Using ESOPs to solve succession problems.
There is no best way to transfer a closely held business, particularly when no traditional buyers--family members or other owners--are available. Since each owner's individual circumstances typically are unique, the first step is for CPAs to determine the owner's objectives. Although an outright sale to an unrelated party almost always is possible, such sales are rare because of the lack of ready buyers or the unwillingness of outsiders to pay a business's current value. As a result, most closely held businesses are sold or transferred to insiders.
If family members or other owners are not interested in acquiring a business (or if there are none), the only insiders left are employees. Employee stock ownership plans (ESOPs) are an often overlooked way of transferring closely held businesses. Widely used by large corporations as employee benefit plans since they were created 20 years ago, ESOPs are tax-favored retirement plans, organized as trusts, that invest in an employer's own stock. Small companies' objectives in offering ESOPs probably are less benefit-oriented and more directed toward finding a means to transfer ownership.
In a company organized as a C corporation, a closely held business owner can use an ESOP to dispose of the business while also expressing his or her appreciation to existing employees. (Proposals in Congress to extend ESOPs to S corporations are still under consideration.) An ESOP can not only meet the owner's financial goals but also enable him or her to fulfill nonfinancial objectives such as continuing the business as a going concern (as opposed to selling only the assets) and maintaining an ownership or employment role, something an outsider might not tolerate.
ABCs OF ESOPs
Although ESOPs formally were created in 1974, they actually date back much earlier. Complete details are covered in sections 409 and 4975 of the Internal Revenue Code. An ESOP is a qualified defined-contribution plan. Employer contributions to such plans are tax deductible. Benefits are tax deferred for employees.
An ESOP must be invested primarily in securities issued by the employer (this is an exception to the pension plan rules outlined in the Employee Retirement Income Security Act of 1974). Securities are defined as common stock and noncallable convertible preferred stock. An ESOP can be either a stock bonus plan or a stock bonus plan plus a qualified money purchase pension plan.
Surprisingly, ESOPs rarely are used to transfer ownership in closely held businesses. To date, there are only about 11,000 ESOPs nationwide, and perhaps 15% of them are in large publicly traded corporations. One problem may be that ESOPs are not simple entities; the rules for forming them are tricky. In addition, ESOPs are inherently risky for employees since their pension assets are invested primarily in employer securities. If the company goes out of business, employees not only lose their jobs but also their retirement funds. On the other hand, ESOPs can be motivational tools. When employees own the company, they are motivated to work harder, knowing any incremental profits accrue to their own retirement accounts.
Given the apparent advantages of ESOPs, one would expect CPAs to recommend them to small business clients more often. If there is no obvious buyer for a closely held company, the majority shareholder can sell his or her stock to a leveraged ESOP (explained later). The transaction can take place all at once or over a period of months or years. The sale price must be the stock's fair market value, which requires valuation by an independent appraiser. The best part of the process is the seller can, under certain circumstances, defer taxes on any gain.
IRC section 1042 allows deferral of any gain on the sale of securities to an ESOP (sometimes called a 1042 rollover) if at least 30% of all classes of stock are sold and the sale proceeds are reinvested in qualified replacement property, which is defined as stocks and bonds of U.S. operating companies (but not mutual funds or real estate investment trusts). The securities may be purchased within 3 months before the sale to the ESOP, but not more than 12 months after.
The tax deferral lasts as long as the seller retains the qualified replacement property. If the seller holds the replacement stocks and bonds until his or her death, no capital gains tax is due; the heirs receive a step-up in cost basis. (Note: Tax deferral under section 1042 is contingent on the stockholder's ownership of stock in the closely held company for at least three years before the shares are sold to an ESOP.)
ESOP FUNDING SOURCES
Where do ESOPs get the money to buy out majority stockholders? The answer often is simple: An ESOP can borrow the money from a bank (or other lender). The entity is then known as a leveraged ESOP. IRC section 133 provides an incentive for lenders to loan money to ESOPs, provided the loan term is not more than 15 years. If more than 50% of all classes of stock (or 50% of the value of all classes of stock) are sold to an ESOP, the lender is taxed on only 50% of the interest received on the ESOP loan. Because such loans provide partially tax-free income for lenders, many banks, even small rural banks, are setting up ESOP departments. Because most of the interest income is tax-free, banks typically charge a lower interest rate on ESOP loans than on traditional business loans.
The company gets a deduction for any principal and interest payments the ESOP makes. This is one of the few instances when principal payments are tax deductible. If the marginal corporate tax rate is 34%, the employees can buy the company for only $.66 on the dollar. The government pays the other $.34. The deduction for principal payments is limited to 25% of covered payroll. All interest is deductible (provided not more than one-third of ESOP benefits goes to "highly compensated employees"). All full-time employees who have been employed by the company for more than one year typically are included in the program.
The tax deductibility of principal payments also is advantageous to banks or other lenders since there is more incentive to repay the loan if payments are tax deductible. The majority stockholder disposes of his or her stock and diversifies without having to pay capital gains taxes. The bank earns partially tax-free interest, and the buyer effectively gets a tax deduction for loan principal payments.
Before an ESOP can be used as a business succession tool the company must have the cash to service the ESOP loan. Since only 25% of covered payroll can be used for principal payments (plus interest and dividends), the payroll must be large enough so allowable payments are sufficient to meet the bank's demands. (This usually is not a problem; since the interest is partially tax-free, a bank may be less concerned with principal payments.)
Another source of ESOP funding is an existing pension or profit-sharing plan. Existing plans can be converted to ESOPs. If an old plan has substantial assets, these assets can be used to buy the employer's stock. Some employees, however, might consider this a risky alternative.
One disadvantage is that lenders sometimes ask the majority stockholder to pledge some of his or her replacement securities (in addition to the company securities) as collateral on an ESOP loan. This pledge should, however, be accompanied by a significant drop in the interest rate.
One reason lenders require additional collateral is to ensure the selling stockholder gives adequate consideration to management succession. If the seller still has a financial interest in the company, he or she will have greater incentive to see that young managers are trained properly. Some lenders even specify that the seller remain in control of the company for some period to ensure a smooth transition. Some sellers who are not yet ready to retire might urge a lender to make such a requirement part of the loan agreement.
Another potential disadvantage: Covered employees must be allowed to receive the value of their vested shares at the time they retire or otherwise leave the company. Larger companies sometimes issue shares to retiring employees. Closely held companies, however, typically repurchase retirees' shares, necessitating a periodic appraisal of the stock. Some view periodic valuations as a disadvantage; however they already may be required if a sale to an ESOP is made over time.
Deductibility of dividends is another consideration. Dividends paid on stock owned by an ESOP are deductible by the corporation if they are either distributed in cash to ESOP participants or used to pay principal or interest on an ESOP loan (to the extent the loan proceeds were used to acquire those shares). The dividend deduction is in addition to the deduction for principal and interest, which means it is not subject to the 25%-of-payroll restriction.
MORE THAN A FRINGE BENEFIT
ESOPs are more than fringe-benefit programs. A study of the history of ESOPs shows Congress's intent was not so much to offer an employee benefit as it was to make the benefits of capitalism available to the masses. Using an ESOP for small business succession is, indeed, using the concept for its original purpose. The costs of starting an ESOP can be minimal and primarily include expenses for establishing the trust, appraising the stock and annual administration costs.
An ESOP offers favorable tax benefits for a number of business and personal objectives; using a leveraged ESOP to transfer ownership in a closely held corporation is probably the best way to use an ESOP. Solving business succession problems with ESOPS requires extensive planning, but the tax laws are favorable. As the exhibit on page 47 illustrates, an ESOP offers tax benefits to the buyer, the seller and the lender--all at the same time.
* EMPLOYEE STOCK OWNERSHIP plans (ESOPs) can be used by closely held business owners to transfer ownership to employees when no traditional buyers are available or family members do not wish to continue the business.
* ESOPs NOT ONLY MEET the owner's financial goals but also can meet nonfinancial objectives such as ensuring the business continues, retaining a management role or rewarding loyal employees.
* ONE IMPORTANT BENEFIT of using an ESOP to transfer ownership in a closely held business is the owner can defer paying tax on any capital gains if certain conditions are met and the sale proceeds are reinvested in qualified replacement property--stocks and bonds of U.S. operating companies--within a certain time period.
* ESOP FUNDING TYPICALLY comes from a bank or similar lender. Interest received on ESOP loans is tax-free to the recipient. Funding also can come from an existing pension or profit-sharing plan.
* PRINCIPAL PAYMENTS ON ESOP loans are tax deductible to the corporation and dividends are deductible if they are either distributed to participants in cash or used to pay principal or interest on an ESOP loan.
Using an ESOP to transfer a small business
Hannah Taxpayer has a $100,000 cost basis in a manufacturing business that is worth $1,000,000. She is the sole owner. Hannah wants to retire soon and there are no interested outside buyers and no family members who wish to continue the business. Some of her employees have expressed an interest in buying the business, but none has the necessary funds.
On the advice of her CPA and attorney, Hannah decides to sell the company to her employees and establishes an employee stock ownership plan with the help of a local bank. The bank loans the ESOP $1,000,000 at 7% interest to buy all the outstanding shares in the corporation. To postpone the tax on the $900,000 gain, Hannah reinvests the proceeds in a portfolio of stocks and bonds in U.S. domestic operating companies. Both the ESOP stock and Hannah's new portfolio secure the loan.
Effect on Hannah
Hannah's $900,000 capital gain will not be subject to tax since she invested the entire $1,000,000 in stocks and bonds of U.S. companies. She can live on the dividends and interest from her now diversified investment portfolio. If Hannah retains the portfolio until her death, her heirs will owe no capital gains taxes as well because the securities' cost basis will be stepped up to the market value on the date of her death.
If she wishes, Hannah can continue working for the company to ensure a smooth transition. She also has the satisfaction of knowing the business she spent her life building will continue after she retires.
Effect on the employees
Hannah's employees are able to buy the company with pretax dollars. Thus, they effectively buy a $1,000,000 company for $660,000. (This assumes the company's payroll is sufficient for all principal payments on the ESOP loan to be tax deductible.) At the same time, the new owners are assured a smooth transition. There are no job-loss fears that often exist when a new owner takes over. Employees are motivated to work harder because they know profits will accrue to their retirement plans. The interest rate on the ESOP loan is probably less than the market rate. In addition, the employees are borrowing the money to buy a business without having to put up any of their personal assets as collateral.
Effect on the lender
At 7%, a bank or other lender receives $70,000 in interest during the first year, only half of which is subject to tax. At the same time, the lender's risk is minimal because not only the company's stock but typically also the previous owner's new for security.
DALE L. FLESHER, CPA, Phd, CMA, is the Arthur Andersen Alumni Professor of Accounting at the University of Mississippi, University, and serves as associate dean of the School of Accountancy. He is a member of the American Institute of CPAs, the Mississippi Society of CPAs and the American Accounting Association.
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|Title Annotation:||employee stock ownership plans|
|Author:||Flesher, Dale L.|
|Publication:||Journal of Accountancy|
|Date:||May 1, 1994|
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