Why an ESOP? Why Now?

Over the last several months our offices have been deluged with calls from owners and their advisers wishing to explore the possibility of "doing an ESOP." While the well-known tax benefits of employee stock ownership plans have been around since the mid-1970s, this old liquidity, estate planning, and ownership transfer technique is suddenly attracting vivid interest among family businesses.

Part of the reason is that public companies are moving toward greater employee ownership through stock option plans; competition for good employees in a tight labor market is tough, and stock options can be a key incentive for attracting and keeping good people. Financial institutions flush with cash are also looking to provide credit to successful midsize companies. It is an appropriate time for family business owners to revisit the pros and cons of employee ownership.

How it works

In the United States today, more than 8 million employees own stock in their companies through an ESOP. The more than 11,000 companies with ESOPs range from large to small, public to private, and include some of the most prominent family businesses, such as Cargill, Tyson Foods, and Amsted Industries.

An ESOP, by definition, is a qualified, defined contribution employee benefit plan that invests primarily in the stock of the employer company. ESOPs are tax "qualified" in that in return for meeting certain rules designed to protect the interest of plan participants, ESOP sponsors receive various tax benefits.

There are two types of ESOPs, nonleveraged and leveraged. The latter is more widely used because of the attractive debt financing available in today's capital markets. A leveraged ESOP borrows money on the credit of the employer or other related parties to buy company stock. The ESOP then purchases the company's stock, creating ownership for employees and cash for the company or the shareholders. The loan is repaid through distributions the company makes to the ESOP on an annual basis.

The ESOP is a tax-advantaged mechanism for family businesses to create liquidity and share ownership with its employees. Family owners can use an ESOP to create a ready market for their shares. Under this approach, the company can make tax-deductible cash contributions to the ESOP to buy out an owner's shares, or it can have the ESOP borrow money to buy the shares. A company may also simply issue new or treasury shares to an ESOP, deducting their value from taxable income. Or it can contribute cash, buying shares from owners.

The benefits

Congress has enacted tax incentives for employee stock ownership plans that provide significant advantages for the company and its employees. The annual contributions made by the company to the ESOP are used by the ESOP for repayment of interest and principal on the ESOP loan. These contributions are thus deductible from the company's yearly taxable income. Unlike any other loan, an ESOP loan allows the company to borrow money with pretax dollars. Annual dividends paid to the ESOP may also be deductible, as long as they are of a "reasonable" amount. Under ESOP legislation, earnings relating to the percentage of stock dedicated to the ESOP are excluded from taxable income, creating additional savings in cash flow.

As the business and employees are rewarded through ESOP plans (new growth capital and ownership privileges), family shareholders also receive benefits. The most significant is the long-term deferral of the capital gains tax. Once the ESOP owns 30 percent or more of the company's stock, shareholders selling stock to the ESOP may defer capital gains taxation if they reinvest the proceeds into qualified replacement property (QRPs)-stocks or bonds of domestic operating companies-within 12 months. This obviously represents a significant saving, since most family businesses have a low tax basis in the stock.

The tax deferral has one downside: A subsequent sale of the replacement securities will trigger the deferred capital gains tax. To address this problem, an innovative investment has been developed, known as ESOP floating-rate notes.

ESOP floating-rate notes are publicly registered securities, issued by highly rated companies such as Ford Motor Credit or General Electric Capital Corp. They have up to 40-year maturity terms and bear a floating-rate coupon. ESOP notes can be margined up to 90 percent of their market value, allowing family business owners access to a substantial portion of their initial sale proceeds without triggering any tax liability. In effect, the floating-rate notes become the QRPs under the ESOP structure.

In addition to providing liquidity to the family business owners, floating-rate notes offer some interesting estate planning advantages. If held until death, these securities will escape capital gains taxation, when beneficiaries of the estate receive a stepped-up tax basis.

The drawbacks

As attractive as these tax benefits are, however, there are limits and drawbacks to ESOPs. First of all, the law does not allow ESOPs to be used in partnerships and in most professional corporations. And private companies must repurchase shares of departing employees, which can become a major obligation in the future, depending on the ages of employees.

Perhaps the biggest issue is that any time new shares are issued, the ownership share of existing family owners is diluted. That dilution must be weighed against the tax and employee motivation benefits an ESOP can provide. ESOPs also create a host of nonfinancial issues. Does the family feel comfortable selling part or all of its business to the employees? Will management be comfortable with the disclosure requirements? And will management be able to combine this incentive package with others to gain the maximum efficiency and productivity benefit from employees?

There has never been a better time to consider the ESOP for family business owners who are considering liquidity needs, grappling with estate and ownership transition issues, needing growth capital, or investigating employee incentives. Because of the current capital markets, lending institutions want long-term relationships with clients, and are offering competitive rates on a multitude of products. Of those products, the ESOP loan, although specialized, affords the bank the comfort of increased cash flows, strength in management, and company-wide alignment of direction and growth.

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