You Can’t Stop the ESOP …

but is one right for your company?

If you’ve paid any attention to business headlines during the past year, you’ve probably read about the sale of national media conglomerate Tribune Co. to real estate magnate Sam Zell. A key part of the sale (still pending, as of this writing) is an employee stock ownership plan (ESOP).

This is hardly an isolated occurrence. The ESOP has been a virtually unstoppable force on the employee benefits scene for some time now. As of just last year, there were 9,225 of the arrangements up and running with about 10.1 million participants, according to the National Center for Employee Ownership.

Whether an ESOP is right for your company, however, depends on a variety of factors.

How does it work?

On its face, an ESOP is a qualified retirement plan, similar to a profit-sharing plan. But, as the name indicates, these arrangements enable employees to own part of the employer company.

Generally, to start an ESOP, a business sets up a trust and contributes new shares of its own stock to the trust. It also can contribute cash that is then used to buy shares from existing owners. The company then makes annual contributions in either stock or cash that are allocated to individual employee accounts within the trust.

There are two types of ESOPs. First, in an unleveraged arrangement, the company sets up a retirement plan/trust and contributes to the trust. The trust uses this money to buy new or existing shares of the company’s stock.

Alternatively, in a leveraged arrangement, the ESOP borrows money from a financial institution and uses the loan money to buy new or existing shares. The company then makes cash contributions to the plan over a period of years to repay principal and interest on the loan.

Whichever approach you choose, an ESOP must predominantly invest in “qualifying” employer securities. A qualifying security is any common stock of the company or a member of its controlled group (an entity with 50%-or-greater common ownership).

What makes it pop?

ESOPs pack plenty of potential “pop” for business owners. Let’s start with taxes: Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.

In addition, selling equity to employees allows you to cash out your investment while deferring tax on any capital appreciation. If you sell 30% or more of the company to the ESOP, you may roll over the proceeds into other “replacement” securities without currently incurring taxes on the gain.

Yet even though employees will own part of the company, they won’t be running it. An ESOP allows you and other owners to retain primary management control. This is accomplished through buy-back requirements, which allow you to buy back stock from employees when they leave the business or die.

From a retirement and estate planning standpoint, selling a portion of your stock to an ESOP provides a means for converting assets into a diversified portfolio of investments you can use to fund your retirement. By doing so, you can defer gain on the sale by buying qualified replacement property, such as certain publicly traded stocks.

Finally, there are potential strategic benefits as well. When workers possess an ownership stake in the business, they’re more driven to work hard and remain loyal, because they stand to gain or lose from their actions.

Could it flop?

Naturally, an ill-devised or poorly executed ESOP could be a flop. For starters, can you afford one? It takes a sizable upfront investment, generally $50,000 or more, to establish an ESOP. Plus, there are the ongoing costs for annual filing, maintenance and valuation requirements. It is not a simple strategy to create or implement.

There are costs in time and effort as well. An ESOP requires annual filing and maintenance of various IRS forms and compliance with rules and regulations specified by the Employee Retirement Income Security Act.

In addition, there is added fiduciary responsibility and liability for plan administrators, who must make sure transactions are properly handled. And if you increase your business’s retirement contributions beyond what you otherwise would have done, you’re essentially giving away some of the ownership of your company.

Yay or nay?

As you can see, saying yay or nay to an ESOP is no simple matter. But these arrangements show no signs of disappearing from the business world. And it never hurts to consider ways to grow and improve your company while creating a strategy to sell some or all of your investment in the business.

ESOPs raise tricky valuation issues

Along with raising financial and compliance issues, employee stock ownership plans (ESOPs) raise tricky valuation issues. For instance, ESOPs are prohibited from paying more (or less) than adequate consideration for the employer’s stock. A qualified, independent appraiser must determine the fair market value of a closely held company’s ESOP shares both annually and when shares are acquired from the existing owners.

Plan fiduciaries are responsible for arranging regular appraisals, and those who fail to act in the participants’ best interests risk liability for breach of fiduciary duty. They may also be subject to excise taxes on prohibited transactions, such as selling stock to the ESOP at inflated prices.

Please contact Feeley & Driscoll's Boston Accounting Firm by Email or call 1 (888) 875-9770 to explore ways to grow your business in a down economy.

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