ESOPs And KSOPs
Chang Ruthenberg & Long provides the complete suite of ESOP services. We begin with a focused discussion to promptly help you determine whether an ESOP is a good fit for your company or an alternate strategy is more appropriate. We do not "sell" ESOPS, and ESOPs are not the only solution we can offer. No two companies are exactly alike. There is a broad spectrum of ESOP applications. That's why effective ESOPs are not one-size-fits-all.
If an ESOP is identified as appropriate, our independent, unbiased approach assures a solution tailored to your unique goals. Read about how we put clients in control of the planning process with our client-centric approach (link, right). Together with you, we chart the path that's right for your company. We provide:
- Formal suitability analysis
- Feasibility analysis
- ESOP team development
- Plan design
- Transaction management
- Legal counsel and documents
- Fiduciary representation
- Plan Compliance
- IRS and DOL defense
We encourage you to explore this site. Browse our ESOP library, take our preliminary suitability quiz, learn about the basic types of ESOPs. If you have questions, would like to receive a package of ESOP information including CD material, or need information more specific to your situation, please feel free to call or email one of our ESOP specialists.
Understand What An ESOP Is
An ESOP is a form of qualified retirement plan, very similar to a profit sharing plan. However, an ESOP is specifically designed by Congress to be invested primarily in employer stock and used as a vehicle for corporate succession planning and finance. Due to their unique purpose, ESOPs are often misunderstood. Since an ESOP is actually a retirement plan like a standard profit sharing or 401(k) plan, it follows the same coverage, participation, and nondiscrimination provisions that govern all retirement plans. The primary difference is that an ESOP:
- Is required to invest primarily in company stock.
- Is not required to diversify its investments.
- May borrow money to purchase stock from shareholders.
- Contains flexible rules for financing stock transactions, funding benefit distributions, and retaining control of company stock or trading in publicly traded stock.
Every ESOP contains the tools needed to accommodate many types of transaction strategies and benefit formulas. The following discussion 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. All of these plans, if properly designed, can be an effective means for including equity as a component of an employee benefit plan structure. It is important to note then, that the ESOP, even with its different variations, is just one of the alternatives in this area.
The most common use of an ESOP is to sell part or all of an owner's interest in a closely held company. In this situation, an ESOP provides substantial advantages over other alternatives:
- It provides a ready market for the stock.
- The company can fund the transaction with pretax dollars.
- The owner(s) may sell to the ESOP partially, or in stages over a period of years so they can gradually ease out of the company — a particularly important consideration for sellers with management responsibilities.
- In a C corporation, the selling owner(s) may defer taxation on the gains by using the Section 1042 "rollover" explained above.
- In an S corporation, distributions that would otherwise be used for shareholders to pay taxes on S corporation income may be used to fund a portion of the ESOP share purchase.
There are now more than 9,700 ESOPs and similar stock bonus plans covering more than 11 million employees — about 9% of the nongovernmental U.S. work force. Although some ESOPs are found in publicly traded companies, most (about 95%) are in closely held companies. ESOPs are usually set up in healthy companies, although a handful have been used to save distressed companies. Most ESOPs are set up in companies that have at least 20 or so employees, due to the cost of setup and administration. ESOPs are found in companies ranging from family-owned machine shops to public companies like Proctor & Gamble.
In 2000, in the largest and most significant study to date on the performance of ESOPs in closely held companies, Douglas Kruse and Joseph Blasi, both of Rutgers University, found that ESOPs increased sales, employment, and sales per employee by about 2.3% to 2.4% per year over what would have been expected absent an ESOP. ESOP companies also were somewhat more likely to still be in business several years later.
Overview Of The Three Basic Types Of ESOPs
Since 1986, there has been technically only one type of ESOP defined in the Internal Revenue Code. Even so, there are essentially three methods of funding an ESOP or an ESOP transaction to take advantage of ESOPs tax benefits, transfer buy out an existing shareholder or provide stock benefits to employees. There are many variations on these themes, including KSOPs, S Corporation ESOPS, tax deferred "rollover" transactions, management leveraged buy outs, and on and on. However, all of the transactions that involve ESOPs are simply variations on one of these three basic themes.
Nonleveraged ESOP. This first method of ESOP funding does not involve borrowing any funds to acquire employer stock. It is funded by contributions of cash or stock directly from the company plan sponsor. Sometimes these ESOPs are referred to as "Stock Bonus Plans."
If shares of stock are contributed by the corporation they are "newly issued shares." New shares are issued to the ESOP (sometimes loosely referred to as "treasury shares"). The corporation takes a tax deduction equal to the shares' appraised fair market value for the year it contributes the shares.
Alternatively, cash can be contributed to the plan in annual discretionary amounts as cash flow permits, to purchase shares. The cash contributions are tax deductible. Shares can be purchased from existing shareholder with the ESOP contributions
Finally, cash can be contributed to the ESOP in annual discretionary amounts and held by the ESOP for future ESOP purchases from existing shareholders. This allows an ESOP to buy larger amounts of shares in single transactions without using financing.
Figure 1 illustrates the nonleveraged ESOP process. It works like this:
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Employer adopts the ESOP plan and trust document.
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Fair market value of the stock is determined.
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Company calculates the amount of the annual contribution to the ESOP (up to 25% of participant compensation).
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Company contributes shares or cash to the ESOP.
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Company claims a deduction for the cash or the shares contributed at fair market value.
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Cash or shares are allocated to participant accounts in the plan.
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Employee accounts vest over time.
If a non-leveraged ESOP is established to create tax deductions with newly issued shares, it promotes the growth of the company by improving cash flow and reducing taxes. It is also the best plan for giving stock to employees on a deductible basis and for promoting participatory management structures. In fact, it is the only way to compensate employees with stock and take a current tax deduction without the employees being taxed when the stock is given. All forms of stock options or restricted stock grants require the employee to be taxed if the employer takes a tax deduction.
Using a non-leveraged ESOP will avoid the impact of debt on the corporation's value and balance sheet. Table 1 shows a brief comparison of the ESOP's tax and cash flow advantage over other retirement and profit sharing plans.
|
Table 1
Comparing ESOP Tax And Cash
Flow Advantages |
No Employee
Benefit Plan |
Employee
Benefit Plan |
ESOP |
|
Pre-Tax Income |
$150,000 |
$150,000
(Cash) |
$150,000
(Cash) |
|
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 |
Leveraged Buyout ESOP. This form of leveraged ESOP is used to buy stock from a selling (and sometimes retiring) shareholder. The ESOP uses financing to buy the shares. However, since an ESOP does not have its own assets or credit worthiness, the company guarantees the loan or takes out the loan to fund the ESOP debt. The shares purchased with the loan are placed in a special ESOP account, called a "suspense account." As the loan is repaid, the shares are released from the suspense account. For example, for a ten year loan, one tenth of the shares are released from the suspense account each year. As they are released, the shares are allocated to the participants' accounts according to formulas developed by the IRS, much like benefits are allocated in a profit sharing plan.
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 on a fully deductible basis to buy out a shareholder. Even the principal on the loan becomes tax deductible. This is the only tax deductible way to buy out a shareholder. The alternatives are to either redeem the stock with non deductible company profits; or distribute profits to a shareholder (who is taxed at ordinary income tax rates) who then purchases shares from the seller, who is taxed at capital gains rates.
Figure 2 illustrates the leveraged buyout ESOP process. It works like this:
- Employer adopts the ESOP plan and trust document.
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Fair market value of the stock is determined.
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Company borrows money from a bank.
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Company loans these funds to the ESOP.
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ESOP purchases shares with the funds from an existing shareholder.
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Seller reinvests his or her sales proceeds in stocks or bonds and elects to defer tax on the sale.
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Company contributes cash to the ESOP as the annual contribution to the ESOP (up to 25% of participant compensation).
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ESOP makes payments on the loan from the company.
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Company makes payments on the loan from the bank.
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Shares are released from a suspense account and are allocated to participant accounts in the plan as the loan is repaid over its term.
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Employee accounts vest over time.
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, and 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 immediately pay capital gains tax on the sale. This is commonly referred to as a "1042 Rollover Transaction," named after the Internal Revenue Code Section that makes it possible. The seller must reinvest the sale proceeds within 12 months of the stock sale to defer the capital gains tax liability indefinitely. Some or all of the proceeds must be reinvested in "Qualified Replacement Property" which means stocks or bonds of U.S. corporations to defer the tax on the reinvested amount. Mutual funds and governmental bonds do not qualify. The seller is taxed when the reinvested portfolio is sold. Other detailed and technical requirements apply.
This is much like the Code section 1034 mechanism 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.
Issuance ESOP. An issuance ESOP uses financing to acquire newly issued shares from the employer sponsor. The shares are placed in a special ESOP account, called a "suspense account." As the loan is repaid, the shares are released from the suspense account. For example, for a 10-year loan, one-tenth of the shares are released from the accounts for the ESOP participants. As they are released, the shares are allocated to the participants' accounts according to formulas developed by the IRS, much like benefits are allocated in a profit sharing plan.
Figure 3 illustrates the issuance ESOP process. It works like this:
- Employer adopts the ESOP plan and trust document.
- Fair market value of the stock is determined.
- Company borrows money from a bank.
- Company loans these funds to the ESOP.
- ESOP purchases newly issued shares with the funds from the company.
- Company contributes cash to the ESOP as the annual contribution to the ESOP (up to 25% of participant compensation).
- ESOP makes payments on the loan from the company.
- Company makes payments on the loan from the bank.
- Shares are released from a suspense account and are allocated to participant accounts in the plan as the loan is repaid over its term.
- Employee accounts vest over time.
The corporate advantages of a leveraged 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. Even the principal on the loan becomes tax deductible. 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
Several side effects of issuance ESOPs must be considered. 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. For whatever purpose. This improves the corporation's cash flow, pending a required retirement or other future plan distribution when shares are distributed and repurchased.
Explore Whether An ESOP Is Right For You, Your Company, Or Your Client
We are frequently asked by companies and their advisors, "Will an ESOP work for my company ... or my client's company?" This question really requires an ESOP specialist to analyze the client situation, including the corporate objectives, existing business plan, employee benefits structure and the shareholders' personal objectives to determine whether some form of ESOP will advance the client's goals.
However, there is a basic level of review that can be performed to provide a first look at whether an ESOP is a suitable vehicle for accomplishing certain goals. A minimum amount of data is needed to find out what you have in mind. With this basic information we can contact you within three business days with our assessment and additional information, if desired.
Learn What It Takes To Implement An ESOP
Investigating and implementing an ESOP can be a daunting task. It requires a lot of hands-on investigative work by the client and a good team of advisors. The positive side of the challenge is that it yields a more satisfying ESOP experience. Chang, Ruthenberg & Long helps clients take the right steps in the right order. We involve the client and their resources every step of the way. This accounts for our higher level of certainty that our client will end up with an ESOP transaction that is feasible, suitable, and compatible with the objectives of the company and the shareholders.
For a narrative of the process of determining suitability, feasibility and implementing a typical succession planning ESOP, read our article "Some Assembly Required: Putting Together an ESOP Program."
See How We Put Clients In Control Of The ESOP Planning Process
Business owners who are considering an ESOP have been successful in building and running their companies. We believe that they can be equally successful in implementing an ESOP and using it to improve their company's performance. That's why our approach puts the business owner at the center of the ESOP process. We surround our clients with and then manage the best available advisors and support team to ensure their success. It's an approach that sets us apart from other ESOP advisors.
- We allocate all issues in the right order to ensure that the client understands and efficiently achieves all of the necessary planning steps.
- We systematically achieve the right ESOP strategy, out of the many available alternatives.
- We ensure our clients gaining a complete understanding of their ESOP strategy, and how it integrates with all aspects of their business.
In comparison, the "turn-key" or one-stop ESOP provider offers a fixed fee engagement for delivering all ESOP advice and services. This model offers predictable pricing, however, in our experience not all of the client's multi-faceted needs and issues may be raised. The client truly needs to work through the issues affecting the company, the sellers, the fiduciaries and other affected parties, and assimilate the solutions into the strategy.
Also in comparison, the "quarterback" model provides bundled pricing and managed fees to provide a perceived cost control and coordinated service. This system too can have drawbacks. Direct interface with the service providers isn't always thorough. Dealing with sophisticated legal and financial issues through an intermediary does not, in our experience, foster complete client understanding and thorough examination of the nuances of the issues involved.
Our client-centric model allows us to offer the right service providers for each client, including the client's existing advisors, working "inter-dependently." The client is at the center of that process.
Each select ESOP team member, from experience in working on our teams, understands the issues and challenges of the other advisors. This expertise is coordinated, supported and directed by Chang, Ruthenberg & Long. The client can rely on each individual service provider at any time to correctly reflect the issue to the appropriate advisor for resolution. Sophisticated and integrated relationships allow prompt and accurate issue resolution, and the best plan and transaction design. The services provided may appear similar to the other models' functions; but the quality of the result is greatly enhanced.
Our approach objectively reconciles the trade-offs in deciding when, whether and how to use an ESOP. We don't sell ESOPs. At Chang, Ruthenberg & Long we do not believe in installing an ESOP or ESOP transaction unless deemed by the client to be the best solution after all issues are identified and addressed. Our process arranges those issues and variables in the proper sequence so that our clients can best apply them to their company. Education, disclosure and objectivity coupled with informed decision making result in ESOP success.