOP. As a result, they could lose other retirement benefits, which could only be continued under other retirement plans maintained by the employer. If these plans are terminated, the company could also set up nonqualified retirement plans so that selling shareholders can replace any benefits lost by adopting an ESOP.

Paying the Bill

Paying off an ESOP puts two additional burdens on a company--buying out owners now and repurchasing employees' shares in the future. If a company is barely getting by without these burdens, it is unlikely it can afford an ESOP without major sacrifices. Banks will generally not make a loan if they are not confident of a company's cash flow. Future repurchase liability is a frequently neglected area in ESOP feasibility planning. The need for cash continues as an ESOP matures. A high growth rate and favorable stock price can easily lead to a liquidity problem when an aging work force begins to retire.

Diversification rules also raise cash flow concerns. For stock acquired after 1986, an ESOP must offer participants who satisfy certain age and participation requirements the right to diversify the investments in their accounts. Such diversification requires cash flow to repurchase shares and acquire new investments.

Cash flow should be addressed as part of a feasibility study. Lenders may require that these concerns be addressed before they commit to an ESOP. The lender's concern is not difficult to understand. The company's need for cash will have an impact on its ability to repay the ESOP loan.

Having employees as owners is a significant change for most companies. Management needs to ask if it is really comfortable with this concept. Is management willing to have employees involved in decisions affecting their work? Is management willing to share financial information? Unless employees are treated as owners, an ESOP will not live up to its potential.

The issue of voting rights generates more discussion than any other. If a company's stock is traded on a stock exchange, ESOP participants must have the right to vote on all issues affecting the shares in their accounts, on which other shareholders vote.

Most private companies are only required to allow participants to vote on matters such as closing, sale or liquidation. However, if an ESOP loan was obtained after July 10, 1989 and before Aug. 10, 1996, and qualified for a lender's exclusion under Sec. 133, it must provide for full passthrough of voting rights on stock allocated to participants.

ESOPs make sense for many, but not all, companies. By conducting a thorough feasibility study, management can anticipate impediments to successful implementation and maximize its objectives in adopting an ESOP.

From Karen Bonn, CPA, Chicago, IL