Why companies should hire advisors before considering ESOPs.
May 12, 2011
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:
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.
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:
When Hare decided to pay dividends, the company was entitled to a tax deduction for any dividends that were:
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.