The Benefits of an Employee Stock Ownership Plan (ESOP)

An Employee Stock Ownership Plan ("ESOP") is a defined contribution employee benefit plan that invests primarily in the stock of the employer company. To set up an ESOP, a company creates a trust fund for employees and funds it by one or a combination of the following methods:

  1. Contributing company shares;
  2. Contributing cash to buy company shares; or
  3. Having the plan borrow money to buy shares and then making payments to the ESOP trust to repay the loan.
From the perspective of the principal owners of closely held businesses, ESOP's can be used effectively to accomplish important estate planning objectives. They can provide a source of liquidity with which to pay estate taxes, while deferring or completely avoiding the recognition of a gain and converting ordinary income into capital gain. An ESOP can facilitate private business ownership succession and reduce the after-tax cost of borrowing and effectively reduce the rate of transfer taxes (estate and gift taxes).

Contributions to an ESOP are deductible by the employer, within certain limits. Income earned by the sub-trust is exempt from tax and participants in the ESOP do not recognize income until their benefits are withdrawn.

Under certain circumstances, the tax laws provide special benefits for owners of stock which is sold to an ESOP. The special benefits are generally available only with respect to sales of common stock of private "C" corporations. The stock must have been owned by the seller for at least 3 years and immediately after the sale of the company stock to the ESOP, the ESOP must own at least 30% of the employer's stock. The sale proceeds received by the seller of the stock must be invested in "qualified replacement property", which includes marketable securities and bonds of domestic operating corporations. In this way, the owner of stock in a closely held business has the opportunity to diversify his or her portfolio through the creation of the ESOP. Furthermore, the seller can elect to defer income tax on the sale of the closely-held stock until the disposition of the "qualified securities". If the qualified securities are not disposed of until after the death of the owner, there is a step-up in basis and the gain may be largely or entirely eliminated.

One of the obvious questions in such an arrangement becomes, how does the ESOP get the cash to buy the stock from the company's principal shareholder? Ordinarily, fiduciary rules applicable to tax-qualified deferred compensation plans prohibit sponsoring employers from lending money to a qualified plan, guaranteeing the loan to a plan or providing collateral for a loan. However, special exemptions provide for loans to ESOP's where the loan proceeds are used to acquire common stock of the sponsoring employer. For example, an ESOP may use loan proceeds from a commercial institution to purchase shares of the sponsoring corporation, either from the corporation or from shareholders. The corporation makes annual cash contributions to the ESOP in amounts sufficient to amortize the loan and the corporation is allowed to deduct the amount so contributed (with both the amount used to pay principal as well as the amount used to pay interest). Furthermore, a tax deduction is allowable to a C corporation for cash dividends paid on employer stock held by an ESOP if either the dividends are used to make payment on an ESOP loan, the proceeds of which were used to acquire the employer's securities with respect to which the dividends are paid, or the dividends are paid in cash to the plan participants or paid to the plan and then distributed to the participants within 90 days after the close of the plan year in which the dividends are paid.

Obviously, ESOP's are a very technical device and will not suit every situation. However, where appropriate, they can present an attractive alternative to the sale of a closely held business, if younger executives have been adequately trained to manage the business. Furthermore, an ESOP sale provides a source of liquid assets which can be used to pay estate taxes and to diversify the holdings of a family business. Also, control over the business can be retained by the family, since only a minority interest in the business need be sold to the ESOP. Finally, the receipt of "qualified replacement properties" (i. e., marketable securities) as a result of the ESOP sale, can be used by the family members in conjunction with other estate planning techniques, such as charitable remainder trusts, family limited partnerships, generation-skipping trusts, etc.

ESOP's can...

  • provide estate liquidity while deferring or avoiding gain.
  • facilitate portfolio diversification.
  • promote business succession planning.