In this podcast episode, Senior Attorney Sheryl Bayani-Alzona discusses ESOP transactions and how they are funded.
Speaking of Benefits, this is Sheryl Bayani-Alzona. In this episode, we are going to talk about three things about an ESOP.
- The ESOP is a buyer
- What happens to the shareholder after the transaction
- How the transaction is funded
Let’s play Two Truths and a Lie, ESOP style. I will tell you three things and one of them is a lie. You might just be surprised.
- An ESOP is a ready buyer for some or all of the shares of the company.
- Sellers to an ESOP can define their role in the company after the sale.
- An ESOP is a giveaway.
If you guessed that number one is the lie, well, you guessed wrong. Number one is true. An employee stock ownership plan, an ESOP, is an available buyer for the shares of the company. The ESOP is also a buyer who’s willing to purchase a minority interest. And most importantly, an ESOP is the only retirement plan permitted to borrow funds to purchase stock. Congress put these laws in place to encourage comfortable capitalism, not by forcing everybody out, but by opening up capitalism to everyone.
If you guessed that number two is the lie, well, you guessed wrong. Number two is true. The seller to an ESOP can continue to say as an officer, a director, a manager, or as an employee of the company, and in certain situations as part of the ESOP. This is true even if the seller sells some or all of the shares in the company. Immediate loss of control is not a concern insofar as the ESOP is a very flexible tool. No more control has to be given away than the minimum required by the Internal Revenue Code and ERISA.
Now, if you guessed that number three is the lie, then you are correct. Many company owners and even some ESOP advisors think that ESOPs are giveaways. Even though the employees do not take out their checkbooks or use part of their paychecks to pay the sellers, nothing is given away for free. Selling to an ESOP is not a giveaway because the ESOP is permitted by law to pay an appraised fair market value for the shares. The truth is the company funds the buyout with tax subsidies. Why do I say tax subsidies? Well, because all principal and interest payments are tax-deductible, even in situations where an ESOP is funded with contributions of newly-issued shares. In most situations, the contributions are in lieu of cash contributions or represent tax and cash flow advantages to the company that cannot be obtained with another type of benefit plan.
I have a bonus question for you. Who among the former Presidents of the United States was a big advocate of the ESOP model even before he became President? If you guessed Ronald Reagan, then you got it right. Ronald Reagan’s administration added incentives to the tax code in 1984 to allow company owners to sell stock to an ESOP and defer the capital gain. And in some cases, never pay it. Reagan believed that this helped preserve and perpetuate American companies. And yes, he was right.
If you need specific guidance on this topic, let’s start a conversation. This podcast is for informational purposes only. It does not create an attorney-client relationship between Employee Benefits Law Group and the listener or the reader and does not constitute legal advice for a specific situation.