ESOPs:  ADVANTAGES FOR BOTH EMPLOYERS AND SHAREHOLDERS
By Matthew J. Straub, CPA,

Employee stock ownership plans (ESOPs) are qualified retirement plans that invest primarily in an employer’s stock.  ESOPs have been around for many years.  As a result of very favorable tax rules for the plan sponsors and shareholders, they have become increasingly attractive as corporate finance vehicles and exit strategies by creating a market for closely held stock, as well as offering a retirement plan that offers a financial interest to employees.  The following are advantages of ESOPs to both employers and employee shareholders.  

Advantages to Employers 

Employee shareholders 

One of the most obvious advantages of an ESOP plan is having employee shareholders of the company.  In most cases, an employee who has stock in the company will take more of an interest in the performance of the company and therefore will be more motivated.  These employees also tend to stay with companies longer. 

Higher limits on contributions 

Tax-deductible contributions to defined contribution plans are generally limited to 25% of the eligible participants’ covered compensation.  The tax deduction for ESOP contributions may exceed this limit, because certain dividends on stock owned by the ESOP are tax-deductible.  In addition, in the case of a C corporation that sponsors an ESOP, interest expense on an ESOP loan is deductible above the 25 percent deduction limit.

Positive Cash Flows

An employer can contribute either cash or qualifying stock to its ESOP. However, a contribution of stock will create positive cash flow as a result of the tax savings.

Example: X Corporation can make a $500,000 deductible contribution to its ESOP. The following comparison shows how X will increase its cash flow by contributing stock instead of cash:

	Stock Contribution	Cash Contribution
Tax deductible Contribution	$500,000	$500,000
Tax savings – 40%	200,000	200,000
Less cash contribution	0	0
Cash increase (decrease)	$200,000	$(300,000)

An ESOP is one of the few tax-favored plans to which contributions may be made in property other than cash, i.e., qualifying employer securities.

Defiance of tax physics with leveraged ESOPs

An ESOP that borrows money to buy employer securities is called a leveraged ESOP. Funds can be borrowed from either the employer or a third party. However, for the purpose of providing an additional layer of security for the debt, third parties generally prefer to loan funds to the employer. The employer uses tax-deductible ESOP contributions, in addition to tax-deductible dividends, to repay the borrowed funds. This defiance of tax physics is among the main ESOP tax advantages.  Employer contributions used by the ESOP to repay principal on ESOP loans are deductible, up to 25 percent of the eligible participants’ covered compensation. As pointed out before, an employer that is a C corporation can deduct all contributions to an ESOP that are used by the ESOP to pay interest on loans taken out to buy the employer’s stock.  In 2004 the IRS issued Private Letter Ruling 200436015, which allowed a C corporation to consider the 25 percent deduction limit on contributions to repay ESOP loan principal separate and above the 25 percent deduction limit on other defined contribution plans. This PLR effectively increased their total deduction limit to 50 percent (25 percent for repaying the ESOP loan and 25 percent for other defined contribution plans).

Low-Cost Capital

An existing profit sharing or money purchase pension plan can be converted to an ESOP. If this converted plan has accumulated substantial assets from employer contributions and investment income, these assets may be used to buy unissued stock from the employer. This technique enables an employer to get back some of the cash it previously contributed to the old plan at no tax cost, since the sale of its stock to the ESOP is not taxable. Corporations considering major projects can obtain inexpensive capital by converting a profit sharing or money purchase pension plan into an ESOP.

Owners of closely held corporations are often reluctant to establish ESOPs because they do not want a large number of small shareholders. The tax law solves this problem by permitting an ESOP to make distributions in cash rather than the employer’s stock, where the plan is sponsored either by a corporation whose charter or bylaws restrict substantially all of the stock ownership to the employees and the ESOP, or by an S corporation.  In addition, the employer or the ESOP can have a right of first refusal to repurchase stock distributed to employees if the ESOP, with the proceeds of certain loans, previously purchased that stock.  These two provisions can be used to limit ownership of the employer corporation.

Advantages to employee shareholders

Sales of Closely Held Stock

A major problem for shareholders of a closely held corporation is the lack of a public market when they want to sell some or all of their stock. The corporation is usually the only buyer available. However, it frequently cannot afford to pay for the stock with after-tax dollars. Selling the stock to an ESOP instead can solve this problem. This permits the stock to be bought with pretax dollars, since the ESOP pays for it with tax-deductible contributions from the corporation. If a selling shareholder wants all cash up front, the ESOP can borrow the money and repay the loan with future contributions from the corporation.

Deferral of Gain Recognition on Sale of Securities to an ESOP

A shareholder can sell certain stock of an employer to an ESOP without reporting any taxable gain if the sales proceeds are reinvested in stock or bonds of another corporation which actively conducts business operations.  The cost basis of the qualified replacement property (QRP) must be reduced by the untaxed gain on the sale of the employer’s stock to the ESOP. This will cause the gain to be taxed when the QRP is sold.  Certain rules and time restrictions exist for a sale to qualify for this tax-free rollover.

Conclusion

An ESOP can be very useful for transferring ownership of a corporation to employees, if this is deemed advisable from a business or tax standpoint. However, ESOPs are not a cure-all and do have disadvantages such as the dilution of shareholders’ equity, the cost of both time and money to implement and maintain an ESOP, and last but certainly not least, the repurchase obligation for which many companies fail to plan. Whether an ESOP’s advantages outweigh its disadvantages must be determined for each particular situation.

Matthew J. Straub, CPA, is a manager with Mengel, Metzger, Barr & Co. LLP.  He may be reached by telephone at 585-423-1860.