How to Benefit from Creative Use of an ESOP

By David L. James

An employee stock ownership plan is not just a way to reward longstanding, loyal employees with a stake in the business. Creatively employed, it can bring significant tax benefits to owners and employees alike.

Let's take the case of a fictional couple, Jim and Dolores Becker, who, like the heads of many family businesses, think of their employees as part of an extended family. The Beckers, who started their company 25 years ago, are now well off. They own 100 percent of the stock in the company, which represents virtually their total assets. While they plan to remain active in the management of the business, they want to transfer most of their holdings to their six children and ten grandchildren, and to their extended family — the employees — through an ESOP.

To create an ESOP, they contribute stock (or the cash to buy stock from the holders) to an ESOP, which must be approved by the board of directors. Or they can establish an ESOP that borrows the money to buy stock from the holders. The stock is then held in trust for the benefit of the company's employees. Shares of stock are allocated to the accounts of individual employees on the basis of a formula related to pay levels. Normally, participation is limited to salaried employees 21 or older who have at least 1,000 hours of service in a year.

Employees become "vested" in their ESOP accounts as they accumulate seniority with the company. When vested, the allocated shares become theirs, and they or their estates will be entitled to them, or their cash value, when they retire, leave the company, or die. Federal law requires that employees become fully vested within five years, or within seven years if vesting is at a rate of at least 20 percent a year after three years of service. If additional shares are allocated to an employee's account, they are immediately vested to the extent of the employee's vesting rights under the plan at the time.

Let's say the Beckers need cash to buy a retirement home. If they want to sell some of their stock to raise cash, they will be taxed on the gains — and it isn't easy to find a private buyer for stock in a small unlisted company. Besides, the owner may not want to have outside stockholders.

But if the new ESOP borrows funds to purchase at least 50 percent of the stock, the Beckers will be able to roll over the proceeds into a diversified portfolio of stock in other companies without any current taxation of the profit. The replacement stock will give them liquidity. They might then buy that retirement home and have money left for the four children who chose careers unrelated to the family business. Their other two children, who work in the business, would be given some of the company stock retained by the Beckers, and as employees they will also be credited with some of the ESOP's shares.

The Beckers' employees will benefit, too. They will not be taxed on the company's cash contributions to the ESOP (used to pay off the ESOP loan). And, as with other types of tax-favored retirement benefit plans, there will be no tax on dividends that accumulate from the ESOP shares, or on any appreciation in the value of the shares, until the employee retires or leaves the company and receives a distribution of their cash value. Even then, the employee may be able to roll over a lump sum distribution into a new employer's retirement plan, or roll over a partial or lump sum distribution into an individual retirement account, further postponing taxation.

The company will also benefit, because there is clear evidence that an ESOP helps motivate employees to achieve greater productivity. Employees simply work harder for an enterprise in which they have an ownership stake. In a 1986 study, the National Center for Employee Ownership in Oakland, California, analyzed samples of ESOP and non ESOP companies of comparable size and growth, and found that the employment and annual sales of the ESOP companies increased significantly faster relative to the others in the five years after they established ESOPs than in the previous five years.

An ESOP can be established without draining the company of its cash. The Becker ESOP will borrow the funds in order to purchase its stock from Jim and Dolores Becker. And since it will own at least 50 percent of the company's outstanding shares, the ESOP will qualify for lower interest rates on the loan (because the lender can exclude 50 percent of its interest income on such loans). In addition, the company will receive tax deductions for contributions it makes to the ESOP over a period of years to pay off the ESOP loan (up to 25 percent of payroll) as well as for dividends it pays on the ESOP shares.

Art and Beth Peck, the founders of Peck's Markets, a chain of supermarkets in upstate New York with sales exceeding $10 million, went all the way with an ESOP. In November 1987, the Pecks sold all of their stock to the company's ESOP, which had been established several years earlier. Funds to purchase the stock were borrowed from The National Cooperative Bank of Washington, D.C., which specializes in providing financial services to businesses owned or controlled by their employees, members, consumers, or users.

The Pecks realized substantial rollover tax savings in the transaction, and in addition, they retained title to the chain's real estate, so they will receive rental income in the years ahead.

Jim Nichols, general manager of Peck's Markets and a trustee of its ESOP, say that employee ownership is working well. At the outset, 20 of Peck's employees qualified to participate in the ESOP. (they used the normal eligibility standards: An employee must be 21 years old and have worked full-time or part-time for Peck's for a year, logging at least 1,000 hours annually.) Now there are 66 employee-owners, and only one full-time employee has left Peck's since it went ESOP. "Moreover," says Nichols, "sales were up 8.5 percent this year, and profits were up proportionately."

Art and Beth Peck are doubly pleased. They have literally left their business "in trust" to their employees, and they have obtained tax-advantaged financial security for themselves and have secured time to pursue other interests. Beth is delighted to have more time for her grandchildren and for the development of a new public library that she and Art are helping to build in Narrowsburg, New York. Art is absorbed in a number of new business projects and in his hobby of restoring antique cars.

As for leaving Peck's Markets, Art says,"We've sold our employees a going concern that's going to thrive."

David L. James, a senior corporate attorney for the Chicago law firm Arnstein & Lehr, has structured many ESOPs for small and mid-size companies.

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May 1990


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