Time to Cash Out? ESOP’s an Option

An Employee Stock Ownership Plan or ESOP is among the most important financial tools available to business owners. Whether used to buy the shares of a departing shareholder/owner, to borrow money at a lower after-tax cost or to create an additional employee benefit, an ESOP is a solution that owners and operators of service centers may wish to explore.

An ESOP can be established and funded in a variety of ways. For one, the business can borrow funds that are loaned to the ESOP. The ESOP uses the funds to buy out the selling owner. All contributions to the ESOP are deductible, which means the business is buying out the owner using pre-tax dollars. Following the purchase, the business makes annual tax-deductible contributions to the ESOP, which the ESOP uses to pay down the debt.

ESOPs are most commonly used to provide a market for the shares of departing owners of successful, closely-held metal centers, to motivate and reward employees or to take advantage of incentives to borrow money for acquiring new assets using pretax dollars. Remember, however, that ESOPs are in every case a contribution to the employee, not an employee purchase.

With an ESOP, the service center establishes a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. As an alternative, the ESOP can borrow money to buy new or existing shares, with the business making cash contributions to the plan to help it repay the loan. Regardless of how the ESOP acquires stock, contributions by the business are generally tax-deductible.

Shares in the ESOP trust are allocated to individual employee accounts. Generally, with few exceptions, all full-time employees over 21 participate in the plan. Allocations are made based on relative pay or some more equal formula. As employees accumulate seniority, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100 percent vested within a period of three to six years, depending on whether vesting is all at once or gradual.

When employees leave the business, they receive their stock, which the business must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual outside valuation to determine the price of their shares.

Benefiting from an ESOP
As the owners of many service centers approach retirement age, they face the dilemma of how to cash out while ensuring the future success of their company. Fortunately, ESOPs do not always mean relinquishing control of the operation. Employees must be allowed to vote their allocated shares on major issues, such as closing or relocating, but the business decides whether to pass through voting rights on other issues. In publicly held businesses, employees must be able to vote on all issues.

There are many reasons, each unique to a specific situation, for creating an ESOP. Owners of privately held services centers can, for example, use an ESOP to create a ready market for their shares. Since almost all of the value of his or her stock in the business represents capital gain, the selling owner may reap the biggest benefit.

Under this approach, the business can make tax-deductible cash contributions to the ESOP to buy out the owner’s shares, or it can have the ESOP borrow money to buy the shares. In a regular corporation (often called a C corporation), once the ESOP owns 30 percent of all the shares in the business, the seller can reinvest the proceeds of the sale in other securities and defer tax on the gain.

In other words, when the owner sells to an ESOP and reinvests the proceeds within a 15-month window, the gain on the sale is deferred until the newly purchased securities are sold. If the owner dies before selling those securities, the capital gains escape taxation altogether.

ESOPs are also useful in helping metal center operators borrow money at a lower after-tax cost. ESOPs are unique among benefit plans in their ability to borrow money. The ESOP borrows cash, which is used to buy company shares or shares of the existing owner or owners. The business then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are tax-deductible.

The ESOP also makes an excellent employee benefit. Businesses can simply issue new or treasury shares to an ESOP, deducting their value (for up to 25 percent of covered pay) from taxable income. Or the business can contribute cash, buying shares from existing public or private owners.

In publicly traded companies, which account for about 5 percent of all ESOP plans and about 40 percent of all ESOP participants, ESOPs are often used in conjunction with employee savings plans. Rather than matching employee savings with cash, the company will match them with stock from an ESOP, often at a higher matching level.

Why not ESOP
Despite the many benefits offered by ESOPs, there are downsides. For one, there is the question of whether you want your employees as co-owners. When an employee who is vested in the plan leaves the business, that employee is entitled to take shares of the company stock, which the business may be required to buy back.

While the service center must be ready to repurchase its shares, the employee is not required to sell them back to the business. A disgruntled former employee could theoretically sell that stock to a competitor.

Because an ESOP is a benefit plan, it is subject—in combination with any other corporate retirement plan—to contribution limits of 25 percent of payroll, looking at the first $225,000 (in 2007) each employee is paid. Many experts advise that at least 20 employees are necessary for an ESOP, otherwise contributions won’t total enough to service the debt, making the whole plan unworkable.

Every service center business owner should also keep in mind that the tax benefits of an ESOP, particularly the owner’s deferral on gain, apply only to regular or C corporations. The laws do not allow ESOPs to be used by partnerships or most professional corporations. ESOPs can be used in S corporations, but they do not qualify for the rollover treatment and have lower contribution limits.

If an S corporation is involved, owners frequently convert to a C corporation before establishing an ESOP. Recently, the IRS added to the woes of S corporations by issuing new rules for ESOPs owning S corporation stock.

Despite the growing popularity of limited liability companies or LLCs, the S corporation remains the most popular operating entity among small businesses. The S corporation is an incorporated business with a limited number of stockholders that elects in the manner of a partnership. The S corporation generally pays no taxes, instead passing on all capital gains, ordinary income, tax preferences and the like to shareholders, who include in their personal tax returns their pro rata share of these items.

New IRS regulations are intended to ensure that the special tax benefits afforded to ESOPs holding S corporation stock do not extend to cases in which ESOP ownership is concentrated among a small number of owners.

Whether because of a concentration of ownership, or for a number of other reasons, ESOPs owning S corporation stock may face IRS disqualification. Should this occur, contributions made by the business to the ESOP are no longer deductible, while an excise tax may be imposed on the “illegal” contribution. Obviously, the new S corporation regulations make professional guidance more important than ever.

How much will it cost?
The cost of establishing and maintaining an ESOP can include both out-of-pocket expenditures and a number of subtle charges. Small businesses are required to repurchase shares of departing employees, for instance, and this can become a major expense.

What’s more, any time new shares are issued, the stock of the existing owners is diluted. That dilution must be weighed against the tax and motivation benefits an ESOP can provide.

The actual cost of establishing and maintaining ESOPs varies, but usually includes attorney fees, corporate valuations and the costs of obtaining financing. Many business owners pay, before the annual maintenance fees, at least $30,000. This is often far less than what would be paid to a business broker to sell the business, however.

Whether an ESOP is used to help an owner cash out, to borrow money at a lower after-tax cost or to create an additional employee benefit, it is an option many metals distributors might want to discuss with their advisers.

Mark E. Battersby is a freelance writer and consultant on tax and financial issues based in Ardmore, Pa. He can be reached at (610) 789-2480 or by e-mail at MEBatt12@Earthlink.net.