This article will acquaint you with the utility of the ESOP as both a technique of corporate finance and an employee benefit plan. It is important to note, however, that there are other employee benefit plans that can be used to invest in stock of the employer sponsor. There are profit sharing plans, stock bonus plans which are not ESOPs, and combinations of 401(k) arrangements and profit sharing plans. An ESOP, even with its different variations, is just one of the alternatives in this area. You can find answers to other questions you may have in our ESOP Video FAQs.
Overview of Three Types of ESOPs
From a tax law standpoint, the IRS defines only one type of ESOP. However, to conceptualize the different uses and characteristics of ESOPs, we will discuss three “types” of ESOPs. Although these three “types” are really three “uses,” in practice it helps to think of ESOPs in this manner. All transactions or qualified plans involving ESOPs are simply variations on one of these three types.
1. Nonleveraged ESOP
This first type of ESOP (Diagram 1) does not involve borrowed funds to acquire the sponsoring employer’s stock. It is funded by contributions of cash or stock directly from the employer sponsor. Shares of stock contributed by the corporation are “newly issued shares.” New shares are issued to the ESOP and a deduction is taken by the corporation for their appraised fair market value as of the date of contribution. Alternatively, cash can be contributed to the plan in annual discretionary amounts as cash flow permits, to purchase shares at a later date, or simultaneously, from either the corporation or from another shareholder.
Generally, a nonleveraged ESOP is established to promote growth of the company sponsor by creating tax deductions with newly issued shares, thus improving cash flow and reducing taxes. It is also one of the best plans for gradual accumulation of retirement benefits tied to the value of employer stock and for promoting participatory management structures. The purpose of the ESOP can be to purchase shares from a shareholder on a cash flow basis where the tax incentives attributable to leveraged ESOPs are either not important or do not require borrowing funds. Using a non-leveraged ESOP will also avoid the impact of debt on the corporation’s value and balance sheet. Also, funding an ESOP on a cash flow basis suggests that the company’s obligation to repurchase shares from departing participants may be easier to manage than with the leveraged variety. This corporate obligation is called “repurchase liability.” Table 1 is brief comparative example of the ESOP’s cash flow advantage over non-ESOP.
Table 1
| Comparing ESOP Tax and Cash Flow Advantage | No Employee Benefit Plan | Employee Benefit Plan | ESOP |
|---|---|---|---|
| Pre-Tax Income | $150,000 | $150,000 (Cash) | $150,000 (Stock) |
| Contribution / Deduction | $0 | $50,000 | $50,000 |
| Taxable Income | $150,000 | $100,000 | $100,000 |
| Income Tax | $60,000 | $40,000 | $40,000 |
| Net Income | $90,000 | $60,000 | $60,000 |
| Cash Flow | $90,000 | $60,000 | $110,000 |
2. Leveraged Buyout ESOP
This form of leveraged ESOP (Diagram 2) is a lot like the Issuance ESOP, except the financing is used to buy stock from a selling (and usually retiring) shareholder.
These transactions have gained notoriety as a succession planning tool for closely held businesses. The tax incentives that accompany these types of transactions include tax deferred capital gains, tax favored financing.
They can be very compelling from an estate planning or succession planning view point. A seller who properly structures his transaction may sell his stock to an ESOP and not pay any immediate capital gains tax on the sale. The seller may reinvest the sale proceeds within 12 months of the stock sale to the ESOP and defer the capital gains tax liability indefinitely (known as a “1042 Rollover Transaction). This is much like the election available to reinvest the proceeds from the sale of your house. As a result, the seller will have all of the deferred taxes at work in his reinvestment portfolio. The company, in turn, will have paid the purchase price entirely in pre tax dollars.
As in the Issuance ESOP, the debt principal is repaid with pre tax dollars. Another consequence is that the corporation’s future repurchase liability will be equal to the fair market value of the stock purchased by the plan. In contrast to the Issuance ESOP, no dilution is suffered by existing shareholders.
Shareholders who do not sell their shares to the ESOP may find themselves competing with the corporation for assets with which to sell their stock in the future, if repurchase liability or growth in the stock value, or a combination of both, create a significant drain on corporate cash flow. It also may not be prudent to overburden a company with ESOP debt.
3. Issuance ESOP
An “Issuance ESOP” (Diagram 3) uses financing to acquire newly issued shares from the employer sponsor. The shares are allocated to the participants’ accounts as the loan is repaid. During this repayment, the shares are released from a special ESOP account, called a “suspense account,” to the ESOP participants’ accounts according to formulas developed by the IRS.
The corporate advantages of an Issuance ESOP are that it creates tax advantaged financing for purchasing capital goods, for expanding by merger or acquisition, or simply by increasing capital formation. For whatever purpose, the principal borrowed to buy the stock effectively becomes tax deductible by virtue of it being repaid via plan expense/contributions. The company is therefore able to borrow money this way on a fully deductible basis.
Several side effects of Issuance ESOPs must be considered. First, they have a dilutive effect on existing shareholders if company value does not grow faster than the value of the percentage of stock sold to the ESOP. Second, there is repurchase liability for the future retirement benefits in the plan. The company will some day have to repurchase shares distributed from the ESOP to participants. For whatever purpose, therefore, the ESOP is effectively permitting the company to “borrow from its retirement plan” by permitting current deductions for contributions that are used as capital in the company, until benefits need to be paid. This improves the corporation’s cash flow, pending a required retirement or other future plan distribution when shares are distributed and repurchased.
What to Do?
In order to fully understand whether some type of ESOP or ESOP transaction can be good for a company and its employees, it is critical to first identify the objectives of all those involved. Often there are overlapping and conflicting objectives. For example, the company’s expansion objectives or other shareholders’ objectives, may compete with the objectives of the potential selling shareholders. Furthermore, the impact of an ESOP on the employees and the ability to motivate employees must be seriously considered. In this regard, employee questionnaires, feasibility studies and further information and assistance from organizations like the National Center for Employee Ownership (NCEO) and the ESOP Association can go a long way towards helping you answer these questions. Alternatively, our firm has a wide range of outlines and information which cover these various ESOP applications and some of the related tax, financial, and employee benefits issues which accompany them.
How Do I Know If I Should Consider A Leveraged Or Non-leveraged ESOP For My Company?
In this concise video, ESOP attorney Kevin Long explains how.
