ESOP – Is it an Option for My Exit Strategy?
A few years ago, December 2013 to be exact, with the help of Gregory Brown, now a partner at Holland & Knight in Chicago, we presented this email because of interest that is periodically raised about ESOPs. Before folks even begin to think about an ESOP as a viable alternative as an exit strategy, they should consider the characteristics of a company that even qualifies to become an ESOP. The following is a list of characteristics that reflect eligible candidates for an ESOP:
· Revenues should be a minimum of $10 million
· EBITDA should be in the $2-$3 million range
· Number of employees should be in the 25-30 range
· Minimum of 11 employees to actually operate the ESOP plan
· The business should have a value of $15-$20 million
One of the advantages of an ESOP is its tax-deferred treatment of the sale. Until the current Congress decides how these aspects of the tax code may change, there is some risk to pursuing this ESOP conversion. Below, you will find the information that we shared in December 2013. Take a look and let us know if you agree that the information is still relevant and how it has assisted you in your business planning.
Is an ESOP Appropriate for Your Company?
What is the best legal structure for you? ESOP?
It is an ever-changing business environment in which we, as business owners, operate and live. It’s been stated that if you are NOT constantly reinventing yourself, then you are falling behind. To that end, we at CAPSTONE Business Advisors constantly strive to stay informed and help our clients and friends stay current on things that matter to business owners. One of the often misunderstood strategies in business is what type of ownership is best. Of course, that historic meaningless but accurate answer is: “It depends.” This month we wanted to share with you one of these ownership options: the ESOP. The following was provided to CAPSTONE by Gregory Brown, Partner, Katten Muchin Rosenman LLP in Chicago.
Is an ESOP Appropriate for Your Company?
What is an ESOP?
Employee Stock Ownership Plans, or ESOPs, are innovative, exciting and—because they involve employee ownership of the company where they work—controversial. These plans can help to achieve multiple corporate ownership goals. When used appropriately, ESOPs play a unique role in employee compensation and corporate succession.
ESOPs are often promoted as a means of giving workers “a piece of the action.” ESOP advocates claim that employee-owners have a greater incentive to produce, since they share in the fruits of their efforts. Indeed, many companies have shown impressive productivity gains after establishing an ESOP. But it would be a mistake to assume that every ESOP will result in improved corporate performance. Companies not willing to adapt to the special dynamics of employee ownership and to put forth the extra effort often needed to make the ESOP successful may not be able to realize all the benefits ESOPs can provide.
How and ESOP Works
An ESOP is a tax-qualified, defined-contribution employee benefit plan that invests primarily in the stock of the employer. As a tax-qualified plan, an ESOP provides meaningful tax benefits to the employer and its owners. In exchange, the ESOP must meet certain U.S. government rules designed to protect the interests of plan participants.
To set up an ESOP, an employer creates a trust fund for employees and funds it in one of three ways: (1) by contributing employer stock, (2) by contributing cash to buy employer stock, or (3) by having the plan borrow money to buy shares, after which the employer makes payments to the ESOP to repay the loan. Employer contributions—not employee contributions—are normally used to fund the plan.
Uses of ESOPs
ESOPs can be used for many purposes, such as:
- To create a market for owners of closely held companies who wish to sell their shares on a tax-deferred basis and allow the corporation to use tax-deductible dollars to pay for those shares.
- To allow shareholders with management responsibilities in closely held companies to sell gradually on a tax-deferred basis and ease out of the business over a planned period.
- To finance corporate acquisitions. The ESOP could borrow funds (likely with a corporate guaranty) and use those funds to purchase stock from the corporation. The corporation would use the stock sale proceeds to purchase the stock or assets of a target company and thereafter make tax-deductible contributions to the ESOP to enable it to repay its borrowings.
- To enhance corporate performance and job satisfaction by creating a corporate “ownership” culture.
- To reward employees with a benefit tied to corporate performance while affording the company substantial tax benefits.
ESOP Tax Incentives
Employees participating in an ESOP are not taxed on stock allocated to their accounts until they receive distributions when they leave the company. Additionally, ESOPs offer four significant tax advantages for corporations and selling shareholders:
- The owner of a closely held C corporation can defer taxation on his or her gains from the sale of employer stock to the ESOP, provided the ESOP owns 30% or more of the employer’s equity after the sale, and provided the seller reinvests the sale proceeds in stocks, bonds or other securities of U.S. operating companies within 12 months after the sale.
- The employer can deduct contributions to the ESOP, including both principal and interest on loans the ESOP uses to buy company stock. Moreover, ESOPs allow for higher contribution and deduction limits than are normally available for profit-sharing plans.
- The employer, if a C corporation, generally can deduct reasonable cash dividends paid on ESOP stock and used to repay an ESOP loan or passed through to participants.
- S corporation ESOPs are not taxed on their share of corporate earnings. Because S corporations as pass-through vehicles pay no tax, if an ESOP owns 100% of the stock of an S corporation, neither the ESOP nor the S corporation pay any tax.
An employer should carefully consider whether the business has the characteristics that foretell a potentially successful ESOP. Among these factors are the following:
- There must be sufficient payroll to amortize the loan if the ESOP is leveraged. In other words, the size of the potential ESOP transaction depends upon a company’s payroll.
- The company must be profitable. While ESOPs have sometimes been used to save a failing company, most are adopted by companies that can easily afford to repay the loan to purchase company stock.
- The business must be stable. This is an important factor not only from the obvious standpoint of loan repayment, but also because yearly fluctuations will be reflected in the annual stock valuations, possibly resulting in adverse employee reaction.
- Management must be committed to employee ownership. The real value of the ESOP as a method of improving operating results would be lost without this commitment.