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      ESOPS: The Frequently Asked Questions

      Every business is unique, but most business owners have the same goal – to fully realize the promise of their most valuable asset, the business they put so much time and sweat equity into building. Because most non-publicly traded corporations eventually face the challenge of succession planning to perpetuate and flourish, the only big questions for the owners and shareholders are how and when? Experts advise that planning should begin at least 5 to 10 years in advance in order to realize the business's full value and ensure a smooth transition. We are asked every week by business owners (as well as their advisers) approaching the transition stage of their company's life, "Will an Employee Stock Ownership Plan (ESOP) work for my company?"

      They've heard about successful ESOPs at other companies in their industry or read about them in business publications. The question really requires an ESOP specialist to analyze the company owner(s) and the company's situation, including corporate objectives, the existing business plan, employee benefits structure and the shareholders' estate planning and personal objectives to determine whether some form of ESOP will advance the client's goals.

      This article addresses some of the most frequently asked questions we hear.

      What Is An ESOP?

      An ESOP is basically a vehicle for providing a benefit to employees. Like any vehicle, though, its design can be customized to meet the needs of the driver. The basic ESOP vehicle is designed to give employees who participate in the ESOP the opportunity to obtain stock in the corporation they work for.

      How Does The Basic Model ESOP Work?

      The employer sets up a trust to hold some amount of the corporation's stock, either newly issued or purchased from the owner. If the ESOP will buy stock from the owner, the trust will hold a cash contribution from the employer or loan proceeds to pay for the stock. The company's owner and the ESOP trustee decide how much stock the ESOP will purchase and the terms of the sale. The price must be supported by a third-party appraisal of the company's value. If the owner and the ESOP trustee reach an agreement, the ESOP purchases the stock and holds it in a reserve account in the trust as an investment for the benefit of the ESOP participants.

      The ESOP often borrows some or all of the purchase price – a "leveraged" ESOP. Shares that are fully paid for (i.e., paid for in cash or released from the reserve account as the ESOP makes payments on the loan) are "allocated" to participants. Each participant gets a statement showing how much of the company's stock has been allocated to the participant's account. As additional stock is allocated to the participant's account, the value of the account grows (assuming the stock value has not dropped). Similarly, as the value of the company's stock increases, the value of the participant's account increases.

      Each year, the employer decides whether to contribute additional newly issued stock to the ESOP and/or make a cash contribution. Contributed stock is allocated to participants as described above. If a cash contribution is made, a leveraged ESOP will use the cash to make a payment on its loan. That loan payment means that more shares are now fully paid for and can be allocated to participants. In either event, the participants get a statement showing the allocation of additional stock to their accounts. This general pattern continues until all of the stock in the ESOP has been allocated to participant's accounts. If the ESOP has not already purchased 100% of the company's stock, the non-ESOP owner can always decide to sell additional shares to the ESOP if the owner and the ESOP trustee agree on terms.

      As participants approach retirement age, they have the right to request that the stock in their account be diversified into other investments. At retirement, the ESOP distributes cash or stock to the participant, depending on the vehicle design. If stock is distributed at retirement, it is usually restricted by a right and/or obligation of the company to buy it back when the retiree wants the cash.

      That's it. That's how the basic vehicle is designed. We'll look at some of the design options that add complexity, but also allow the driver to reach destinations beyond simply providing employees with a benefit. But first, we'll start with an overview of some of the tax issues relevant to ESOPs.

      What Are The Tax Benefits?

      Being aware of ESOP tax features makes it easier to understand how an ESOP vehicle can be designed to suit the needs of the parties involved. Following is a brief summary of the tax features that are relevant to the ESOP, the corporation, the owner, and participants.


      The corporation can deduct (up to certain limits):

      • The value of stock it contributes to the ESOP.
      • Cash contributions the ESOP uses to buy stock.
      • Cash contributions the ESOP uses to make principal payments on a loan incurred to buy stock.

      Generally speaking, the corporation can deduct an amount of the contribution up to 25% of payroll. This limit applies across all of the employer's defined contribution plans. In other words, if the employer has a 401(k) and an ESOP, the deduction for contributions to both plans cannot exceed 25% of payroll. However, there is a separate 25% deduction limit for contributions by a C corporation to a leveraged ESOP that are used to pay down principal on the ESOP's loan. An S corporation cannot take advantage of this separate 25% deduction limit. S corporations must also include in the deduction limit contributions which are used to pay interest on the ESOP's loan in addition to principal payments. Generally, dividends paid on ESOP-owned shares are also deductible and are not subject to the 25% deduction limit.


      The ESOP trust is a tax-exempt vehicle and pays no tax on its income. This means that in an S corporation, because the corporation's income is only taxed at the shareholder level, the ESOP's share of the corporation's income is tax-free.


      If the ESOP owns at least 30% of a C corporation's stock, an owner who sells stock to an ESOP can defer tax on the gain from the sale by rolling the proceeds of the sale into a similar investment – a "1042 exchange." This option is not available to S corporation shareholders.


      No tax is due when stock is allocated to a participant's account because the ESOP is a qualified retirement plan under the Internal Revenue Code. The participant will pay capital gain tax and income tax on distributions, plus a 10% penalty if the distribution is before normal retirement age. These taxes may be deferred by rolling distributions into an IRA or another retirement plan.

      With this knowledge of the basic tax features of an ESOP, we can move on to some design options that highlight the flexibility of the ESOP vehicle.

      How Many Shares Should The ESOP Buy?

      Deciding how many shares to sell to the ESOP is complicated, but worth working through. Again, because the ESOP is so flexible, the decision process can seem daunting, but going through the process helps owners clarify their short- and long-term goals for themselves and their company. When an owner decides how many shares to sell (while the ESOP trustee simultaneously decides how many shares the ESOP can prudently buy), the decision is often based on a combination of factors.

      For example, how much financing is available to complete the purchase and at what cost? Does the owner/seller want or need to receive a certain percentage of the purchase price in cash? Is maximizing the income tax deduction a priority? If so, how large a deduction can payroll support given the deduction limits? Does the owner want to continue owning shares and, if so, how many? A majority? Does the owner want to complete a 1042 exchange? The answers to these questions will take the parties a long way toward deciding how many shares will be sold to the ESOP.

      One place to start is by picturing the "perfect" ESOP design from a tax point of view - the 100% ESOP-owned S corporation. In this design, 100% of the company's income is passed, tax-free, to the ESOP. However, this "perfect" tax ESOP design may not be the best vehicle if maximizing deductions is a priority because of the deduction limits for S-corporation ESOPs. This design also won't fit an owner who wants to continue owning shares or defer tax on the sale proceeds in a 1042 exchange. When you consider these factors, the "perfect" number of shares in the ESOP will likely be something less than 100%.

      For C corporations, the "perfect" vehicle may be an ESOP that owns more than 30%, but fewer than 100%, of the corporation's outstanding shares. That vehicle would let the owner do a 1042 exchange (which requires at least 30% ESOP ownership) while still retaining direct ownership of a desired number of shares. But, again, the number of shares sold to the ESOP may depend more on whether the company's payroll can support a full deduction for the value of those shares, on the availability of financing, or a number of other factors.

      This design element – how many shares are sold to the ESOP -- can change over time. The owner may initially want to remain a majority shareholder but may later decide that he wants to sell his remaining shares to the ESOP as he nears retirement. In this example, the ESOP's initial purpose is to provide a benefit to employees, but gradually morphs into an exit strategy for the owner.

      As you can see, many factors play into the decision of how many shares are sold to the ESOP. The real message here is that the ESOP vehicle design is flexible enough to benefit the corporation, employees and shareholders throughout the life of the ESOP while preserving the owner's options for the future.

      Can The Purchase Be Financed?

      Advisors and owners are probably aware that all-cash stock sales are rare. It is unlikely that an owner who wants to sell his shares will be able to do so without the buyer financing at least some of the purchase price. Given that fact, why not consider an ESOP as an alternative to a third-party sale? If an ESOP is the buyer, not only is there a ready-made market for the shares, the purchase price can be paid with pre-tax money. (Remember our basic tax features, above?) Congress intended this favorable tax treatment to encourage owners to consider their employees as not just an attractive alternative to a third-party buyer, but arguably one of the best alternatives available for selling a closely-held business.

      In a sale to an ESOP, just as with a third-party sale, the purchase price can be financed by an outside lender or financed by the seller. The purchase price can also be financed as a loan from the company to the ESOP at a more favorable rate of interest than would likely be available through commercial financing. This company loan has the added bonus of creating a deduction for the company when contributions to the ESOP are used to make payments on the loan.

      The structure of the financing can be flexible enough to satisfy the needs of the selling owner and the ability of the ESOP to support the loan payments. The combination of cash and financing can be structured to let sellers recognize gain on the sale sooner rather than later to take advantage of currently low capital gain tax rates. A cash payment could be made sufficient to cover the selling owner's tax liability and the remainder of the purchase price financed over a number of years. Alternatively, the seller can choose to recognize gain on payments as they are made over time.

      Again, financing is an ESOP vehicle option that is flexible enough to meet the needs of many selling owners, companies and shareholders, including the ESOP.

      What Situations Are Prime Candidates For An ESOP?

      There are particular situations in which an ESOP might be the best choice among a sea of business planning options. Because of its flexibility, an ESOP can:

      • Lower the transaction costs and facilitate cash flow in a management-led purchase of the company;
      • Give the selling owner the ability reinvest the sale proceeds while deferring capital gains;
      • Provide a ready-made market for stock;
      • Acquire shares with pre-tax cash flow;
      • Acquire shares to buy-out a dissident or unhappy shareholder;
      • Provide liquidity for heirs who wish to continue in the family business;
      • Establish minority discounts on family-held stock for estate planning purposes through the appraisal process;
      • Attract financing at about 85% of the cost of conventional financing;
      • Provide asset diversification by being a minority shareholder;
      • Allow the selling owner to remain involved during the purchase, thus lowering the seller's risk;
      • Attract minority-subordinated equity investors in a management-led buyout.

      Often, one or more of these ESOP design features are optimally suited to help the owner achieve his business-planning goals. This is true whether the owner's goal is an immediate sale and exit from the company, setting the stage for an ownership transition at some point in the future, or something in between. If any of these features are attractive to you or your client, an ESOP should be on your short-list of business planning options.

      Is An ESOP Really Right For Me, For My Company, For My Client?

      Now that you know what an ESOP is, how it works, the basic design features, and whether those features are of interest to you or your client, there are some questions you can ask to help you decide if an ESOP is a suitable option. For example, you should consider the following:

      • Is the company in an industry that is labor- or people-intensive and can take advantage of an ESOP's potential to enhance productivity? ESOP-owned companies typically see a productivity boost often attributed to a boost in employee morale and sense of ownership.
      • Is the company in a highly cyclical industry with extreme ups and downs in stock value? If so, an ESOP may not provide the benefits employees expect and owners want to provide.
      • Is the company in an industry with a high risk of obsolescence? Could a change in technology put it out of business at any time for reasons beyond its control? Again, in this situation, an ESOP may not be the best choice – they are typically designed for longevity.
      • Does the company have such thin margins and poor cash flow that it can't afford a financed buyout?
      • Does the company have enough employees and eligible payroll to permit an ESOP to support contributions to the plan?
      • Does the company have a second level of management ready, willing and able to take over the operation and growth of the company after the buyout?
      • Would the ESOP be the only retirement plan the company offers, or would a 401(k) or other plan also be available?
      • Does the owner have family members who want to take over the business and control it in a legal and absolute sense? If so, this may preclude ESOP ownership.
      • Is the owner willing and prepared to give up complete control of the company and share ownership with employees?

      Answering these questions may help clarify whether an ESOP is an appropriate vehicle for you or your client's long-range business planning. But, if you look closely at the questions, you'll notice that many of them are not ESOP-specific. In other words, if the owner and the company are not prepared to implement a plan, then no plan will be the right plan – even the flexible ESOP.

      Additional Questions

      Now you have the tools to identify whether an ESOP may be an appropriate solution for your or your client's business planning needs. If you decide an ESOP merits further consideration, you will likely have additional questions. For instance, who can serve as the ESOP's trustee(s)? What does being a trustee involve? What other options are available to finance the purchase of stock by the ESOP? Do ESOP participants have a say in how the company is run? How are ESOP shares voted? Should my C corporation become an S corporation? What else can an ESOP invest in other than stock of the employer corporation? These are more advanced questions that we would be happy to help you answer.