2010.42 ESOP: an alternative to a traditional company sale or outside investment
An ESOP is a tax qualified retirement plan in which the ESOP becomes a shareholder of the company and also provides retirement benefits to employees. Unlike most retirement plans it can borrow money to buy company stock while also providing tax benefits to business owners selling stock to the plan. Essentially, in a leveraged ESOP the ESOP or its corporate sponsor borrows money and provides the lender with a guarantee that it will make contributions to the trust enabling the trust to pay back the loan on schedule. Related Internal Revenue Code provisions include 1986 provisions Section 401(a), Section 4975(e) and Section 407(d) (6).
As a defined contribution plan the ESOP must comply with certain requirements. It must meet minimum eligibility and participation levels. It must be non-discriminatory with respect to highly compensated employees relative to those not highly compensated, and meet related limits on contributions. It must be designed to invest mainly in the company’s securities . The purchased stock is held in trust to be released to employees over time. For existing shareholders the plan provides liquidity and a favorable tax treatment when the ESOP buys over thirty percent of the company’s shares. As stock is vested to employees the company gets a tax-deductible compensation expense. Thus existing shareholders can cash out and other employees can purchase company shares. This structure is an alternative to an outright sale of the company and especially useful where the founders or other shareholders want to achieve liquidity while other shareholders want to retain or expand their ownership (but can’t necessarily fund the related share purchases upfront).
Investment in the company’s securities, should, on balance, be over 50% of the holdings. Permissible securities are typically most classes of public and private stock (the latter subject to voting right and dividend preference requirements), with certain debt sometimes making the grade. An independent appraiser must value the securities once a year. The securities of S corporations qualify but the sponsor loses certain tax benefits (and state law must be checked: California, for example, imposes a 1.5% income tax on all S Corporations).
If the requisite conditions are met, capital gains on non-publicly tradable stock of a C corporation can be deferred or permanently avoided. Since ESOP contributions are tax deductable, a corporation which repays an ESOP loan can essentially deduct principal and interest from taxes. And, dividends paid on ESOP stock passed through to employees or used to repay the ESOP are tax deductible if the corporate sponsor is a C corporation. If the sponsor is an S corporation, dividends can be used to pay the ESOP but there is no tax deduction (an S corporation doesn’t pay corporate income tax).
Typically annual contributions of 25% of eligible payroll are allowed, the funds being used to pay off debt principal and interest. Exception on interest payments (allowing them to be paid with contributions above the 25% above) exist.
A participant reaching 55 years old with at least ten years participation in the plan must be given the option to diversify his/her assets outside of the company stock. The percentage goes up over a defined period of years. The diversification can either be done within the plan or cash distributed to the individual for outside diversification.
Some common uses of ESOPS in ownership succession planning:
-Minority interest stock purchase in which only a minority of shares are sold to the ESOP
-100% ESOP leveraged buyout where existing shareholders cash out entirely
This explanation is a very simplified overview of a leveraged ESOP. Check with your advisors for specifics on the applicability for your company.
This data is based upon a more detailed piece written by lawyer Laurence A Goldberg, Esq. of Sheppard, Mullin in San Francisco. Feel free to email me for more information at jones@hadleypartners.com
