Rough economy has brought bright side to Esops

The employee stock ownership plan (ESOP) is hardly a new concept, but it seems to be catching on with small and midsize business owners lately. The number of ESOPs rose to 11,400 in early 2009 (the latest point for which data was available) from roughly 11,000 in 2008 and about 10,600 in 2007, according to a study by the National Center for Employee Ownership.

What’s the story behind this uptick? One possible answer is, believe it not, the rough economy. Lower profits mean lower values on company shares, which, in turn, have made ESOPs a bit more affordable. To help you decide whether now may be a good time for your company to “pop” for an ESOP, let’s take a closer look at these arrangements.

The basics

An ESOP is a form of qualified retirement plan, specifically a profit-sharing plan. The primary distinguishing feature of these arrangements is that they essentially allow employees to own part of the company that employs them through the ESOP and then cash in their shares when they retire or otherwise leave the business.

Generally, an employer creates an ESOP by setting up a trust and contributing new company shares to it. Cash contributions, which can then be used to buy shares from existing owners, are also generally permissible. The trust becomes the legally recognized owner of the company shares and is managed by a trustee that oversees the employees’ interests. The trustee is most often appointed by the company’s board of directors (or another upper-management body). Once it’s up and running, the ESOP receives annual, tax-deductible contributions from the company that fund participants’ retirement accounts.

Typically, there are two types of ESOPs. An unleveraged one receives either contributions of stock or cash contributions used to buy new or existing shares of the company’s stock. In other cases, a leveraged ESOP borrows money from a financial institution and uses the loan to buy new or existing shares. The business then contributes cash to the plan to repay principal and interest on the loan over a period of years.

Tax benefits

ESOPs have several advantages, including increased employee motivation and ease of ownership transition. But the immediate tax benefits are worth considering as well.

For ESOPs that buy out at least 30% of a closely held C corporation, selling owners may defer their gains indefinitely by reinvesting the proceeds in qualified replacement property (most securities issued by domestic operating companies will qualify) within one year after the sale. Doing so gives them an advantage over an outright sale.

With leveraged ESOPs, the business can deduct contributions used to pay the interest and the principal on loans used to acquire the stock. And if the company is a C corporation, it may be able to deduct certain dividends paid on ESOP shares. In addition, interest payments don’t count against contribution limits.

If your company is structured as an S corporation with multiple shareholders, you can set up an ESOP. But the tax benefits are more limited: You can’t defer gains or deduct dividends, and interest payments on loans from leveraged ESOPs do apply toward the contribution limits.

Rules for distributions

The rules for distributions of ESOPs are fairly complex, but let’s run down some essential points. When a participant leaves your company, you generally must buy back his or her shares at fair market value (unless there’s a public market for the shares). In addition, as a privately owned company, you must annually engage an independent third party to appraise your ESOP and determine the share price based on a value estimate of your business.

Bear in mind, however, that there are important rule differences among the various ways a participant may leave your company — job change, retirement, disability, death, and so forth. In the case of retirement, death or disability, an ESOP typically initiates distributions of vested benefits during the plan year following the event unless an exception for termination for other reasons or an in-service distribution is triggered.

If a participant leaves your company for a reason other than retirement, disability or death, the ESOP must distribute his or her shares before the sixth plan year after the plan year in which the departure occurred — unless you rehire the participant before then. In the case of a leveraged ESOP, however, you may be able to delay distribution of ESOP-held shares acquired through the loan (used to make contributions to the trust) until the plan year after the ESOP loan is fully repaid.

Your ESOP doesn’t necessarily have to pay out distributions in lump sums, though it can if you want. Substantially equal payments (at least annually) over a five-year period are allowed.

Current employees may receive ESOP payouts in some situations. Plans must generally start distributions to participants who own 5% or more of a company after the participant reaches age 70½ whether he or she is still employed or not. Some hardship rules may also trigger payments to workers still on staff.

A big decision

As you can see, there are a lot of rules and administrative technicalities to implementing and operating an ESOP. It’s a big decision for any company, large or small. But there are some good reasons behind the surging popularity of these arrangements.

Don’t underestimate the importance of ESOP valuations

If you decide to implement an employee stock ownership plan (ESOP) at your company (see main article), you’ll need to have the company appraised by a third-party valuator.

The rules governing these arrangements require valuations to ensure ESOPs pay no more than fair market value for shares of their related companies. Noncompliance with valuation rules could subject your business to costly excise taxes as well as trigger litigation by unhappy ESOP participants. An appraiser will review your company’s financial statements, assessing information such as:

• Historical earnings and projected future earnings capacity,
• Operational history and financial strength,
• Dividend-paying capacity,
• Goodwill and other intangible value,
• Recent stock sales,
• Amount of debt, and
• The regional and national economic outlook.

In addition, the valuator will consider the industry’s history and economic forecast and the market price of publicly traded companies in the same business or similar ones. He or she may even make one or several on-site visits to interview management and other key employees.

If you have any questions, please contact Feeley & Driscoll's Boston Accounting team, Email us or call 1 (888) 875-9770.

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