\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Innovative and Tax-Efficient Tools to Meet Your Clients' Business Planning Needs
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0ESOPs are a type of tax-qualified retirement plan. If that statement just stirred you to yawn, consider this: ESOPs are where business law meets tax law. They are a vehicle for meeting business planning needs in an extraordinarily tax-efficient manner. And, what's more: ESOPs are used to meet estate planning and employment goals. So, read on and do not hesitate by the fact that ESOPs are governed by the Internal Revenue Code and the Employee Retirement Income Security Act of 1974, as amended (ERISA).
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0As customary, however, with tax law "perks" comes the tax law "price" of numerous compliance requirements—legal hoops to jump through, as one might say. This article covers the basics of some of these requirements. Additionally, it is intended to arm the reader with the knowledge needed to determine if an ESOP should be presented as an option for consideration.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0What is the basic structure for using an ESOP to purchase company stock?
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0In South Carolina, ESOPs most often are established to meet business succession planning goals. The ESOP becomes the buyer of the company stock from a selling shareholder who wishes to reduce or eliminate his ownership interest. This typically is accomplished in a number of steps.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA01. Establishment of the ESOP
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0First, the company forms the ESOP in compliance with the Internal Revenue Code and ERISA. The ESOP must be designed to expressly concentrate its investments in employer stock. The company also will select a trustee to act on behalf of the ESOP and make fiduciary decisions relating to the purchase of employer securities. The trustee position may be filled by one or more owners or key employees or by an independent trust company.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA02. Determination of the purchase price
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Second, the ESOP trustee will negotiate with the seller and reach an agreement on the purchase price for the company stock. If the stock is not publicly traded, the stock must be valued by an independent valuation firm. Under ERISA, the ESOP may not pay more than the current fair market value of the stock based on accepted valuation techniques, and the valuation must support the ultimate purchase price. The valuation also must apply a minority discount for the shares the ESOP is purchasing, if that is the case.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Because the interests of a buyer (i.e., the ESOP) and seller are inherently adverse under the law, the trustee and the valuation firm must be independent from the selling shareholder. If the selling shareholder is named as a trustee, the selling shareholder should recuse himself from the fiduciary decisions related to the purchase of his shares, and an independent, special trustee should be appointed to make these decisions. This independence requirement assures that the purchase price is negotiated at arm's length, and the ESOP is not manipulated to improperly provide a market for the selling shareholder.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA03. Procurement of funding
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Third, once a purchase price is determined and validated by an independent appraisal, the trustee must obtain the funding to purchase the shares. Due to the contribution limits applicable to all qualified retirement plans, in most cases borrowing is necessary to fund the purchase price.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0ESOP trustees usually borrow money from the employer, the seller or an outside lender. While the ESOP loan is outstanding, the ESOP is referred to as a "leveraged ESOP." Generally, ESOP loans are for seven to 10 years and must carry a market rate of interest. Very often there is a loan to the company from an outside lender ("external loan"), and the company in turn loans such funds to the ESOP ("internal loan" or "mirror loan"). There are tax law restrictions on the type of collateral that may secure an ESOP loan. So, this external/internal loan structure tends to be more appealing to outside lenders who prefer securing their loans with...