ESOPs: Not A Magic Bullet…

…but a viable retirement vehicle for business owners

According to a recent survey conducted by the Employee Benefit Research Institute, workers’ confidence in their ability to live comfortably in retirement has hit a new low. Confidence about having enough money for a comfortable retirement this year hit its lowest level (13 percent) since 1993, continuing a two-year decline.

Retirees also posted a new low in confidence about having a financially secure retirement, with only 20 percent now saying they are very confident (down from 41 percent in 2007). For many business owners, the company is their source for funding retirement. However, creating enough liquidity in the business to generate retirement funds can be difficult if not planned appropriately. Owners should engage in a strategic plan to achieve financial goals and create a sound retirement vehicle. One such plan is an employee stock option plan (ESOP) that not only creates liquidity, but also motivates employees and retains key employees to continue the business legacy.

What is an ESOP?

An ESOP is a qualified, defined contribution employee benefit plan, under Sections 401(a) and 4975(e)(7) of the Internal Revenue Code, that invests primarily in the stock of a sponsoring employer company. ESOPs allow employees to acquire an ownership interest in their employer company by participating in the ESOP. An ESOP is unique from other qualified plans in that it may borrow money and engage in related party transactions to acquire company stock from the business owner. As such, the ESOP functions as a means of financing the ownership transition in a taxfavored manner.

However, similar to other qualified retirement plans, ESOPs are subject to the same general regulatory requirements and laws of the Internal Revenue Service (IRS), the Department of Labor (DOL) and the Employee Retirement Income Security Act of 1974 (ERISA). The IRS oversees the deductibility of the contributions to the ESOP, and the DOL ensures the plan is properly administered and that participants in the ESOP are treated fairly. Federal and state securities laws, including Securities and Exchange Commission (SEC) regulations, may apply if the company is publicly traded.

Some common uses of an ESOP include:

• Buying stock of a retiring or departing shareholder
• Creating liquidity for shareholders
• Estate planning
• Management succession planning
• Capital for expansion
• Acquisitions
• Leveraged buy-out by management
• Motivating employees
• Employee benefit
• Charitable giving

Implementation of an ESOP
If done properly, an ESOP can be a very effective employee retention tool that motivates workers to take ownership of the business, both literally and figuratively. Employees are able to gain stock ownership in the employer corporation and therefore, have a financial interest in increasing the value of the company. Employees are motivated to be more effective, accountable and productive.

The initial setup and maintenance of an ESOP can be somewhat complicated depending on the complexity of the employer corporation and ESOP design. Basically, the employer company creates a trust to which it will make annual contributions. The contributions are appropriated to employee accounts within the trust. The allocation may be in proportion to compensation or years of service or a combination of the two. Employees may be eligible for allocation after one year of employment or 1,000 hours.

Stock or assets allocated to employee accounts must vest before they are distributed to employees. Vesting is an ERISA guideline that stipulates employees are entitled to the plan benefits within a certain period of time. The vesting period may range from 20 percent per year until employees are fully vested after seven years of service, to the entire employee account vested immediately.

When an ESOP employee who has at least 10 years of participation in the ESOP reaches age 55, he or she must be given the option of diversifying his/her ESOP account up to 25 percent of the value. This option continues until age 60, at which time the employee has a one-time option to diversify up to 50 percent of his/her account. Employees may receive the vested portion of their accounts upon termination, disability, death or retirement. The employer corporation must give the participating employee a “put option” on the stock. A “put option” gives the employee the right to sell a specified amount of stock at a specified price and time. Therefore, the company must have enough liquidity to satisfy this obligation when the employee exercises the option.

Leveraged ESOPs
Only a small number of companies are in a strong enough financial position to buy out an owner in an all-cash purchase. Consequently, utilizing an ESOP in conjunction with debt financing is an attractive means of accomplishing an owner’s exit strategy.

If structured properly, a leveraged ESOP can provide benefit to all parties involved. The advantages of a leveraged ESOP include: (1) enhancing cash flow; (2) obtaining financing; (3) increasing productivity; (4) motivating employees; and (5) attracting employees. In a leveraged ESOP, the employer corporation borrows money from a lending institution or the existing owners to buy company stock. The stock is put in escrow and released as the loan is repaid. With a leveraged ESOP, both the loan interest and principal are tax deductible (up to certain limits). This is a distinct tax advantage, and can greatly increase operational cash flow. A leveraged ESOP also allows a company to defer paying some of the plan’s benefits to employees until the loan is fully repaid. Additionally, dividends paid on the ESOP stock passed through to employees or used to repay the ESOP loan are tax deductible, which increases cash flow availability versus conventional financing.

Advantages & Disadvantages of an ESOP
There are several tax advantages of an ESOP, including the deductibility of principal payments and dividends discussed previously. These deductions provide additional working capital to the company. Another advantage is a tax-free rollover. (In a §1042 rollover, the seller must have owned the stock for a minimum of three years.) In a tax-free rollover, shareholders selling stock to the ESOP can defer federal income taxes on the gain from the sale. To qualify for the tax-free rollover treatment, the ESOP must acquire at least 30 percent of the employer corporation stock. Additionally, there are certain time constraints and participation limits for qualification.

Contributions made to the ESOP are tax deductible to the employer corporation up to certain limits. With this advantage, contributions can be either in the form of cash (the cash is then used by the ESOP to buy more employer stock) or employer corporation stock. When stock is contributed directly, the employer corporation can take a tax deduction for the contributed stock’s full fair market value. Thus, the employer corporation increases its earnings by the value of the taxes saved by taking the deduction. If a leveraged ESOP is utilized, the value of the deductions is even more beneficial.

As stated earlier, an ESOP can be a viable tool for motivating employees and increasing productivity. The increase in productivity is likely to lead to significant profits, company value and future employee benefits. Further, owners do not have to give up operational control of the business. An owner can sell as little as 30 percent of the employer corporation to the plan. Essentially, an ESOP provides the owner with a means to retain control of the business while selling off a portion of the stock free of capital gains tax.

Of course, as with any qualified employee benefit plan, there are disadvantages. An ESOP can be complicated to plan and administer. An ESOP transaction involves several different professionals: (1) valuation; (2) legal and regulatory; (3) qualified plan administration; (4) finance; and (5) fiduciary responsibility. Owners must be aware of the legal and tax issues to reap the full benefits of the ESOP. Further, the employer corporation must be financially strong enough to handle debt payments without jeopardizing company operations. The departing owner must also have a knowledgeable management team if he/she desires to retire. Also, when exercised, the “put option” may cause a cash flow shortage if too many employees exercise this option at once. (To avoid this, the company can set aside cash or buy insurance to offset cash flow depletion.) Another ESOP negative may arise from a failure on behalf of fiduciaries if fiduciary duties are breached; this may expose the employer corporation to potential damages, claims and/or hefty excise taxes (i.e., selling stock to the ESOP at inflated prices).

It must be mentioned that S corporations may have ESOPs as owners. However, these ESOPs do not qualify for tax-free rollover treatment, cannot deduct dividends and must apply interest payments on an ESOP loan toward contribution limits. Nevertheless, as with all pass-through entities, income is not taxable at the corporate level.

ESOP valuations
Every qualified ESOP is part of a trust that is covered by the ERISA. The trust is overseen by the ESOP trustee. Under ERISA Section 401(a)(28) (C), all valuations of employer corporation stock that are not readily tradable must be conducted by an independent appraiser. The valuation of the stock must be conducted annually. It is important that the price paid by the ESOP for the employer stock is of adequate consideration. Adequate consideration is defined by ERISA Section 3(18) (B) as, “the fair market value of the asset as determined in good faith by the trustee or named fiduciary […] pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary of Labor.” Fair market value is defined by the DOL proposed regulations as the amount at which the company stock would change hands between a willing buyer and a willing seller, each having reasonable knowledge of all relevant facts, neither being under any compulsion to act, and with equity to both.

An independent valuation analyst must provide a theoretically supportable valuation that incorporates all appropriate methodology and analysis as well as provides the ESOP trustee the necessary information on which to make sound financial decisions for the plan. The valuation analyst must understand ERISA, DOL and IRS guidelines, as well as take into consideration the impact of the employee put options, especially the payment terms and the company’s ability to meet repurchase obligations. ESOP trustees must only engage experienced valuation analysts who are certified by one or more of the recognized professional valuation associations: the National Association of Certified Valuation Analysts (NACVA), the American Society of Appraisers (ASA), the American Institute of Certified Public Accountants (AICPA) or the Institute of Business Appraisers (IBA).

Feasibility – is an ESOP right for you, your employees and your company?
One of the first things to consider when assessing the feasibility of an ESOP is the value of the employer corporation. However, other factors, quantitative and qualitative, must be considered.

• Successor management team: For an ESOP to be a successful means of exit for a business owner, there must be a successor management team identified who will support the ESOP. If this team does not exist, an ESOP is not a viable option.
• Corporate culture: The corporate culture must be favorable to a shared management style.
• Company size: The employer corporation must be large enough to warrant an ESOP (i.e., must have more than 20 employees and more than $250,000 in payroll).
• Company age: The more mature the employer corporation, the better. An ESOP is not suitable for start-up companies or those that are already highly leveraged, as the ESOP will likely interfere with business growth plans.
• Earnings history: The employer corporation must have a strong history of earnings and cash flow. This level of earnings must be expected to continue into the future.
• Balance sheet: If owners are contemplating a leveraged ESOP, the employer corporation must have a strong balance sheet with sufficient equity and therefore not overly leveraged.
• §1042 Rollover: If a leveraged ESOP is planned, the employer corporation must be a C corporation for the owner to take advantage of §1042 rollover treatment. The owner of a C corporation can defer the capital gains tax on stock he or she sells to the ESOP if: 1) the ESOP owns 30 percent or more of each class of outstanding stock or of the total value of all outstanding stock; and 2) the seller reinvests (“rolls over”) the sale proceeds into qualified replacement property during the period from three months before to 12 months after the sale.
• Existing Retirement Plans: The employer corporation may already contribute to an existing benefit plan for its employees. An existing plan may indicate the company’s ability to engage in a new plan as well as indicate the employees’ ability to be motivated or incentivized by another employee benefit plan.
• Administration Costs: All parties involved must be aware of the administrative costs of an ESOP. ESOP administration, both initially and ongoing, can be costly. A company’s cash flow must be able to sustain additional annual legal, accounting and appraisal fees.

ESOP Statistics

(Information provided courtesy of The ESOP Association)

• There are approximately 11,500 ESOPs in place in the U.S., covering 10 million employees (10% of the private sector workforce).
• These employees draw in excess of three percent of their total compensation from ESOP contributions.
• The growth of ESOP formation has been influenced by federal legislation. While the rapid increase in new ESOPs in the late 1980s subsided after Congress removed certain tax incentives in 1989, the overall number has remained steady with new plans replacing terminated ESOPs. Currently, it is estimated that there are approximately 11,500 ESOPs in place in the U.S. However, there is no precise way to measure this figure accurately since the overwhelming majority of ESOP companies are privately held and do not file public reports with the SEC.
• An estimated 7,000 of the 11,500 companies have ESOPs that are large enough to be a major factor in the corporation’s strategy and culture.
• About 330 ESOPs (three percent) are in publicly traded companies. However, these companies employ just under 50% of the nation’s 10 million employee owners.
• Approximately 4,000 ESOP companies are majority-owned by the ESOP.
• Approximately 2,500 are 100% owned by the ESOP.
• About two percent of ESOP companies are unionized.
• While ESOPs are found in all industries, more than 25% of them are in the manufacturing sector.
• At least 75 percent of ESOP companies are or were leveraged, meaning they used borrowed funds to acquire the employer securities held by the ESOP trustee.
• A majority of ESOP companies have other retirement plans, such as defined benefit pension plans or 401(k) plans, to supplement their ESOP.
• Of the 11,500 employee-owned companies nationwide, fewer than two percent were financially distressed when they established their ESOP.
• Total assets owned by ESOPs were estimated to be $800 billion at the end of 2006.

In conclusion
Perhaps Indiana State Treasurer Richard Mourdock* said it best. “An ESOP is not a silver bullet or magic pixie dust, and running a business is always tough. Converting a failing company into an ESOP is never a good idea, and many ESOPs that failed were created as a last-ditch effort. The truth remains that thousands of large and small ESOP companies, some 100 percent employee-owned and others partially employee-owned, are succeeding during these difficult times because of the entrepreneurial environment created by the ESOPs.” He goes on to say, “ESOPs may appear complex, but they are simply a retirement plan that allows employee-owners to have a real stake in their future.”