Creating a Company Legacy
Every 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 options, 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, which could help retain wealth and financial security.
An employee stock ownership plan (ESOP) is one of many succession strategies available. While an ESOP isn’t the right fit for everyone, it may be an attractive option for many companies.
What’s an ESOP?
An ESOP is a qualified defined contribution plan, governed by the Employee Retirement Income Security Act of 1974. While it’s similar to a 401(k) plan, the primary difference is that an ESOP is designed to invest primarily in the company sponsor’s stock.
According to the National Center for Employee Ownership, there are now approximately 6,600 ESOPs in the U.S. covering more than 14 million employees. Nearly 4,000 of these ESOPs 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.
Owners of closely held companies often 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 above the door. For many owners, this isn’t a palatable option.
An ESOP can help address these concerns while providing a viable means of creating stockholder liquidity over time. When considering an ESOP transaction, it’s important to remember that selling stockholders can continue to manage 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 to take 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 all or 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 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 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. To take advantage of §1042, the company must be a C corporation at the time of the sale transaction and the ESOP must own at least 30 percent of the employer stock after the transaction’s completion. The taxpayer also must have held the securities for at least three years prior to the sale.
The selling stockholder is required to reinvest in qualified replacement property (QRP) within 12 months of the sale date. 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 income tax avoidance.
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, §1042 gain deferral hasn’t been widely used in recent years.
The selling stockholder certainly isn’t the only one to reap an ESOP transaction’s tax advantages. The company can realize substantial tax savings as well. Because a leveraged ESOP company 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 certain 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. The company can retain this cash to pay off acquisition debt, support company growth or even fund acquisitions.
ESOPs can provide significant retirement benefits to long-term employees of construction companies. 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 annual contributions to the plan, 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, participants 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 will usually participate in the ESOP along with other employees. However, to retain key management and help ensure their goals and objectives are properly aligned with the ESOP’s, it’s often 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.
The ESOP Solution
An ESOP can be a powerful succession planning tool for certain 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’re seeking.
ESOPs are inherently complex, but an experienced advisor can help business owners determine if an ESOP is the right tool for accomplishing their goals and objectives. For more information, reach out to your BKD Trusted Advisor™ or use the Contact Us form below.