The ABCs of ESOPs

Sun, 02/12/2017 - 18:00


Last week, Jill Owner met with an advisor she’d seen mentioned in a local business columnist’s article about the tax advantages of selling one’s company to an employee stock ownership plan (ESOP). Before she jumped in, she called her accountant to confirm that the ESOP Exit Path was the yellow brick road to wealth and happiness that the ESOP advisor described. Jill was disappointed to hear her CPA recount the disastrous experiences two of his clients had encountered in sales to ESOPs. Jill left her CPA’s office confused and deleted the issue from her To-Do List.

This scenario—in which owners retreat to the safe, default, no-action position—is not at all uncommon. In fact, ESOPs can, at times, be great buyers for a company. The problem is that ESOPs turn out to be costly failures when poorly designed or implemented.

As an Exit Planning Advisor, you may frequently encounter business owners who are baffled by contradictory and strong opinions on a variety of Exit Planning topics. When that topic is an ESOP, what can you advise your clients to do?

This article will help you answer owners’ questions by providing initial information about ESOPs and introducing you to a possible decision-making process. Of course, our premise (as it is for all Exit Planning topics) is that owners need advisors armed with ESOP information who are not guided by professional financial interest or limited professional experience to promote one Exit Path (or concept) over another.

What to Expect

In this article and the two upcoming articles, we’ll provide basic information about ESOPs, a summary of the benefits and challenges of ESOPs as an Exit Path, and finally, an outline of the owner’s decision-making process. These articles are not comprehensive but curated: They provide information for you and for your owner-clients to begin an analysis of whether an ESOP is an appropriate Exit Path.

Never Forget

ESOPs are a creature of federal law. They are qualified defined-contribution retirement plans and, as such, are regulated and subject to oversight by the IRS and U.S. Department of Labor (DOL). Because the IRS and DOL are the chief regulators and enforcers, the laws and regulations governing ESOPs are complex and plentiful. It’s no wonder most owners and advisors find ESOPs to be a quagmire best avoided1. This article leaves government-created complexities to ESOP specialists and provides you with enough information to make an initial recommendation regarding whether your clients should pursue an ESOP as an Exit Path. In the balance of this article, we look at the ESOP sale process, tax issues, and post-ESOP control of the company.

The ESOP Sale Process

In Step 1, the company obtains a loan, often from its current bank. This is referred to as the “Outside Loan.” Due to technicalities in lending laws, banks almost never loan money directly to an ESOP. Instead, banks loan money to the company.

In Step 2, the company lends money to the ESOP. Generally, the company loans the same amount it borrowed from the bank in Step 1, although the company could lend the ESOP more or less. This is referred to as the “Inside Loan.” The terms (repayment period, interest rate, etc.) of the Inside Loan often mirror the terms of the Outside Loan, but there may be reasons, in certain situations, for the terms of the Inside Loan to be different from the Outside Loan.

In Step 3, the ESOP Trust (or Employee Stock Ownership Trust [ESOT]) uses the cash it received from the Inside Loan to purchase company stock from the selling shareholder(s). The stock that is purchased is held initially in the ESOT’s “Suspense Account.”

Tax Issues

A company can deduct its contributions to an ESOP (and sometimes even more) as it would with any other qualified plan, including contributions used to repay the loan principal.

There is no income tax assessed on the income earned by the assets (i.e., the original owner’s stock) that the ESOT owns until that stock (or cash) is distributed to plan participants, usually when they retire.

There is a capital-gains tax deferral to the owner who sells his or her C-corporation stock to an ESOT, provided several requirements are met2.

If a company is an S corporation, to the extent that an ESOT owns its stock, the company’s otherwise-taxable income is no longer taxed, because the ESOT does not pay taxes3.

Post-ESOP Ownership/Control

A board of directors–appointed trustee, not employees or plan participants, largely controls the stock owned by the ESOT. Employees generally only vote their ESOP shares on matters that, under state law, require a super-majority vote. Typically, these matters include the approval or disapproval of any corporate merger or consolidation, recapitalization, reclassification, liquidation, dissolution, sale of substantially all of the assets of the company, or similar transactions.

What’s Ahead?

In the next article, we will examine the advantages and disadvantages of an ESOP as an Exit Path. If you can’t wait that long, or if you’d like access to some of the best information and publications about ESOPs, visit the National Center for Employee Ownership’s (NCEO) website, NCEO is a non-profit organization dedicated to providing information to owners and advisors on employee ownership. NCEO has graciously made a free six-month membership available to readers of this newsletter. Simply use this link to take advantage of this offer:



[1] Our thanks to BEI Member and ESOP consultant, Kelly Finnell, author of The ESOP Coach (2010), for guiding us through this quagmire. Much of the content in this article is derived from his book.

[2] The main requirement is that the ESOT owns at least 30% of the company’s outstanding stock following the sale. With planning and by meeting additional requirements, this tax deferral can be permanent. In other words, if you sell your stock to an ESOT for $6 million, you can invest those proceeds in stocks and bonds (meeting the definition of “qualified replacement property”) and defer paying capital-gains taxes until you sell that replacement property. If you own those securities at death, the capital-gains tax is permanently avoided (though dying is not the most pleasant way to save on taxes).

[3] An S corporation normally makes cash distributions to its owners to cover their taxes. Since the ESOP does not pay taxes, the S corporation does not need to make a distribution for taxes and can retain the cash for growth. If an ESOT owns 50% of a company and the original owner owns 50%, the original owner is taxed on his or her 50% of the income, but the ESOT is not taxed on its share of the company’s income. (Although, if the company makes a distribution to the original owner, it must also make a distribution to the ESOP.)