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ESOP Basics
What is an ESOP?
 An Employee Stock Ownership Plan (ESOP) is a retirement plan designed to provide employees with an ownership interest in the company for which they work by investing primarily in the stock of the employer. ESOPs are unlike any other employee benefits plans, which typically diversify their holdings by investing in a variety of assets.

An ESOP is funded with tax-deductible contributions by the employer, which can be in the form of company stock or in cash used to purchase company stock. An ESOP operates through a trust under the direction of a trustee or other named fiduciary.

To be an ESOP, the plan must be specifically designated as an ESOP in the plan document. It must also comply with special ESOP requirements of the Internal Revenue Service (IRS).

Learn more by viewing SES Advisors Introduction to ESOPs webinar (Registration required).

In what kinds of privately held companies do ESOPs work best?
ESOPs operate successfully in a broad range of companieslarge and small, public and private. The ideal private company candidate will meet most of the following criteria:

  • The company has strong cash flow and a history of increasing sales and profits.
  • The company has consistently been in a high federal income tax bracket.
  • The company has substantial stockholder equity.
  • The company has capable second-line management in place.

SES Advisors also offers an online tool to help you self-assess ESOP feasibility. Our qualifying questions may help you in deciding to take the next step.

How does the ESOP benefit stockholders?
One of the most popular uses for an ESOP is to provide a ready market for some or all of the shares owned by shareholders in a closely held company. With an ESOP in place, a majority or controlling shareholder has en exit strategy when he or she is ready to retire. Likewise, and ESOP is often the only market for a minority shareholder in a closely held company.

The ESOP rollover permits a shareholder to sell stock to an ESOP and defer capital gains taxes. This option can also be used to obtain estate planning benefits.

With an ESOP, a majority shareholder has the option of selling all or only a portion of his or her stock to increase personal liquidity while maintaining control of the company.

Read more about ownership transition options.

How does the ESOP benefit the company?
An ESOP is a technique of corporate finance as well as employee benefit plan, As ESOP can be used to raise new equity capital, to refinance outstanding debt, or to acquire productive assets using cash borrowed from third-party lenders. ESOPs can also be used to increase cash flow by making plan contributions in stock instead of cash.

Since contributions to the ESOP are fully tax deductible, an employer can fund both the principal and the interest payment on an ESOPs debt service with pre-tax dollars.

Dividends on ESOP stock are tax-deductible if they are applied to repay ESOP loan principal the proceeds of which were used to acquire the employer securities with respect to which the dividends were paid. Reducing loan principal with pre-tax contributions and dividends generates significant tax savings, which in turns increases the ESOP company’s cash flow.

There is strong statistical evidence that employee ownership improves employee morale and productivity and reduces turnover. Surveys conducted by The ESOP Association show that most Association members report improved employee morale and productivity due to their ESOPs. A study by the National Center for Employee Ownership (NCEO) during the 1980s found that ESOP companies grew more than 5% faster than their non-ESOP counterparts. Moreover, the study showed that ESOP companies with participative management styles grew at a rate three to four times faster than traditionally managed ESOP companies. The NCEO results have been replicated by a number of later studies, and it is now generally accepted that ESOPs especially in participatively managed companies can improve a company’s productivity.

Discover why SES Advisors is uniquely qualified to help organizations design, install and administer ESOPs.

How does the ESOP benefit employees?
Each year, company contributes to the ESOP, both cash and stock, are allocated to the accounts of participating employees in the trust established as part of the ESOP. The accumulated balance in a participants account is distributed to the participants after his or her retirement or other termination of employment with the company.

So long as a participants account remains in the ESOP trust, the value of the account including the appreciation in stock value is not taxable to the employee.

Employees age 55 or older with 10 or more years of participation in the ESOP must be allowed to diversify a portion of their ESOP accounts.

ESOP financing permits the repayment of acquisition debt with pre-tax dollars. This favorable tax treatment means that ESOPs are effective vehicles for financing management buyouts.

Read an article on the Mutual Benefits of an ESOP and contact SES Advisors to learn more about how we can help your company.

How do I set up an ESOP?
The first step in the process is determining the company’s value, since the ESOP cannot pay more than fair market value for the stock it purchases. Both the Internal Revenue Service (IRS) and the US Department of Labor (DOL) have issued guidelines governing the valuation of company stock in ESOP transactions.

The next step is a feasibility study to analyze the overall framework for the transaction. Among the issues the study should address:

  • How much the company can afford to contribute to the ESOP each year
  • Whether part of the contribution cost can be offset by eliminating other benefit programs
  • How the ESOP will affect the companys earnings and cash flow
  • How the transaction will be structured
  • How it will be financed

If a leveraged ESOP is established, a loan must be secured to finance the stock purchase transaction. Financing an ESOP transaction can be difficult if the lender is not familiar with ESOPs. If the seller finances the purchase transaction, the companys costs will likely be reduced.

Once financing has been arranged, legal counsel should prepare the ESOP plan documents. An ESOP sponsor has many choices to make in designing a plan that will work well in its own corporate culture. For that reason, it is advisable to work with experienced ESOP counsel in designing the ESOP.

The next step is to negotiate a stock purchase agreement between the ESOP fiduciary and the selling shareholder(s). The stock purchase agreement sets forth the price and other terms and conditions under which the ESOP will purchase stock from the selling shareholder(s). As in any stock purchase transaction, the stock purchase agreement typically contains representations and warranties about the company’s assets, operations and financial condition.

The final step before closing the transaction is an opinion from an independent appraiser. This opinion is required under DOL proposed regulations, and provides the necessary assurance that the ESOP is not paying more than fair market value for the company stock it purchases. In some cases the appraiser will also be asked to give an opinion that the transaction as a whole is fair to the ESOP from a financial point of view.

SES Advisors offers services at every stage of the ESOP life cycle from assessing feasibilityto designing and installing a plan , providing ESOP legal services  and helping in obtaining financing . You may also wish to review our webinar, ESOP Structure Case Studies: How to Meet Various Owner & Company Goals [link to ESOP Structure Case Studies: How to Meet Various Owner & Company Goals.mp4].

Are annual contributions to the ESOP mandatory?
Although annual contributions are not mandatory for each year, the IRS does require that recurring contributions be made to a tax-qualified retirement plan to maintain its qualified status. However, in a leveraged ESOP, employer corporations need to commit to contribute enough cash each year to service the ESOP loan debt. If the ESOP has sufficient cash to pay the ESOP debt, additional contributions are not required. In some instances, it may be wise to make contributions in excess of the required ESOP debt payments to accumulate cash in the ESOP for years in which cash flow may be restricted.

SES Advisors offers services and support for the entire ESOP life cycle helping to ensure that an ESOP stays on track.

Do all company employees have to participate in the ESOP?
No. However, in order to satisfy IRS nondiscrimination guidelines, the ESOP must cover a substantial percentage of non-highly compensated employees who have attained age 21 and completed a year of service. For this reason, ESOPs established by smaller companies usually cover all employees who have satisfied these minimum age and service requirements.

SES Advisors Plan Administration services  can help you to address a full range of reporting and compliance requirements.

Can an S corporation set up an ESOP?
Yes. Effective January 1, 1998 it became advantageous for an ESOP to be a shareholder of an S corporation under the federal tax laws. To the extent that the S corporation is owned by an ESOP, no federal income taxes on corporate income are payable by either the shareholder or the company. This can create a significant competitive advantage for S corporations which are substantially ESOP owned.

Explore SES Advisors ESOP design and installation services and then contact us to learn more about how we can help you explore options for plan structure.

Are ESOP accounts required to be fully invested in company stocks?
ESOPs are not required to invest exclusively in company stock; many ESOPs have substantial investments in cash or other securities. However, ESOPs normally have more than half their assets invested in company stock.

In addition, ESOP participants who are approaching retirement age must be given an opportunity to diversify their ESOP accounts. For shares acquired by an ESOP after December 31, 1986, the ESOP must provide any participant who has attained age 55 and completed 10 or more years of service of participation in the ESOP with an annual option to diversify 25 percent of his or her ESOP account into investments other than company stock for five years. In the sixth year, the participant must be given a one-time option to diversify up to 50 percent of his or her account.

At least three investment options must be offered within the ESOP to meet the diversification requirements. Alternatively, the ESOP may transfer assets to another qualified plan, or make a distribution directly to the participant to satisfy the diversification requirements.

SES Advisors ESOP administration services  can help ensure that your ESOP addresses reporting and compliance requirements.

How are the company's contributions to the ESOP allocated among ESOP participants?
An ESOP must include a definite formula for allocating employer contributions and forfeitures annually to the individual accounts of plan participants.

Usually, employer contributions to an ESOP are allocated among the participants’ accounts in the plan based on their compensation from the company during the plan year. However, the allocation can also be based on a combination of compensation and years of service with the company. The latter option is more complicated to administer because of IRS rules designed to prohibit discrimination in favor of the highly compensated.

There is a ceiling on the amount of annual compensation that can be recognized for determining participant allocations in ESOPs and other tax-qualified retirement plans. The ceiling is set at $220,000 for plan years beginning in 2006, with future adjustments based on cost of living increases.

For calendar 2006, an employee who is compensated at an annual rate of $350,000 will receive the same allocation within the ESOP as an employee who earns $220,000.

The Code also imposes limits on the maximum annual additions to a participants ESOP account. Annual additions consist of the participants allocated share of the companys contribution and any forfeitures. For 2006, the maximum annual addition is the lesser of $44,000 or 100% of a participants compensation from the employer. For leveraged ESOPs which satisfy a special nondiscrimination test, interest paid on the ESOP loan and forfeitures do not count as an annual addition. A leveraged ESOP may also use the fair market value of the company stock released from the expense account (See Section 19) to determine the maximum annual additions to participants accounts.

Get educated about ESOPs by reading articles  featuring or written by SES Advisors experts.

How are ESOP benefits distributed?
Benefit distributions from an ESOP may be made in cash or in company stock, subject to the put option. ESOP participants must be given the right to require a distribution of their ESOP account balances in the form of company stock, unless the company’s organizational documents restrict ownership of company stock to active employees, or the company is an S corporation. In these cases, the ESOP can distribute cash or company stock which must be immediately resold to the company.

Benefits may be distributed in a lump sum or in installments. If installment distributions are available, the minimum distribution period may not exceed five years.

Explore SES Advisors archived webinars to learn more about ESOPs. You may also want to read our case study about the have/have not issue and the repurchase obligation .

Can an ESOP be terminated?
Yes. Just as a company can terminate a profit sharing plan, it can also terminate an ESOP. At that point, all participants must become 100 percent vested. Benefit distributions from the ESOP are eligible to be rolled over into an IRA; ESOP distributions not rolled over are taxable, but may be eligible for special favorable tax treatment.

SES Advisors provides expertise and support at every stage of the ESOP life cycle .

Who votes the shares held in the ESOPs?
The Code requires that company stock in the ESOP must have full voting rights. In non-public ESOP companies, voting rights on shares allocated to ESOP accounts must be passed through to ESOP participants for votes on major corporate matters such as a merger or consolidation, recapitalization, reclassification, liquidation, dissolution, or sale of substantially all of the assets of the corporation. Unallocated shares, and allocated shares voting on other matters (such as the election of the Board of Directors), may be voted by a named fiduciary, or as otherwise designated in the plan. Some ESOPs pass through voting to participants on all matters, or provide for proportional voting for all shares held in the ESOP (both allocated and unallocated shares) on the basis of one vote per participant.

SES Advisors provides expertise and support at every stage of the ESOP life cycle.

Who are ESOP fiduciaries, what are their responsibilities and how do they get appointed?
Any person with discretion over the management or administration of a plan, or who exercises any authority or control over plans assets, is a fiduciary under ERISA. The ESOP trustee, or any other person or committee designated in the plan documents as responsible for making investments in company stock, is a named fiduciary.

ERISA requires that plan fiduciaries act prudently and solely in the interest of plan participants. Three of the most important responsibilities of an ESOP fiduciary are:

  • Securing a proper valuation of the stock;
  • Assuring that the interests of plan participants are protected in ESOP transactions; and
  • Approving all purchases and sales of ESOP stock.

SES Advisors provides expertise and support at every stage of the ESOP life cycle .

Can a majority shareholder remain in control of the company after selling stock to an ESOP?
The best way to accomplish this is to sell only a minority interest in the company to the ESOP. In addition, a shareholder may participate in the administration of the ESOP, subject to the fiduciary requirements.

Read a case study on selling a minority stock interest in a Private Company

What costs are involved in establishing and maintaining an ESOP?
What costs are involved in establishing and maintaining an ESOP?

Costs are a function of the complexity of the transaction. If owners take the time to get a better understanding of ESOPs, initial costs can be reduced.

Ongoing ESOP administrative expenses are similar to most profit sharing plans, with the exception of the annual valuation update needed to value company stock held in the ESOP.

SES Advisors delivers ESOP administration services  with a simple and transparent fee structure empowering you to achieve better results while saving time and money.

Leveraged ESOPs
What is a leveraged ESOP?
An ESOP is leveraged if it borrows money to purchase shares of the employer’s stock. The loan may be from a bank or financial institution, or the selling shareholder may finance the transaction by taking back a note for part or all of the purchase price. The ESOP loan is usually secured by assets of the sponsor company. In some cases, the selling shareholder may be required to guarantee the loan or provide security for its repayment. An ESOP is the only kind of employee benefit plan that can use the credit of the company and its shareholders to finance the purchase of company stock. For all other qualified employee benefit plans, this would be a prohibited transaction under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).

Most ESOPs used for ownership transition purposes are designed as leveraged ESOPs, although non-leveraged ESOPs can also be structured to provide significant tax benefits in connection with corporate acquisitions and divestitures.

Read more about SES Advisors ESOP financing services . You may also want to read our article, Leveraged ESOPs Provide Exit Opportunity, or view our webinar, Floor Price Protection in Second-Stage, Leveraged ESOP Transactions (registration required).

Can I use the ESOP to refinance existing corporate debt?
Yes. Refinancing existing corporate debt through an ESOP should improve after-tax cash flow. The refinance is accomplished through a loan to the ESOP which uses the borrowed money to purchase newly issued stock from the company. The company uses the cash to pay off the existing debt, which is thus replaced with ESOP debt. After the refinancing, the companys contributions used to pay the principal portion of the ESOP debt will be tax deductible, whereas principal payments on the prior corporate debt were not.
Taxation
What is a tax-free ESOP rollover?
A tax benefit of selling to an ESOP: Shareholders who sell their stock to an ESOP can elect to defer federal income taxes on the gain from the sale, if the sale qualifies as a tax-free rollover under Section 1042 of the Code.

In order to qualify for the rollover:

  • The ESOP must own at least 30 percent of the companys stock
  • The proceeds must be reinvested in Qualified Replacement Property
  • The stock sold to the ESOP must be common stock with the greatest voting power and dividend rights
  • The stock sold to the ESOP must have been acquired as an investment and not in an employment-related transfer
  • The seller must have owned the stock being sold for at least three years
  • The company is not an S corporation

To find out more about this seller benefit, contact Bob Massengill , or complete our online self assessment tool.

Other things to note about the tax-free ESOP rollover:

  • The selling shareholder, any 25% or greater shareholder, and certain family members, are generally prohibited from receiving allocations of stock acquired through a tax-free ESOP rollover.
  • A shareholder may elect to roll over all or any portion of the ESOP sale proceeds. The election must be filed with the selling shareholders federal income tax return.
  • The company must agree to pay a penalty tax if the ESOP shares acquired through the rollover are sold or disposed of by the ESOP within three years after the date of sale.
When are dividends paid on ESOP shares tax-deductible?
A special tax-deduction is permitted for reasonable dividends on C corporation stock held in the ESOP if they are (i) used to repay an ESOP loan the proceeds of which were used to acquire the employer securities with respect to which the dividends were paid, (ii) distributed in cash to participants no later than 90 days after the close of the plan year in which they were paid, or (iii) paid to the plan and reinvested in company stock. Distributed dividends are taxed as ordinary income.
Are ESOP participants taxed on their ESOP accounts?
The value of a participating employee’s ESOP account, including company contributions and any appreciation in the value of the account, is not taxable to the employee while it accumulates in the ESOP.

Distributions from the ESOP are subject to taxation, but favorable tax treatment may apply to lump sum distributions in the form of company stock.

For distributions received prior to age 59-1/2, an additional 10 percent excise tax is generally imposed unless the distribution was made on or after the employees death, disability, or separation from service after attaining age 55. Deductible cash dividends paid to ESOP participants are not subject to the early distribution excise tax; this favorable treatment does not extend to S corporation distributions.

Eligible ESOP distributions may be rolled over into an IRA or another qualified plan, in which case income taxes will be deferred.

Can I sell stock to an ESOP in return for a note from the ESOP and still qualify for a tax-free rollover?
Yes. However, the Qualified Replacement Property must be purchased within a 15-month period, beginning 3 months prior to the date of the sale. If the note has not been fully paid by the time the Qualified Replacement Property must be purchased, the selling shareholder will have to use other funds to purchase enough Qualified Replacement Property to roll over the entire sale proceeds. Seller-financed transactions can use floating rate notes to avoid this problem.
Can I make a tax-deductible charitable contribution of Qualified Replacement Property?
Charitable contributions of Qualified Replacement Property are tax deductible under the Code and are not taxable dispositions under the ESOP rollover rules. Qualified Replacement Property may also be contributed to a charitable remainder trust or annuity, which allows the donor to receive continuing income on a tax-advantaged basis, and removes the property from the donor’s estate for estate tax purposes. Charitable giving techniques can maximize the tax and financial benefits of an ESOP rollover.
Valuation
Who determines the value of company stock in the ESOP?
Valuation of company stock in the ESOP must be made by an independent appraiser annually, and any time the ESOP purchases company stock from the company or an employee, officer, director, or 10% or greater shareholder.

The DOL and IRS have issued guidance on the factors that must be taken into account when appraising a company, and who should do the valuation. Basically, a qualified appraiser must (i) hold himself/herself out to the public as an appraiser or perform appraisals on a regular basis, and be qualified to make appraisals of the type of property being appraised; and (ii) be independent with respect to the company and other parties to the ESOP transaction.

The credibility the IRS or DOL attaches to the appraisers conclusion of fair market value will be greatly influenced by their assessment of the expertise demonstrated by the individual or firm doing the appraisal. The same can be said for the independence of the appraiser. In order to satisfy the independence criteria, the valuation cannot be done by:

  • The taxpayer who maintains the ESOP
  • A party to the transaction in which the ESOP acquired the property
  • An employee of the taxpayer who maintains the ESOP
  • An individual or firm regularly used by the taxpayer maintaining the ESOP who does not perform a majority of his or her appraisals for entities other than the taxpayer maintaining the ESOP

SES Advisors helps companies address a range of mature ESOP issues , as well as reporting and compliance requirements.

How often does the stock have to be re-valued?
Company stock held by an ESOP must be value at least annually typically at the end of the sponsor’s fiscal year. If the ESOP is buying or selling stock, the shares must be appraised as of the transaction date.

SES Advisors helps companies address a range of mature ESOP issues , as well as reporting and compliance requirements.

Additional Resources: ESOP Industry Websites

SES Advisors is pleased to support our national and local ESOP trade associations as sponsors, board and committee members, speakers and chapter officers. If you would like to further research Employee Stock Ownership Plan (ESOPs), we encourage you to visit these helpful industry websites:

National Center for Employee Ownership (NCEO) is a private, nonprofit membership and research organization that serves as the leading source of accurate, unbiased information on ESOPs, equity compensation plans such as stock options, and ownership culture.

The ESOP Association represents the interests of all corporations that sponsor ESOPs providing advocacy and educational services on behalf of its members.

Vermont Employee Ownership Center is a statewide nonprofit whose mission is to promote and foster employee ownership in order to broaden capital ownership, deepen employee participation, retain jobs, increase living standards for working families and stabilize communities.

Ohio Employee Ownership Center  is a nonprofit outreach center of Kent State University. It supports the development of business across Ohio and around the world by its efforts that are proven to save jobs, create wealth and grow the economy.

Ready to Learn More?

For education and insight tailored to your organization and its unique needs, please contact SES Advisors.