UNDERSTANDING ESOPS
A Primer on Employee Stock Ownership Plans
Corey
Rosen
Scott Rodrick
The
National Center for Employee Ownership (NCEO)
Oakland, California
Published by NCEO at Smashwords
This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.
Legal, accounting, and other rules affecting business often change. Before making decisions based on the information you find here or in any publication from any publisher, you should ascertain what changes might have occurred and what changes might be forthcoming. The NCEO’s Web site (including the members-only area) and newsletter for members provide regular updates on these changes. If you have any questions or concerns about a particular issue, check with your professional advisor or, if you are an NCEO member, call or email us.
Understanding ESOPs
Corey Rosen and Scott Rodrick
Copyright © 2008, 2010 by The National Center for Employee Ownership. All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior written permission from the publisher.
First published 2008. Reprinted 2010 with minor updates and additions.
ISBN: 978-1-932924-79-4
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Chapter 1: An Overview of How ESOPs Work
Corey Rosen
Chapter 2: Selling to an ESOP in a Closely Held Company
Scott Rodrick
Chapter 3: ESOPs in S Corporations
Corey Rosen
Chapter 4: Things to Do with an ESOP Besides Buying Out the Owner
Corey Rosen
Chapter 5: ESOP Valuation Issues
Corey Rosen
Corey Rosen
Chapter 7: ESOP Distribution and Diversification Rules
Scott Rodrick
Chapter 8: Choosing Consultants and Trustees
Corey Rosen
Chapter 9: ESOPs, Corporate Performance, and Ownership Culture
Corey Rosen
When the National Center for Employee Ownership (NCEO) was founded in 1981, employee ownership was a relatively unknown and somewhat suspect notion. Today, we estimate that 25 to 30 million Americans own stock in their companies through one kind of plan or another. Over 13 million of these employees are participants in an employee stock ownership plan (ESOP), the subject of this book.
Understanding ESOPs grew out of The ESOP Reader, NCEO’s most venerable publication and one that goes back to the NCEO’s founding in 1981. In its various incarnations, the Reader served as a nontechnical reference on the subject for decades. Nowadays, we at the NCEO provide a wide variety of ESOP publications (and other information resources, online and offline), and our aim in producing this new book is to present the topic in a more streamlined and efficient way so that the reader gets the depth he or she needs on certain topics, while other matters that need not be discussed in an introductory work are quickly passed over.
The first chapter of this book presents an overview of what ESOPs are, how they work, and what they are used for. Subsequent chapters delve into important topics that deserve more detailed treatment. Finally, the last chapter discusses how an ESOP can improve corporate performance and how that is linked to creating an ownership culture.
This book is for the reader who desires a comprehensive overview of the subject. There are many other issues, however, and beyond that there are other equity plans that can be used in addition to or instead of an ESOP. For more information on technical matters, communicating to employees, creating an ownership culture, and using other equity plans, see our books and informational resources.
Corey Rosen
An employee stock ownership plan (ESOP) is a specific way to share ownership with employees that can provide tax benefits to the company, to sellers of stock to an ESOP, and to employees. Given statutory authority in 1974 under the Employee Retirement Income Security Act (ERISA), ESOPs are governed by many of the same rules that cover 401(k) plans, deferred profit sharing plans, pension plans, and other retirement plans. Unlike these other plans, however, only ESOPs are designed to invest primarily in the stock of the employer, and only ESOPs can borrow money. ESOPs should not be confused with employee stock option plans, which are covered by a very different set of rules. Nor are ESOPs to be confused with stock purchase plans. In fact, ESOPs are almost always funded by the company, not by employee contributions.
The basic concept of an ESOP is simple. A company sets up a trust fund to acquire and hold company stock. The company can contribute shares directly, contribute cash to buy shares, or have the trust borrow money to buy stock, with the company repaying the loan through contributions to the plan. The company also can contribute cash to the trust or pay dividends or distributions on shares held by the trust. The shares, and any other contributions, are allocated to employee accounts based on an equitable formula. Companies cannot, however, make allocations based on discretionary approaches, such as performance assessments. Employees acquire vesting rights to these allocations over time. After employees terminate, their account balances are distributed to them, with some exceptions described below. The plan is governed by a trustee, usually appointed by the company’s board of directors; the minimum allowable governance rights for employees are very limited, although some companies provide more extensive ones. Within broad limits, contributions to the plan are tax-deductible. Employees pay no tax on what is in their accounts until they actually receive a distribution, and even then they can roll the distribution into an IRA or other retirement plan. Some sellers to an ESOP can defer capital gains taxes on the sale, and the profits attributable to the ESOP in an S corporation are not taxable at the federal and, usually, state levels.
ESOPs are used for many reasons. The most common is to provide a vehicle for the company to fund the purchase of an owner’s shares on a pretax basis, but ESOPs are also used simply to provide an additional benefit, to acquire other companies, to spin off subsidiaries or divisions, and to finance capital growth. For all their many benefits, ESOPs are not right for every company. They are more complex than other retirement plans, they do not allow as much flexibility as less tax-favored approaches to sharing ownership, and they usually are a poor fit for extremely small companies (typically under 10 to 15 employees) and companies that either are not or do not soon anticipate making a profit.
This book is written for people thinking about ESOPs. It walks you through the various rules and applications, discusses what to think about in setting up a plan, and provides guidance on how to make the plan work well for your company. As an introduction to the topic, it is not meant to be comprehensive. The NCEO does, however, have a variety of detailed publications on ESOP applications, tax issues, administrative practices, and ownership culture. For a list, go to our Web site at www.nceo.org.
This chapter provides a broad overview of ESOPs. Subsequent chapters look at ESOP applications and rules in more detail, while a final chapter discusses what may be the most important potential benefit of an ESOP, namely the potential to create a more engaged and productive culture.
The Development of ESOPs
Back in the 1950s, Louis Kelso, an investment banker and attorney in San Francisco, was pondering the question of why in a country as wealthy as the U.S. so few people had much wealth. Over half the productive assets in the country were owned by just 1% of the population. Kelso was no Marxist, however. Capitalism was one of the greatest inventions in history, he believed. The problem was there were just too few capitalists. And that, Kelso believed, augured poorly for the future.
Kelso believed that over the ensuing generation, returns to capital would greatly outpace returns to labor, something that had never been true in the U.S. Economists scoffed, but Kelso noted that more capital would be created in the next generation than all the prior ones combined. That growth rate would mean movement out of manufacturing jobs, which paid well even for relatively low skills, into jobs that paid less. That’s just what happened. Real wages since the early 1970s have barely moved, but returns to capital have soared. The Dow Jones Average, for instance, only had three digits back then. As people felt more economically stressed, they would demand that the government help them out more by creating and expanding entitlement programs, another prediction that held true. Even so, people would find it harder to accumulate enough money to retire comfortably, especially as life expectancy grew. The government would have to either tax more or borrow more (and slow the economy) to deal with the problem. Kelso was prescient on every point.
But Kelso also had a solution. If more workers were capital owners, they would have an additional source of wealth besides what they could save from wages. Of course, workers couldn’t easily become capitalists by buying stock precisely because their wages were stagnating, while their perceived consumption needs were growing, pushing savings rates down. Kelso noted that people with money could also borrow money to buy productive capital, something ordinary workers could not do. But if business owners would put up the collateral for their employees to become owners, the employees could borrow the money to buy shares in their employer. The company could then repay the loan out of future earnings. Kelso believed a combination of tax incentives, a special Federal Reserve lending rate for this kind of financing, and the promise of improved employee productivity would be enough to persuade many owners to agree to do this.
The special loan rates never came to be, but in 1974, Congress agreed to Kelso’s ideas about tax benefits, incorporating them in a massive reform of retirement law known as ERISA (the Employee Retirement Income Security Act of 1974). Congress basically made a deal with employers: share ownership with employees and in return get a tax deduction for doing so. In addition, ESOPs would be allowed to borrow money to buy company stock, something no other benefit plan could do. That loan would be repaid out of tax-deductible corporate contributions, not employee purchases. Over the years, Congress sweetened that basic deal with a variety of additional tax incentives, including allowing certain sellers to ESOPs to defer capital gains tax on the sale of their stock, letting companies deduct dividends paid on ESOP shares if certain rules were met, and, ultimately, excluding from federal corporate income tax the ESOP’s percentage of ownership in an S corporation, making a 100% S ESOP non-taxable. In return for all this, companies had to make sure the plans were run in a way that truly benefited employees on a broad and equitable basis.
That basic deal has led today to over 11,000 ESOPs as of 2010, covering over 13 million employees and holding over $900 billion in assets. Of these, only about 5% are in publicly traded companies; the rest are in closely held companies. The median percentage ownership for ESOPs in public companies is about 10% to 15%. Most public companies maintain an ESOP along with other benefit plans. The median ownership percentage for private companies is about 30% to 40%, and about 3,000 companies are majority employee-owned. While the typical company has 20 to 500 employees, employees own a majority of the stock of such companies as Lifetouch (20,000 employees), Publix Supermarkets (142,000 employees), and Nypro (18,000 employees). About three-quarters of ESOPs in private companies are used to buy out an owner; the rest are typically used simply as employee benefit plans, sometimes in conjunction with borrowing money for capital acquisition.
Overall, providing generous tax incentives for ESOPs has been a good policy. Employees in ESOP companies have somewhat higher wages than comparable employees in comparable non-ESOP companies, but they also have about three times the company-related retirement assets. ESOP companies grow about 2% to 3% per year faster than would have been expected without an ESOP. Those that combine an ESOP with an “ownership culture” (one that emphasizes open-book management and high employee involvement in work-level decisions) grow 6% to 11% per year faster. Of course, these are averages. Some companies do incredibly well; others (such as Enron and United Airlines) are disasters.
The ESOP Proposition
As noted above, in creating an ESOP, a company sets up an employee benefit trust, which it funds by contributing cash to buy company stock, contributing shares directly, or having the trust borrow money to buy stock, with the company making contributions to the plan to enable it to repay the loan. Generally, at least all full-time employees with a year or more of service are in the plan. To assure that these rules are met, the company must appoint a trustee to act as the plan fiduciary. This can be anyone, although larger companies tend to appoint outside trust institutions, while smaller companies typically appoint managers or create ESOP trust committees. ESOPs are designed to invest primarily in the stock of the employer and can buy treasury shares, newly issued shares, or shares from exiting owners.
There is one very important point that is widely misunderstood: employees almost never contribute to the plan; instead, contributions are funded by the company as a benefit, and shares are allocated to employee accounts on a nondiscriminatory basis, much as in a profit sharing plan. It’s worth repeating that: as a rule, employees do not buy shares in an ESOP. Over the years, we have found that many people considering an ESOP have a difficult time understanding how that can be. The answer is simple: the company funds the plan instead.
An ESOP can be used for many purposes, including the following:
* To buy the shares of a departing owner of a closely held company. This is the most common application. In C corporations, owners can defer tax on the gains they have made from the sale to an ESOP if the ESOP holds 30% or more of the company’s stock and certain other requirements are met. Moreover, the purchase can be made in pretax corporate dollars.
* To divest or acquire subsidiaries, buy back shares from the market, or restructure existing benefit plans by replacing current benefit contributions with a leveraged ESOP.
* To buy newly issued shares in the company, with the borrowed funds being used to buy new productive capital. The company can, in effect, finance growth or acquisitions in pretax dollars while these same dollars create an employee benefit plan.
* To simply be an employee benefit plan for companies that want to share ownership broadly. In public companies especially, an ESOP contribution is often used as part or all of a match to employee deferrals to a 401(k) plan.
These benefits come in return for operating the plan under ERISA guidelines. Passed in 1974 in the wake of pension scandals, the law was broadly drafted to cover a variety of employee benefit plans, including health insurance, pension plans, profit sharing plans, ESOPs, retirement savings plans, cafeteria plans, and other benefits meant to provide financial security to a broad group of employees. The basic idea is straightforward: the government provides employees and employers with tax breaks if their plans provide benefits on a nondiscriminatory basis across the work force. To do that, ERISA relies on several key concepts:
* Operate the plan for the “exclusive benefit of plan participants.” Despite how it sounds, a plan can benefit companies and other people as well, but when there is a conflict of interest, the interests of participants should prevail.
* Govern the plan with an “eye sole” to the interests of participants. The plan trustee is required by law to make sure the plan is operated primarily for the benefit of the people in it, not for the company or its owners. In an ESOP, this means, among other things, not overpaying for company stock.
* Make prudent investment decisions for the plan. Any funds in ERISA plans used for retirement should be invested in a way that a sensible, careful investor would invest them. Excess risk is discouraged, but so is parking all the money in a passbook savings account. There is a special exception for ESOPs, however. Here, ERISA not only permits but requires plans to be primarily invested in company stock, unless it is clear that that investment is in imminent danger of failing.
* Broadly include those who work for the company and meet minimal requirements. Generally, this means at a minimum all employees who have worked for at least 1,000 hours in a year must become eligible in the following year. There are some exceptions, however, such as employees covered by a bargaining agreement or employees in a separate line of business.1
* Allocate benefits fairly. Benefits can be allocated based on relative pay or a more level formula, but pay over $245,000 (as of 2010; this amount is indexed for inflation) does not count.
* Make benefits subject to vesting. Most retirement plans allow companies to require that employees stay a certain amount of time before they earn any benefits contributed by the company.
* Have a process for employees to contest decisions. ERISA spells out a variety of specific procedures by which employees can argue that they were improperly denied benefits. The first level is to try to resolve the matter within the company. The second is to ask the government to step in (usually the U.S. Department of Labor [DOL], although the DOL’s resources for this are limited). The third is to sue in federal courts.
* Preserve the benefit in a trust for long-term wealth building. All retirement plans governed by ERISA provide the employee with special tax benefits. Unlike other ownership arrangements we discuss in this book, ownership through an ESOP is not taxed when the employee is vested in the benefit, but rather when it is received (which normally is some time much later, such as after the employee leaves the company). But employees usually have only a limited ability to take money out of the plan while still working (mostly in 401(k) plans through loans) and face a tax penalty if they don’t put the money in an IRA or other retirement account when they actually get it after leaving the company.
In short, if you want the benefits of one of these plans, you have to meet a number of rules. You cannot pick and choose who you want to allow to be in the plan, nor can you base their awards on assessments of merit or adopt other discretionary approaches. If you can live with that, however, these plans are greatly more financially advantageous, to the company and the employee, than other approaches.
Funding
The most sophisticated use of an ESOP is to borrow money. The company borrows money from a lender and reloans it to the ESOP; the ESOP then uses the money to buy shares. The company makes tax-deductible contributions to the trust to enable it to repay the loan. This is called a “leveraged” ESOP. The company can also use dividends on the shares to repay the loan; these dividends become deductible to the company. In effect, the parallel loan structure allows the company to borrow money to acquire stock and, by funneling the loan through the ESOP, deduct both principal and interest. The company can use proceeds from the loan for any legitimate business purpose. Sellers to an ESOP can also be lenders. The stock is put into a “suspense account,” from where it is released to employee accounts as the loan is repaid.
The ESOP can also be funded directly by discretionary corporate contributions of cash that are used to buy existing shares or simply by the contribution of shares. These contributions to an ESOP are tax-deductible, generally up to 25% of the total eligible payroll of plan participants.
How Shares Get to Employees
If the company contributes shares or cash to buy shares, these contributions are immediately allocated to employee accounts in the plan. In a leveraged ESOP, the acquired shares are placed in a suspense account. As the loan is repaid, a percentage of the total shares acquired is released to employee accounts in an amount equal to either the principal paid that year or the percentage of total principal plus interest due that is paid that year. The amount contributed to repay the principal on the loan is what counts for determining whether the company is within the limits for contributions allowed each year and for the purpose of calculating the tax deduction. The value of the shares released, however, is the amount used on the corporate income statement, where it counts as a compensation cost. From the employees’ perspective, it is this value of shares released that will also matter to them because this is the amount they will see added to their accounts.
Companies can also use dividends or earnings distributions (in S corporations) to pay for leveraged shares. In that case, the dividends paid on the shares not yet allocated to employee accounts must release shares that have that much value to employee accounts, based either on the employees’ current relative account balances or on the same formula for releasing shares paid for out of company contributions. For shares already allocated, however, the shares in the suspense account that are released must be allocated on the basis of relative account balances.
Once the shares are in the plan, the rules for ESOPs are similar to the rules for other tax-qualified ERISA plans in terms of who is a plan participant, how allocations are made, vesting, and distribution, but several special considerations apply.
At least all employees over age 21 who work for more than 1,000 hours in a plan year must be included in the next plan year (or earlier) unless they are covered by a collective bargaining unit (and the ESOP issue is negotiated in good faith) or are in a separate line of business with at least 50 employees not covered by the ESOP, or fall into one of several limited anti-discrimination exemptions. Companies can always have more liberal rules for participation.
An alternative approach provides three tests for coverage. To use this approach, a company applies percentage tests to at least a minimum employee group. This group must include all employees 21 or older who have completed at least 1,000 hours of service in a plan year, but it can exclude nonresident aliens, employees in a separate line of business with 50 or more employees, and employees covered by a collective bargaining agreement. After these exceptions have been taken, the tests can be met if:
1. At least 70% of non-highly compensated employees are covered, or
2. The percentage of non-highly compensated employees who are covered is at least 70% of the percentage of highly compensated employees covered, or
3. There is a classification system that does not discriminate in favor of highly compensated employees, and the average benefit percentage (generally, the percentage of compensation contributed to the plan) for the covered non-highly compensated group is at least 70% of that contributed to the covered highly compensated group.
Few ESOPs, however, use these alternative tests, both because they want to create a culture of ownership that is inclusive and because how much can be contributed to a plan overall is limited by the payroll of employees in the plan (meaning that a company wishing to maximize the amount the ESOP can buy will want to maximize plan participation).
Plans have one or more “entry dates” for employees once they become participants. An employee who has satisfied the plan’s minimum age and service requirements must begin participation in the plan not later than the first of (1) the first day of the plan year beginning after the date on which the requirements were met or (2) the date six months after the date on which the requirements are met. Participation can begin at an earlier date, however. Many plans, for example, have entry dates every six months or every year, and employees become participants at the first entry date after requirements are met.
Shares are allocated to individual employee accounts based on relative eligible compensation. Generally, all W-2 compensation is counted, but there is leeway to define compensation differently, such as by excluding bonuses, provided that it does not favor more highly compensated individuals; on a more level formula, such as per capita, by seniority, or by placing a cap on pay that can be considered; or some combination of the two, such as one point for seniority and one for relative pay. If relative pay is not used, however, plans must be tested annually to determine whether any highly compensated individual, generally defined as someone belonging to either the top 20% by payroll in the company or those making more than $110,000 per year (as of 2010), is receiving more than what the relative pay formula would indicate. In that case, the excess must be returned to the plan and reallocated to other participants. Finally, ESOP allocations can be used as a match to employee deferrals to a 401(k) plan, in which case all or part of the allocation may be determined by how much the employee defers. This approach requires complex anti-discrimination testing for both plans. Relatively few ESOPs use this approach.
Eligible compensation includes the pay of only those employees actually participating in the plan. As noted earlier, it excludes pay over $245,000 (as of 2010). It also excludes the pay of sellers to an ESOP who take advantage of the ability to defer tax on the gains from the sale proceeds, as well as their immediate relatives, more-than-25% owners, and certain relatives of the more-than-25% owners.
The allocated shares are subject to vesting. If the plan provides for vesting all at once, called cliff vesting, employees must be 100% vested after three years of service; if vesting is gradual, it must not be slower than 20% after two years and 20% more per year until 100% is reached after six years. Plans can vest faster than these schedules. Companies do not have to provide credit for years of service before the ESOP, but many companies do. Some companies give a year of credit for every year of prior service; some give a year for every x number of years.
When employees reach age 55 and have 10 years of participation in the plan, the company must either give them the option of diversifying 25% of company stock in their account balances among at least three other investment alternatives or simply pay the amount out to the employees. At age 60 with 10 years of service, employees can have a cumulative total of 50% diversified or distributed to them.
When employees retire, die, or become disabled, the company must distribute their vested shares to them not later than the last day of the plan year following the year of their departure. For employees leaving before reaching retirement age, distribution must begin not later than the last day of the sixth plan year following their year of separation from service. Payments can be in substantially equal installments out of the trust over five years, or they can be made in a lump sum. With the installment method, a company normally pays out a portion of the stock from the trust each year.
Closely held companies and some thinly traded public companies must repurchase the shares from departing employees at their fair market value, as determined by an independent appraiser. This so-called “put option” can be exercised by the employee in one of two 60-day periods, one starting when the employee receives the distribution and the second period one year after that. The employee can choose which one to use. This obligation should be considered at the outset of the ESOP and be factored into the company’s ability to repay the loan.
This repurchase obligation should be assessed on a periodic basis. There are a variety of ways to fund the obligation, including making cash contributions to the ESOP to enable it to buy back the shares, building a cash reserve, using insurance proceeds, releveraging the ESOP, and other techniques. The impact of the obligation on valuation should be calculated. Normally, the obligation will reduce future share prices somewhat if share prices are growing, making future repurchases more manageable.
Limitations on Contributions
Congress was generous in providing tax benefits for ESOPs, but there are limits. Generally, companies can contribute and deduct an amount equal to up to 25% of the total eligible payroll of plan participants, whether contributed in the form of cash or stock or in payments to fund the repayment of an ESOP loan. Eligible pay is essentially all the pay (including employee deferrals into benefit plans) of people actually in the plan up to $245,000 per participant (as of 2010; this and other dollar limits described here for defined contribution plans are indexed annually for inflation).
In C corporations, there are separate 25% deductibility limits for (1) contributions to pay principal on an ESOP loan (interest is deductible as it always is on a loan) and (2) additional contributions to the ESOP or to other defined contribution plans, provided they are not used to repay interest or principal on the ESOP loan. A company with a leveraged ESOP and a profit sharing plan, for example, has a 50% total deductibility limit (up to 25% for a leveraged ESOP plus up to 25% for other defined contributions not related to the loan). However, in S corporations, company contributions to a leveraged or non-leveraged ESOP and other defined contribution plans all fall under a single 25%-of-eligible-pay calculation. Interest payments on the ESOP loan are deductible as interest, but the company cannot deduct more than 25% of eligible pay to cover both the interest and principal payments.
On top of this, in C corporations, “reasonable” dividends paid on shares acquired by the ESOP can be used to repay an ESOP loan, and these are not included in the 25%-of-pay calculations. S corporations can use distributions on earnings to help repay the loan, although these are not deductible as they are in C corporations (but they are also not taxable to the ESOP). In a leveraged ESOP in a C corporation, if employees leave the company before they have a fully vested right to their shares, their forfeitures, which are allocated to everyone else, are not counted in the percentage limitations. They are counted in an S corporation ESOP, however.
There are a number of limitations to these provisions, however. First, no one ESOP participant can get a contribution of more than 100% of pay in any year from the principal payments on the loan or the direct ESOP contributions made that year that are attributable to that employee, or more than $49,000 (as of 2010), whichever is less. In figuring payroll, pay over $245,000 per year (as of 2010) does not count toward total contribution limits. Second, if there are other qualified benefit plans, these must be taken into account when assessing this limit. This means that employee deferrals into 401(k) plans, as well as other employer contributions to 401(k) plans, stock bonus, or profit sharing plans, are added to the ESOP contribution and cannot exceed 100% of pay or $49,000 (as of 2010) in any year.
Third, the interest on an ESOP loan repayment in a C corporation is excludable from the 25%-of-pay individual limit only if not more than one-third of the benefits are allocated to “highly compensated employees,” as defined by Internal Revenue Code Section 414(q). If the one-third rule is not met, forfeitures are also counted in determining how much an employee is getting each year.
Voting
In private companies, employees must be able to direct the trustee as to the voting of shares allocated to their accounts on several key issues, including closing, sale, liquidation, recapitalization, and other issues having to do with the basic structure of the company. They do not, however, have to be able to vote for the board of directors or on other typical corporate governance issues, although companies can voluntarily provide these rights. Instead, the plan trustee votes the shares, usually at the direction of management. In public companies, employees must be able to vote on all issues.
What these rules mean is that governance is not really an issue for ESOP companies unless they want it to be. If companies want employees to have only the most limited role in corporate governance, they can; if they want to go beyond this, they can as well. In practice, companies that do provide employees with a substantial governance role find that it does not result in dramatic changes in the way the company is run.
Finally, in private companies and some thinly traded public companies, all ESOP transactions must be based on a current appraisal by an independent, outside valuation expert.
Tax Benefits to the Selling Shareholder
One of the major benefits of an ESOP for closely held C corporations is found in Section 1042 of the Internal Revenue Code. Under it, a seller to an ESOP may be able to qualify for a deferral of taxation on the gain made from the sale. Several requirements apply, the most significant of which are:
1. The seller must have held the stock for three years before the sale.
2. The stock must not have been acquired through stock options or other employee benefit plans.
3. The ESOP must own 30% or more of the value of the company’s shares and must continue to hold this amount for three years unless the company is sold. Shares the company repurchases from departing employees do not count. Stock sold in a transaction that brings the ESOP to 30% of the total shares qualifies for the deferral treatment.
4. Shares qualifying for the deferral cannot be allocated to the accounts of the selling shareholder(s); to lineal descendants, brothers or sisters, spouses, or parents of the selling shareholder(s); or to any more-than-25% shareholders.
If these rules are met, the seller (or sellers) can take the proceeds from the sale and reinvest them in “qualified replacement property” during the period running from 3 months before to 12 months after the sale and defer any capital gains tax until these new investments are sold. Qualified replacement property essentially means stocks, bonds, warrants, or debentures of domestic corporations receiving not more than 25% of their income from passive investment. Mutual funds and real estate trusts do not qualify. If the replacement securities are held until death, they are subject to a step-up in basis at that time, so capital gains taxes would never be paid.
Very often, lenders ask for replacement securities as part or all of the collateral for an ESOP loan. This strategy may be beneficial to sellers selling only part of their holdings because it frees the corporation to use its assets for other borrowing and could enhance the future value of the company.
As with all transactions in closely held ESOP companies, the price the ESOP pays for the shares cannot be more than fair market value as assessed by an independent appraiser. The price is what a financial buyer would pay—someone who would operate the company as a stand-alone entity, not as part of another enterprise as a synergistic buyer might. That means an ESOP may not be able to meet the price of some synergistic buyers, although it does offer better tax benefits on the sale.
Corporate Tax Benefits
As noted above, companies can use ESOPs to borrow money and repay the loan entirely in pretax dollars. In addition, companies can take a tax deduction for reasonable dividends that are used to repay a loan, that are passed through directly to employees, or that employees voluntarily reinvest in company stock. Contributions not used to repay an ESOP loan are tax-deductible as well, even if made in the form of treasury or new shares.
ESOPs in S Corporations
ESOPs can own stock in S corporations. While these ESOPs operate under most of the same rules as they do in C corporations, there are important differences. As noted above, interest payments on S corporation ESOP loans count toward the contribution limits (they normally do not in C companies). Dividends (i.e., S corporation “distributions”) paid on ESOP shares are also not deductible. Most important, sellers to an ESOP in an S corporation do not qualify for the tax-deferred Section 1042 rollover treatment.
On the other hand, the ESOP is unique among S corporation owners in that it does not have to pay federal income tax on any profits attributable to it (state rules vary). This can make an ESOP very attractive in some cases. It also makes converting to S corporation status very appealing when a C corporation’s ESOP owns a high percentage of the company’s stock.
For S corporation owners who want to use an ESOP to provide a market for their shares, generally it will make sense to convert to C status before setting up an ESOP. Where selling shares is not a priority, or where the seller either does not have substantial capital gains taxes due on the sale or has other reasons to retain S corporation status, an S corporation ESOP can provide significant tax benefits. However, keep in mind that any distributions paid to owners must be paid pro-rata to the ESOP. The ESOP can use these distributions to purchase additional shares, to build up cash for future repurchases of employee shares, or just to add to employee accounts.
While the S corporation rules make an ESOP very attractive, legislation passed in 2001 makes it clear that companies may not create an ESOP primarily to benefit a few people. For instance, some accountants were promoting plans in which a company would set up an S corporation management company owned by just a few people that would manage a large C corporation. The C corporation’s profits would flow through the S corporation’s ESOP and thus not be taxed.
The rules Congress enacted are complicated, but they boil down to two essential points. First, people who own more than 10% of the “deemed-owned” shares, or who own 20% counting their family members, are considered “disqualified” persons. “Deemed-owned shares” is defined to include what is allocated in the ESOP, a pro-rata share of unallocated shares in the trust, and any synthetic equity rights, such as phantom stock, stock options, stock appreciation rights, warrants, and certain kinds of deferred compensation the IRS considers equity-rights equivalents. Second, if these disqualified people together own 50% or more of the company’s equity (counting their synthetic equity), then there will be devastating tax penalties. Congress also directed the IRS to apply this onerous tax treatment to any plan it deems to be substantially for the purpose of evading taxes rather than providing employee benefits.
Financial Issues for Employees
When an employee receives a distribution from the plan, it is taxable unless rolled over into an IRA or other qualified account. Otherwise, the amounts contributed by the employer are taxable as ordinary income, while any appreciation on the shares is taxable as capital gains. In addition, if the employee receives the distribution before normal retirement age and does not roll over the funds, a 10% excise tax is added.
While the stock is in the plan, however, it is not taxable to employees. It is rare, moreover, for employees to give up wages to participate in an ESOP or to purchase stock directly through a plan (this raises difficult securities law issues for closely held firms). Most ESOPs either are in addition to existing benefit plans or replace other defined contribution plans, usually at a higher contribution level.
Accounting
In nonleveraged plans, the contribution to the ESOP shows up directly as a compensation cost. In leveraged plans, the principal payments and dividend payments on unallocated shares that are used to repay a loan show up as a compensation charge as well; dividends on allocated shares show up as a charge to retained earnings. The debt of the ESOP shows up as corporate debt, with an offsetting contra equity account that is reduced as the loan is repaid.
Ownership, Corporate Culture, and Corporate Performance
Many executives believe that if they share ownership and explain it well enough to people, then employees will perform better. It is not that simple, however. Employee ownership can improve corporate performance significantly, but only when combined with what we call an “ownership culture.” Ownership culture companies share financial information with employees on a regular basis and get employees involved in work-level decisions. They seek out not just more employee effort to do the same things better, but more employee ideas to do things better—or do new things entirely.
On the financial level, these companies typically share some version of the income statement and balance sheet on a periodic basis. More important, they break numbers down into usable small pieces that measure key performance issues for the company and for employee groups, such as quality control, output, backlog, customer satisfaction, on-time delivery, etc. These numbers provide employees with targets they can easily grasp and work to meet or exceed. The best companies get employees involved in generating these numbers as well.
Employees also have regular opportunities for input through work teams, quality circles, ad hoc committees, suggestion systems, informal and formal meetings with managers, and other opportunities. Management does not just pay lip service to the idea of empowering employees to make more decisions; it really does it. Ownership culture companies find that, over time, employee ideas get better and better, and that more of the work force becomes engaged in finding ways to help the company make money.
Conclusion
ESOPs are hard work. They take time to understand and implement; it takes even more time and effort to create a true ownership culture. But go to an ESOP meeting and you will meet company leaders who are not just glad they did it, but absolutely evangelical. Not only are they succeeding and enjoying the tax benefits of ESOPs, but they are also just flat-out having more fun. ESOPs are not right for everyone, but if you are willing to make this effort, they are well worth considering.
Selling to an ESOP in a Closely Held Company
Scott Rodrick
As chapter 1 states, the most popular use of an ESOP is to buy the shares of a departing owner in a closely held company. This chapter goes into more detail on why this happens and discusses the rules for a major tax incentive for selling owners in C corporations, the tax-deferred “rollover” of funds from an ESOP sale, plus some major considerations that go into deciding whether to sell to an ESOP and whether to elect the tax-deferred “rollover.”
Why a Sale to an ESOP Often Makes Sense
An ESOP is not for everyone, but in many cases, it is the best way for someone to sell shares in a closely held company they own. As a tax-exempt employee benefit plan trust, the ESOP offers flexible, tax-advantaged treatment and does not have the restrictions, covenants, employment consequences, and other problems that can arise with an outside buyer.
The ESOP Creates a Market for the Shares in Any Amount
After years of building their companies, many small business owners find themselves at an impasse when the time comes to leave. Sometimes a family member or members may be willing and able to take over, but even then, the owner may wish to sell part or all of his or her ownership interest, and it may not be practical for personal or financial reasons for family members to buy out the owner. Company managers or other employees may be interested in buying shares, but buying the entire company may be financially unfeasible. Moving beyond the sphere of family members and employees, the owner may seek an outside buyer, but that too can be difficult (and expensive if a business broker is used).
If the would-be seller owns a minority interest in the company, or owns more but wants to sell only a part of the company, outside buyers may not be interested. Often, there are multiple owners of a closely held company, and at any given time, only a few may be interested in selling. And even if several people want to sell, their interests may still amount to a small percentage. The remaining owners may not want to deal with the proposed new owners.
An ESOP solves these dilemmas by creating a market for the shares. It can buy any percentage of the company; thus, an owner or owners can sell anything from a small percentage to all of the company to the ESOP.
Owners Can Sell Gradually to the ESOP While Staying with the Business
A potential buyer, especially an outside one, often will want to buy an owner’s interest all at once. In contrast, an ESOP is flexible and, in addition to being able to buy any percentage of the shares (as noted above), can buy shares gradually so the owner can slowly exit his or her investment.
If the selling owner is the CEO or holds another major executive position at the company, an outside buyer often will wish to replace him or her with someone else (perhaps retaining the owner as a consultant for some period). If the ESOP is the buyer, however, there is no need for the selling owner to leave the company unless he or she desires to.
An ESOP Preserves the Stability of the Company
Sometimes people worry that since rank-and-file employees become beneficial owners through the ESOP trust, the company will be turned upside down and “the inmates will run the asylum.” The truth is actually the opposite. If someone sells a company to an outsider, especially one that merely wants the company for its assets or to gain a strategic advantage over a competitor, the seller may wake up one day to find that all the managers have been fired (they are often the first people to be discarded or replaced), that beloved rank-and-file employees have been fired, or even that the company has been shut down after being stripped of its assets. With an ESOP, in contrast, the company stays the same; the only difference is that the stock now happens to be held by an employee trust (the ESOP trust) instead of the former owners. The ESOP trustee, selected by the company’s board, in turn votes for the board in the trustee’s capacity as a shareholder, unless the company chooses to pass the vote through to the ESOP participants.2
Employees Will Gain Ownership and Motivation
From the seller’s point of view, an ESOP provides an excellent market for company shares. Something else to consider is that employees will gain a valuable benefit (i.e., stock in their ESOP accounts). Furthermore, as discussed elsewhere in this book, the combination of employee ownership through an ESOP and a management style that recognizes that ownership can result in a more motivated workforce and thus a more profitable company.
An ESOP Is Cost-Effective for the Owner and Company
If a business broker is used to sell the company to an outside buyer, a large fee may be charged. Aside from this, the selling owner will have to pay what may be an enormous tax bill if it is a cash transaction. It is possible to structure a company sale as a tax-free reorganization in which another company acquires the seller’s company in exchange for stock. Again, this raises the issue of having to sell most or all of the company, which may not be desirable or even possible, given other owners or a desire to sell only a part of the company. And, depending on the transaction structure, the company may cease to exist, at least in its old form. Finally, the owner ends up with an undiversified investment in somebody else’s company and has two choices: either keep that stock and pray that it does not lose value as the years go by and that it can be sold someday, or sell the stock now and pay taxes.