So what is an ESOP and how does it work? Basically, an ESOP is a tax-qualified retirement program that owns stock of the sponsoring company for the benefit of the company’s employees. ESOPs have been around for over 30 years, but most have been implemented since 1985.
Because an ESOP is a tax-qualified retirement plan, it is subject to many of the same rules and restrictions as other tax-qualified retirement programs, such as 401(k) plans and pension plans. But ESOPs are perhaps better known as tools of corporate finance than as employee benefit plans, and this dual function can produce some confusion. The two major differences between ESOPs and these other retirement plans are that an ESOP can borrow money to purchase its sponsor’s stock either from outside shareholders or directly from the company, and that Congress has established significant tax incentives to encourage employee ownership of their employing companies through ESOPs.
ESOPs allow employees to participate in the ownership of a company in two ways. First, the company can simply make annual contributions of stock to the ESOP as an additional employee benefit. This type of arrangement is commonly referred to as a “nonleveraged ESOP.” Second, by borrowing funds from either an outside lender or the company itself to purchase company stock, the ESOP can become a tool of corporate finance. This second type of arrangement is commonly referred to as a “leveraged ESOP.” In either case, the shares of stock acquired by the ESOP are held in a trust where the shares are allocated to an account for each eligible employee. The stock is then held in this account until the employee retires or otherwise becomes eligible to receive a distribution.
ESOPs are especially effective when combined with a Subchapter S corporation (or simply “S corporation”). Together, they create a powerful tool for income tax deferral and capital accumulation within a business. Here’s how it works. S corporations are considered “pass through” entities, meaning their income is not subject to a corporate level income tax. Instead, income is passed through to the company’s shareholders, who individually pay tax on the income. Since ESOPs are tax-exempt entities, to the extent that income from the S corporation is passed through to an ESOP as a shareholder, that income escapes current income taxation at both the corporate and individual levels. Since the corporation doesn’t have to distribute any cash to the shareholder to use to pay taxes on income, that money can be kept in the corporation and used for other (business) purposes.
An example may help illustrate these points. If ABC Company, an S corporation, is owned 50 percent by its ESOP and 50 percent by Shareholder A, and the company has taxable income of $1,000,000, then only $500,000 of that income (the amount allocated to Shareholder A) is subject to federal income tax in the current year.
Therefore, the ESOP has produced a tax savings of nearly $230,000 at a combined federal and state tax rate of 46 percent. If the ESOP had owned 100 percent of ABC Company, no income tax would be paid on the company’s current income (because it is allocated to the ESOP, which is a tax-exempt shareholder).
In either case, since ABC Company will not need to distribute cash to the ESOP to pay income taxes, that money can be retained in the company and used for business purposes.
ESOP Tax and Planning Incentives
ESOPs provide shareholders the ability to obtain liquidity and diversify their wealth without necessarily losing control of their company. To encourage employee ownership, Congress added Section 1042 to the Internal Revenue Code to provide eligible selling shareholders with the opportunity to sell their shares to the ESOP and defer tax on the proceeds. As long as the selling shareholder reinvests the proceeds in qualified replacement property (debt or equity in U.S. companies) within twelve months after the sale, the selling shareholder does not pay capital gains tax on the shares sold to the ESOP. If properly structured, the selling shareholder can have complete flexibility in the use of the sale proceeds and will never pay the capital gains tax on the sale.
ESOPs also provide shareholders the opportunity to minimize their estate tax burden, and the period immediately following an ESOP sale is an attractive time to implement an estate tax reduction strategy. This is because an ESOP transaction generally will reduce the value of the shares of the company temporarily, thereby creating a window of opportunity to make gifts of stock to the shareholder’s family. The use of a family limited partnership in conjunction with an ESOP can substantially reduce, if not eliminate, the future estate tax burden. Additionally, if the selling shareholder has a charitable intent, an ESOP combined with a charitable remainder trust is a powerful charitable giving strategy.
Similar to other qualified retirement plans, company contributions to an ESOP are tax deductible. Consequently, the contribution to the ESOP to repay the loan are tax deductible within certain limits. This means that both the principal and interest can be deductible on an ESOP loan (as opposed to an ordinary loan where only interest is deductible). This tax benefit creates the opportunity to raise tax efficient capital for the company.
Similar to other qualified retirement accounts, the growth of the employees’ ESOP accounts is tax deferred until retirement. In addition, special tax advantages are available to employees who receive company stock from the ESOP.
ESOP Operational Incentives
In addition to the tax and cash flow benefits of an ESOP, participative employee ownership can be a powerful tool for adding value to a company.
Owners of a company can derive as much operational benefit from the ESOP as they wish. Some owners are content with taking the tax and cash flow benefits and are not concerned with the operational benefits. Other owners make a tremendous commitment to involve employees in the business, and they enjoy the performance benefits derived from their efforts.
Characteristics of an ESOP Candidate
All of this raises the question, “If ESOPs are so great, why doesn’t everyone have one?” ESOPs are very dependent upon the economy. When the economy is strong and the values of companies are high, owners are more interested in selling shares to their employees. The robust economy of the 1990s has fueled an increase in the value of companies and as a result, ESOPs are a very favorable current planning tool. However, not every business in the Carolinas is a good prospect for an ESOP. An ESOP may be worth investigating, if the company is:
profitable, with taxable income in excess of $100,000 per year;
of sufficient size, most ESOP companies have minimum of 10 full time employees; and
in a growing Industry, although not essential it is a very positive characteristic.
An ESOP can be a powerful planning tool for maximizing financial strength, increasing employee performance and minimizing tax liability. ESOPs are a complex planning tool and the laws related to them are constantly changing, therefore, if you are interested in exploring ESOP planning options, be sure to consult with an experienced ESOP practitioner.
The authors are members of Womble Carlyle Sandridge & Rice, a Charlotte-based law firm, as well as the national ESOP Association and the Carolinas Chapter of the ESOP Association. The firm is planning an ESOP Life Cycle seminar in the fall of 2000. For more information, call 704.331.4900.