RSM Resources

Smart companies are always on the hunt for management tools thatstrengthen their organizations, reward their employees and provide newplatforms to grow. One of the most effective strategies available todayisn’t a hot-off-the-presses business trend. It’s an establishedfinancial vehicle that’s been around for more than 30 years: theemployee stock ownership plan (ESOP).

ESOPs are tax-qualifiedbenefit plans that can motivate your employees, reduce your taxliability, attract new equity and expand financing options for yourcompany. With ESOPs, employees do not actually buy shares. Instead, thecompany contributes its own shares to the plan, provides cash to buyits own stock or directs the plan to borrow money to buy stock, withthe company repaying the loan. Employees gradually vest in their ESOPaccounts and typically receive their benefits when they leave thecompany.

Since their official recognition in 1974, ESOPs havegrown substantially. In 2006, there were 9,225 ESOPs in the UnitedStates with 10.1 million participants and total assets of more than$600 billion, according to the National Center for Employee Ownership.

"Forboth financial and nonfinancial reasons, selling stock to an ESOPshould be irresistible to many closely held companies and theirshareholders," says Corey Rosen, executive director of the NationalCenter for Employee Ownership.

ESOPs provide significant taxbenefits in situations such as the spin-off of a division or corporateexpansion — and are a valuable acquisition planning tool. They can begiven a special class of preferred stock to minimize equity dilutionand be combined with a 401(k) plan to attract employee equity into acompany.

An ESOP also can produce greater commitment andproductivity from employees and, in turn, greater stock value,according to Rosen. This is provided that employees "understand howtheir work affects the stock value and are given an opportunity to haveconstructive input on their day-to-day efforts in the workplace," saysRosen.

How an ESOP works

In an ESOP, a companysets up a trust fund, into which it contributes new shares of its ownstock or cash to buy existing shares. Generally, all full-timeemployees over 21 and with at least one year of service participate inthe plan. The company allocates shares in the trust to individualemployee accounts, with those allocations made either on the basis ofrelative pay or another equitable formula.

In most cases,employees must be 100 percent vested in their ESOP account within sixyears. When employees leave the company, they receive their stock,which the company must buy back from them at its fair market value.Private companies must allow employees to vote their allocated shareson certain major issues, such as sale of company assets. For lesssignificant issues, companies can choose whether to pass through votingrights to employees (such as for the board of directors). Publiccompanies cannot restrict employees from voting on any issue.

ESOP advantages

Oneof the most popular tax advantages of an ESOP for C corporations isthat a shareholder can sell his or her stock to the ESOP withoutgetting taxed on the gain from the sale. To qualify for this taxdeferral, the shareholder must reinvest sale proceeds in other domesticstock or securities but not government obligations or mutual funds.

Regardlessof whether the employer is a C or an S corporation, because, the sourceof repayments on the origination loan used to fund the ESOP comes fromemployer’s retirement plan contributions, both the principal andinterest payments are tax deductible within the applicable limits.ESOPs of C corporations may get an extra benefit of expanded deductionlimits.

If the ESOP sponsor is an S corporation — which, unlikea C corporation, generally does not pay any federal corporate incometax — there is no federal income tax on the portion of the incomeassociated with the ESOP ownership interest. So, if an ESOP owns 30percent of an S corporation, 30 percent of the company’s earnings wouldbe exempt from federal (and most state) income tax.

Here’s an example to illustrate the financial advantages of ESOPs:

Ms.Founder started her company in 1960, a business that is now valued at$10 million. She’s ready to retire but has no family members to takeover the business and does not want to sell to an outsider, so shesells 100 percent of her stock to the ESOP. Although the ESOP must be aC corporation for purposes of rollover of domestic stock or securities,a subsequent S corporation election provides a significant tax benefit.Now, Ms. Founder does not have to pay the almost $1.5 million ofcapital gains tax that would normally apply to a sale this size, andthe ESOP can buy her stock with tax-deductible financing.

Oncethe company makes the S corporation election, it essentially becomes atax-exempt entity. The dollars Ms. Founder would have paid to thegovernment can now be used to pay off the ESOP debt or finance thefuture growth of the company.

With all this promising data andfinancial good news, you may be eager to get on board with ESOPs.Before diving in, however, the National Center for Employee Ownershipadvises companies to take these initial steps:

Conduct a feasibility study.This analysis should assess how much extra cash flow the company needsto devote to the ESOP and whether this is adequate for the ESOP’spurposes, determine if the company has adequate payroll for ESOPparticipants to make the ESOP contributions deductible, and estimatethe company’s repurchase obligation.

Commission a valuation.The valuation consultant will look at a variety of factors, includingcash flow, profits, market conditions, assets, comparable companyvalues, goodwill and overall economic factors.

Hire an ESOP attorney.If the feasibility study and valuation prove positive, the plan can nowbe drafted and submitted to the IRS. You should carefully evaluate youroptions and discuss with your attorney how exactly to structure theESOP.

Obtain funding for the plan. Potential fundingsources include ESOP loans, ongoing company contributions, existingprofit-sharing plans and employee ESOP contributions. In structuringthe financing, remember that seller financing is permissible.

Establish a process to operate the plan. In most private companies, an ESOP management committee will direct a trustee from inside the organization.

Engage employees. Reach out to employees to explain how the ESOP works and motivate them to become involved as owners.

Accordingto Steven Freeman of the University of Pennsylvania’s Center forOrganizational Dynamics, research confirms that engaged employeeownership, on average, leads to increased productivity, profitabilityand longevity.

"Studies have found significantly higher salesgrowth among firms that adopted ESOPs or profit-sharing plans, and thatthe sales growth of ESOP firms significantly improved after ESOPadoption," Freeman says. "Evidence suggests that combining employeeownership with increased employee participation may generate astoundingreturns on investment."