ESOP - is it right for your business?

• Author: Groll, Chris
• Position: LEGAL INSIGHTS

Is an ESOP right for your business? In the appropriate circumstances an ESOP offers a multitude of economically superior ways to accomplish numerous important objectives. These objectives might be desired by a company's owners, management team and other employees, and include, among others:

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* Selling either the entire company or partial ownership of it

* Rewarding and incentivizing employees

* Facilitating a business divorce

* Financing business expansion

* Tax deferred diversification of all or a portion of concentrated and illiquid share ownership in the company into a portfolio of publicly traded stock and debt securities and

* Charitable giving objectives.

What is an ESOP? "ESOP" is an acronym for Employee Stock Ownership Plan. An ESOP is a qualified retirement plan that has a mandate to invest primarily in the stock of the corporation that adopts it.

Another feature of ESOPs that distinguishes them from other retirement plans and makes them attractive in many circumstances is their ability to borrow funds to purchase employer securities. Often this leveraging is done in two parts - one is a loan to the company by an outside lender, secured by the equipment and other collateral of the company. The second part is a "mirror" loan by the company to the ESOP, secured by the shares being purchased from the shareholders. (Often the selling shareholders carry a portion of the purchase price with subordinated debt that yields a market rate return.) The company makes annual tax-deductible cash contributions to the ESOP which trigger the release of shares to participants' accounts, while at the same time the ESOP returns the cash to the company as payment on the ESOP's mirror loan. The company then has that cash available to make payments on its loan to the outside lender.

This mechanism can provide substantial retirement and ownership benefits to the employees, and yield superior economic results for all of the other parties. In some cases an ESOP can permit transactions to occur that otherwise would not be economically possible.

Why and how are the results offered by an ESOP economically superior? Because Congress has endowed the ESOP, the company and qualifying selling shareholders with tax incentives to subsidize and encourage their use. These tax incentives include:

1. No tax to the seller upon the sale of qualifying corporate stock to the ESOP, in what is known as a "1042 rollover." There are many conditions that must...