Employee stock ownership plans are excellent business ownership transition tools, especially if no other positive options exist, which applies often to closely held businesses. This summary highlights the installation steps for an ESOP for ownership transition purposes. First, a review of key ESOP benefits:
1. Selling shareholders can defer the capital gain tax on stock sold to the ESOP if the proceeds are rolled over into “qualified replacement property.” This represents a 21 percent deferral or “savings” in 2012 (assuming a Kentucky resident) — probably 26 percent to 31 percent after anticipated federal tax law changes.
2. The sale can be gradual; current owners maintain control during the transition.
3. There’s no need to sell to a third party.
4. It helps to create liquidity and diversify assets.
5. ESOP-owned companies generally outperform competitors by significant margins.
6. ESOPs provide a significant benefit and incentive to employees.
7. ESOPs are effective tools for raising capital prior to exit. Both loan interest and principal repayments are deductible when an ESOP is involved.
8. It can enhance your company’s ability to grow by acquisition prior to exit.
9. For S corporations owned entirely by an ESOP, 100 percent of the company’s income is generally tax-exempt — a powerful incentive to explore an ESOP.
10. And last but not least, your community benefits through the continuation of your business (jobs, taxes, corporate citizenship). You leave a tremendous legacy.
Making the transition
While there are many formation considerations, two critical, early steps include:
1. Get your CPA on board early. Your company’s accountant will be a key member of your ESOP team, both at the exploration and formation stage and beyond. He or she will provide critical data and advice to you and the niche ESOP advisors on your ESOP team. Frequently, due to his or her longer-term involvement with client companies, the CPA serves as lead advisor for the formation project and ongoing administration of the ESOP.
2. After making the decision to explore an ESOP, the next step is a feasibility study. It measures your company’s ability to repay the outside loan to the ESOP, which enables it to purchase your stock. (A loan is not required, but roughly 75 percent to 80 percent of all ESOPs have been formed with an outside loan.) Your accountant can prepare such a study, perhaps with the assistance of an ESOP consultant. Furthermore, such studies measure the company’s ability to meet the repurchase obligation associated with ESOPs, assuming your company is a closely-held business whose stock is not readily traded. The repurchase obligation gives plan participants the right to require that the company buy their shares when they are distributed upon retirement or other defined events.
Coincident with the feasibility study, an initial, informal valuation of the company will be performed. The initial valuation can also be performed by the company’s accountant, but is usually performed by an independent valuation specialist who will conduct a final valuation study before the ESOP is launched. Also, an actuarial firm will provide part of the initial data needed to calculate the company’s repurchase obligation.
Further steps
As a qualified plan under the Internal Revenue Code, a trust holds the ESOP assets. Thus, an ESOP trustee must be appointed. While most ESOPs utilize an “internal trustee” who is a company employee, the better practice, if feasible, is employment of an independent, qualified third party to serve as trustee.
The company’s ESOP lawyer and the trustee’s counsel will then draft ESOP-related documents. The principal documents are an Employee Stock Ownership Plan; an ESOP Trust Agreement; a “Summary Plan Description;” and a Stock Purchase Agreement between the selling shareholder(s) and the trustee. Various companion documents will also be prepared. Selling shareholders may have counsel as well.
Like most companies, if your company’s stock is not readily traded, the trustee must obtain an opinion letter from a qualified business consultant that confirms that the trustee pays no more than “adequate consideration” for the company’s stock (i.e., fair market value).
Like 401(k) plans, ESOPs require specialized administration. Thus, third-party administrators (TPAs) typically handle that function. Since ESOPs are unique plans, a TPA with ESOP experience is recommended.
If a lender will provide part of the cash to fund the ESOP’s purchase, then the lender must be identified. Company counsel and ESOP counsel will work with lender’s counsel to document and close the financing.
Last, but absolutely not least, two internal committees will be recommended that play key roles in (a) ESOP administration and (b) employee education and ownership culture-building.
In addition, two attributes will enhance the chance that a company maximizes the benefits of an ESOP: At-or-above-market employee compensation and a “high-performance culture.” If already present, that’s a head start. If not, one or preferably both should be developed over time.
While there are many other details, the foregoing represent the key elements associated with formation of an ESOP. It’s a task, but if handled well, ESOPs transform companies. Give an ESOP serious thought if it might fit for your company. Like others, you will find that something actually exists that not only seems “too good to be true,” but is, in fact, that good.
John Cramer is a partner on the Business Law Service Team at Wyatt, Tarrant & Combs, LLP in Lexington. He is co-chair of its ESOP Practice Group. He can be reached at jcramer@wyattfirm.com or at (859)288-7480.