How Can an ESOP Help My Company?

An ESOP is a versatile tool that can accomplish the following objectives:

• Enable business owners to extract tax-free funds from one company to diversify or even invest in new or fledgling corporations that engage in active business.
• Facilitate estate and business succession planning for business owners who desire to pass the business on to family and/or key employees.
• Create a market for closely held business owners who want to sell their shares for their full value and receive sale proceeds without incurring a tax. This provides business owners with both liquidity and diversification.
• Convert ordinary income into tax-free income through the sale of stock to an ESOP.
• Reduce borrowing costs by up to 40 percent by enabling a business to make tax deductible contributions and even dividend payments to its ESOP in order to pay stock acquisition debt.
• Allow the use of leveraged ESOP financing instead of conventional debt financing which enables the company to deduct the full amount of loan payments, not just the interest portion of those payments.
• Devise a tax-advantaged corporate finance strategy that increases working capital and facilitates business expansion.
• Enhance employee performance by creating a correlation between company performance and individual employee compensation.
• Enable S corporation ESOPs to completely avoid tax on their share of corporate earnings.
• Resolve shareholder disputes on a tax-favored basis, effectively substituting an ESOP in place of disgruntled shareholders.

Who Can Benefit From an ESOP?

• Private business owners who want to:
  • Cash out tax-free while continuing to control the company.
  • Deduct principal payments on existing or new loans to finance growth.
  • Make a tax-free sale of some or all of the business to its employees.
  • Develop a business succession strategy.
  • Implement estate planning that includes equal treatment for children who are not involved in the business.
  • Tie employee compensation to company performance.
  • Cash out while retaining an equity interest in a tax-free company.
  • Sell some or all of their current business and invest in another.
• Businesses that want to:
  • Deduct the cost of buying out some of the stockholders.
  • Increase working capital through significant reduction of tax liability.
  • Repay stock acquisition debt with pre-tax dollars.
  • Outbid their competitors and deduct the cost of acquisitions.
• Management groups that want to buy the subsidiary or division that employs them using pre-tax dollars.
• S Corporations that want to operate tax-free.

How Does an ESOP Work?

An ESOP functions like a profit-sharing plan. The company creates a trust to which it makes contributions. The contributions are then allocated to individual employee accounts within the trust. The shares of company stock and other plan assets allocated to employees' accounts vest over time, and the employees receive vested portions of their accounts at termination or retirement. Moreover, employees incur only long-term capital gain tax on the appreciation in stock value, rather than ordinary income tax on the appreciation. The company makes discretionary contributions on an annual basis of at least 25 percent, and up to 50 percent, of covered payroll. The contributions can be made in either stock or cash.

With a leveraged ESOP, the company obtains a loan from a commercial lender and then lends this money to the ESOP, which uses it to buy stock from either existing shareholders, or the company itself. Thereafter, the company makes deductible contributions to the ESOP to service the loan. Consequently, even principal payments on the loan are tax-deductible to the company. Also, the company can pay tax-deductible dividends to the ESOP to amortize the loan. As the loan is repaid, the stock held in a suspense account as collateral on the loan is released and allocated to participant accounts within the ESOP.

Retirement Planning and Employee Buyout using an ESOP

It is quite common for owners of closely held businesses to approach retirement age without having adequately planned a way to successfully finance that status. While many have had the foresight to set up and fund qualified deferred compensation arrangements, such as pension or profit-sharing plans, into which they have built sizable retirement accounts, this is usually inadequate to fully fund their retirement.

Owners of a closely held business often have much of their personal wealth tied up in that business. While this asset can be very valuable, usually it is also illiquid. If a purchaser is found who is willing to buy the corporation for cash or debt, the seller can realize long-term capital gain. However, purchasers often want to buy assets, not corporations, and in these cases, depreciation recapture and double taxation will extensively diminish value. Moreover, a business built largely around the founder may not be readily marketable; the most logical buyers may be key employees.

If employees do not have ready access to the large amount of cash or debt needed for the purchase, as is usually the case, an ESOP allows the seller to essentially fund his or her own sale. An ESOP can permit employees to finance the stock purchase by means of plan-to-plan transfers from other qualified plans and rollover IRAs. The founder/seller gets a tax-free rollover through IRC §1042, or other means, while the employees are able to use before-tax money (rather than after-tax money) to buy an interest in their employer, and receive the purchased stock directly into their ESOP accounts with no dilution.

Using an ESOP as an Estate Planning Tool

Employee Stock Ownership Plans can be a flexible tool for a business owner's estate planning needs. An ESOP can allow for business succession planning with minimized tax consequences, and also enable a parent to extract wealth from the company for any child who is not actively involved with the business. This can help a business owner to minimize friction regarding the business as an asset of the estate. Without an appropriate plan in place, sibling(s) who remain employed by the business pay themselves compensation, while the other sibling(s) receive little or no benefit from their ownership share in an ostensibly valuable business. Bitterness and sometimes even litigation can follow.

In situations where only some children are employees of the business, an ESOP can enable the business-owning parent to extract from the business sufficient liquidity to provide pro rata wealth to the nonparticipating siblings. The owner can then leave the remainder of the business, including all of its goodwill and growth potential, to those siblings who remain with the business. In cases where all children actively work in the business, or non-involved children have been otherwise provided for, ESOP can set the stage for transitioning ownership of the business to the next generation with minimum tax cost. If none of the children work in the business, the parents can use the ESOP to preserve the full value of the business for the benefit of their heirs, and to allow them to maintain control until they have extracted that value and, should they so desire, control the company until they choose to relinquish it.

The combination of family limited partnerships (FLPs) or limited liability companies (LLCs) and ESOPs can serve to substantially reduce, or even eliminate, the estate tax burden. This combination establishes substantial discounts in the value of business interests owned by the FLPs or LLCs by creating minority interests for estate and gift tax purposes. ESOPs can also be used in conjunction with charitable remainder trusts (CRTs) as an effective strategy for retaining control of the company while preserving cash flow which ultimately benefits both the family and charities. It also enables a selling shareholder to not only cash out on a tax-free basis, but to participate in future allocations within the ESOP.

ESOPs as Financing Vehicles

An important advantage of leveraged ESOP financing over conventional debt financing is that ESOP financing provides a mechanism for the company to deduct the full amount of loan payments, not just the interest. This benefit can ease the tax burden on a growing company.

In addition, leveraged ESOPs can be an integral part of stock acquisitions, not just from the ESOP sponsoring company, but also from other stockholders interested in:

(a) Diversifying their holdings,

(b) Implementing business succession and estate planning,

(c) Financing new ventures,

(d) Resolving stockholder discord, and more.

The ESOP loan takes the form of a bank (or other commercial lender) lending money to the company (the "outside loan") that, in turn, lends that money to the ESOP (the "inside loan"), which uses it to acquire stock from either the company or its shareholders. Over time, the company makes tax-deductible contributions to its ESOP, which returns that money to the company as payments on the inside loan. The company then uses those funds to pay the bank. It is not unusual for those selling stock to an ESOP to take some of their sale proceeds as "take-back" notes from the ESOP, the payment of which can be tax-free under IRC §1042. Generally, since studies have shown that ESOP companies outperform their non-ESOP competitors, ESOP companies constitute good credit risks and lenders are eager to provide financing.

ESOPs for Government Contractors

After years of uncertainty, Proposed Federal Acquisition Regulation 31.205-6(q) acknowledges that contributions to an ESOP are "allowable costs" if not excessive, and can be fully covered by cost reimbursement on cost-plus contracts so that, in effect, the government bears this cost. And, even if the ESOP contributions are not reimbursed, the company still gets a deduction attributable to those unreimbursed ESOP contributions that is usually worth forty cents on the dollar. Under such an arrangement, owners of a closely held government contracting company can adopt an ESOP, sell at least 30 percent of the company's stock to it, and receive the proceeds from that sale tax-free. Then, the company can make annual cost-reimbursable (or at least deductible) contributions to the ESOP in order to amortize the stock purchase indebtedness that the ESOP incurs to finance its stock purchase. To the extent that contributions to the ESOP qualify as reimbursable costs, the government essentially finances the cost of the ESOP's purchase of the owner's stock. This produces attractive tax savings for the owners while providing the workforce with the benefits and incentives inherent to employee ownership.

We can help government contractors (1) avoid losing the opportunity to include the ESOP contributions as reimbursable costs under their contracts, (2) avoid accepting inferior financing terms, or (3) even use the benefits of ESOP to enhance their competitiveness by keeping expenses down. By communicating with the contracting agencies upfront, and ensuring that they understand ESOPs are reimbursable costs, we can structure and implement ESOPs for government contractors and assist them in maximizing the benefits attainable through this planning alternative.

ESOPs and Subchapter S

An S corporation is a "pass through" entity that, with few exceptions, pays no income tax on its earnings, which are, instead, taxed pro rata to its shareholders. ESOPs are tax-exempt employee benefit trusts that are now eligible S corporation shareholders. The combination of these factors produces the result that, when an ESOP is a stockholder in an S corporation, its passed-through share of the S corporation's income is not taxed. For example, if an ESOP owns 30 percent of an S corporation, 30 percent of its income will not be taxed. And, when an ESOP wholly owns the S corporation, its income is not currently taxed at all.

This can significantly enhance corporate performance, because non-taxed corporate earnings can be retained and used to increase the corporation's IRR. The resulting increase in cash flow can then be used to fund growth. Also, because the growing value of employee ESOP accounts provides them with strong incentive to maximize company performance, both the employees and corporation will prosper. In addition, various forms of nonstock equity (e.g., warrants, options, stock appreciation rights (SARs), restricted stock and phantom stock) can be created for the benefit of lenders and key employees to provide equity-type incentives to those who provide substantial benefits to the corporation.