Funding the ESOP
Most later-generation family businesses will face a liquidity crisis at some point in their life cycle—all too often when it is least expected, and when the family can least afford to be divided by a contentious issue.
A company, for example, may require reinvestment of profits to meet business needs while, at the same time, family owners inactive in the business may need dividends to help support their lifestyles. There also may be liquidity issues related to the death of a senior business leader—cash may be needed to fund taxes, estate administration fees and other expenses related to the senior leader’s estate.
Unfortunately, in many cases these situations result in conflict among family members that can affect the business. Employee Stock Ownership Plans—commonly known as ESOPs—can be an effective way of resolving liquidity issues such as these while maintaining family harmony. What’s more, ESOPs are a way of rewarding employees, who receive stock in the company without paying for it (but must vest over time). The owners can maintain control over the company if there are different classes of stock. There is yet another benefit—if a vehicle known as a “1042 rollover” is used, an ESOP program offers significant tax advantages.
What is an ESOP?
An ESOP is a type of qualified defined contribution plan that is invested primarily in employer stock. ESOP assets are held in trust for the benefit of plan participants. ESOPs are regulated by the Internal Revenue Service and the Department of Labor under the Employment Retirement and Income Security Act of 1974 (ERISA).
A simple way to think of an ESOP is as a profit-sharing plan that purchases company-owned stock instead of other public or private company stock.
Altogether, there are about 11,000 ESOPs covering 13 million employees, almost all in closely held companies. Another estimated 15 million employees participate in one or more of these plans in public companies.
Studies in Massachusetts, Ohio and Washington show that, on average, employees participating in ESOPs have considerably more in retirement assets than comparable employees in non-ESOP firms. The most comprehensive of the studies, a report on all ESOP firms in the state of Washington, found that the retirement assets were about three times as great, and the diversified portion of employee retirement plans was about the same, as the total retirement assets of comparable employees in non-ESOP firms. Many more ESOPs would be in place if individuals were properly educated on the functionality and overall structure of an ESOP.
Defined contribution vs. defined benefit plans
A defined contribution plan—such as an ESOP, a 401(k) or a 403(b) plan—is a retirement savings program under which an employer promises certain contributions to a participant’s account during employment, but with no guaranteed retirement benefit. The ultimate benefit is based exclusively upon the contributions to the plan and the plan’s investment earnings. The benefit ceases when the account balance is depleted, regardless of the retiree’s age or circumstances.
By contrast, a defined benefit plan is a pension plan (traditional pension or fixed pension) under which an employee receives a set monthly amount upon retirement, guaranteed for the life of the plan member or the joint lives of the member and spouse. This benefit may also include a cost-of-living increase each year during retirement. The monthly benefit amount is based upon the participant’s wages and length of service.
Leveraged and unleveraged ESOPs
There are two types of ESOPs: leveraged and unleveraged.
• In an unleveraged ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares.
• A leveraged ESOP borrows money to buy new or existing shares. The company makes cash contributions to the plan to enable it to repay the loan.
Funding the ESOP
The accompanying diagrams illustrate a leveraged ESOP transaction structure and movement of money over time. Figure 1 shows a financial institution lending money to the company (Step 1). Next (Step 2), the company lends an equal amount to an ESOP Trust to facilitate the purchase of stock, thereby creating an internal loan between the company and the ESOP Trust. Then (Step 3), the ESOP Trust uses the proceeds the company has lent to it to purchase shares of company stock from the selling shareholder(s).
Figure 2 shows the internal loan and the external loan from the financial institution being repaid over time. In Step 1, the company makes a contribution to the ESOP Trust. This contribution is tax-deductible because the ESOP is a qualified retirement plan. In Step 2, the ESOP Trust repays the principal and interest due on the portion of the internal loan between the company and the ESOP. In Step 3, the company uses the proceeds received from the ESOP Trust to repay the principal and interest on the loans provided by the lender.
Employee vesting
An ESOP must comply with one of two minimum schedules for vesting. (Plans more generous to participants may provide different standards).
• “Cliff” vesting: No vesting at all in the first years, followed by a sudden 100% vesting after not more than three years of service.
• “Graded” vesting: 20% vesting after the second year of service, with 20% more each year until 100% vesting occurs after the sixth year of service.
A “year of service” generally refers to a plan year in which a participant has worked 1,000 hours; it may include past service—to reward long-term employees for their contributions toward building the company and to motivate them going forward. If an employee has worked at the company for five years, for example, the company can elect to have a certain percentage of stock vested immediately.
ESOP stock is allocated to employees based on ongoing eligible compensation (up to $245,000 per year per employee). When employees leave the company before they are fully vested in their accounts, they forfeit the amount that is not vested. The forfeited stock is then reallocated to remaining participants. This may limit the amount of other contributions that can be allocated to such participants.
When employees leave the company, they receive their stock. The company must buy the stock back from them at its fair market value (unless there is a public market for the shares).
ESOP valuation
Since ESOPs exist within a regulated environment, it is required for the underlying shares held within an ESOP to be valued at the time of an ESOP transaction as well on an annual basis. An independent valuation is performed and presented to the ESOP trustee for review. The ESOP trustee reviews and negotiates the initial ESOP transaction and sets the valuation price annually thereafter.
In a leveraged ESOP scenario, the company’s equity value just before and after the ESOP transaction differs significantly. Let’s assume that in order to facilitate the transaction, the company must take on debt to acquire shares from shareholders. Thus, the company’s capital structure changes, and the company’s balance sheet has additional debt on a post-transaction basis. This has the effect of reducing the company’s equity value immediately after the transaction. Figure 3 shows the company’s equity value vs. its enterprise value and how equity value subsequently recovers as the financing is repaid over time.
Deferring taxation using the ‘1042 rollover’
Under Section 1042 of the Internal Revenue Code, an owner of a closely held C corporation can defer capital gains taxes on stock he or she sells to an ESOP if (1) the ESOP owns 30% or more of each class of outstanding stock or of the total value of all outstanding stock, excluding nonconvertible, non-voting preferred stock; and (2) the seller reinvests (“rolls over”) the sale proceeds into qualified replacement property (stocks or bonds of domestic operating companies) between three months before and 12 months after the sale.
The money “rolled over” into replacement property need not be the actual proceeds from the sale; it can be an equivalent amount of money from another source. Any or all of the proceeds can be rolled over; the seller(s) will simply pay taxes on the rest. Two or more owners may combine their sales to meet the 30% requirement if the sales are part of a single, integrated transaction.
Sellers using the Section 1042 rollover often avoid taxation completely by retaining the replacement property until death, at which time the property transfers to their heirs with a stepped-up basis. Section 1042 is a powerful tool for avoiding taxes within one’s estate planning.
The regulations allow for a fair amount of structural flexibility in meeting corporate objectives and timing expectations. Knowledge of the structural limits is critical in the implementation of an ESOP.
Tax benefits of an ESOP
Because of the ESOP’s status as a qualified retirement plan, there are several tax benefits.
• Contributions used to repay a loan that the ESOP takes on to buy company shares are tax-deductible. Contributions to repay the loan principal are deductible for up to 25% of the company’s eligible payroll of plan participants.
• Interest associated with the ESOP is tax-deductible.
• Dividends are tax-deductible when they are used to repay the ESOP loan (but only dividends on the shares bought with the loan can be used to make such payments).
• Cash and stock contributions are tax-deductible.
• Employees pay no tax on the contributions to the ESOP. They pay tax only on the distribution of their accounts.
• Sellers in a C corporation can get a tax deferral under Section 1042 of the Internal Revenue Code.
• Any profits attributable to the ESOP’s ownership of stock in an S corporation are not subject to federal income tax. A 30% ESOP pays no tax on 30% of its income; a 100% ESOP pays no tax at all.
Family involvement
The former family owners who have sold their shares to the ESOP can continue to be involved in the company’s operations in the following ways:
• Continuing to participate as a member of the company’s board of directors.
• Continuing to participate in the company’s day-to-day operations by performing the ongoing duties of a corporate officer. (This implies that former family owners are active managers in the business.)
• Becoming an internal ESOP trustee after the transaction. (Like other trusteeships, this involves risks.)
Two case studies
The owners of two companies recently were researching various alternatives, including selling the companies on the open market. In both cases, the M&A market was not receptive because the economic downturn had compressed valuation multiples significantly.
• Partial ESOP purchase: The owners of an industrial company implemented a partial sale via a 30% ESOP transaction that provided the sellers with the ESOP tax-deferred qualification. The entire transaction was funded with senior financing from a financial institution. Principal and interest payments were effectively tax-deductible to the company. The controlling shareholders plan to sell additional shares to the ESOP Trust before testing the market in the future. If the market does not yield an expected range of value that is suitable for shareholders, then a sale of the remaining shares to the ESOP may occur.
• Total ESOP purchase: The owners of a health-care company sold 100% of the company to an ESOP Trust through a combination of senior mezzanine and subordinated financing. The sellers elected to defer their proceeds using Section 1042 of IRS code. At the close of the transaction, the company elected S Corporation status and currently pays no taxes because the company is 100% owned by an ESOP.
Key points
Family business owners who sell stock to an ESOP receive fair market value for the stock (as if public) and can defer capital gains taxes indefinitely by electing the “1042 rollover” tax provision. Debt principal and interest is amortized with pre-tax dollars, thereby increasing working capital by saving 35% to 40% of every dollar repaid to the lender. If preferred dividend-bearing stock is used within the ESOP, the dividend can be deducted from the company’s profits for tax purposes.
For an ESOP to function properly, the company must have consistent earnings and a substantial non-union payroll. Always conduct a feasibility study before adopting an ESOP.
An ESOP can provide many financial advantages—but each situation should be financially analyzed in depth before implementation.
Richard Houlihan, CPA/ABV, ASA, is co-founder and chairman of Houlihan Smith & Company (www.houlihansmith.com), a national investment banking firm that provides financial options, valuation and corporate advisory services to public and private businesses.