ESOPs: Creating a Legacy
Author: Cara Benningfield
Privately held companies and their owners will eventually face succession issues. Owners choosing 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 chance of a smooth transition. An employee stock ownership plan (ESOP) is one of many succession strategies available.
What’s an ESOP?
An ESOP is a qualified defined contribution plan governed by the Employee Retirement Income Security Act of 1974. While similar to a 401(k) plan, the primary difference is that an ESOP is designed to primarily invest in stock of the company sponsor.
An important characteristic of an ESOP is its ability to borrow money to purchase company stock—a leveraged ESOP. This is similar to a traditional leveraged or management buyout, but with significant tax advantages and greater employee participation in 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.
The ESOP trust is the legal stockholder; however, employees have a beneficial interest in the value of the shares allocated to their account. This is an important legal distinction allowing the ESOP trustee to vote the shares in most situations.
Owners of closely held companies often are concerned with retaining the company name and history, protecting employees and preserving the communities in which they operate. An ESOP can be used to address these concerns while providing a viable means of gradually creating stockholder liquidity. When considering an ESOP transaction, remember that the selling stockholders can continue to manage the company, even if 100 percent of the stock is sold.
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. Sellers with a holding period longer than one year can take advantage of long-term capital gain (LTCG) rates. In addition, a seller financing all or part of the purchase price can opt for installment treatment, allowing the seller to pay the capital gains tax as the seller note is repaid.
Sellers taking back a note may be provided with detachable warrants as an interest rate enhancement for financing a portion of the transaction. The warrants are considered part of the overall financing package, along with the cash payments of interest. Warrants give sellers the right to purchase company shares 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 sale. QRP is essentially stocks or bonds of domestic operating companies. The tax basis in the company stock carries over to the QRP. The deferred gain is only realized when the QRP is sold. If held 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 LTCG rates and certain credit market factors, §1042 gain deferral hasn’t been widely used in recent years.
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, most state income taxes.
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. This allocation typically is on a pro rata basis according to each employee’s eligible compensation.
Key members of management will usually participate in the ESOP along with other employees. However, to help retain key management and properly align goals and objectives with the ESOP, it’s often important to provide additional equity incentives, such as incentive stock options or stock appreciation rights. Such incentives, when taken into consideration with the total compensation package, must be considered reasonable by the ESOP trustee.
The ESOP Solution
ESOPs are inherently complex, but an experienced advisor can help guide a company through the process of determining if an ESOP is the right tool for accomplishing its goals and objectives.