Features of ESOP Trust Transactions

A company can create a “private stock market” for minority or majority interest transactions (the typical savings to sellers & corporations are often over $600,000 per $1.0 million in such sale transactions, as compared to conventional corporate or personal stock purchases). The usual ESOP purchases are 20% to 60% of the typical closely-held company. Control can remain with non-ESOP shareholders unless the owners want the ESOP to have control. Often, in closely-held “C” corporations, the seller does not pay capital gains taxes, and the company receives tax deductions for funding the ESOP purchase.

Since an ESOP is an ERISA-defined contribution plan, it provides for vesting schedules, distribution and other rules much like its profit-sharing cousin. These rules can effectively allow the assets (stock) in the plan to be concentrated in the loyal, remaining core employees over time.

A seller stockholder in a “C” Corporation electing the tax-free rollover must preclude certain family members from receiving allocations of such stock in the ESOP (as well as other 25% or greater shareholders). There are mechanisms to mitigate or eliminate this effect.

There are limits on what can be contributed to the plan annually:

1. Generally 25% of eligible payroll is deductible to the company.
2. Tax-deductible (“reasonable” dividends in “C” Corporations and untaxed “S” distributions can bring contributions well above this 25% limit.
3. Eligible employee compensation is currently capped at $200,000 per employee (or a $40,000 maximum addition to the participant’s account)
4. The tax relief act of 2001 (EGTRRA 2001) improved the way ESOPs work with 401(k) plans. Note that the use of 401(k) employee deferrals in an ESOP with a 401(k) feature for the purchase of company stock in closely held companies is not recommended due to State and Federal Securities Rules.

ESOPs combine well with charitable trusts, family partnerships and similar estate planning vehicles. Often a seller can eliminate estate and capital gains taxes, while receiving some personal income tax deduction in the process. None of these techniques impair the ability of the ESOP to use pre-tax dollars to purchase the stock

Note that any stock held by an ESOP ultimately results in a “repurchase” obligation: departing, vested plan participants must receive the cash value of their shares under the terms of the plan distribution rules. This long-term liability should be projected before committing to a specific purchase amount.

Pre-funding an ESOP as a “cash warehouse” not on the balance sheet can reduce or eliminate the need for later leverage to buy out a shareholder (often tax-free). The cash contributed to the ESOP is an immediately deductible contribution by the Company and compounds tax-free in the Plan.

Corporations interested in rewarding key executives on a discriminatory basis can use the ESOP as a tax shelter or financial “engine” to support tax-free deferred compensation funding. This is an important and poorly understood application of ESOPs in a competitive market for key employees.

Besides payment of ESOP loans with tax-deductible dollars, corporate debt can also be restructured for the payment of principal amounts on a pre-tax basis. Note: with liquid retained earnings above working capital needs, the company can loan its own cash to the ESOP, roll the cash to a selling shareholder of a “C” Corporation on a tax deferred basis and repay the loan to itself with tax-deductible principal and interest payments.