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Part I: Using ESOPs to Grow Your Business and Build a Dedicated Workforce

March 6, 2018 | Financial Executive Magazine
Allen P. Fineberg

*This article originally ran in FEI Daily on March 6, 2018. Click here to read the article in its entirety.*

Given the right circumstances, an employee stock ownership plan (ESOP) can be used as a vehicle to enhance the economic viability of the proposed growth transaction by making debt repayments fully deductible, while also providing benefits to the company’s employees.

The “grow or die” business ethos may have been discredited, but sometimes growth is essential to maintain market share or fend off challenges from competitors. A business growth strategy can take many forms, such as expanding capacity or a strategic acquisition, but the common element is the need for capital. A great strategy will come to nothing if the company cannot pay for it.

What is an ESOP?

An ESOP is a tax-qualified employee retirement plan (specifically, a form of “stock bonus plan”) to which a company makes discretionary contributions of its stock or cash that is used to buy the company’s stock. Alternatively, an ESOP can borrow money itself from a third party to buy existing or new stock in the company. The stock contributed or purchased is then allocated to separate accounts established for each participating employee under the ESOP. While contributions are not required to be made to an ESOP every year, the Internal Revenue Service (IRS) will require the company to make substantial and recurring contributions to the plan. For practical purposes, an ESOP loan typically requires annual employer contributions. 

Tax-qualified retirement plans permit the employer to deduct contributions to the plan on a current basis, but allow the employee participants to defer recognition of income on their share of these contributions (including earnings) until actually distributed, generally after retirement or other separation from service. When an ESOP is used to fund an acquisition or capital expansion, the tax benefit of current deductibility can significantly enhance the financial viability of the transaction.

Key Objectives and Uses of an ESOP

Perhaps the most common use of an ESOP by a privately owned corporation is to purchase the stock of a deceased or retiring stockholder, but this article focuses on two quite different uses, which can be pursued simultaneously and in a synergistic fashion to enhance the likelihood of achieving both objectives:

ESOP Basics

There are a number of legal requirements that must be satisfied in order to qualify for the favorable ESOP tax treatment. The limitations imposed by these rules will often define the parameters of an ESOP transaction and will determine whether use of an ESOP is viable in a given situation.

Non-Discrimination Rules. Subject to a few important exceptions that will be addressed below, ESOPs are generally subject to the same minimum coverage, participation, non-discrimination and other rules that apply to all tax-qualified retirement plans. Two of these rules will be of particular importance for any analysis of the viability of an ESOP in a particular situation:

Prohibited Transactions and Fiduciary Responsibility. There are also fiduciary responsibility requirements imposed on employers, trustees and others serving in a fiduciary capacity with respect to a retirement plan: 

Qualifying Employer Securities. An ESOP is only permitted to invest in “qualifying employer securities.” As long as the employer has only one class of common stock, it will be a qualifying employer security. However, if the company’s stock is not publicly traded and it has more than one class of stock, the employer securities that may be acquired by the ESOP must be common stock having a “combination of voting power and dividend rights” equal to or greater than: (a) the class of stock having the greatest voting rights; and (b) the class of stock having the greatest dividend rights. For purposes of applying this rule, the employer stock may be stock of another corporation that is a member of a controlled group that includes the employer.

Fair Market Value. If the employer’s stock is not publicly traded, the stock must be valued by an independent appraiser both at the time it is acquired by or contributed to the ESOP and annually thereafter. This valuation is used for all purposes under the ESOP, including: (a) determining the price for ESOP purchases of company stock; (b) applying the annual addition limits for allocations of company stock to participants’ accounts; and (c) determining the amount to be paid to a terminated participant.

Exempt Loans. There is a prohibited transaction exemption for certain loans between the ESOP and the employer that facilitates use of an ESOP to acquire company stock: 

Part Two of this article will discuss in detail how an ESOP can be used to meet the twin goals of corporate growth and development of a stronger and more committed workforce.

Allen Fineberg is a corporate attorney at Flaster Greenberg PC.

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