Oct 21, 2019

The Advantages and Disadvantages of ESOPs

CPAs with clients who are exploring succession planning and exit strategies may want to consider employee stock ownership plans (ESOPs). Mark Flinchum, Mark Kossow, and Andy Manchir discuss the advantages and disadvantages of ESOPs for companies, sellers, and employees. Flinchum and Manchir are co-chairs of the ESOP Services Group of Katz Sapper & Miller in Indianapolis, Ind., and Kossow is a member of Clark Hill PLC in Princeton, N.J.

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By: Jim DeLuccia, Manager of Learning Content

Podcast Transcript

Our topic for today's episode is employee stock option plans, or ESOPs, as they are more commonly known. ESOPs have their advantages and disadvantages for companies, sellers, and employees. Joining me on the phone to discuss how CPAs can work with their clients on this matter are Mark Flinchum, Andy Machir, and Mark Kossow. Mark Flinchum and Andy Machir are co-chairs of the ESOP Services Group for Katz, Sapper and Miller in Indianapolis, Ind. Mark Kossow is a member of Clark Hill PLC in Princeton, N.J. All three are very active in the ESOP community.

Gentlemen, thank you so much for joining me on the phone today.

[Kossow] Sure thing. I'm glad to be here.

[Machir] Thank you for having us.

[Flinchum] Thanks Jim.

Great. I promise I'll try not to get the Marks confused here during our conversation, but I am going to start with Mark Kossow. Mark, our listeners may already know this, but for purposes of setting up our discussion today, what is an ESOP?

[Kossow] Okay, well an ESOP is an employee stock ownership plan. You can think of an ESOP as being partly a retirement plan and partly a corporate finance tool. As a retirement plan, an ESOP is similar to other defined contribution plans such as profit-sharing plans, 401(k) plans, in the sense that they all have to follow the Internal Revenue Code and ERISA. Similar to profit sharing plans, contributions to an ESOP are going to generate a tax deduction for the company. Also, tax deferred growth for employees is possible with ESOPs. In fact, employees do not recognize income until they receive a distribution after they retire or terminate service. That can be many, many years in the future. It's an excellent way to get tax deferred growth for your employees.

Unlike a profit-sharing plan, an ESOP is designed to invest primarily in employer securities. In fact, an ESOP can hold 100% of its assets in company stock. Profit sharing plans are simply not allowed to do that. In addition, ESOPs can borrow money from the company in order to purchase stock from a selling shareholder. This is what's known as a leveraged ESOP transaction. Finally, like all retirement plans, an ESOP must have a trustee. A trustee exercises control with respect to the management and disposition of the assets held by the ESOP.

Now that's the retirement plan aspect of an ESOP. As a corporate finance tool, there are certain tax advantage financing for the company. As I just mentioned, since contributions to the ESOP are going to generate a tax deduction for the company, the company is actually able to pay back bank financing in a leveraged ESOP transaction with pre-tax dollars. This makes a leveraged ESOP deal very, very tax efficient. I think Andy is going to touch on that in a second, but in addition to tax advantages for the company, the company can also make deductible dividends to the ESOP in certain cases.

Finally, S corporation ESOPs are generally income tax exempt. The reason for this is that the income from an S corporation is passed through to the shareholder. In this case, it's the ESOP. There's going to be no shareholder level tax imposed on the ESOP because the ESOP is a tax-exempt entity. This creates a very good mechanic for accumulating cash in the S corporation that's owned by an ESOP. That accumulation of cash can be used to fund future acquisitions by the company or it can be used for internal investments or things of the sort. It's a really good growth mechanic in order to really take advantage of competition. That, in a nutshell, is an ESOP.

Great. Well, thank you Mark for laying that out for our listeners here. As you mentioned, I am going to turn my next question to Andy. What is a typical leveraged ESOP structure, Andy?

[Machir] Sure. I think that the typical leveraged ESOP structure involves the company borrowing money from a bank to help fund the transaction. This ESOP transaction is a form of a leveraged stock buyout, so that one or more shareholders can sell their stock to the employees through this benefit plan. The company's typically going to borrow money from a commercial bank. In that respect, it looks like other commercial business loans, right? It'll be dependent upon the company's cashflow and collateral ability to borrow, but most banks will incorporate in their analysis the fact that the ESOP plan has tax advantages and make sure that those are accounted for in the underwriting. Once this company borrows money from the bank, the company will lend it to its ESOP plan so that the ESOP plan has money to buy the stock from the shareholder or shareholders.

Now it's Mark Flinchum's turn. Now, Mark, can you explain the post-transaction cashflows?

[Flinchum] As Mark and Andy have kind of alluded to, you have a company that's taken on a lot of leverage to buy the stock from the selling shareholder. Of course, that debt's got to be paid over time. Mark had mentioned that the contributions that are tax deductible to an ESOP are created by servicing that debt so that the cashflow in an ESOP after the transaction is an annually, at least annually, and sometimes more often, the company is going to make a contribution to the plan, an ESOP contribution. That contribution is paid from the company to the plan. The plan then uses those funds to pay what we refer to as the inside debt to release shares. Most times those shares are released evenly through over a period of time between 10, 15, 20, some cases 35, 40 years. As those payments are made back to the company from the ESOP trust, those shares are released.

If you look at that cashflow cycle, company puts cash out to the ESOP trust and the trust uses that money to pay the debt on the shares that they're buying. You see that that's a cash neutral cycle there. That's very beneficial. You get a tax deduction. The company is not depleting their cash, it's coming back to shares or being released. We find often with that structure, there's some education we have to do so that the banks understand, who finance the transaction, that that's cash neutral, make sure those transactions are built into the covenant calculations appropriately and that that's all understood. Then each year those shares are released based on those payments.

Going back to Mark Kossow. Mark, you, obviously at the start of this conversation, you laid out some of the basics of an ESOP. I wanted to take a few minutes here with you to see if you could drill down to some of the advantages, advantages of an ESOP for a company, a seller, and an employee. Can you kind of go over those for us?

[Kossow] Sure. Under the right circumstances, ESOPs can be an excellent business succession strategy. There is empirical data out there that says ESOP-owned companies are more profitable, have lower turnover, and fewer layoffs than non-ESOP-owned companies. In addition, from the company's perspective, as I mentioned before, you can pay back bank financing with pre-tax dollars, something you cannot do in a non-ESOP type transaction, coupled with the fact that S corporation ESOP's can be 100% tax exempt. Again, you can use the funds to be reinvested in the company or used to fuel future acquisitions and really take advantage of the competition in that respect.

From the selling shareholder, business owner perspective, a selling shareholder can make what's known as a 1042 tax deferral election if the underlying corporation is a C corporation. What that means is the individual selling shareholder does not have to pay capital gains tax on his or her sale proceeds. If he sells stock for $10 million, makes a 1042 election, he gets to keep the full $10 million, no tax bite there. Finally, from the employee perspective, it's a supplemental retirement plan. Employees enjoy tax deferred growth at no cost to the employee, mind you. This is all employer-funded money and it's being used to fund retirement benefits down the road when the employee separates from service or reaches normal retirement date. Those are the basics.

Great, thank you. Now Andy, I turn to you to talk about some of the disadvantages. What are some of those?

[Machir] One disadvantage a business owner might want to consider when looking at the ESOP is that the ESOP, as an acquirer of their stock, can only pay a fair market value price, an appraised fair market value price. To use the numbers Mark referenced earlier, if it's a $10 million company and fair market value is 10, could that selling shareholder find a strategic buyer that might want to pay $12 million or $13 million in a different type of transaction. They have to weigh those alternatives when thinking about an ESOP.

I think another disadvantage relative to maybe a third-party sale for an ESOP is that the seller may not be in position to get 100% cash at close. I think back to what we talked about as a leveraged buyer of the stock, right? The ESOP plan is going to need the credit worthiness of the business to help it have cash to pay the owner. The selling shareholder to an ESOP would have to be comfortable taking maybe a seller note for the portion of the company value that they can't borrow, right? That works best for the business owner who is setting this up maybe five years from when they want to retire and can have that money paid to them over time. The disadvantage would be a seller that's trying to get out right now and get all cash might want to look to a third party.

I see. Mark Flinchum, are there any little-known items regarding ESOPs that CPAs should consider when discussing this matter with their clients?

[Flinchum] Sometimes we talk among our colleagues about ESOPs sometimes being the little-known secret and best kept secret, I guess, as we talk about this, because there's a lot of things that aren't known about ESOPs that are beneficial. We've talked a little bit today about the tax benefits and a lot of people aren't aware of those. Those tax benefits can be very powerful in financing transactions. A lot of times we're dealing with owners that have built this business their whole life and it's their legacy and they want to protect it. Maybe it's the biggest employer in a small community and they're really concerned what happens to those jobs if they sell to a third party. An ESOP allows you to preserve those jobs in that community and continues to build on the owner's legacy. That's a real powerful thing for ESOPs and selling shareholders to consider.

We've talked a little bit here today about third party sales versus ESOP sales. Andy mentioned that sometimes a third party might be able to offer a higher purchase price than what an ESOP can pay because they can only pay what the cashflows will dictate as a reasonable price, but because of those tax attributes, a lot of times the after tax proceeds can be greater than they are in a third party sale. You've got to be real careful, analyze that and make sure you know what the real after tax proceeds are going to be taking into account all the benefits that an ESOP provides.

The other thing that's maybe not known is once you become an ESOP, we get a lot of questions about if the selling shareholder is staying involved and running the business, who's my boss? Can my employees fire me? There is a level of almost public type governance that you have to put into place, but it's really kind of business as usual. If the business has been successful, that's what the ESOP trustee wants to see is the business continuing to be successful as it's been. I think those are some of the things that are maybe not known out there in the CPA community.

Great. Well thanks for running through that with our audience there, Mark. Finally, Andy, it's the ninth inning, so you're going to be our closer today and I was hoping that you would provide some recommendations of resources that our CPAs can consult to get a little bit more comfortable with with ESOPs.

[Machir] Oh, you bet. I think that a website I would point our CPA listeners to would be NCEO.org. That is the website of the National Center for Employee Ownership and they're a trade organization that promotes and encourages employee ownership as a model. They have lots of good articles. They'll often host webinars and other types of learning opportunities for both the CPA and their client to look at this more. I would also mention the ESOP Association. ESOPAssociation.org has a great website, especially for the CPA or the company who wants to go attend some in-person training. I believe later in the fall of 2019 there's a conference in Pennsylvania about ESOP plans, and then there's always national conferences that a CPA can attend and learn more while also getting CPE credits. Finally, I would reference Mark Kossow as a great legal advisor whose practice keeps him near Pennsylvania. Mark Flinchum and I work at a CPA firm that is employee-owned through an ESOP. We would love to be resources for those people that need it as well.

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Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of PICPA officers or members. The information contained in herein does not constitute accounting, legal, or professional advice. For professional advice, please engage or consult a qualified professional.