Think About It Is Written By

Leimberg’s

Think About It

Think About It is written by

Stephan R. Leimberg, JD, CLU

and co-authored by Linas Sudzius

MARCH 2010 #409

What Every Planner Needs to Know About

Employee Stock Ownership Plans (ESOPs)

Introduction

Owners of closely held businesses face challenges when seeking to transfer their companies to successor ownership. In some cases, the business owner has trouble identifying the next owner. In others, planning to fund the transfer at the key moment is a problem.

An employee stock ownership plan (ESOP) is a special kind of defined contribution retirement plan that can help closely-held business owners solve succession issues. Where it fits, an ESOP offers substantial advantages over traditional buy-sell planning. The main advantage is that the business owners and the company are able to fund a buyout with pre-tax money.

Because an ESOP is a retirement plan, the rules that apply to other qualified plans apply to it.

All eligible employees must be included.
The plan cannot discriminate in favor of certain employees.
Related businesses must be aggregated together.
A plan document must be implemented and kept up-to-date.
Other strict administrative requirements must be observed.

Most closely held business owners, if they are considering an ESOP, would need to have several questions answered:

If all employees must be included in an ESOP, how can it be used effectively to transfer the business to the right group?
How can the business owner use the ESOP to buy his business interest?
What tax advantages are available to the business and its owners?
What if the business owner is not ready to turn over control of the business right away?
What special steps need to be taken to effectively implement an ESOP?
How does an ESOP integrate with the rest of the business owner’s financial and estate plans?

Those who present ESOPs to closely held business owners will also want to understand the role life insurance plays in the process.

The authors wish to thank Kelly Finnell, J.D., CLU, and Benjamin Buffington of Executive Financial Services, Inc., in Memphis, Tennessee( for their technical assistance in the preparation of this issue of Think About It.

how an ESOP Works

Unlike other retirement plans, an ESOP is required to invest primarily in the sponsoring company's securities. Most often, the securities take the form of the company’s common stock.

To set up an ESOP, the sponsoring company first needs to create a pension trust, into which shares of the company stock will go.

The employer might contribute new shares of its own stock into the trust, or it may contribute cash to buy existing shares. The ESOP plan might be empowered to borrow money to buy additional shares, with future employer contributions anticipated to repay the loan. If the ESOP trust borrows money to buy shares, it can borrow funds backed by the credit of thesponsoring company. Further, company contributions to the ESOP trust are deductible, both for the loan principal and loan interest.

Shares owned by the trust are in turn allocated to individual employee accounts, as with most kinds of defined contribution plans. Plan allocation formulas must not discriminate in favor of highly compensated employees, and are typically based on employee compensation.

When an employee leaves the company, the employee receives either the stock from the employee’s account, or an amount of cash equal to the value of the stock. If stock is distributed, the plan document requires the company to buy back ESOP stock from the employee at its fair market value.

Distributions from ESOPs are generally taxed the same way as distributions from other qualified plans. For example, distributions prior to age 59½, death, or disability are usually subject to a 10% penalty. ESOP distributions, when turned into cash, are generally eligible for rollover.

In certain circumstances, an employee who gets a distribution of stock and sells it back to the employer may be entitled to capital gains treatment with respect to a portion of the sale price. See Technical Advice Memorandum 200841042.

special esop rules

Eligible Entities

While many retirement plans may be implemented by corporations, partnerships or proprietorships, ESOPs are available to corporations only.

Shared Control

While the trustee of the ESOP trust usually exercises voting control over the stock controlled by the ESOP, the ESOP passes through the voting rights associated with the shares owned by the trust to the employee to whom the shares are allocated in certain limited circumstances.

In closely-held businesses, employees must be able to vote their allocated shares on major issues, such as

(a) approval or disapproval of any corporate merger or consolidation, recapitalization, reclassification, liquidation, or dissolution; or

(b) sale of substantially all assets of the trade or business.

Diversification for Older Participants

ESOP rules protect those who have reached age 55 and who have at least 10 years of participation in the plan. Those employees must be entitled to diversify investments in their accounts. For the six year period after becoming eligible for this election, the participant can elect annually to diversify a total of up to 25% of the account balance. In the last year, diversification of 50% of the account balance can be elected.

Repurchase of Shares Rules

If the employer sponsoring the ESOP is a closely held company, the company’s bylaws can restrict the ownership of its stock to just employees or the ESOP itself. Under those circumstances, the ESOP will not usually distribute company stock to a terminating employee. It will distribute cash, or the employer can require the employee to sell distributed stock back to the employer.

There are twousual methods of financing this buy-back of company shares in a closely-held company.

An asset reserve or sinking fund can be maintained by the employer.

Life insurance can be owned by the employer. Life insurance contracts on key company employees can provide funds either in the form of cash values accessible at the employee’s retirement, or funds available at the employee’s death.

Valuation Requirement

Private companies with ESOPs must have annual outside valuations to determine the price of their shares. The valuation is necessary at the plan’s inception to establish a baseline for fair market value. This valuation will help determine proper allocation of shares to participants’ accounts, and also the proper purchase price for the ESOP trust’s shares.

Finally, the annual valuations also establish the purchase price of shares upon an employee’s separation from service.

SPECIAL ADVANTAGES OF an esop

Section 1042 Tax Deferral for Owner

A shareholder of a C corporation can sell stock to the ESOP, and reinvest the proceeds, with all taxes deferred, by making a Section 1042 election. This option is not available to owners of S corporations.

The C corporation owner can elect to defer capital gains tax on stock sold to the ESOP if

After the sale the ESOP owns30% or moreof all outstanding stock; and

The seller reinvests an amount equal to the sale proceeds into qualified replacement property, during the periodbeginningthree months before and endingtwelve months after the sale to the ESOP.

Not all eligible owners of C corporations will elect tax deferral under Code Section 1042. Making the choice will depend on a variety of factors, including the seller’s currentand expected future capital gains tax rates.

Potential for Greater than Usual Tax Deductions

In general, companies can deduct up to 25% of eligible pay to defined contribution plans. However, in a leveraged ESOP implemented in a C corporation, contributions used to repay the principal on an ESOP loan are apparently subject to a separate 25% of pay limit. See PLR 200436015.

In C corporations, the interest on payments on an ESOP loan does not count towards the 25% limit; but in S corporations, it does.

In a C corporation, dividends used to pay off the ESOP loan do not count toward the contribution limits. Similarly, S corporation distributions can be used to repay an ESOP loan without limit.

No Federal Income Tax on S Corporation Stock Owned by an ESOP

S corporation owners pay income tax on all the taxable income a company earns in a year. For the S corporation shares owned by the ESOP, company profit is allocated there tax-free on a pro-rata basis.

For example, say that the S corporation is owned 60% by the majority owner and 40% by the ESOP. If the business has $1 million of taxable income in a year, $600,000 would be allocated to the individual owner and be taxed at his personal rates. The other $400,000 would be allocated to the ESOP and would not be subject to income taxes.

LIFE INSURANCE OPPORTUNITIES

An advisor helping a closely held business owner implement an ESOP may have several opportunities to talk about life insurance. For example:

The employer might own life insurance on the majority owner of the business, intending to redeem the owner’s shares at death.

The employer might own life insurance on the majority owner of the business, intending to collect the insurance proceeds at the owner’s death. The death proceeds could be used to retire third-party ESOP debt, or help the ESOP purchase additional company shares.

If a closely-held company is successful enough to consider implementing an ESOP, additional life insurance for estate planning purposes may be needed on the majority owner.

Key person permanent life insurance can be used to help fund the obligation of the company to buy back employees’ shares upon separation of service.

HOW IT WORKS – A CASE STUDY

Daniel and Iona Crump, married and each age 62, are the sole owners of Crump Enterprises, Inc. They are the parents of two children; Scott, who is 35 and active in the business, and Charlotte, who is 32 and not involved in the family business. Crump Enterprises has been valued at $10 million.

Daniel and Iona have decided to set up an ESOP, and sell 51% of their stock to it for $5.1 million. Crump Enterprises will borrow the money to fund the ESOP trust.

Since Crump Enterprises is a C corporation, the elder Crumps will be able to invest their ESOP sales proceeds in qualified replacement property without paying federal income tax on the proceeds. The Crumps have decided to invest in high quality corporate bonds, from which they expect to earn substantial retirement income.

The Crumps are selling the other 49% of the business to their son Scott, using a 20 year self-financed installment note.

What is the 49% interest in the company worth for purchase price purposes?

As a result of the ESOP transaction, the Company will take on $5.1 million of new debt to finance the ESOP’s stock purchase. This reduces the net value of the whole Company from $10 million (pre-ESOP) to $4.9 million (post-ESOP).

Taking the debt into account, the 49% interest should be valued at $2.4 million (49% of $4.9 million).

The Crumps’ valuation expert believes that the minority 49% interest in the company is entitled to a further discount—to $2 million—for its lack of marketability.

Scott’s 20 year buyout of the 49% interest in Crump Enterprises will cost him about $12,500 monthly, based on an interest rate of 4.35%, the current federal long-term rate.

But if Scott only owns 49% of the business, hasn’t the Crump family effectively lost control of the company? Not really. As ESOP participants become entitled to distributions as a result of their death, disability or retirement, the Company will purchase the shares in their ESOP accounts. In relatively short order, this process will result in Scott’s shares being transformed from a minority interest to majority ownership.

Here’s how it might work. Assume that the parents own 1,000 shares (100%) of the Company’s stock. They sell 51% (510 shares) to the ESOP. They gift their remaining 490 shares to Scott.

During the first few years of the ESOP’s existence, several employee participants quit. The Company purchases the vested shares from their account. Cash is distributed to participants and stock purchased by the Company is retired.

Assuming that 30 shares are purchased by the Company through this stock redemption, there will be 970 shares outstanding. The 30 shares that were redeemed will be retired as treasury stock. If all that happens, there will be 970 shares outstanding, the Company’s ownership breakdown is as follows:

ESOP - 480 shares (49%)
Scott - 490 shares (51%)

As a result of this redemption and distribution process, Scott will be able to keep control of the company through a majority ownership of the stock.

Finally, the Crumps’ life insurance agent has the opportunity to propose the following coverages to help make sure the plan succeeds:

Scott may buy coverage on his own life, collaterally assigning it to the elder Crumps, as added security for the 20 year promissory note in the event of Scott’s premature death.

The company may buy key person permanent life insurance on Scott’s life to help fund the company’s obligation to buy back shares from employees as they separate from service.

Daniel and Iona may require additional life insurance, because they could have potential estate tax concerns based on the money they will receive from the liquidation of their business interests, as well as from other personal assets.

Conclusion

Where ESOPs are a fit, their tax and practical advantages can make them very attractive for the closely held business owner, as well as the company’s employees.

Is an ESOP a fit for every closely held business? Of course not. There are a few situations that seem tailor-made for ESOPs though:

The 100% owner of a closely held C corporation is looking to diversify personal wealth without giving up control of the company.

An owner or owners of a company seeks to create an employee culture of ownership, in order to increase accountability and profitability.

The 100% owner of a closely held corporation wants to transfer control of the business to a family member without giving ownership away.

The owner of a family corporation wants to transfer the business to a key management group on a tax-favored basis.

The ESOP is not indicated in the following circumstances:

The business is not generating enough revenue to justify the administrative costs associated with ESOP implementation and administration.

The business has the short-term potential to find a strategic third-party buyer willing to pay more than fair market value for the company.

Life insurance professionals especially should be prepared to explain ESOPs to their closely held business owner clients. When properly used, the ESOP can solve key issues facing the business owners, tying those clients more closely to the professional advisor. Also, there are plenty of opportunities to use life insurance to solve the ancillary issues.

Would You Like to Turn this Month’s Issue of Think About ItInto a Dynamic Presentation for Your Next Company Meeting?

Tired of boring presentations at company meetings? Want to spice things up with a fun, interactive session focused on increasing results? Make the current issue of Think About It work for you and your producers!

Linas Sudzius, J.D., CLU, ChFC, one of the authors of Think About It, will show you how to use the information in the attached newsletter to make more money.

/ Linas is one of the principals of the ICS Law Group, PC. The ICS Law Group provides estate planning legal services to individuals, and non-litigation legal services to business owners. Its principal office is in Franklin, Tennessee.
Linas worked for a Chicago-based insurance company as their Director of Advanced Sales and most recently as their Chief Marketing Officer.
Linas also co-authors the publication Think About It with Steve Leimberg.

Linas is now scheduling 90 minute and half-day presentations for early 2010. Contact Brenda Harvill at 615-224-1291 or for availability and pricing information.

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