DEBORAH GROBAN OLSON
ATTORNEY AT LAW
1021 Nottingham Rd.
Grosse Pointe Park, MI 48230
Phone (313) 331-7821
Fax (313) 331-2567
Email dgo@esoplaw.com
Many owners of closely held businesses are unable to find a buyer who will pay a fair price for their stock, especially if they are initially offering only a minority block of shares. An ESOP provides a market for closely held stock, at a fair price determined by an independent appraiser.
The Company can deduct from taxable income the amount of contributions made to finance the purchase of your stock by the ESOP (within limits). In a leveraged ESOP, this means that the Company can, in effect, deduct interest and principal payments on the loan used to purchase your stock. Without an ESOP, only interest payments would be deductible. This savings boosts after tax profits and the Company's ability to buy your stock.
ESOPs are very flexible. You can cash out all your shares immediately, or you can gradually sell your shares to an ESOP over many years.
If you sell your stock to an ESOP and reinvest the proceeds from the sale in stock of another U.S. Company, your capital gain from the sale will not be taxed until you sell the newly acquired stock. If you decide not to sell the new stock during your lifetime, you will avoid taxation of the ESOP sale income entirely. This tax "rollover" is only available if, after the sale, at least 30% of the Company stock is held by the ESOP. Certain other federal requirements must also be met.
You can provide your employees and your company with the motivational benefits of employee stock ownership without converting your S corporation to a C corporation. In fact, an ESOP in a Sub S company is exempt from payment of unrelated business income tax (UBIT). Thus, a 100% ESOP Sub S company pays no income tax. Rather, the ESOP participants pay taxes on their shares when they are received upon termination of employment. Employer contributions are deductible for up to 15% of covered compensation. A Sub S ESOP can make distributions in cash instead of stock. An ESOP in combination with a 401(k) plan, allows the company match to be made in Company stock. A Sub-S ESOP is not eligible for the expanded tax or dividend deductions of a leveraged ESOP, nor the capital gains rollover.
You may be reluctant to sell your company to a buyer with no ties to the community. Frequently the sale of a local business to an outsider results in alienation of the work force, curtailment of operation, sale of assets, plant shutdown, or relocation. Sale to your employees through an ESOP may be the best way to ensure the continued success of your business.
In a "leveraged" ESOP, the ESOP borrows money and buys the owner's stock. The Company usually guarantees the loan, and contributes enough money each year to enable the ESOP to repay the loan. In a "non-leveraged" ESOP, the company contributions are used by the ESOP to purchase stock each year, rather than to repay a loan.
The company deducts the contributions from its taxable income. The ESOP stock is allocated to employee trust accounts and when employees retire they receive their shares, or the cash value of those shares. There are many variations on this arrangement. ESOPS are extremely flexible.
Mr. Fulton owns 100% of the shares of Tool and Die, Inc., a company worth $6 million. Mr. Fulton is getting older and would like to sell his company and enjoy the proceeds. If he sells to an outside buyer, he will pay taxes, perhaps at the 20% rate, on his net long term capital gain. If his original basis in the stock was -0-, he would pay $1,200,000, and keep $4,800,000 after taxes.
If the company, instead of an outsider, buys him out by borrowing money or using cash reserves, Mr. Fulton faces the same tax sting. In addition, the payments will not be deductible to the company and might impoverish it (perhaps making it impossible for the company to complete a gradual buyout).
These problems can be avoided if Mr. Fulton creates a company ESOP. The ESOP finances the purchase with company contributions, or by borrowing from a lender, using stock as collateral. The company typically would guarantee the loan. The purchase price of the stock is set by an independent appraisal.
If Mr. Fulton initially sells at least 30% of outstanding company stock to the ESOP, he can "rollover" the proceeds of the sale into stock or bonds in U.S. companies and avoid paying any tax on the proceeds unless and until he sells that "replacement" stock. Any replacement stock that remains in his estate until his death gets a stepped-up basis and the capital gain is never taxed.
The company deducts the full amount of contributions to the ESOP used to buy Mr. Fulton's stock, or to make interest and principal payments, within limits, on a loan used to buy Mr. Fulton's stock. If the company is taxed at a corporate rate of 36%, this deduction would mean that $2,160,000 (36% of $6 million) of the cost of cashing out Mr. Fulton would be paid out of company funds that otherwise would have been used to pay taxes.
The stock is held in trust for employees. When they retire or leave the company they are paid their vested and allocated stock or the cash value of that stock, usually in installment payments over five years (or longer if the company stock was purchased with borrowed funds).
There are several permissible vesting schedules so that employees who leave with less than five years of service need not get any stock upon termination.