Owners of private corporations should know the answers to the following questions.
After 30 years of working with ESOPs we have been asked many questions. Here is our list of the most frequently asked questions about ESOPs.
Congress is firmly committed to broadening the ownership of capital in the United States and has structured laws favoring private companies which take advantage of ESOPs. The following questions stress the key points regarding the operation of an ESOP. We have attempted to be as concise and straightforward as possible, allowing you the opportunity to quickly understand the practical economic considerations of an ESOP. If you have any other questions, or are interested in determining how an ESOP would work for your specific company, please feel free to contact us.
Why does congress favor ESOPs?
"A strong case for expanded ownership could be made on equitable grounds alone - or on motivational grounds alone. Certainly a nation that puts its faith in a private enterprise system should conduct its tax policy to insure that the voting public has a personal stake in that system." Congressional Record, May 12, 1981.
What is best - to sell to an ESOP or to an outsider?
Owners of private corporations have two distinct advantages in selling to an ESOP versus an outsider - control and terms of sale. In other words, you negotiate the sale with yourself. If you have attempted to sell out, or know a friend who has, you realize the advantages of an ESOP.
Can a stock sale to an ESOP be structured tax-free?
Yes. A provision of the 1984 Tax Reform Act provides for a deferment of taxes on the sale of company stock by owners of private companies. To take advantage of the deferment, the stock must be sold to an ESOP and within 12 months after the sale and the seller must acquire stock of certain domestic corporations. Non-recognition of gain will be available only if, after the sale, the ESOP holds at least 30% of the company stock. Upon request, we will supply complete details of this provision including deductions for dividends paid on ESOP stock.
Can employees invest money in an ESOP?
No. The ESOP is funded by tax-deductible contributions from the corporation. Employees of privately owned companies are not permitted to use their money to buy stock in an ESOP.
Why should I have an ESOP?
An ESOP can provide the security of asset diversification. Your company, more than likely, represents the bulk of your estate. To convert a portion of those assets into more liquid investments makes sound economic sense. An ESOP is the only plan that provides pretax financing and employee benefits, simultaneously.
What is the difference between an ESOP, ESOT and Stock Bonus Plan?
The terms "ESOP" (Employee Stock Ownership Plan) and "ESOT" (Employee Stock Ownership Trust) are often used interchangeably. An ESOP describes the provisions for operating the trust while ESOT describes the legal entity, - i.e., the trust that holds the stock or other assets of the plan under your control. ESOP/ESOT may legally borrow (leverage) to acquire company stock. A stock bonus plan is similar to an ESOP with the exception that it may not borrow money to buy stock.
How does an ESOP work?
An ESOP is a legal entity that operates as a tax-exempt market for stock. Because it is "qualified," contributions of cash or stock are tax deductible to the company and the trust is tax exempt to the participants.
Are valuations the same for ESOPs and estates?
No. A valuation for estate tax purposes will typically be significantly lower than for ESOP purposes. Stock held outside an ESOP will be discounted for its inherent lack of marketability. The discount typically ranges from 20-50%.
May I have other plans?
A company is allowed any number of or combination of plans including ESOPs, pension plans, 401(k) plans, profit sharing plans, etc. The only limitation is the maximum tax deduction allowed for all plans, as a group, - i.e., 25% of a company's participating payroll.
Can my employees tell me what to do?
No. An ESOP is a legal document approved by the IRS. It does not contain any implied or expressed granting of management decision-making. Employees have no right to company financial information or voting. The owner continues to operate and manage the company in the same manner as before the ESOP was installed.
Who determines the value of my company?
It is recommended that an experienced and independent corporate appraiser determine the value of your company. But, the owner is under no obligation to accept a given value. The IRS has not prescribed any specific ESOP appraisal formulas, nor does it require that the appraisal be submitted for approval as part of the ESOP documentation.
What are the costs for installing an ESOP?
Cost depends entirely on who does the work and how their fees are structured. The key element to an ESOP's long-range success is structuring the plan to meet the requirements of the shareholders and the company, now, and in the future.
The first step involves drafting the Plan and Trust. It is then submitted to the IRS. Next, corporate adopting resolutions and employee booklets must be prepared, and employee meetings must be conducted. Last, a professional appraisal of the company value is completed. The most economical approach is to package all the necessary steps into one total fee, including a guarantee for IRS approval. AQP fees can range from $36,000 to $40,000 depending upon corporate complexity.
How long does it take?
This simply depends on how fast the company wants to move. Plans have been drafted and submitted to the IRS, with the company buying stock, all in two to three weeks. However, three to four months is a more realistic time frame for completing all phases of the plan's installation.
May I get out of an ESOP later?
Yes, absolutely. You may convert it to a profit sharing plan, have it frozen or have it terminated.
When should I set up an ESOP?
An ESOP should be considered seriously once your company is generating income that is taxable at the maximum federal and state corporate rates. At that time, simply determine the number of tax advantages offered by an ESOP that would benefit the owners of your company.
Who should be participants in the ESOP?
Generally, an ESOP should include all full-time employees, excluding certain groups such as union or hourly employees. However, these groups must be reviewed in companies where they could have a significant impact on the overall employee compensation structure of the ESOP.
Who administers the ESOP?
Legally, the company itself administers the ESOP. However, the majority of companies appoint a contract administrator who provides the service. Upon request, AQP will provide detailed administrative requirements.
Who votes the stock of the ESOP?
Regardless of who administers the plan, the voting rights are retained by the selling shareholder(s) through their appointment to the Plan Committee.
Where does the ESOP get the money?
The company contributes the cash or stock to the ESOP and deducts that amount from its taxable income. The IRS allows the company to contribute and deduct up to 25% of participating payroll.
Will my financial information be confidential?
There is no requirement to disclose any company financial information to the participants in an ESOP.
Do I have to sell a specific amount of stock to the ESOP?
There is no set amount of stock that must be sold to the ESOP. The decision lies strictly with the shareholders. No lower or upper limits exist on the amount of stock that may be sold to an ESOP.
Can I retain future family control with an ESOP?
Yes. Stock held outside the ESOP exercises the voting rights on all stock held in the ESOP. Therefore, stock held by the family will continue to control the company.
How much stock can I sell to the ESOP while still maintaining 100% control?
You can sell 100% of your company stock to an ESOP and still maintain 100% control of your company. However, from a practical matter it is advisable to retain 2-5% outside the ESOP for transfer of control to successive management.
How will I be taxed on stock sold to an ESOP?
All stock sold to the ESOP is taxed at the capital gains rate to the selling shareholder. However, it is not taxed if certain requirements are met and the proceeds are reinvested in other domestic stocks or bonds, either public or private.
Can I still sell out to a buyer if I have an ESOP?
A company with an ESOP may, and many do, sell all or part of its stock to an outsider or to key employees.
Can I convert my profit sharing plan to an ESOP?
A profit sharing plan may be converted to an ESOP and its assets can be used to purchase company stock. Or, the assets may remain invested as they were, - i.e., in a separate profit sharing account within the ESOP.
How large should a company be, in order to have an ESOP?
Company size is not a factor in the installation of an ESOP. Profitability is the key.
Are ESOPs gaining or losing popularity?
ESOPs are definitely gaining popularity. In 1974, when ESOPs were first authorized, approximately 300 ESOPs existed in corporate America. Today, there are approximately 11,000 ESOPs with 11.5 million United States workers participating existed in both public and private companies. This represents approximately 13% of the civilian work force in the United States. The National Center for Employee Ownership estimates that one thousand public companies are now more than 4% employee owned. From all indications, ESOPs have considerable appeal to both the public and private company.
If I have an ESOP, will the IRS tell me how to run my company?
The IRS has no special authority regarding the operation of your company, even if you have an ESOP. In fact, the reporting requirements for ESOPs are the same as for profit sharing plans.
Do all shareholders have to sell stock to an ESOP?
Each shareholder determines independently when, if, and in what quantities he wants to sell his stock. One group of shareholders may plan to sell on a pro rata basis, while older shareholders may decide to sell-in the largest quantities, etc.
What happens if I have an ESOP and my company goes out of business?
If your company goes out of business and has an ESOP, the portion of the trust's value that is represented by company stock will be its liquidation value after company dissolution. The ESOT is not subject to creditors' claims.
How can an ESOP help my company financially?
An ESOP can help your company financially by amortizing the principal portion of debt with pretax funding. Contributions of company stock are non-cash expenses, but fully deductible from pretax income. For example, a company contributing $1 million to a profit sharing plan can increase its after-tax cash flow by $1 million by simply replacing the profit sharing plan with an ESOP and contributing company stock.
Can an ESOP improve my cash flow?
In its simplest form, the company can contribute treasury stock to the ESOP, up to 25% of covered payroll. Such a contribution is a non-cash expense and fully deductible as a qualified plan expense. In expanded form, company financing can be achieved through a leveraged ESOP with the proceeds of the loan going to the company. The loan is then amortized by tax-deductible principal payments, up to 25% of covered payroll. The interest expense is an additional deductible.
Will an ESOP help future growth?
A University of Michigan Survey Research Center study of 98 companies that have ESOPs concluded that: "Employee ownership may be associated with better attitudes toward the job and higher productivity and profits." Recent surveys by the ESOP Association of America, although less formal, have reached similar conclusions.
What effect does an ESOP have on employees?
An ESOP's effect on employees corresponds directly to their comprehension of the plan. Once the employees understand that their future benefits depend on the growth and success of the company, they see the importance that their productivity plays in that success.
When do employees receive stock from the ESOP?
Employees who have stock in their ESOP account can only get the stock upon retirement, death, disability or a 5-year break in service. However, the ESOP can be, and often is, structured so that company stock is never distributed to employees. The portion of a participant's account that is represented by company stock is simply converted to its cash value and paid out either in a lump sum or in installments upon an employee's retirement, death, disability or 5-year break in service.
Can the ESOP distribute cash, not stock, to the employees?
Yes. The ESOP may distribute cash, and not stock, to employees. And, only on rare occasions is a stock distribution ever made.
Did the Tax Reform Act of 1986 hurt ESOPs?
No. The Act continues to promote ESOPs as both a tool of corporate finance, specifically a vehicle providing liquidity for shareholders, and as an employee incentive program. The Act extended a company's deduction for dividend payments to the amount used by the ESOP to repay the loan that acquired company stock. The exclusion of interest on ESOP loans was expanded to include regulated investment companies (RICs). Various administrative and operational changes in areas of diversification, distributions, vesting and appraisals also were made a part of the law.
Did the Revenue Reconciliation Act of 1993 hurt ESOPs?
No. In fact, with the top individual tax rate now equivalent to 39.6%, an owner of a profitable corporation should find ESOP transactions even more beneficial.
Did the Small Business Job Protection Act of 1996 and the Taxpayer's Relief Act of 1997 hurt ESOPs?
No. TRA97 instituted new tax rates for long-term capital gains. Generally, after May 6, 1997, sales of long-term capital assets (those held more than 18 months), the maximum capital gains rate are 20% (10% for individuals in the 15% tax bracket).
Also under the new law, ESOPs in S corporations can require employees to take the cash value of their plan distribution rather than stock. The bill also exempts them from the prohibited transaction rules of the IRC or ERISA. These exemptions include sales of stock to an ESOP as well as loans to an ESOP by a 5% shareholder/employee of the Company. The bill repeals the provisions of the '96 bill requiring ESOPs to pay unrelated business income taxes on their share of S Corporation earnings. The two important tax benefits that are still unavailable to S Corporation are:
- The deductibility of dividends to repay ESOP loans or passed through to ESOP participants.
- Section 1042 tax free rollover treatment on sales to ESOPs
What effect did the economic growth and Tax Reconciliation Act of 2001 have on ESOPs?
"The Act" did not affect C-Corporation ESOPs, however, "The Act" made significant changes in the operation and tax advantages of ESOPs in an S-Corporation. There is now a closely held test called the 10/20 test, which "looks" inside the ESOP as if it were fully allocated. Any individual with 10% of the ESOP's assets or whose family has 20% of the ESOP's assets become disqualified persons. If all disqualified persons control 50% or more of the S-Corporation stock than the S-Corp has a non-allocation year, triggering massive excise taxes up to 50% of the value of the allocation and paid by the corporation. The individual is treated for income tax purposes as if he/she had received a distribution. In year one falling to pass this two-part test there is the imposition of these taxes even if there is no allocation. The effective date for compliance for existing S-Corp ESOPs is for plan years commencing after December 31, 2004. For those S-Corps that do not have ESOPs the effective date is for plan years ending after Mach 14, 2001. All S-Corps will have to eventually comply.
How can I find out if an ESOP is good for my company and me?
Upon request, AQP will provide you with specific information regarding how an ESOP can be structured and operated, in line with your own objectives. If you desire more detailed information, please request our booklet, ESOP Solutions.