Employee Stock Ownership Plans: An Innovative Succession Planning Strategy For Business Owners
 
March 17, 2004
 
David O'Leary - Chicago

The recent rebound in the stock market has brought about renewed interest in Employee Stock Ownership Plans (ESOPs). While much of the focus is on large, publicly traded companies, ESOPs can provide owners of small and mid-sized corporations with a strategy to sell their stock for “top dollar” in a tax-advantaged manner without having to relinquish control of the corporation.

Planning Strategies

Sale of stock to an ESOP is an innovative estate planning and corporate financing strategy, especially useful in today’s difficult capital markets. It is extremely effective when used in conjunction with business succession planning. It is also very effective for a corporation desiring to purchase the stock of a retiring shareholder and for business owners seeking alternatives to selling their business to a third party.

Often, the value of the stock of a family business will comprise a significant part of an owner’s net worth. Sale of all or a portion of the owner’s stock to an ESOP may provide the owner with funds to diversify his investments or implement lifestyle changes. Occasionally, the price paid by an ESOP exceeds what a third-party buyer would pay, thereby providing the owner with “top dollar” for his stock. For the owner who wants to sell his stock, but doesn’t want to give up control of the business, various techniques are available to enable the owner to maintain control.

As part of an owner’s estate plan, sale of stock to an ESOP may provide an owner with liquidity to facilitate his desire to equalize inheritances, thereby permitting other family members not participating in the business to share in the wealth created by the business. The additional liquidity also may reduce or eliminate the need to sell the owner’s stock on an emergency basis to raise funds for payment of estate and income taxes and expenses of administration upon the owner’s death. For those owners who are concerned about the future of their long-term employees, sale of stock to an ESOP may help ensure the preservation of their jobs.

Tax Benefits

A sale to an ESOP is the only strategy available whereby the stock of a selling shareholder can be acquired utilizing pre-tax rather than after-tax earnings. The corporation makes tax-deductible contributions to an ESOP and the ESOP uses the contributions to acquire stock from the selling shareholder. Use of pre-tax earnings may provide a very significant cash flow benefit to the corporation.

Certain tax benefits available to the corporation and its shareholders are a function of whether the corporation which sponsors the ESOP is a “C” Corporation or an “S” corporation under the Internal Revenue Code. For example, if the corporation is a “C” corporation, a shareholder selling his stock to an ESOP may defer income taxes on his gain on the sale if certain conditions are met. Properly structured, this deferral can be a permanent tax deferral. If the corporation is an “S” corporation partly or wholly owned by an ESOP (a tax-exempt trust) the ESOP pays no income taxes on the corporation’s income, which is allocated to the ESOP. Maximum tax saving are sometimes achieved when a “C” corporation establishes an ESOP, the ESOP purchases the stock of one or more shareholders and the corporation then elects “S” status. In this situation, the shareholders pay no current tax on the sale of their “C” corporation stock because their gain is deferred and the ESOP pays no taxes on its share of the future earnings of the corporation because the corporation has elected “S” status; a very attractive scenario.

Types of ESOPs:

An ESOP is a special kind of qualified plan under the Internal Revenue Code designed to give employees an ownership stake in their company by investing primarily in the stock of the sponsoring employer. An ESOP can be leveraged or non-leveraged.

A leveraged ESOP uses borrowed funds to purchase company stock. Many banks are eager to finance ESOP transactions. Usually, the loan is made to the ESOP and the company guarantees payment. The stock purchased with the loan proceeds is pledged as collateral. In some cases a bank loans funds to the company, which in turn loans funds to the ESOP.

A non-leveraged ESOP buys a company’s stock using existing plan assets, assets or other qualified plans of the company, or annual company contributions. As an alternative to leveraged financing, the ESOP can “self finance” by making installment payments to the selling shareholders over time.

Summary

An ESOP provides business owners with a unique estate planning and financing tool. The ability of the corporation to deduct principal payments for stock purchases, the resources available for obtaining outside financing and the flexibility in designing innovative “exit strategies” for selling shareholders make sales of stock to an ESOP a preferred solution for many planning situations.

For more information, e-mail David O’Leary at david.oleary@hklaw.com or call toll free, 1-888-688-8500.