WHAT IS AN ESOP?

An Employee Stock Ownership Plan, an ESOP, can be an extraordinary financial tool to accomplish corporate goals and generate tremendous tax savings for both the corporation and its shareholders. An ESOP is a tax qualified retirement plan sanctioned by the Employee Retirement Income Security Act of 1974 (ERISA) and more than 20 other pieces of legislation. The ESOP movement is fully supported by both aisles of Congress. ESOPs are similar to Profit Sharing and Pension Plans in that they are all subject to ERISA. However, there are two major distinctions between ESOPs and other tax qualified plans. An ESOP’s primary purpose and mandate is to acquire stock of the sponsoring corporation and the ESOP is permitted to borrow money to accomplish this goal. Other tax qualified plans are expressly prohibited from this type of transaction. These two differences between an ESOP and other tax qualified plans turn the ESOP into a financial tool for the corporation. In fact, the IRS defines an ESOP as a tool of corporate finance.

WHAT CAN AN ESOP ACCOMPLISH?

In an ESOP company, the ESOP often becomes the centerpiece of the financial architecture of the company. Listed below are the traditional uses of ESOPs and there exist numerous non-traditional uses about which we can provide more information. ESOPs are very flexible in that they can be used to simultaneously accomplish any combination of the following:

• Creation of a liquid marketplace for closely held stock which provides a viable tax advantaged exit strategy for shareholders under Section 1042.

• Maximizing the stockholder's cash-out proceeds via Section 1042 rollover that allows the stockholder to eliminate, through proper planning, federal and state income taxes on the long term capital gain on the sale of the stock.

• Sell some or all of your privately held stock and still maintain control.

• Repay the principal portion of corporate debt with tax deductible dollars.

• The corporation is provided with the ability to buy out minority or majority shareholders with tax deductible dollars.

• Motivate and reward employees and attract and retain good management.

• Closely associated with the above 1042 transaction is the ability of an ESOP to help a stockholder diversify his or her personal net worth. Many of our clients have 90% or more of their net worth tied up in their business and this method allows tax-free diversification of shareholder equity.

• ESOP purchases of stock are deductible to the corporation. Corporate redemptions are done with after-tax dollars. In terms of pre-tax earnings, a profitable corporation will have to have $1,667,000 of pre-tax earnings to complete a $1,000,000 redemption. An ESOP purchase requires $1,000,000 of pre-tax earnings to complete a $1,000,000 purchase. In addition, the selling shareholder must pay taxes on his gain in a redemption versus the tax free treatment with an ESOP as mentioned earlier.

• Transfer the business to a son, daughter or management group with huge tax advantages and guarantee the perpetuation of the company.

• Sell the company to an outside buyer with significant tax advantages to both buyer and seller.

• Cash out investors with pretax dollars and tax free to the investors.

• Redirect tax dollars to non-qualified tax advantaged deferred compensation plans for selected employees.

• Corporate acquisitions can be done with deductible dollars. An ESOP acquisition allows a corporation to acquire a business entity of a larger size than what would normally be allowed in a traditional acquisition.

• Current long-term debt can be refinanced via ESOP providing the corporation with tax deductible principal, as well as interest, for debt repayment.

• Dividends, if paid through an ESOP, are deductible to the corporation. Many ESOP companies replace their bonus programs with dividend dollars via ESOP because dividends are not subject to FICA taxes, saving both the company and its employees taxes on "bonus" income.

• Recover C corporation income taxes paid over the prior two years. This is accomplished by making either a cash or stock contribution to the ESOP in an amount equal to the taxes to be recovered.

• Reduce or eliminate estate taxes with ESOP planning techniques.

• Increase employee productivity. The Department of Labor has statistics that indicate for every 1% improvement in productivity in ESOP companies, there is a 20% increase in gross profits. This benefit should not be underestimated as many ESOP transactions can be funded exclusively through productivity increase.

• Takeover defense tool. Having stock in the "hands" of "friendlies" such as employees makes hostile takeovers difficult.

• Eliminating a current union or discouraging a unionization effort.

Some of these areas need to be reviewed in more detail:

THE CAPITAL GAINS TAX DEFERRED SALE OF STOCK TO THE ESOP

Section 1042 allows the owners of privately held C corporation companies to sell some or all of the stock to the ESOP and defer or possibly eliminate the capital gains tax on the transaction. To qualify for the deferment, three basic criteria must be met:

1. The selling shareholder must have owned the stock for three years prior to the sale to the ESOP.

2. After the transaction the ESOP must own a minimum of 30% of all the outstanding classes of stock.

3. Within 12 months of the transaction the sale proceeds must be reinvested in Qualified Replacement Property which is generally defined as the debt or equity of any U.S. operating company such as IBM, General Motors, Xerox, etc.

On a sale of $1,000,000 of stock, assuming an effective zero basis, the selling shareholder in the 25% combined federal and state tax bracket will save $250,000 of taxes and have the full $1,000,000 to invest rather than only $750,000 to invest as in a traditional sale.

Investment of the sales proceeds within 12 months of the transaction into Qualified Replacement Property (QRP) will defer the capital gains tax on the sale. If the QRP is held until death the property receives a stepped up basis and the gains tax is eliminated. A frequently used QRP is the Floating Rate Note (FRN). This note pays an interest rate akin to a money market instrument. However, up to 95% of the value of the note can be borrowed and, if used for investment purposes, the after tax cost of borrowing may nearly approximate a wash. The loan proceeds of the note can then be given to, say, an investment manager, who can trade them as frequently as desired to achieve the maximum possible gains in the market.

The selling stockholder could also invest the sale proceeds into another privately held company, either existing or new, and this company would qualify as QRP as long as the company does not generate its income from passive investments.

TAX DEDUCTIBLE PRINCIPAL & INTEREST ON LONG TERM DEBT

The interest on traditional debt service is tax deductible, but the principal portion of the payment to the bank is not deductible. Contributions made by the corporation to the ESOP are tax deductible by the company. With proper structuring, these contributions can be used for debt service, which makes both the interest and the principal payments deductible.

The corporation seeks a loan from a lender. The lender loans the money to the corporation which in turn makes an identical mirror loan to the ESOP. As the ESOP has no funds to repay the company, the corporation makes tax deductible contributions to the ESOP in the amount of the debt service, making both the interest and the principal portions of the debt service deductible. The ESOP uses the contribution to service its debt to the company and the company, in turn, uses the payments from the ESOP to service the debt to the bank. Using this technique, a company in the combined federal and state tax bracket of 40% can borrow money and the after tax cost of the interest and principal payments may be less than the amount of funds originally borrowed.

CONTROL OF THE ESOP STOCK

A properly designed ESOP will "pass through" the voting rights of shares held by the ESOP to one of the fiduciaries, either the ESOP Trustee or Administrative Committee. In some cases, an ESOP company would want to employ a bank trust company as Trustee with no discretionary authority. The Administrative Committee makes strategic decisions and votes the shares held by the ESOP and the Trustee simply executes financial transactions and instructions provided by the Administrative Committee.

Employees who participate in the ESOP have no minority shareholder rights. In a properly designed ESOP, the employees never see, feel, touch or own a single share of stock. The employees have no access to confidential financial information. Their interest in the ESOP essentially begins and ends with their account balance being based on the underlying value of the company's stock. The only time an employee can vote allocated shares is on issues of merger, acquisition, divestiture, recapitalization or a sale of substantially all of the assets of the corporation.

The company's Board of Directors, elected by the outside shareholders, has the authority to appoint and remove members of the Administrative Committee of the ESOP. The Committee could be comprised of Board members or officers of the company. In some cases the outside shareholders, having elected themselves to the Board, may appoint themselves as the Administrative Committee just as they might elect themselves as the President or the Chairman of the company - a change in fiduciary hats or responsibilities.

REWARDING EMPLOYEES WITH A "PIECE OF THE ACTION"

Many company owners want to reward their loyal employees who have worked hard over the years to make the company what it is today. What better way to reward them than to make them employee-owners of the company through an ESOP. The ESOP can be used as a method to get company equity into the hands of the employees through tax deductible stock contributions to the ESOP and no current taxable income to the employees. Employees, through the communications process are educated to understand that they are no longer just employees, they are now employees owners and an ownership culture is developed throughout the company. Employee owners begin to think and act like owners. They are taught that for each dollar of extra profit they can generate through sales or, for each extra dollar of savings they can generate through efficiency in the specific area of their job, this extra productivity will increase the profitability of the company. In turn, the increased profitability will increase the value of company stock and this is the same stock that they have in their individual ESOP accounts.

IMPROVING EMPLOYEE PRODUCTIVITY

In today's business environment, employees will seek an employer who will provide some form of welfare and/or retirement program. Employees view these programs as a demonstration by the employer of the intent to provide permanent employment, offer opportunity for advancement within the company and ultimately to retire comfortably.

Employers who provide no plans will find difficulty in retaining not only line employees but middle and upper level management as well. Pension plans have lost their appeal to employers as tax laws have changed. Profit sharing plan contributions are often only a token amount. An ESOP can not only replace the basic function of a pension or profit sharing plan, but additionally, can reap a tremendous change in attitude by the employee which benefits the employer.

ESOP participants perceive themselves as company owners. This perception, this change in attitude, this feeling the employee develops has direct financial rewards for the corporation. Employees are quickly taught that if they waste company money by inefficiency, carelessness, lack of incentive or irresponsibility, it directly impacts their own personal financial status. Lower corporate profits due to the "it's only a job" attitude will tend to reduce or retard the growth of company stock. Employees who are ESOP participants recognize that their own individual improvement on the job will increase corporate profits which, in turn, will increase the potential allocation to their accounts, which will increase the value of the stock in their accounts.

The change in attitude by employees in ESOP companies, from the bottom all the way to the top, has been repeatedly demonstrated in studies by the Department of Labor. The studies have consistently shown that a 1% increase in employee productivity can directly translate in up to a 20% increase in profitability for the employer.

Given a choice, nearly everyone would choose to be an "owner" rather than just an employee.

ESOP Corporate Resources, Inc. can guide you through the ESOP process from A to Z to maximize the effectiveness of your ESOP. For additional information or a personal free initial consultation, contact ECR.