What Is An ESOP And Is It Suitable For Your Company?

This article will acquaint you with the utility of the employee stock ownership plan (ESOP) as both a technique of corporate finance and an employee benefit plan. It is important to note, however, that there are many other types of employee benefit plans and benefit plan combinations that can invest in stock of the employer sponsor. There are profit sharing plans, stock bonus plans that are not ESOPs, and plans involving combinations of 401(k) arrangements and profit sharing plans. All of these plans, if properly designed, can be effective means for including equity as a component of an employee benefit plan structure. While we cannot cover all of these alternatives in a single article, we will comment on them in future editions. It is important to note, that the ESOP, even with its different variations, is just one of the alternatives in this area.

Overview of Three Types of ESOPs

Ever since the Tax Reform Act of 1986 when certain types of ESOPs were repealed, there has been technically only one type of ESOP defined in the Internal Revenue Code. For the purposes of this article, however, and for conceptualizing the different uses and characteristics of ESOPs, this article will discuss three "types" of ESOPs. Although these three "types" are really three "uses," in practice it helps to think of ESOPs in this manner. All of the transactions or qualified plans that involve ESOPs are simply variations on one of these three types of ESOPs.

Non-Leveraged ESOP

This first type of ESOP is one that does not involve borrowing any funds to acquire stock of the sponsoring employer. It is funded by contributions of cash or stock directly from the employer sponsor. Shares of stock contributed by the corporation are "newly issued shares." New shares are issued to the ESOP and a deduction is taken by the corporation for their appraised fair market value as of the date of contribution. Alternatively, cash can be contributed to the plan in annual discretionary amounts as cash flow permits, to purchase shares at a later date, or simultaneously, either from the corporation or from another shareholder.

Generally, a non-leveraged ESOP is established to promote growth of the company sponsor by creating tax deductions with newly issued shares, thus improving cash flow and reducing taxes. It is also one of the best plans for gradual accumulation of retirement benefits tied to the value of employer stock and for promoting participatory management structures. The purpose of the ESOP can be to purchase shares from a shareholder on a cash flow basis where the tax incentives attributable to leveraged ESOPs are either not important or do not require borrowing funds. Using a non-leveraged ESOP will also avoid the impact of debt on the corporation’s value and balance sheet. Also, funding an ESOP on a cash flow basis suggests that the company’s obligation to repurchase shares from departing participants may be easier to manage than with the leveraged variety. This corporate obligation is called "repurchase liability."

Leveraged-Issuance ESOP

An "Issuance ESOP" uses financing to acquire newly issued shares from the employer sponsor. The shares are allocated to the participants’ accounts as the loan is repaid. During this repayment, the shares are released from a special ESOP account, called a "suspense account," to the ESOP participants’ accounts according to formulas developed by the IRS.

The corporate advantages of an Issuance ESOP are that it creates tax advantaged financing for purchasing capital goods, for expanding by merger or acquisition, or simply by increasing capital formation. For whatever purpose, the principal borrowed to buy the stock effectively becomes tax deductible by virtue of it being repaid via plan expense/contributions. The company is therefore able to borrow money this way on a fully deductible basis.

Several side effects of Issuance ESOPs must be considered. First, they have a dilutive effect on existing shareholders. Second, there is repurchase liability for the future retirement benefits in the plan. The company will some day have to repurchase shares distributed from the ESOP to participants. For whatever purpose, therefore, the ESOP is effectively permitting the company to "borrow from its retirement plan" by permitting current deductions for contributions that are used as capital in the company, until benefits need to be paid. This improves the corporation’s cash flow, pending a required retirement or other future plan distribution when shares are distributed and repurchased.

Leveraged Buyout ESOP

This form of leveraged ESOP is a lot like the Issuance ESOP, except the financing is used to buy stock from a selling (and usually retiring) shareholder.

These transactions have gained notoriety as a succession-planning tool for closely held businesses. The tax incentives that accompany these types of transactions include tax-deferred capital gains tax-favored below prime rate financing from qualified lenders. They can be very compelling from an estate planning or succession-planning viewpoint. A seller who properly structures his transaction may sell his stock to an ESOP and not pay any immediate capital gains tax on the sale. The seller may reinvest the sale proceeds within 12 months of the stock sale to the ESOP and defer the capital gains tax liability indefinitely (known as a "1042 Rollover Transaction"). This is much like the election available to reinvest the proceeds from the sale of your house. As a result, the seller will have all of the deferred taxes at work in his reinvestment portfolio. The company, in turn, will have paid the purchase price entirely in pre-tax dollars.

As in the Issuance ESOP, the debt principal effectively becomes payable with pre-tax dollars. Another consequence is that the corporation’s future repurchase liability will be equal to the fair market value of the stock purchased by the plan. In contrast to the Issuance ESOP, no dilution is suffered by existing shareholders. Shareholders who do not sell their shares to the ESOP may find themselves competing with the corporation for asset with which to sell their stock in the future, if repurchase liability or growth in the stock value, or a combination of both, create a significant drain on corporate cash flow. It may not be efficient, or prudent, however, to overburden a company with such debt.

TAX ADVANTAGES OF LEVERAGED ESOPs
The following is the briefest laundry list of tax advantages built into the Internal Revenue Code for ESOPs. For specific information on how they operate, contact our office, or look for future articles.

1. Tax deferred "1042 Rollovers" of capital gain from sale of stock.
2. Purchase stock with pre-tax cash flow.
3. Deductible principal on ESOP loans.
4. Partial or complete purchases of ownership interests.
5. Tax deductible dividends on ESOP shares.
6. Increased contribution and deduction limits for ESOPs.
7. S corporation ESOPS.

What to Do?
In order to fully understand whether some type of ESOP or ESOP transaction can be good for a company and its employees, it is critical to first identify the objectives of all those involved. Often there are overlapping and conflicting objectives. For example, the company’s expansion objectives or other shareholders objectives may compete with the objectives of the potential selling shareholders. Furthermore, the impact of an ESOP on the employees and the ability to motivate employees must be seriously considered. In this regard, employee questionnaires, feasibility studies and further information and assistance from organizations like ours and the National Center for Employee Ownership (NCEO) and the ESOP Association can go a long way towards helping you answer these questions. Our firm has a wide range of information which covers these various ESOP applications and some of the related tax, financial and employee benefits issues that accompany them.

Editors Note:
We did the best we could to make sure that the information and advice in this article were current as of the date shown above. Since the laws and the government's rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to be specific legal advice to you. If you would like that, visit us at http://www.seethebenefits.com/ or give us a call at (916) 362-5558.

Copyright 2003 Chang Ruthenberg and Long PC All Rights Reserved.