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Advantages of ESOPs

by contributor Erin Turley, K&L Gates  |  Published May 3, 2012 at 1:03 PM
With employee stock ownership plans, or ESOPs, in their fourth decade and S corporation ESOPs in their second decade, the financial attributes and tax advantages of ESOPs, combined with the higher tax rates on the horizon and pent-up demand for liquidity from an aging baby boomer generation, make ESOPs a proven and attractive exit strategy for closely held businesses, especially private middle-market companies.

An ESOP is a tax-qualified defined contribution employee benefit plan intended to primarily invest in the stock of the plan sponsor company. The ESOP is managed, and the assets of the ESOP are held, by a trustee, just like the assets of a 401(k) plan. The ESOP trustee is the legal owner of the stock but holds the stock for the beneficial interests of the employees. The ESOP purchase is flexible in terms of its ownership of the sponsoring employer and can own any amount of equity of the sponsoring employer up to 100%.

In its simplest form, an exit using an ESOP is structured as follows: The sponsoring employer establishes the ESOP. An ESOP trustee is engaged to serve as single buyer and decision maker for the ESOP. The sponsoring employer borrows money from its lender, which it then loans to the ESOP (the terms of these two loans do not have to be identical or even similar). The ESOP -- through the ESOP trustee -- then uses the loan proceeds from the sponsoring employer to purchase some or all of the shares of stock in the sponsoring employer from the selling shareholder. Once the transaction is complete, the ESOP has a debt outstanding to the sponsoring employer, which it repays on an annual basis. The ESOP's repayment of this debt is funded through the sponsoring employer's annual deductible contributions to the ESOP.

The unique benefits to the selling shareholder(s) from an ESOP exit include: (1) being able to transition (or begin to transition) the business while (a) maintaining control of the transaction, (b) continuing to operate the business and remaining active in the day-to-day management of the business and (c) maintaining the corporate culture and legacy of the company; (2) the ability to defer tax on capital gains that would otherwise be due on the sale of stock to the ESOP, which maximizes the after-tax sales proceeds received by the selling shareholder; and (3) engaging in a transaction with a friendly buyer compared to a sale through the auction process, or to a strategic or financial buyer.

The unique benefits to the sponsoring employer from an ESOP exit include: (1) ability to buy out exiting shareholders without upheaval in the business; (2) significant tax savings (potentially tax avoidance if S corporation status is elected) and improved cash flows, which can be used to repay debt, fund capital expenditures or seek acquisitions; and (3) proven employee motivator -- because the employees now have a "stake" in the sponsoring employer, take a more active role in the business and have more loyalty to the company, resulting in increased productivity, better financial performance and a more stable employee population.

Lastly, an ESOP exit carries with it benefits to the employees of the sponsoring employer, which include: (1) a meaningful retirement benefit to employees without immediate cash outlay by the company; (2) contributions to the ESOP and earnings/appreciation accumulate tax-free for the benefit of an employee's retirement (for example, employees not subject to tax on contributions or earnings/appreciation allocated to their accounts until benefits distributed out to them upon termination of employment); and (3) employees have an equity stake in the company and therefore share in growth and increases in the plan sponsor company's value.

Erin Turley is an employee benefits partner in the Dallas office of K&L Gates LLP.
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Tags: employee stock ownership plans | Erin Turley | ESOPs | K&L Gates

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