The Employee Stock Ownership Plan: A Useful Tool for the Business Owner
Are you a business owner looking for an exit strategy? Is liquidity of your privately-held shares a concern? Are you looking for a better way to transition a co-owner into retirement? Would you like innovative corporate financing with additional benefits?
If you answered yes to any of the above questions, you should consider an Employee Stock Ownership Plan (“ESOP”).
An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it may contribute new shares of its own stock or cash to buy existing shares of company stock. More commonly, the ESOP will become “leveraged” by borrowing money to buy new or existing shares, with the company making deductible cash contributions to the plan to enable it to repay the loan. It is this ability to borrow funds which allows a company to do things with an ESOP that are not possible with any other retirement plan.
TRANSITION OF OWNERSHIP
One of the most common uses of an ESOP is to act as a vehicle for the sale of all or part of an owner’s interest in a closely held company. In this situation, an ESOP provides substantial advantages over other alternatives because of the flexibility and significant tax advantages. Owners of privately held companies can use a leveraged ESOP to create a ready market for their shares. The company can make tax-deductible cash contributions to the ESOP to buy out an owner’s shares, or it can have the ESOP borrow money to buy the shares. The owner’s may sell portions of their shares to the ESOP or in stages over a period of years so they can gradually ease out of the company – a particularly important consideration for sellers with management responsibilities. Once the ESOP owns 30% of all the shares in the company, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain using a Section 1042 exchange (discussed below).
CORPORATE FINANCE
A leveraged ESOP can also be used to create working capital for a business. The company issues new shares and sells them to the ESOP in a leveraged transaction, using the proceeds from the sale to finance acquisitions or to refinance debt. While this dilutes the ownership of the non-ESOP shareholders, it allows a much less costly repayment of the loan and simultaneously provides an employee benefit plan.
THE “1042 EXCHANGE”
Section 1042 of the Internal Revenue Code is a unique provision that can create huge tax advantages for shareholders who sell their shares of stock to an ESOP. Section 1042 provides that a taxpayer may elect to defer the recognition of gain realized from a sale of employer stock to an ESOP if, within a specified replacement period, the taxpayer acquires certain qualified replacement property.
“Qualified replacement property” means securities or debt instruments issued by a domestic operating corporation, other than the plan sponsor. Generally, the IRS wants to see the funds reinvested in the stock market or in another entrepreneurial venture. Government bonds and mutual funds do not qualify.
The replacement property must be acquired during the 15-month period that begins three months before date of the stock sale to the ESOP and ends 12 months after the date of the sale. And, nonrecognition treatment may not be elected unless, immediately after the sale of employer stock, the ESOP owns at least 30% of the total value of all outstanding stock of the employer. The taxpayer must have held the employer stock for at least three years before the date of the sale, and may not participate in ESOP allocations following the sale.
Once the seller has elected deferral of gain and reinvested the sale proceeds in qualified replacement property, the seller’s basis in the newly acquired securities will be reduced by the amount of gain not recognized. However, tax on the gain can be avoided altogether if the taxpayer holds the replacement property until his or her death, at which time the taxpayer’s estate or heirs will receive a step-up in basis to date of death value.
CORPORATE GOVERNANCE
One of the major concerns for owners of closely held businesses looking at sponsoring an ESOP is the fear of turning control of the company over to the ESOP participants. As a practical matter, adoption of an ESOP will shift very little control away from current company ownership. The ESOP participants will have the right to vote their shares on corporate issues related to sale or merger of the company. On all other issues, however, the ESOP Trustee (generally, the owner of the company) votes the shares held in the ESOP. Decisions, such as election of the Board of Directors, will continue to be made solely by the owners of shares outside the ESOP.
ESOPs can be a versatile tool used to accomplish a wide range of financial and employee relations objectives. If you are interested in discussing whether an ESOP may be right for your company, give us a call.