Introduction to ESOPs
An important issue that owners of closely held businesses face when attempting to diversify their personal wealth and/or to achieve management succession to either family member(s), an existing management or employee group is that these people often do not have the personal funds or borrowing capacity to purchase the business outright from the owner. The problem is that obvious solutions, such as “funding” the transition by redeeming the owner’s shares or bonusing money to the family or management group, result in “stacked” levels of federal and state income taxation, which may end up costing the business as much as $3 in revenue for every $1 received by the owner, net of tax. This multiple taxation can create significant cash flow issues for the company and the business owner.
One option for the business owner is to use the tax benefits of an ESOP to ease the ownership transition. Through the ESOP, company revenue can flow through to the business owner without taxation or at favorable capital gains tax rates. By resolving this issue, company cash flow available to fund a stock buy-out can be dramatically improved. This scenario allows the business owner to diversify his wealth and provide a smooth transition of management succession with untaxed corporate earnings.
For instance, a privately held company can use an ESOP to create a ready market for their shareholders. Under this approach, the company can make tax-deductible cash contributions, and accumulate or “warehouse” this cash in a tax deferred account within the ESOP, for the purpose of buying out the owner’s shares. Alternatively and more commonly, the ESOP can borrow money from a bank, and/or the selling shareholder(s), to buy the shares.
ESOPs are unique among ERISA qualified retirement plans in their ability to borrow money. The ESOP borrows cash, which it uses to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible. There is no other M&A structure available under current tax law where the acquisition costs associated with a stock purchase transaction can be paid with pre-tax corporate earnings and profits.
A final use for an ESOP is to create an additional employee benefit. A company can simply issue new or treasury shares to an ESOP, deducting their value (for up to 25% of covered pay) from taxable income. Or a company can contribute cash, and then buy shares from existing owners. Some companies choose to use ESOPs in conjunction with other qualified retirement plans. Rather than matching employee 401k contributions with cash, the company will match them with a contribution of stock in the ESOP, often at a higher matching level.