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    ESOPs Benefit Both Buyers And Sellers - The "Why's" Of ESOPs

    [fa icon="calendar"] May 15, 2015 9:00:00 AM / by Kevin Long

    Kevin Long

    At some point, all privately held companies are going to be sold to or merged with a third party, transferred to family members, sold to their employees – or not survive. That's a stone cold fact. Very few companies have the option of going public. Oddly, the question of what offers owners, shareholders and their companies the most cash flow efficient and tax-advantaged option isn't always given the careful consideration it should. When it is, the tax deferred internal succession planning tool of an Employee Stock Ownership Plan (ESOP) jumps to the top of the list. The ESOP was deliberately designed by the federal government to be both a corporate finance vehicle and a retirement plan to benefit employees and sellers.

    Just bear this in mind: Congress and almost every administration since 1974 (Democrats and Republicans) have bent over backwards to encourage this. Congress wants companies to self perpetuate and more employees to have capital assets – to be capitalists. This is the most efficient way to do it. Read on.

    Lets Put it in Perspective

    Think of an ESOP as a friendly buyer for the owner's stock that comes with some unusually large income tax incentives for all three parties and a host of employee benefit plan rules to make it all work. The income tax rules were deliberately written to incentivize owners to sell stock to ESOPs and to allow ESOP companies to subsidize the purchase with tax deductions and actual (erstwhile) tax dollars, so that:

    • Sellers can defer their capital gain on the sale to the ESOP.
    • The corporation deducts principal, interest and even dividends paid to service the financing.
    • Actual tax dollars can be redeployed to pay for stock and benefits. (Not joking)
    • The corporation can become a partially or completely tax exempt, for profit corporation, due to its ESOP ownership. (Yes, seriously.)
    • Employees pay no tax until they take a retirement distribution.

    The employee benefit plan rules are the same ones that govern other qualified pension plans like a 401(k) and profit sharing plans, with some modifications for ESOPs to accommodate employer stock investments.

    The Whys for the Seller

    Why would the owner of a closely held business want to sell some or all of his or her shares to an ESOP? Answer: Tax incentives and legacy.

    From an income tax perspective, the reason is to defer and potentially avoid a 33 to 61 percent income tax on the sale. The 33 percent tax rate would apply if the entire sale of the company were capital gain (a stock sale - California rates included). The 61 percent tax would be the maximum double tax if it's a sale of the corporation's assets.

    In contrast, if the shareholder sells to an ESOP and reinvests the proceeds in the stocks or bonds of an operating U.S. corporation (e.g., Apple, Starbucks), the sale is not taxed until the reinvested stocks or bonds are sold. (Remember selling your home and rolling it over to a new residence? Same concept – you get to "move up.") This means the seller has diversified the equity and still has Uncle Sam's tax dollars invested and growing for his/her needs. If the stocks and bonds are held until death and pass through the seller's estate, the deferred capital gain is never taxed. (Could this be one instance where death and taxes are not inevitable?)

    From a legacy perspective, there are two concerns. First, some company owners don't want to sell to a competitor, private equity group, "roll up" or other investor if it ultimately means the consolidation or bust up of the company and loss of jobs for loyal employees. No matter how a company is sold, buyers want to wring their return out of it. That's just the way it works. (Bain Capital anyone? – Not that there is anything wrong with that.) Second, many owners find it difficult to "pull the rip cord" and exit, liquidate their holdings and immediately cut all ties to their life's work and passion. (No, they don't want you around after the transaction, Mr. Owner.) The ESOP allows a very gradual, controlled, staged and involved succession pathway for the "genius founders" and the management team in place.

    The Whys for the Company

    Why would a company consider an ESOP? First, there's the capability of the ESOP to purchase the company's stock with 100 percent deductible (before-tax) cash flow. Second, is the potential to become a partial or completely tax-exempt company.

    The thing is, not every stock transaction situation is a 100 percent sale of a company. Yet, sometimes corporations need liquidity. Shareholders have to be bought out by remaining shareholders, and companies can strain under the burden of financing a cross purchase or redemption of a significant percentage of shares. You normally can't deduct it. It is normally only funded out of retained earnings, which is after tax working capital.

    In contrast, compare the costs of purchase. Excluding interest expense, a non-ESOP buyer would need to earn more than $1.6 million in before-tax profit to purchase $1 million of stock in the company, because the purchase – or principal on the loan used to fund the purchase is not deductible. An ESOP company, in contrast, can deduct the entire purchase price. Therefore, it needs only $1 million to accomplish the purchase.  (Now, add together the corporation’s tax deduction and the sellers tax deferral, and you may be approaching $1M of tax subsidy on $1M worth of stock sale)

    As for the tax-exempt feature of being an ESOP company, it works like this. If the corporation is a Subchapter S Corporation (or becomes one) the corporation can apply the cash distributions it normally makes to its shareholders (to pay their taxes on their share of the corporation’s taxable income) to pay for the purchase of the stock. How? Well, if the ESOP becomes an S Corporation shareholder, it pays no federal taxes on its share of the income. It's tax exempt. It can use its share of the distributions for the purposes of the ESOP – which is to buy stock.

    It is difficult to imagine what else Congress could add to the equation.

    The Whys for Employees

    From a benefits standpoint, a well-designed ESOP transaction will provide greater allocations to employees' plan accounts than a 401(k) or profit sharing plan (if the company is even contributing to one). Also, it will provide an opportunity for equity participation that most employees would not otherwise have. It is the only pretax method for employees to acquire share ownership. Every other method or stock option has a tax cost.

    Both independent and government studies document that employee productivity and loyalty improve when an ESOP is combined with a "participative management culture." What does that mean? Different things for different companies – but on average, ESOP-based companies outperform non-ESOP companies in their industries, according to the National Center for Employee Ownership (NCEO), the Employee Ownership Foundation and numerous independent studies.

    This is very important. To gain the maximum ROI on the cash flow used to fund the ESOP and not squander the considerable tax benefits, it is necessary to structure the purchase of company stock to be prudent for the company and "fair" to the ESOP. The company and selling shareholders must understand that the ESOP has to be designed and operated for the primary benefit of the employees. This means qualified independent appraisals of stock purchases, on an arm's length, fully informed basis. These standards must be scrupulously adhered to. However, making sure the purchase price of stock is indeed prudent and fair is the right thing to do when the potential gain for all concerned is so great.

    The “Why Nots?”

    An ESOP is admittedly a very complex planning tool. (Now you know why it doesn't come up often enough.) With overwhelming tax and cash flow advantages, comes complexity. (Not a law of physics, just…law) But those tax and cash flow advantages massively outweigh the cost of implementing the complexity. What is least understood about ESOPs though is the vast flexibility with which they can be used in different situations. It's almost impossible to have heard it all, when it comes to ESOPs. This is just a brief synopsis of the fundamental "why fors."

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    Kevin Long

    Written by Kevin Long

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