Michael Redemske

ESOP’s Fable

Why companies should hire advisors before considering ESOPs.

May 12, 2011
by Michael Redemske, CPA

Once upon a time there were two companies, Hare Industries and Tortoise Enterprises. Both companies were reasonably successful, comfortably profitable, privately owned companies. Seeking ways to share ownership with employees, both company’s owners and managers sought advice from professionals.

Hare Industries (Hare) opted to establish an employee stock ownership plan or ESOP. Hare’s approach was not unique. Over 11,000 companies now have ESOPs, with more than 13 million participating employees. Hare sought several advantages from its ESOP:

  • Motivating and rewarding employees;
  • Providing a market for the shares of retiring owners; and
  • Taking advantage of incentives to borrow money for acquiring new assets with pretax dollars.

Tortoise Enterprises (Tortoise) decided to follow a more traditional approach toward shared ownership. It chose to allow employees to purchase company stock directly. Tortoise also established a stock bonus plan and a stock option plan for its employees.

Hare’s ESOP

An ESOP is somewhat like a profit-sharing plan. A company sets up a trust fund into which it can contribute new shares of its own stock or cash to buy existing shares. Shares in the trust are allocated to individual employee accounts. Generally, all full-time employees over age 21 participate in the plan. Employees must be 100 percent vested within three years to six years.

When employees leave the company, they receive their vested stock. Since the stock of Hare is not publicly traded, the company must be willing to buy back the employees’ stock at its fair market value. In addition, the company must pay for an annual outside valuation to determine the price of the shares. In private companies like Hare Industries, employees must be able to vote their allocated shares on major issues, such as closing or relocating. It can choose whether to pass-through voting rights on other issues, like the election of directors. Public company employees must be able to vote on all issues.

Hare’s Fast Start

Hare and its owners initially gained significant tax advantages from its ESOP:

  • Hare opted to allow the ESOP to borrow money to buy shares from a major owner who wanted to retire. Hare then made annual cash contributions to the trust to enable the ESOP to repay the loan. By keeping its annual contributions within statutory limits, Hare was entitled to a tax deduction for these amounts.

    When the retiring owner sold her shares to the ESOP, the trust wound up owning more than 30 percent of its outstanding stock. Since the company operated as a C corporation, the former owner was able to defer her gain on the stock sale by reinvesting the proceeds in a diversified portfolio of U.S. stocks and bonds.

    If the company operated as an S corporation, the deferral of gain would not be available to the selling shareholder. However, corporate profits allocable to the company shares held by the ESOP would not be subject to federal income tax.

    Since Hare provided the funds for the buyback through contributions to the ESOP, it was able to claim a tax deduction for the entire cost of the former owner’s shares.
  • To fund its expansion plans, Hare sold additional new shares to the ESOP. To purchase these shares, the ESOP negotiated a bank loan that Hare guaranteed. The company used these new funds to purchase depreciable assets, the cost of which it deducted immediately under the temporary 100-percent bonus depreciation rules. Finally, when it made cash contributions to the trust to cover the ESOP’s principal and interest payments to the bank, Hare deducted these payments as well.
  • When cash was short, Hare funded its annual contribution obligation by contributing newly issued shares to the ESOP. Hare received a tax deduction for the value of these shares as well.

When Hare decided to pay dividends, the company was entitled to a tax deduction for any dividends that were:

    • Used to repay the bank loan;
    • Passed through to employees; or
    • Reinvested by employees in company stock.
  • The employees participating in the ESOP were able to roll over their distributions to an individual retirement account (IRA) or other retirement plan, instead of paying current tax on the distribution. Those who decided against a rollover were able to treat any gains accumulated over time as long-term capital gains.

Tortoise’s Approach

Tortoise decided to forego the immediate attractiveness of an ESOP. As a result, it had a choice of business entities not available to Hare, including limited liability corporation (LLC), partnership and most professional corporations. Although ESOPs can be used by S corporations, the employer has lower contribution limits and employee distributions do not qualify for rollover treatment.

As time passed, the company did not suffer the same cash drain as Hare. Tortoise avoided the potentially burdensome commitment to provide the cash to fund the ESOP’s loan obligations. Moreover, as Hare’s business and employees both matured, Hare found it more and more difficult to find the funds necessary to repurchase the growing amount of shares owned by departing employees.

Tortoise also avoided the cost of setting up the ESOP, which can be significant for even the simplest of plans in small companies and the cost of an annual stock appraisal. Its owners also did not suffer the dilution that occurs each time new shares are issued.

While Tortoise got off to a slower start by not taking advantage of all the tax benefits offered by an ESOP, it avoided the “drag” that an ESOP can place on a successful company, if its workforce begins to age and its growth curve starts to level out.

Moral of This Fable

Companies considering an ESOP should hire advisors to study both the short-term benefits and longer-term obligations before proceeding.

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Michael R. Redemske, CPA, is an instructor in residence at the University of Connecticut where he teaches federal income taxes and personal financial planning.