RESOURCES
ESOP Transactions
There are three basic kinds of employee stock ownership plans transactions listed in order of use by companies today:
- Establishing an ESOP benefit plan for employees.
- 1042 leveraged ESOP transaction.
- Employee buyout.
Employee buyout
An employee buyout occurs when the owners of a company elect to sell a majority of the stock of the company to its employees through an ESOP-structured corporate transaction. These very complex change-of-control transactions can have a major impact on a company and its employees.
Though they are powerful and fascinating transactions, employee buyouts are the least common type of ESOPs covered in this section.
Establishing an Employee Stock Ownership Plan
The most popular ESOP provides a benefit plan to employees, allowing broad-based employee ownership. It is fairly cheap and easy to establish and maintain. A company can hire one of many advisors who specializes in implementing ESOPs as benefit plans. Most employee benefit consulting firms can assist in implementing this kind of ESOP.
An ESOP established as a benefit plan usually begins devoid of stock and slowly grows every year as the company contributes stock on behalf of all employees participating in the plan. Every contribution of stock by the company to the ESOP provides a deduction to the company based on the fair market value of the stock contributed.
Employees receive a tax-sheltered benefit since the contribution of stock to the ESOP and the allocation of the stock to their ESOP account is not taxed as current income. Employees receive distributions of stock from their accounts upon retirement or some time after termination of employment. Employees have a right to put their stock back into the company for its current fair market value, as determined by an independent valuation firm. Only upon receiving their stock are employees subject to tax on the income, based on the stock's fair market value.
A company does not need to raise financing for this kind of ESOP. Instead, it merely issues stock and contributes it to the ESOP.
1042 Leveraged ESOP
This is the second most common use of an ESOP. The 1042 refers to the section of the tax code where the tax treatment is defined.
Leveraged ESOP
A 1042 leveraged ESOP transaction allows an individual or a trust to sell stock to a private company's ESOP and defer capital gains taxes indefinitely. The ESOP usually borrows from the company in order to purchase stock from the selling shareholder. When an ESOP borrows money, it is called a leveraged ESOP.
Qualified Sellers
To be qualified for 1042 treatment, the seller must be an individual, trust, estate, partnership or S corporation
Capital Gains Deferral
Leveraged ESOP transactions are extremely popular because they allow the seller to sell stock to an ESOP at its current fair market value and not incur immediate capital gains taxes. The selling shareholders can elect to defer capital gains taxes by using the proceeds of the sale to purchase securities of domestic corporations. This is called a rollover, and the securities are often called rollover securities.
As long as the seller continues to own these rollover securities, he or she does not have to pay capital gains taxes. Once the seller sells the rollover securities, he or she must pay the capital gains tax. If the rollover securities become part of the owner's estate, capital gains taxes are never paid.
30 Percent Rule
For the seller to elect capital gains deferral, the ESOP must own at least 30% of the company after the transaction.
Floating Rate Notes
It is common for sellers to purchase extremely high-quality rollover securities that can be used as collateral for a loan. These securities are often floating-rate notes (FRNs) issued by blue-chip companies.
FRNs are designed so that interest payments float in tandem with interest expenses incurred by the borrower using the FRNs as collateral.
Advance Rate on FRNs
A seller will purchase FRNs with the proceeds of the sale to an ESOP and borrow against the FRNs. The amount available to borrow varies, but is typically between 85% and 95% of the face value of the FRNs.
Example
As an example, suppose the owner of a company sells 30% of his ownership to an ESOP for $10 million. This transaction is tax-free because he invests the $10 million in a FRN, which bears interest at 7% per annum. The owner decides he needs money to invest short term, so he borrows $9 million against the security of the FRN. The loan can bear a floating interest rate as high as 7.8%, and the owner will still have enough income on the FRN to cover the interest obligation. Since both the FRN and the loan are pegged to the same market index, the owner will always have enough income on the FRNs to cover the interest cost of the loan, whether market interest rates rise or fall. He or she is then free to spend or invest the $9 million in any way.
When the loan comes due, the owner can sell the FRN at face value and pay off his or her loan. The owner is subject to taxation only on the interest he or she earns and can deduct from this amount the interest he or she pays on the $9 million loan. He or she must also pay taxes if further gains on the $9 million put in short-term investments are realized.
Results
The result of the rollover is that the seller can get completely liquid on the portion of the proceeds from the sale to an ESOP represented by the amount borrowed against the FRNs. Let's assume the advance rate is 90%. The balance, 10%, remains as a high-quality asset owned by the seller.
Below is a chart comparing the after-tax effect of the seller selling stock to an ESOP vs. selling to a non-ESOP buyer.
Fair Market Value
An ESOP must receive a valuation opinion from an independent, third-party valuation firm as to the price it can pay for the seller's stock. This kind of valuation generally costs between $5,000 and $35,000 depending on the size of the company and the size and complexity of the ESOP transaction.
ESOP Trustee
ESOPs are controlled by trustees who are responsible for operating the ESOP for the exclusive benefit of the ESOP participants. Sellers may act as ESOP trustees.
Control Issues
A seller can convert 30% to 49% of his or her ownership in the company to an ESOP without changing the company's normal operations; the seller could remain president, officer or board member of the company.
ESOP participants have the right to vote on issues that come before shareholders. These issues can be limited to those that are required by state law, typically having to do with the restructuring, recapitalization, liquidation and issuance of stock.
On all other issues, the trustee can vote the shares held by the ESOP. The trustee also votes shares that have not yet been allocated to employee accounts or that were not voted by ESOP participants.
Therefore, the sellers can often maintain the control they had before the establishment of the ESOP even if the ESOP ends up owning more than 49% of the company's stock.
ESOP Financing
A 1042 leveraged ESOP transaction requires financing, because the selling shareholders typically require that the ESOP pay cash for the stock purchased from them. Since the ESOP has no income-generating ability or any collateral assets except the company stock, it is necessary for the company to raise financing and lend it to the ESOP so that the ESOP can purchase the sellers' stock.
The company agrees to contribute cash to the ESOP annually, sufficient for the ESOP to repay its loan to the company.
Company Financing
Senior Debt Financing
In order to raise sufficient capital to lend to the ESOP, the company will rely on its cash flow and collateral assets to attract capital. If the sellers sell 30% of the company's stock to the ESOP, it is generally easier for the company to raise capital to lend to the ESOP to finance the transaction. This size of transaction can usually be financed with senior debt.
Subordinated Debt Financing
However, if the sellers sell significantly more than 30% ownership, the financing requirements become larger and more difficult. The amount that can be borrowed solely from senior lenders is not generally sufficient to afford the entire purchase price. If the company has sufficient cash flow and growth potential, it can often raise subordinated debt.