Strategies For Aging ESOPs (Employee Stock Ownership Plans)
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 a specific aspect of their ESOP. Short term benefits of a particular ESOP strategy
should not overshadow
longer term objectives of the company. Alternative uses for their ESOP should
be addressed every couple of years.
Typical ESOP Transaction
ESOPS are often used 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
The corporation can deduct the yearly
contributions made to the plan to service a loan. 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.
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
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. The buying 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.
Upon implementation of the initial strategy, objectives and strategies should be
ESOP as a Profit Sharing Plan
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
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.