1. What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is a tax and ERISA qualified retirement plan that provides a mechanism for employees as a group to purchase a stock interest in the company that sponsors the ESOP. Importantly, an ESOP provides tax advantages for both the company and the selling shareholders.

2. Why would a business owner consider selling stock to an ESOP?

A. Nontax Reasons:

– Convert shares of stock in owner’s company to cash and/or marketable securities.
– Simplify management succession.
– Sell the company to employees, not to competitors.
– Diversify business owner’s personal assets without losing control of the company.
– Preserve the company’s independent identity.
– Create a market for closely held shares in a private company.
– Establish a retirement fund for employees who otherwise may not have one.
– Promote pride and productivity among the employees – employee recruiting/retention.
– Reward employees with a benefit directly linked to company performance.

B. Tax Reasons:

– Allow deductibility of the sponsoring company’s ESOP contributions, including contributions used to pay principal and interest on ESOP acquisition debt, i.e., ESOPs can buy stock with pre-tax dollars.

– Permit shareholders of a closely held company to sell company stock to the ESOP and defer federal and state taxes on the gain of the sale.

– Allow a tax deduction for cash dividends paid on stock purchased with an ESOP securities acquisition loan.

– Provide business owners with the opportunity to sell their shares to an ESOP and defer tax on the proceeds in a § 1042 tax-free exchange so long as the business owners reinvest the proceeds in qualified replacement property within a specified period of time.
– Provide additional tax planning opportunities where company is an S corporation, including the opportunity to create a tax-exempt for-profit business entity.

3. How is private company stock valued for ESOP purposes?

An ESOP cannot pay more than adequate consideration for any stock that it acquires. Adequate consideration is determined by an outside, independent business valuation. The independent valuation must be obtained at the time of any purchase or sale of stock by the ESOP and once each year that the ESOP holds employer stock.

4. How are ESOP stock purchase transactions financed?

A. Bank Financing.

(i) Senior Debt Financing. Senior debt financing provided by a financial institution is one of the most common forms of capital used in a leveraged ESOP transaction. Depending upon the size and type of transaction, a company will rely on its cashflow and collateral assets to secure this type of capital.

(ii) Subordinated Financing. The Company may be able to raise additional financing with subordinated debt. Subordinated debt is often used if the amount that can be borrowed from senior lenders is not sufficient to finance the entire purchase price. Subordinated debt typically carries: (a) a longer maturity than senior debt (7-12 years average); (b) a deferred amortization on the principal for the first few years of the financing; and (c) a higher interest rate than senior debt that is often supplemented by an equity kicker in the form of warrants and conversion to common stock.

Subordinated debt financing is senior in the capital structure to common stock and junior (subordinated) to senior debt.

B. Seller Financing.

Seller financing may also be a desirable alternative to conventional bank financing or subordinated debt financing. In a seller financed transaction, the selling shareholder(s) will receive a note as payment for some or all of the sale price of the company stock sold to the ESOP. Seller financed transactions are typically less expensive to accomplish and require less documentation and due diligence than senior and subordinated financed transactions.

C. Cash Warehouse ESOPs.

The ESOP trustee invests the company’s cash contributions for a period of time prior to the ESOP stock purchase in investments (including even life insurance) other than employer securities. These pre-deal contributions are in effect “warehoused” until such time as the shareholders decide to sell and the trustee desires to invest in employer securities. The cash value accumulations held in the ESOP warehouse can be used to reduce or eliminate the outside or seller debt necessary to finance the ESOP stock purchase.

5. Who is a good candidate for an ESOP?

ESOPs work best if your company has:

– a payroll of $1 million or more;
– been in business at least 5 years;
– a strong management team in place; and
– solid earnings history and prospects.

6. Who manages a company owned by an ESOP?

A. ESOP Trustee. The ESOP trustee is the person and/or institution that typically has the formal responsibility to ensure that the ESOP is operated for the exclusive benefit of plan participants. The ESOP trustee votes the shares of stock owned by the plan, other than on major transactions, where voting rights are passed-through to plan participants.

B. Board of Directors & Officers. The Board of Directors and the company officers are responsible for the day-to-day management of the company and may also exercise discretionary authority or control over the management of the ESOP. Members of the Board of Directors also may become fiduciaries of the ESOP if they have responsibility for fiduciary functions under the ESOP, such as selection and retention of the plan administrator or plan fiduciaries.

C. Voting Rights. If the company has a registration-type class of securities, each participant is entitled to direct the ESOP trustee as to the manner in which the company stock allocated to that participant’s account shall be voted.

If the company does not have a registration-type class of securities, the participants are entitled to direct the ESOP Trustee as to the manner in which voting rights on shares of company stock allocated to the participants™ accounts are to be exercised with respect to major corporate transactions, such as corporate merger or consolidation, recapitalization, reclassification, liquidation, dissolution, sale of substantially all assets of the trade or business, or any similar type of transaction prescribed in the Federal Tax Regulations.

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