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The ESOP Option

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Over the last two decades, employee stock ownership plans (ESOPs) - spurred on by various tax incentives - have become widely established among both publicly-traded and closely-held companies. One of the unique features of ESOPs is their effectiveness as tools of corporate finance. However, their use as financing tools also increases their complexity.

Here are some thoughts for consideration.

What is an ESOP? At its core, an ESOP is merely a tax-qualified savings or retirement account plan (such as a profit sharing or 401(k) plan). However, unlike profit sharing or 401(k) plans that invest in mutual funds or other general investments, an ESOP is designed to invest primarily in the stock of the sponsoring employer. And although some special rules apply to ESOPs that do not apply to profit sharing plans, most rules (including eligibility and vesting rules) are the same.

What is a leveraged ESOP?  

One of the unique features of an ESOP is its ability to use borrowed money to purchase employer stock. When an ESOP borrows, it is referred to as a "leveraged ESOP." With the proceeds of a loan, a leveraged ESOP can purchase employer stock on the open market, from any selling shareholder(s) or from the employer itself. Thus, a leveraged ESOP can serve a number of corporate objectives, such as reducing the number of outstanding shares, buying out existing shareholders and financing corporate expansion.

How does a leveraged ESOP work?  

In a typical leveraged ESOP transaction, the ESOP will use the proceeds of a loan from a bank or other lender to purchase employer stock. The employer will guarantee the loan and agree to make contributions to the ESOP in order that the ESOP will have money with which to repay the loan. Because contributions to the ESOP (a tax-qualified retirement or savings plan) are tax-deductible, the employer achieves something that can only be done through an ESOP -- the ability to repay a loan using tax-deductible principal and interest. The amount that can be borrowed is limited by the amount of tax-deductible contributions needed each year to repay principal on the loan (generally, about 25 percent of the payroll of ESOP participants).

The stock that the ESOP purchases with the proceeds of the loan is held as collateral by the lender. Each year, as the loan is repaid, a prorated portion of the shares held as collateral will be released and allocated to accounts of individual plan participants, where they will be held until distributed and/or forfeited following the participants' termination of employment.

ESOP Loan Example

Assume an ESOP borrows $1 million to purchase 100,000 shares of employer stock, which the lending bank holds as collateral. Assume further that the company will make contributions to the ESOP sufficient for the ESOP to repay 10 percent of loan principal each year.

Each year, as 10 percent of the loan principal is repaid, 10 percent of the shares held as collateral will be released. Thus, after the first year, 10,000 shares will be released. The released shares are allocated to each participant's account prorated based on the compensation of such participant to the total of all participants' compensation.

Note that the value of the stock has no bearing on either the number of shares released from collateral or the number of released shares allocated to participants' accounts. Participants therefore receive the full benefit of any stock appreciation.

What other ESOP tax incentives are there?

In addition to enabling an employer to borrow using tax deductible principal and interest, subject to some restrictions, the following tax incentives further encourage ESOP borrowing:

  • Below-Market Rates: A lending bank is permitted to exclude from taxable income 50 percent of the interest it receives on qualifying ESOP debt, thus allowing an ESOP loan to be made at below-market rates.
  • Dividend Deduction: Although dividends are not normally deductible, they are when used to repay a qualifying ESOP loan. In effect, this allows dividends to be used to increase the amount of ESOP loan that can be repaid with tax-deductible dollars.
  • Tax-Deferral Opportunities for Selling Shareholders: A shareholder of a private company who sells his shares to an ESOP can defer recognition of gain on the sale by reinvesting the proceeds in publicly-traded U.S. companies. The seller's basis in the old shares is carried-over to the new shares. In effect, an ESOP provides not only a market for non-tradable shares, but also allows a private shareholder to convert an illiquid investment to one that is readily tradable. To qualify for the tax-deferral, the ESOP must hold at least 30 percent of the stock immediately following the sale and the selling stockholder must have held his shares for at least three years.

What are the drawbacks of an ESOP?

In exchange for the generous tax incentive afforded ESOPs, there are numerous requirements. Some of the more important requirements are the following:

  • Participant Voting Rights: In general, participants must be permitted to vote employer stock that is allocated to their ESOP accounts (regardless of whether or not vested). However, if the employer's stock is not publicly traded and the ESOP has a loan that does not qualify for the 50 percent interest income exclusion discussed above, then participants need only be given the right to vote on significant corporate matters (like a merger or recapitalization).
  • Put Option Requirements: In general, an ESOP can make distributions in either cash or stock, but participants have the right to demand stock. In the case of a closely-held company, participants must have the right to require the company to purchase their shares at fair market value. The "put" price may be paid in installments over not more than a five-year period. Stock of a closely-held company may also be subject to a right of first refusal requiring the shares to be sold to the ESOP or the company. It is important that a closely-held company budget for put option liabilities. If ESOP shares increase significantly in value, the put option requirement could become a drain on the company's cash flow.
  • Annual Stock Appraisals: If the employer's stock is not publicly-traded, the shares must be valued by an independent appraiser at least annually. The appraisal is critical for purposes of valuing distributions and put option rights. Annual appraisals can significantly increase the cost of maintaining an ESOP. Appraisals are also subject to scrutiny to ensure that they are performed independently and adequately reflect the fair market value of the stock. If the appraisal does not meet these standards, the fiduciaries of the ESOP may face liability.
  • Fiduciary Concerns: Fiduciaries of an ESOP are often officers and other key management personnel. As fiduciaries, they owe a special duty of care to the ESOP and its participants. However, they also owe a duty to the company. Because of the potential conflict of these roles, ESOP fiduciaries must be alert to possible conflicts of interest. Just as an independent appraisal of stock is required for ESOPs of closely-held companies, the use of independent fiduciaries and financial advisers to represent the ESOP may be appropriate in connection with transactions involving an ESOP.
  • The cost to maintain an ESOP can be significant.  ESOP’s require audited financial statements and most companies will contract with an independent fiduciary.
  • The annual capital requirements to support the ESOP can have a negative impact on growth.

Is an ESOP right for your company?

There is no quick and easy answer. Companies that establish ESOPs often do so for the following reasons:

  • to buy out shareholders who wish to retire, capitalize on all or some of his or its shares, or otherwise no longer own the Company
  • to reward employees who have contributed to the success of the Company
  • to improve productivity and reduce turnover by giving employees a stake in the business
  • to provide employees with a tax-favored retirement savings plan
  • to provide a tax-favored means of corporate finance

Implementation of an ESOP is a significant event requiring careful planning and analysis utilizing qualified financial and legal advisors. While many of the objectives enumerated above may be achieved in a number of ways, an ESOP is a unique vehicle that delivers on all of them.

- Steve Sink

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This is one of the best concise overviews of an ESOP I've seen. Although fairly long for a blog on here, it's hard to be brief with an ESOP summary. We work with business owners and all retirement plans can be cosmic to some, but the ESOP can be powerful for the right company. Thanks for including the part about what type of companies are right for an ESOP. Well done, Steve.

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