ESOPs – A Solution to Consider

By Maurie Cashman

This week we will continue the discussion of ESOP’s that we began last week. Of the more than 12 million privately owned businesses in the U.S., 70% will be

changing hands in the next 10-15 years. Most of the owners of these companies will not have spent much time planning for how they will sell or transfer ownership of their company.

A solution you may not have considered is selling some or all of the company stock to an Employee Stock Ownership Plan (ESOP).

Using An ESOP, You Can:

• Build Community Wealth
• Design a transaction to meet the needs of the shareholders and the company;
• Attract, motivate, reward and retain valuable employees;
• Monetize shareholder equity free of taxes;
• Increase company value through improved employee productivity.
• Borrow money and deduct both interest and principal.

According to the National Center for Employee Ownership (NCEO) employees in ESOP companies accumulate 2.5 times more in their retirement accounts than those in non-ESOP companies. Employees in ESOP companies also receive 5-12% more in wages than their counterparts at non-ESOP companies.

One surprising aspect of employees of an ESOP is that they have about the same amount of asset diversification as other employees. This is likely due to the ability of the ESOP employee to diversify his account into other investments, much like a 401K.

How Do ESOP’s Improve Return and Sales?

In general employees have been shown to pay much more attention to small details such as process, quality control and customer service. Employees have much more incentive to develop and bring forward new and innovative ideas in many areas. It is a takeoff on the Deming concept that those closest to the work have the best ideas on how to improve it.

Companies that change to ESOPs return on average 2.7% higher return on assets than prior to conversion and increase sales by 2.3-2.4% per year post conversion. While these may not seem like a lot, over 40 years an investment of $10,000 in an ESOP company on average would grow to $430,000 more than that of a non-ESOP.

Tax Considerations

There are different tax treatments between ESOPs depending on how they are organized. You should always involve a CPA and financial advisor with experience in setting up and working with ESOPs on your team.

C-Corporations

• Capital gains on sale to the ESOP are deferred until the owner cashes in his shares
• If the shares are transferred to an estate, they may never be taxable
• The ESOP needs to own at least 30% of the company to qualify for special tax treatment

S-Corporations

• Capital gains are not available on sale to an S-Corporation
• The ESOP is not a taxable entity so long as it owns 60% of the shares
• If an owner owns 40% of the company outside the ESOP (generally an originally who retains 40% of company after sale to ESOP) he will generally demand a distribution to cover his taxes since the S-corporation is a pass-through entity
• A 100% ESOP has a large tax advantage since it is not a taxable entity.

Post-Sale Control by an Original Owner

Perks

• Business judgment rules still apply to owners and top management
• The board and the president can generally make decisions and run the business as they see fit
• There is increased scrutiny to prevent abuse
• The Department of Labor is increasing its monitoring of ESOP’s to ensure they are properly administered
• ESOPs do come under ERISA rules and jurisdiction

Governance of ESOP

Trustee

• A trustee is legally required in an ESOP
• Trustee has a fiduciary responsibility to protect the plan participants
  • This means it is responsible for protecting the assets of the participations as participants
  • It does not mean that it is responsible to protect the jobs of the participants
  • It does not mean it has the responsibility to protect the assets of individual participants
  • There can be a trustee responsible for setting up the ESOP and a trustee who takes over the operation of the trust
  • The trustee can be an inside committee, a former owner of the company or an outside entity
  • If you are a trustee of an ESOP you should have fiduciary insurance

Other Issues

• Diversification
  • It is a good idea to have a 401K plan in place for ESOP employees as well
  • An ESOP is legally required to allow participants to diversity what is in their ESOP account by investing in other vehicles
    • The plan must be ten years old before the diversification rule kicks in
    • An employee with at least ten years in the ESOP may take 25% of their assets and diversify once they reach age 55
    • An employee with fifteen years in the ESOP may diversify 50% of shares upon reaching 60 years of age
    • An ESOP may choose to be more generous than the above requirements
    • Vesting
      • There are two schedules required for vesting in an ESOP
        • Can be 0% vested until 3 years of participation
        • Can then vest 20% for 5 years
        • Can be more generous than this but not less
        • Repurchase and Funding of Repurchase of Shares
          • Most companies finance repurchases out of ongoing cash flow
          • The rate of repurchase for a mature ESOP is 2-5% per year
          • Companies can insure repurchases
          • Companies can borrow money to fund repurchases
            • This can sooth out repurchase obligations
            • Repurchases recirculate shares within the ESOP, which can be positive

Administration

• An ESOP must comply with may rules and regulations
• 409P tests on ESOP compliance are difficult to comply with
• It is important to employ an outsider administrator for your ESOP
  • Charges for an administrator should be roughly what you would pay for a 401K plan

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