To ESOP or not to ESOP?

• Author: Bonn, Karen
• Position: Employee stock ownership plan

Many middle-market business owners have more than 80% of their net worth locked up in an illiquid asset--their company stock. Although the business may be profitable, it does not necessarily provide personal asset liquidity and diversification. A common dilemma is how to achieve liquidity without selling to a strategic or financial buyer and giving up control of the business. However, if they do not sell, the value of their assets remains trapped in their illiquid stock.

Fortunately, with an employee stock ownership plan (ESOP), a business owner can achieve liquidity and diversification and possibly defer or eliminate capital gain tax (while retaining control) by using deductible dollars as the purchase price.

Basics

An ESOP is not only a tool to achieve liquidity, but also a way to finance a buyout or acquisition, or a way for management to acquire an equity interest. Although it appears simple, an ESOP is really a complex web of tax, legal, financial and other technical components. In determining whether one is feasible, a tax adviser has to develop a clear sense of a business owner's goals, as well as the goals of the others involved (including the management team, employees, selling and nonselling shareholders and even lenders providing capital). To accurately define goals, parties to an ESOP transaction should determine the amount of stock to be purchased, the number of plan participants, the company's debt-carrying capacity for a leveraged ESOP, plan provisions, voting rights and the trustee selection process.

Alhough ESOPs are unique in many ways, they share most of the common characteristics of other employee benefit plans. For example, Sec. 401 (a)(28)(C) requires that an ESOP purchase stock at its fair market value (FMV), as determined by an independent appraiser using "adequate consideration" and "fairness" standards. Thus, a preliminary valuation is a key first step in any feasibility study.

Feasibility: All successful ESOPs have undergone a feasibility analysis, whether formal or informal. How ever, even a promising study does not guarantee success. A preliminary valuation does not satisfy all of the necessary requirements to defend the stock's FMV before the IRS or the Department of Labor (DOL); rather, it is a cost-efficient method of determining the underlying economics of the proposed ESOP and a company's value. This value readily determines who will sell, who will buy and at what price. If the ESOP proves feasible, the...