ESOPs: Creating a Legacy
Author: Cara Benningfield
Every privately held company and its owners eventually face succession issues. Owners who choose to ignore succession planning until an unexpected event forces the issue may face fewer choices, little time to react and a decrease in company value. However, proper planning can create peace of mind and increase the chances of a smooth transition that can help retain wealth and financial security.
An employee stock ownership plan (ESOP) is one of many succession strategies available. While an ESOP may not be the right fit for everyone, it may be an attractive option for many privately held business owners.
What Is an ESOP?
An ESOP is a qualified defined contribution plan, governed by the Employee Retirement Income Security Act of 1974 (ERISA). While it’s similar to a 401(k) plan, the primary difference is that an ESOP is designed to invest primarily in stock of the company sponsor.
According to The ESOP Association, there are now approximately 11,500 ESOPs in the U.S., covering 10 million employees. Of this number, nearly 2,500 are 100 percent ESOP-owned.
An important characteristic of ESOPs is their ability to borrow money to purchase company stock, referred to as a leveraged ESOP. This is similar to a traditional leveraged or management buyout but with significant tax advantages and greater employee participation in future growth. The ESOP can purchase any percentage of the company’s stock. Due to significant potential tax savings, many companies are choosing to become 100 percent ESOP-owned. This can be accomplished in a single transaction or a series of smaller transactions.
One common misconception is that once an owner sells his or her stock to the ESOP, employees become legal stockholders. In fact, the ESOP trust is the legal stockholder; employees simply have a beneficial interest in the value of the shares allocated to their account. This is an important legal distinction that allows the ESOP trustee to vote the shares in most situations.
A common concern of owners of closely held companies is the desire to retain the company name and history, protect employees and help preserve the communities in which they operate. The thought of selling the company to an outsider often conjures images of layoffs, undue oversight, a new management team and possibly a new name over the door. For many owners, this isn’t a palatable option.
An ESOP can be used to address these concerns while providing a viable means of creating stockholder liquidity over time. From a daily management and operational standpoint, the transition to an employee-owned company is virtually seamless.
The key point to remember when considering an ESOP transaction is that selling stockholders can retain management and operational control of the company, even if 100 percent of the stock is sold to the ESOP.
Not only can the ESOP pay fair market value for the owner’s stock, but the sale transaction can be structured to create tax advantages for the seller. In general, the ESOP purchases stock instead of company assets. A seller who has held his or her stock longer than one year can take advantage of long-term capital gains rates. In addition, a seller financing all or part of the purchase price has the option of taking installment treatment, allowing the seller to pay the capital gains tax over a period of time as the seller note is repaid.
If the seller is taking back a seller note, he or she may be provided with detachable warrants as an interest rate enhancement for financing a portion of the ESOP transaction. The warrants are considered part of the overall financing package and are taken into consideration of the overall return, along with the cash payments of interest. Warrants give the seller the right to purchase shares of the company at a future date. In general, the exercise price equals the same price per share paid by the ESOP; the put or call price is based on the company’s most recent ESOP appraisal.
Another tax planning strategy that may be used is covered under Internal Revenue Code Section 1042. This allows owners meeting certain qualifications to sell their stock in a tax-deferred or potentially tax-free transaction.
One primary requirement is that the selling stockholder must reinvest in qualified replacement property (QRP) within 12 months of the date of sale. QRP is essentially stocks or bonds of domestic operating companies. Mutual funds, municipal bonds and certain other investments aren’t considered qualifying property. The tax basis in the company stock sold carries over to the QRP. The deferred gain is realized only when the QRP is sold. However, if the selling stockholder holds the QRP until death, the QRP will become part of the stockholder’s estate. At that time, the QRP will receive a step-up in basis (in years where the estate tax is in effect), resulting in avoidance of income tax.
Certain strategies allow the stockholder to invest in QRP and retain the tax deferral while retaining access to most of the sale proceeds. Due to historically low long-term capital gains rates and certain credit market factors, Section 1042 gain deferral hasn’t been widely used in recent years. However, with tax rate increases and an easing of the credit market, this tax planning strategy is regaining popularity.
The selling stockholder certainly isn’t the only one to reap the tax advantages of an ESOP transaction. The company can realize substantial tax savings as well. Because a leveraged ESOP can deduct principal payments on debt used to purchase company stock, a significant portion of the transaction can be repaid with company tax savings.
There are even greater benefits for ESOPs taxed as S corporations. The portion of the company’s earnings attributable to the ESOP is exempt from federal and most state income tax (except in states that don’t recognize S corp status). When an S corp is 100 percent owned by an ESOP, the potential for savings is even greater. In this case, the company no longer pays federal or, in general, state income tax. This cash can be retained by the company to pay off acquisition debt, support company growth or even fund acquisitions.
ESOPs can provide significant retirement benefits to long-term employees. In general, any employee who is at least 21 years old and has one year of service with the company is eligible to participate.
As the company makes contributions to the plan each year, the ESOP uses those contributions to make payments on the ESOP loan. These loan payments trigger the release of shares, which are then allocated to eligible participants. The shares typically are allocated on a pro rata basis based on each employee’s eligible compensation compared to the total compensation of all other eligible participants (within certain IRS limits). For example, a participant making $50,000 per year will receive twice as many shares as a participant being paid $25,000 per year.
Participants who receive allocations of shares become vested in that benefit over time. To become vested in their account, a participant usually must have three to six years of service with the company. Because an ESOP is a type of retirement plan, there are special rules regarding when participants are entitled to receive a distribution of their account balance. In most cases, employees receive a distribution of cash equal to the value of their account instead of stock. With a leveraged ESOP, it’s critical that the plan is designed to delay significant cash distributions until the ESOP debt is repaid. In the early years, this allows the company to retain operating cash flow to service debt rather than pay benefits to terminated participants.
Key members of management usually will participate in the ESOP along with other employees. However, to retain key management and ensure their goals and objectives are properly aligned with the ESOP’s, it often is important to provide additional equity incentives, such as incentive stock options, stock appreciation rights or other types of deferred compensation arrangements. Extending these incentives to the management team is a key element to the success of the ESOP transaction and the company’s future performance. Such incentives, when taken into consideration with the total compensation package, must be considered reasonable by the ESOP trustee.
According to the National Center for Employee Ownership, ESOP companies are less likely to lay off employees. The 2014 General Social Survey (GSS) found that 1.3 percent of employees with employee stock ownership were laid off in 2014, compared to a 9.5 percent rate for employees without employee stock ownership. The estimated cost in saved unemployment benefits and foregone taxes to the federal government varied between $8 billion in nonrecession years to $13 billion in recession years.
ESOPs also are linked to increased employee retention. According to The ESOP Association, the 2010 GSS data indicated 13 percent of the employees with employee stock ownership intended to leave their companies in the coming months, whereas the rate was 24 percent for employees without employee stock ownership. This can translate into significant decreases in turnover.
The ESOP Solution
An ESOP can be a powerful succession planning tool for certain manufacturing and distribution company owners. It may not be the ideal strategy in all situations, but for stockholders looking to implement a permanent succession plan, preserve company legacy and reward employees, an ESOP may be just the solution they are seeking.
ESOPs are inherently complex, but an experienced advisor can help guide companies through the process of determining if an ESOP is the right tool for accomplishing their goals and objectives. Contact your BKD advisor for more information.