ESOP's Advantages

By Denise Norberg-Johnson | Apr 15, 2006
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Last month, we introduced the concept of the Employee Stock Ownership Plan (ESOP). This month, we’ll look at the potential advantages to your company of establishing an ESOP, including positive effects on employee morale, company finances and bonding relationships.

Most ESOPs are structured as trusts and leverage the purchase of company stock. The employer borrows from a third-party lender, loans the funds to the ESOP and the ESOP buys stock from the employer or directly from shareholders. The employer contributes cash or stock annually to the ESOP to repay the borrowed funds. The ESOP distributes the stock directly to the accounts of individual employee shareholders as the loan is repaid.

Company tax advantages

An ESOP is a popular method of transferring the owner’s equity to employees, providing retirement funding and capital gains tax deferral to the owner (as well as departing employees). Shares are purchased with pretax dollars, and annual stock or cash contributions are deductible (up to 25 percent of covered payroll for leveraged plans and less for unleveraged plans), deferring tax liability to participants until final distribution of the proceeds.

For C corporations, if the ESOP will own at least 30 percent of the shares after the transaction, it can use a §1042 rollover to defer capital gains tax on resale of equity shares. The seller must reinvest the proceeds in “qualifying replacement property,” such as publicly traded stock or securities to obtain a similar deferral. Government obligations (such as treasury bonds) or mutual funds do not qualify.

If the seller holds the replacement property until death, the capital gains tax on the sale is permanently avoided. Effective Jan. 1, 1998, S corporations were also given the right to sell their stock to retirement plans. Although they cannot use the §1042 rollover benefit, federal income tax or alternative minimum tax is not applied to the proportion of the company owned by the ESOP. For example, if the ESOP owns 50 percent of the stock of XYZ Electric, the company is not taxed on half of its earnings.

In an attempt to stem abuses of these tax advantages, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) prevents S corporations from providing “disproportionate benefits” to shareholders who directly or indirectly control the company. Any person owning more than 10 percent of the shares is “disqualified,” and if “disqualified” people own a majority of shares, the corporation may face a 50 percent excise tax on their specific ESOP account balances.

Employee motivation

ESOP participation is open to all full-time employees who are not union members, and some companies include union members as well. Studies show effects such as improved retention, increased attention to costs, enhanced morale and relationships between workers and managers. A more positive environment can moderate health care expenses, and a positive corporate culture can improve profits.

Employees who leave the company have “put option,” automatically triggering repurchase of their shares; if the company does well, their stock value improves. Loyal employees can diversity or convert up to half of their shares to outside investments; the same rights apply to those who are 55 or older. Participants receive annual financial statements, and their fiduciary interests are guarded by the plan trustee. Individual plan participants even vote on larger issues directly, such as a potential sale, merger or liquidation of the employer company.

Mergers and acquisitions

As ESOPs mature, acquisitions and mergers may provide additional shares for allocation to newer employees. The ESOP borrows money to buy more shares, and the company acquires a target company.

In a merger, the seller of the target company may receive ESOP shares as part of the sale and can often resell them to the ESOP for cash, with the accompanying tax advantages. The acquiring company expands its pool of available shares. Some C corporation target companies establish their own ESOPs and benefit from the same capital gains tax deferrals mentioned above.

Bonding relationships

Because of the need to closely monitor financial information and perform annual stock evaluation updates, an ESOP program can positively affect the company’s bonding relationship. Conservative surety underwriters may appreciate the efforts of management to retain key employees so critical to efficiently completing contracts as well as risk reduction provided by improved cash flow. Establishing an ESOP also demonstrates a thoughtful investment in transition planning, ensuring future management continuity.

Obviously, the issues are complicated. Next month, we’ll review some of the costs and risks of implementing an ESOP in your company.    EC

NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at [email protected].

About The Author

Denise Norberg-Johnson is a former subcontractor and past president of two national construction associations. She may be reached at [email protected].





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