ESOP - A Brief Introduction

What is an ESOP?

What is an ESOP?

Employee Stock Ownership Plan (ESOP) is a Defined Contribution Plan that invests in Employer Securities. A trust is created, and a Trustee administers the plan for the sole benefit of the Employees. ERISA guidelines (Federal rules that regulate Pension plans) must be followed.

Why should an ESOP structure be considered by a business owner who wants to sell? One notable part of the answer lies in tax incentives. Congress has seen fit to use taxpayer funds to promote and pay for Employee ownership of businesses.

Problem: How to effect a liquidity event for your business, i.e. sell in whole or in part.

Solution Possibilities, Sell to:

1. A Competitor (Strategic Buyer)

2. Private Equity (Financial Buyer)

3. Management Team (MBO)

4. An ESOP.

Selling to an ESOP is the optimum choice in many situations.

Benefits include:

1. TAX savings – tremendous savings for the Selling Shareholder(s), the Company and the Employees:

   1. Company – borrows money equivalent to its Enterprise Value (external source of funding e.g., bank and sometimes supplemented by Private Equity as well as Seller’s Note), and then loans the equivalent amount to the ESOP (internal loan) which then buys the Owner’s equity with the proceeds. The Company then makes yearly payments to the ESOP which in turn uses those funds to repay the loan from the Company. The yearly payments by the Company are tax deductible since they are deemed contributions to a Qualified Pension Plan.

   2. Employees – only Employees can be members of an ESOP, which itself pays no federal and, in most states, no state income tax, creating a huge competitive advantage. Employees pay no taxes on contributions until withdrawal/distribution. The ESOP will have rules for employees who leave the company e.g., retirement, but income tax on distributions to the retiring Employee can be further deferred via rollover to an IRA. Additionally, key Employees (upper management) can be given Stock Appreciation Rights, which have longer vesting periods, so that they are incentivized to stay with the company and work hard to help it succeed.

   3. Selling/retiring Owner – if the Company is a “C” corp., capital gains taxes will be deferred, and in some cases, avoided, if held for at least 3 years, through an IRC 1042 Election. Various rules must be followed but the Seller has 12 months to buy replacement property (US stocks and bonds only). Capital gains tax is paid when the replacement property is sold (tax deferred), and if not sold by the date of the Seller’s death, there is a step-up in cost basis to market value at that time (tax avoided).

   4. If Company is an “S” corp., its income would have formerly passed through to the Seller/Owner and taxed at the Owner’s marginal tax rate. Now the income will be passed through to the ESOP which will avoid paying ALL income tax due to its status as a Qualified Pension Plan. This feature of the ESOP not paying income tax continues indefinitely.

2. Enterprise Value – Highly competitive valuations as the EV are usually maximized via sale to an ESOP. A 100% acquisition by either a competitor or Private Equity often results in a discount being paid whereas an ESOP is required to pay Fair Market Value.

3. Continuity – In a 100% acquisition situation, the acquirer is free to make any management decision it deems appropriate or expedient. If the acquirer is a competitor, it often streamlines operations and eliminates senior management positions e.g., CEO, President, COO, CFO, CIO etc., as those duties can be handled by its own management team. This is not usually appealing to a Seller whose family and key employees currently occupy those positions.

4. Employees become Business Owners – The only people allowed by law to own shares in an ESOP are its Employees. Their shares are vested over time according to the rules set up by the ESOP Board of Trustees. They grow in value, tax-deferred, like a 401(k), increasing in value with the profitability of the Company until they are redeemed (by retirement or another event whereby the employee leaves the Company). Studies show Employees’ productivity increases when they own a “piece of the pie”, and increased productivity leads to increased profitability. This enables a Company to attract, retain and motivate key employees.

5. Future Acquisitions – An ESOP has a competitive advantage by being able to make a strategic acquisition with pre-tax dollars, since it doesn’t pay income tax.

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For additional information and sharable resources please contact:

Tim Sperling, J.D.