CHAPTER 27

Employee Stock Ownership Plans

Many owners of private companies desire partial shareholder liquidity without having to lose control of the business. These owners may also want to transfer beneficial ownership of their companies to their employees. This can be accomplished in numerous ways. Employees can buy stock directly, be given stock as a bonus, receive stock options, or obtain stock through a profit-sharing plan. A common form of employee ownership in the United States is the employee stock ownership plan (ESOP). The ESOP is popular because it can accomplish the transfer objective in a much more tax-efficient manner than the other methods. More than 11,000 companies now have these plans, covering more than 13 million employees. This chapter describes ESOPs in general, illustrates the issues surrounding ESOP implementation, and concludes with a discussion of points to consider regarding an ESOP creation.

The ESOP is at once a corporate finance tool and a qualified retirement benefit for employees; it is also a means of redistributing industrial wealth to workers in an effort to stimulate economic growth. Because of this, ESOPs have enjoyed continued support from both aisles of Congress since their creation several decades ago.

The modern-day ESOP parallels the theory first put forth by a prominent German economist, Johann Von Thunen, during the early days of the Industrial Revolution. Von Thunen put an ESOP of sorts into being when he set aside a share of his farm's profits for his employees. He invested the profits in machinery that would enhance earnings. A portion of the profits was then put in each worker's name. Earnings that were invested in other than capital equipment spun off interest, which was allocated and distributed to the employees as a second income. The principal itself expanded and was distributed to the employee at retirement.

Given the significant tax breaks afforded capital owners, the amplified retirement benefit afforded employees, and the resultant enhanced governance requirements, ESOPs are highly regulated by various government agencies. The Internal Revenue Service (IRS) enforces the tax issues surrounding ESOPs. The U.S. Department of Labor enforces many provisions of the Employee Retirement Income Security Act of 1974 (ERISA). ERISA established the ESOP as a type of tax-qualified retirement plan and continues to be the primary law overseeing its usage. Other governmental agencies, such as the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA), may be involved, especially with regard to ESOPs in regulated industries.

Companies and their owners can use ESOPs for a variety of purposes. Structured properly, with an ESOP, the owner of a privately held company can:

• Sell stock of the company, pay no tax on the proceeds, and still keep control.
• Increase the company's working capital and cash flow with no cash expenditure and no productive effort.
• Buy out minority and majority stockholders with pretax dollars.
• Make acquisitions with pretax dollars that are tax free to the seller.
• Cut the cost of borrowing loan principal nearly in half by deducting principal payments as well as interest.
• Provide employees equity upside with no cash outlay on their part or the owner's part.
• Create the ESOP and achieve these objectives without the approval of employees.

Although ESOPs are used by public companies, this use accounts for less than 15% of all ESOPs. ESOPs are used most commonly to provide a market for the shares of departing owners of successful private companies, motivate employees, and take advantage of incentives to borrow money for acquiring new assets with pretax dollars. In almost every case, ESOPs provide beneficial stock ownership through contributions to the employee, not an employee purchase. Exhibit 27.1 shows the transfer matrix for ESOPs.

EXHIBIT 27.1 Transfer Matrix: Employee Stock Ownership Plans

Transfer Method	Employee Stock Ownership Plans
Definition	An ESOP is a qualified plan under the Employees Retirement Income Security Act of 1974 (ERISA). An ESOP is a tax-qualified defined contribution plan that has two distinguishing features: (1) It is allowed to invest exclusively in the stock of its sponsoring company, and (2) it can borrow money. A sponsoring corporation can contribute cash or stock to an ESOP on a tax-deductible basis. Owners of private companies can sell all or part of their stock to an ESOP at fair market value, often completely avoiding capital gains tax on the transaction.
Owner motives	An owner desires to transfer the company to employees, increase after-tax earnings, diversify personal assets, and still control key decisions.
Means of transfer	An ESOP industry is available to help structure all types of ESOPs. These services range from initial feasibility and financing to annual plan compliance.
Authority	ERISA, Department of Labor, FINRA, ESOP consultants.
Value world(s)	Fair market value.
Capital access point(s)	Bank term loan, possible mezzanine or equity investment for multi-investor ESOP structure.
Key points to consider	With a well-planned ESOP, the selling shareholder may never recognize a capital gain from the transfer. Private foundations and charities can be used in connection with an ESOP. Company cash flow increases because taxes are reduced as the ESOP loan is repaid. Typically, employee performance increases in ESOP companies. An ESOP creates debt in a company, which might restrict its ability to finance future opportunities.

OVERVIEW

Technically, ESOPs are tax-qualified, defined contribution plans that are stock bonus plans or a combination of a stock bonus plan and a money purchase plan designed to invest primarily in the employer securities. Unlike other plans, they may borrow money to do so.

In an ESOP transaction, a corporation sets up a trust fund, called an employee stock ownership trust (ESOT), into which it contributes new shares of its own stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible and cannot exceed 25% of annual qualified payroll expenses.

ESOPs are tax-exempt entities for federal and state corporate income tax purposes. This enables the company to make cash and/or company stock contributions to the ESOT, which are then used to acquire stock of the company or other business assets on behalf of its employees. Through an ESOP, employees can be given beneficial ownership of employer stock without paying current income tax on the stock or typically ever actually owning the stock in the classic sense. This results because the contribution is made entirely by the company and is not taxed to employees personally as it is allocated. The advantage to the company is that the ESOP makes pretax dollars available to finance company growth and/or create ownership liquidity at the time of retirement.

Shares in the trust are allocated to individual employee accounts. Although there are exceptions, generally all full-time employees over age 21 participate in the plan. Employees who are union members and are parties to a collective bargaining agreement may legally be excluded from participating in the ESOP, although they do not have to be. Allocations are made on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within five to six years.

When employees leave the company, they may receive their stock, which the company must buy back from them within a prescribed period of time at its fair market value. However, most plan agreements preclude employees from actually taking title to the shares vis-à-vis a share redemption agreement. Private companies must have an annual outside valuation to determine the price of their shares. As Chapter 8 indicates, when the reason for the appraisal is to value an ESOP, the fair market value world applies. In private companies, regardless of who is the trustee of the ESOT, employees do have very narrow voting rights. They must be able to vote their allocated shares on major issues, such as closing or relocating the business or the sale of substantially all of the company assets, but the company's board can choose whether to pass through voting rights on any other issues.

Uses for ESOPs

There are several primary reasons why an ESOP is used to acquire a business interest:

• To buy the shares of an owner. ESOPs create a captive, ever-willing buyer for private shares of the sponsoring company's stock. Furthermore, the company makes tax-deductible cash contributions to the ESOP to buy out these owner's shares, whether the source of the money was the company's cash flow or a third-party loan made to the company and its ESOP. As such, the ESOP can buy out minority or majority stockholders with pretax dollars. Once the ESOP owns 30% of all the shares in the company (C corporations only), the seller can reinvest the proceeds of the sale in other U.S. securities and defer any tax on the gain. By using a floating rate note (FRN) and a monetization loan, the owner can defer the tax indefinitely. This deferral strategy is discussed in next section, “ESOP Tax Deferral.” The vast majority of ESOTs are trusteed by the controlling shareholder, who may remain a paid employee and controls the voting of the block of stock owned by the ESOP/ESOT.
• To borrow money at a lower after-tax cost. ESOPs can borrow money, which makes them unique among benefit plans. After the ESOP borrows money to purchase company shares, the company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible, within certain limits. For example, for each $1 million of qualifying credit, the company can save approximately $700,000 (assuming a 30% tax rate). Deducting principal enables a company to effectively borrow much less expensively than conventional borrowing.
• Acquire other companies with pretax dollars that are tax-free to sellers. If the acquisition target (seller) sells her company's stock to the ESOP of the buyer, rather than directly to the buyer, and the target company would otherwise qualify for the ESOP tax deferral, then the target may legally elect the ESOP tax deferral. As the money used to acquire the target's shares was the ESOP money, the acquisition was done with substantially less (pretax) dollars, as well.
• To create an additional employee benefit. The stock in the ESOP provides employees equity upside (and downside) with no cash outlay on their part or on the part of the seller or provider of those shares. The shares in the ESOP do not have to have come from an owner selling the shares. The company can also issue new or treasury shares to an ESOP, deducting their value up to 25% of covered payroll expense from the company's taxable income. Or a company can contribute cash, buying shares from existing owners.
• Increase working capital and cash flow. For many companies, 25% of their annual payroll expense is equivalent to all or most of the company's taxable income. Thus, these tax-deductible contributions create a tax shield on the company's earnings, which increase the cash flow and therefore the working capital of the business by the amount that would of otherwise be paid in taxes. If the tax-deductible ESOP contributions were made in newly issued employer stock rather than cash, then these increases in assets and cash flow were made without a cash or productive expenditure. However, this would create dilution to existing shareholders.

ESOP Tax Deferral

Most owners are drawn to an ESOP initially because of the promise of deferring taxes on the sale. This deferral often represents a substantial tax savings. For example, a shareholder who owns stock worth $10, million, with a basis of $1 million, will pay almost $2 million in federal and state income taxes on a typical sale, assuming a combined federal and state tax rate of approximately 20% ($10 million – $1 million × 20%). In contrast, by selling stock to an ESOP, the shareholder will pay no federal income taxes and possibly no state income taxes on the sale. The selling shareholder will net $10 million on the sale, a tax deferral of $2 million. However, this ESOP tax deferral is available only if the next requirements are satisfied pursuant to Section 1042 of the Internal Revenue Code:1

• The selling shareholder must be an individual, a trust, an estate, a partnership, or a subchapter S corporation and must have owned the stock sold to the ESOP for at least three years.
• The selling shareholder must not have received the stock from a qualified retirement plan (e.g., an ESOP or stock bonus plan), by exercising a stock option, or through an employee stock purchase program.
• The company establishing the ESOP is a C corporation (not an S corporation).
• The sale must otherwise qualify for capital gains treatment but for the sale to the ESOP.
• The stock sold to the ESOP must (in general) be voting common stock or preferred stock that is convertible into voting common stock.
• For the 12 months preceding the sale to the ESOP, the company that establishes the ESOP must have had no class of stock that was readily tradable on an established securities market.
• After the sale, the ESOP must own at least 30% of the company that establishes the ESOP (on a fully diluted basis). The company also must consent to the election of 1042 tax-deferred treatment, and a 10% excise tax is imposed on the company for certain dispositions of stock by the ESOP within three years after the sale. There is also a 50% excise tax imposed on the company should there be a prohibited allocation of the stock purchased by the ESOP where the seller deferred the gain.
• Within a 15-month period beginning 3 months before the sale to the ESOP and ending 12 months after the sale, the selling shareholder must reinvest the sale proceeds in qualified replacement property (QRP), which are replacement securities (common or preferred stock, bonds, and/or debt instruments) issued by publicly traded or closely held domestic corporations that use more than 50% of their assets in an active trade or business and whose passive investment income for the preceding year did not exceed 25% of their gross receipts. Municipal bonds are ineligible reinvestment vehicles, as are certificates of deposit issued by banks or savings and loans, mutual funds, and securities issued by the U.S. Treasury. As of this writing, a bill is pending before Congress that would allow many of these ineligible securities to qualify under 1042.

Stock purchased by the ESOP may not be allocated to the seller, certain members of his or her family, or any shareholder in the company that establishes the ESOP who owns more than 25% of any class of company stock.

Careful reinvestment planning for the ESOP sale proceeds is extremely important. As the next section discusses, proper planning enables an owner to defer capital gains permanently. In the event of the selling owner's death after the ESOP sale, the heirs will receive a stepped-up basis on the replacement securities. In other words, taxation on the sale of the business is avoided forever.

Qualifying Replacement Property

To qualify for the capital gains tax deferral described previously, sellers must reinvest the proceeds into QRP within 12 months after the sale. The seller pays capital gains when the QRP ultimately is sold. This effectively creates a static buy-and-hold portfolio limitation on a seller. However, the QRP can be in the form of an FRN, which is a long-term note issued by certain AA and AAA companies. By using this technique, the seller can actively trade a portfolio of securities and defer capital gains permanently. Trading is possible because these notes can be margined up to 90%, which provides collateral for a loan to generate liquidity.

This method allows for some interesting strategies. For example, suppose Joe Mainstreet sells 30% of PrivateCo's stock to an ESOP for $2 million, the fair market value of the shares. The ESOP borrows $500,000 from a bank, and Joe takes back a note for $1.5 million. Joe then arranges a bridge loan for $1.5 million, buys a $2 million FRN, and simultaneously margins the note at 90%, or $1.8 million, which is used to repay the bridge lender.

As the company earns profits, it makes tax-deductible contributions to the ESOP for the repayment of principal and interest, which the ESOP then pays to the seller. The principal repayment is tax-free. The interest part is taxable to the seller, but receiving interest is generally not as bad as paying it.

The FRN pays a London Interbank Offering Rate (LIBOR) plus rate of interest to the owner, who pays a slightly higher rate on the borrowed funds. Since Joe borrows 90% and receives interest on 100%, this may result in nearly a “wash” cost. Joe can have an actively traded portfolio for the 90% value of the stocks sold without being taxed down to the original basis every time he sells a security.

EXHIBIT 27.2 Leveraged ESOP Transaction Flow

LEVERAGED ESOPS

The most sophisticated use of an ESOP involves borrowed money and is called a leveraged ESOP. Exhibit 27.2 shows the leveraged ESOP transaction flow. In this approach, the company sets up an ESOT, which then borrows money from a lender. The company repays the loan by making tax-deductible contributions to the trust, which the trust pays to the lender. The loan must be used by the trust to acquire stock in the company. The stock is put into a suspense account, where it is released to employee accounts as the loan is repaid. After vested employees leave the company or retire, the company distributes to them the stock purchased on their behalf or its cash value. In practice, banks often require a second step in the loan transaction where the bank makes the loan to the company instead of the trust, with the company reloaning the proceeds to the ESOP.

In return for borrowing through the ESOP, the company gets two tax benefits, provided it follows the rules to ensure that employees are treated fairly.

The ESOP can also be funded directly by corporate contributions or cash to buy existing shares, or it simply may be funded by the contribution of shares. These contributions are tax deductible, generally up to 25% of the total eligible payroll of plan participants. For example, if a company has total eligible payroll of $5 million per year, the maximum annual amount that it can deduct is $1.25 million.

It is not a requirement to use an outside lender. If, for example, the company has accumulated funds under a profit-sharing plan, these funds may be rolled over into an ESOP and used to purchase company stock. Of course, this must be done carefully to ensure fiduciary compliance. In addition, the company or the seller may itself be the lender. By using one or more of these sources of internal cash, the company may be able to reduce or eliminate the necessity of borrowing from an outside lender.

How ESOP Shares Vest with Employees

Vesting rules can be fairly complicated, so readers are encouraged to review these rules before implementing an ESOP. In general, all employees over age 21 who work for more than 1,000 hours in a plan year must be included in the plan. If there is a union, the company must bargain in good faith with it over inclusion in the plan.2

Shares are allocated to individual employee accounts based on relative compensation. Generally, all W-2 compensation is counted. The allocated shares are subject to vesting. Employees must be 100% vested after five years of service, or the company can use a graduated vesting schedule not slower than 20% after two years and 20% per year more until 100% is reached after six years.

When participants who have participated in the plan for 10 years reach age 55, they may elect to diversify 25% of their stock account balance among at least three investment alternatives. When they reach age 60, they may elect to diversify an additional 25% of their plan benefit. As an alternative, the plan may pay the requisite amount to the employees.

Private companies must repurchase shares from departing employees at fair market value, as determined annually by an independent appraiser. The employee can exercise this put option in one of two 60-day periods, one starting when the employee receives the distribution, and the second period one year after that. The employee can choose which one to use. Quite often the company's bylaws carry a restriction on share ownership. For example, ownership may be limited to the ESOP and current employees, which may require the company to purchase the shares distributed immediately.

Repurchase Considerations

The legal obligation to repurchase shares of departing employees rests with the company, although the ESOP itself ultimately may purchase shares if required.

The repurchase obligation creates a continual need to plan for the repurchase of shares. Repurchase can be a major problem if companies do not anticipate and plan for it. A detailed repurchase study should be done periodically to help manage this process. The plan's third-party administrator may be able to provide these services as it has virtually all of the information necessary to conduct this study.

ESOPS IN S CORPORATIONS

Originally, ESOPs could own stock only in C corporations. Beginning in 1998, ESOPs could own stock in subchapter S corporations. While these ESOPs operate under many of the same rules as in a C corporation, there are two important differences.

There are benefits, however, with S corporation ESOPs. The S corporation ESOP does not have to pay federal income tax on any profits attributable to it and may not have to pay state taxes. Thus, in the case of an S corporation that is 100% owned by its ESOP, the company's earnings are entirely tax exempt.

SETTING UP AN ESOP

There are several steps in implementing an ESOP. At each point, the decision maker can decide whether to stop or continue.3

The following example describes an ESOP implementation.

POINTS TO CONSIDER

There are a number of points to consider for companies contemplating an ESOP. These points are broken into good points and not-so-good points.

Good Points to Consider

The next attributes make ESOPs highly desirable structures.4

• Beneficial to typical sale. Purchase of an owner's stock by an ESOP usually will be more financially beneficial to the owner than a sale or merger. This is especially true when banks are lending at low multiples of earnings before interest, taxes, depreciation, and amortization (EBITDA) or merger and acquisition transactions and the taxable alternative transactions to an ESOP do not compare well in after-tax dollars. Aside from the capital gains deferral associated with an ESOP, the owner can elect to maintain control of the company after the ESOP transaction. Assuming the company is highly profitable, the owner may not have to reduce discretionary expenses because of the ESOP.
• Investment diversification. ESOPs enable owners to take some chips off the table yet still keep an upside investment potential in the company. By using the FRN strategy described previously, owners can create and trade a public portfolio of securities, instead of having all of their wealth tied to a single illiquid asset.
• The ESOP rollover provision also solves the problem of the locked-in shareholder. Minority shareholders in a private company often would like to sell their shares, but the combination of no ready market plus capital gains taxes on the sale prohibit a transfer. ESOPs are perfect vehicles to purchase the shares plus provide tax relief.
• Charitable contributions. The ESOP can facilitate charitable giving. Every $1 of gift generates $2 of tax deduction. A stockholder can gift shares to a qualified charity and receive a charitable deduction personally in the amount of the gift. The ESOP makes a market for these shares and can purchase them from the charity at a later date, providing the charity with the cash it needs. Because the cash the ESOP uses to purchase this gifted stock was contributed to the ESOP on a tax-deductible basis, the corporation is able to deduct, dollar for dollar, the amount of the gift.
• Private foundations. The ESOP can also help a company owner transfer shares to a private foundation. Private foundation regulations prohibit the owner of a private business from contributing private securities directly to a private foundation. However, using an ESOP can overcome this problem. Owners may sell their securities to the ESOP and reinvest the proceeds tax-free into publicly traded securities. They then can transfer the public securities to a charity or to a private foundation without violating the rules regarding the acquisition and holding of employer securities.
• Cash flow increase. A company can reduce its corporate income taxes and increase its cash flow by issuing treasury stock or newly issued stock to an ESOP in any amount up to 25% of eligible payroll. As the example earlier in this chapter shows, a company increases its equity by the present value of these tax savings. If the contribution to the ESOP is made in lieu of cash contributions to a profit-sharing plan, the cash flow savings are even more dramatic.
• Maximize employee performance. At least one large study on the effects of ESOPs on private companies found that ESOPs appear to increase sales, employment, and sales per employee by about 2.3% to 2.4% per year over what would have been expected absent an ESOP.5

Not-So-Good Points to Consider

The principal disadvantages and possible problem areas that should be evaluated in considering an ESOP are listed next.6

• Dilution. If, by the company contributing newly issued stock to the ESOP rather than cash, the ESOP is used to finance the company's growth, the cash flow benefits must be weighed against the rate of dilution. For instance, if the owner sells 30% of the company's stock to the ESOP, will value be created due to the added growth?
• Disclosure. Once stock distributions are made, employees who hold stock are entitled to receive annual reports and attend shareholders’ meetings. This level of participation makes many owners uncomfortable.
• Valuation. The stock must be valued annually to establish its value for purposes of purchasing, allocating, and distributing it. A qualified third party must prepare the valuation; normally this is someone certified by a national appraisal society. This valuation may cost $10,000 to $20,000 or more initially, with annual updates in the $5,000 to $15,000 range.
  An incorrect valuation affects the company's position. Overvaluation of the stock causes a reduction of the deduction that the company had taken for the contribution. If the ESOP purchased the stock, the deduction would not be affected, but the seller would be required to pay back the excess purchase price. Further, under ERISA, the seller is subjected to a penalty tax for each year that the stock was overvalued.
• Liquidity. Repurchasing stock in the future may be difficult for companies that experience substantial stock appreciation or earnings impairment. This is particularly important beyond the fifth year of the plan, since employees may fully vest at this time. After the first five years, the ESOP normally will need to keep approximately one-third of the fund in liquid investments, to provide liquidity for retiring or terminating employees.
• Stock performance. If the value of the company does not increase, the employees may feel that the ESOP is less attractive than a profit-sharing plan. This may cause some employees to quit and seek more conventional employment. Of course, if the company fails, employees will lose their benefits to the extent that the ESOP is not diversified in other investments.
• Leverage. The ESOP normally borrows money from a financial institution to pay for the stock purchase from the shareholder. This is almost always a large transaction involving millions of dollars. The company will feel this pinch for at least one or two economic cycles. The debt will slow the company's ability to finance its operations in the future and, in some cases, prohibit it from growing.
• Government as a partner. Several government agencies oversee ESOPs, including the IRS, the Department of Labor, and possibly the SEC. In other words, by implementing an ESOP, owners must be prepared to deal with big government more than they currently do with their qualified plans in a non-ESOP status. At the very least, government is more of a partner in the ESOP scenario, positively and negatively.

BOTTOM LINE ON ESOPS

ESOPs are extremely powerful vehicles to assist owners in transferring part or all of their businesses. Unfortunately, they are also complex to implement and administer. An entire industry of ESOP professionals has emerged to help private owners deal with this complexity.

While there is no doubt that an ESOP is a powerful tool, the question becomes: Is implementing an ESOP worth the hassle? Perhaps. A business owner may spend years building a business only to give millions to the government in taxes. An ESOP can eliminate that tax burden. Owners should compare the after-tax liquidity they can receive from all transfer methods, including the ESOP, to help make this determination.

However, private business owners are not known for their tolerance and patience when dealing with the government. Many owners also bristle at the thought of having employees as partners. A certain amount of power is transferred with the beneficial ownership of the stock. All of a sudden, the owner owes a level of diligence not previously experienced to the employee-partners. When it comes to ESOPs, size does matter. Businesses with annual EBITDA of less than $1 million may find ESOPs too constricting from a financial perspective.

TRIANGULATION

The ability to transfer a business interest is conditioned by its access to capital and the value world in which the transfer takes place. ESOPs are especially affected by the value world in which they are viewed. The primary authority for ESOPs, the ERISA laws, decrees that they must be appraised in the world of fair market value. This means that ESOPs are valued in a notional regulated world, which has two ramifications.

Companies that implement ESOPs successfully tend to have many of the attributes of could-be-public companies. There is usually a good, functional management organization in place. The company generally outperforms competitors in its industry segment. Finally, the company has a place in the market, which means the owner is not crucial to the future success of the business.

Banks supply capital for most ESOP implementations. Most banks want their loans personally guaranteed. Owners selling into an ESOP are particularly vulnerable to these pressures since they are liquid borrowers. Many owners will extend credit or guarantee loans in the world of owner value, but they will not backstop a deal in the lesser world of fair market value.

The strength of the linkage between a regulated value world, such as fair market value, and regulated transfer method, as in ESOPs, is quite strong. Prospective sellers to an ESOP should consider long and hard whether they wish to trade being surrounded by the enhanced authority for liquidity when they want it without giving up control. Sellers who wish to share ownership with employees, and are willing to play by the rules, may find ESOPs a powerful tool.

NOTES

1. The National Center for Employee Ownership Web site, www.nceo.org.

2. Ibid.

3. Ibid.

4. R.K. Schaaf Associates Web site, www.rkschaaf.com.

5. Kruse/Blasi study, www.nceo.org/library/overview.html.

6. R.K. Schaaf Associates.