Strategies For Aging ESOPs (Employee Stock Ownership Plans)

By Jeff Faust, AVA

In view of the complexities of the financial accounting and federal tax rules governing ESOPs, many ESOP sponsoring companies lose sight of larger issues and become buried in the technical details of their ESOP and remain fixed on a single use for their ESOP.  Short term benefits of a particular ESOP strategy should not overshadow longer term objectives of the company and alternative uses for their ESOP should be addressed every couple of years.

Typical ESOP Transaction

A very typical scenario in the life cycle of ESOPs is the case where the plan was originally adopted to provide a tax-favored means of buying out the equity of one or more major shareholders in a privately held corporation.  This objective can be accomplished using borrowed funds from a bank lender or funds provided by the corporation in the form of a loan to the ESOP trust.  Whatever the method, over time the buyout is completed, successor management is firmly in place, and the equity that was formerly owned by the selling shareholders becomes equity owned beneficially by the plan’s employee participants.

The Repurchase Liability

Up to this point, the corporation has enjoyed the advantage of deducting the yearly contributions made to the plan to service the loan to accomplish a well defined purpose.  For the publicly traded company, there is little downside in such a case since the shares that are distributed to retiring and terminating employees can be sold on the open market.  The corporation, in this case, is burdened only with the administrative costs of operation of the plan.  For the privately held corporation, however, the benefits of the original objective could all be lost if another strategy is not implemented.  Federal tax rules require that employee participants must be granted a “put option” wherein the company or ESOP is obligated to buy back the shares from separated participants at the then current fair market value.  Without this provision, the prospect of owning shares in a private corporation with little or no market would be of nominal interest to most employees under most circumstances.  This obligation to fund the conversion of ESOP shares into cash is referred to as the “repurchase liability.”  Once this liability is recognized, the company needs to decide whether or not to have the ESOP or the company repurchase the shares.  There are pros and cons to both and this will depend on the long term strategy of the company and the ESOP.

Redemption or Repurchase?

Shares can be repurchased by the ESOP using cash that was contributed to the ESOP on a pre-tax, making this the preferred approach.  Another alternative is to adopt a policy of purchasing shares from separated participants by the company.  This is, of course, an outlay of cash for which no federal tax deduction is available.  When the trust uses deductible cash contributions to buy back shares from separated participants, these repurchased shares are reallocated to the remaining participants and the process continues as the same shares are purchased over and over again by the trust.  Buy back of shares by the company, however, leads to a reduction or possible total elimination of this liability.  If this alternative appears to be the most feasible, other forms of incentive compensation or retirement oriented benefit programs should be considered as part of the transition.  In other words, an overall strategy should be implemented but addressed again as the ESOP mature and the objectives for the ESOP change.

ESOP as a Profit Sharing Plan

Continued federal tax deductible cash contributions can be made to the ESOP and invested in other securities or used to buy additional employer company shares, either newly issued or from non ESOP shareholders.  Launching into a new round of borrowing is not necessary if there is adequate cash in the plan.  Cash funding the ESOP will also mitigate the impact of the repurchase liability.

Increasing Cash Flow

The company can merely contribute newly issued shares for which a federal tax deduction is available.  Remaining plan participants receive additional shares in their accounts from the forfeiture of unvested shares of separated employees.  If the share values increase over time, this is another means of realizing appreciation in the individual ESOP accounts; however, increasing share values mean increasing repurchase liabilities.

Importance of a Strategy

Unless the ESOP is used by successor management to achieve new objectives such as funding acquisitions with tax deductible dollars or other strategies that offset the negative aspects of the drain on corporate cash flow to fund ever growing repurchase liability, the long term advantages of winding down the ESOP’s share holdings should trump the short term advantage of the deductibility of yearly cash contributions to fund repurchases.  Recognition of the need to formulate changing strategies for changing circumstances should be made when the plan is initially adopted and ever few years as the ESOP matures.

For questions or comments, please feel free to contact Jeff Faust at (510) 797-8661 x249 or jfaust@groco.com