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The ABCs of ESOPs

Most financial advisors consider themselves retirement experts. Sure, most of them know the minutiae of individual retirement accounts (IRAs) and 401(k)s and, indeed, most would be able to explain to a client why a 403(b) or a SEP-IRA might make sense. But do you know what an ESOP is? Too many advisors are unfamiliar with ESOPs. Mastering how this obscure qualified retirement plan works can ultimately

Most financial advisors consider themselves retirement experts. Sure, most of them know the minutiae of individual retirement accounts (IRAs) and 401(k)s and, indeed, most would be able to explain to a client why a 403(b) or a SEP-IRA might make sense.

But do you know what an ESOP is?

Too many advisors are unfamiliar with ESOPs. Mastering how this obscure qualified retirement plan works can ultimately benefit at least some of your clients, especially those who have a great deal of their net worth tied up in their own businesses. An ESOP, which is the acronym for employee stock ownership plan, is a tool that allows owners to unlock their wealth by implementing a partial or complete buyout of their shares. Because an ESOP is a retirement plan, the buyers and sellers in these transactions enjoy tax benefits that aren't possible with ordinary leveraged buyouts.

Because of the complexity of ESOPs, no one is suggesting that financial consultants become ESOP experts. But, learning the ESOP basics can help you differentiate yourself from your peers — those who haven't familiarized themselves with this business succession option. Knowing ESOP rules and regs might eventually help you attract more assets. When clients cash in a chunk of their businesses through an ESOP, they're likely to invest that money — and it may as well be with the person who introduced them to this alternative. In fact, in some circumstances a quirk in the ESOP regulations requires that an owner invest the proceeds in domestic securities to obtain a valuable tax benefit. “Whoever drives the liquidity decision and provides a leadership role in that discussion will have first shot at the assets,” observes Jim Nelson, who is a senior vice president with the corporate client group-ESOP advisory at Smith Barney.


ESOPs are used by 9,225 companies, covering 10.1 million employees, according to the National Center for Employee Ownership, a trade group in Washington, D.C. These plans are estimated to own roughly $600 billion in assets. And the demographics suggest that the numbers could grow as aging entrepreneurs begin exploring succession options. About 50 percent of individuals who are worth between $1 million and $10 million have a stake in a privately held company, says Joseph Fahey, who is national director for business-planning services at the financial planning group of Wachovia. Seventy-five percent to 80 percent of individuals with a net worth in the $10 million-to-$50 million range own privately held businesses. “Clients need to figure out how to transition the business from one generation to the next,” Fahey says, “and an ESOP is one way to do it.”

The chief aim of an ESOP is to transition an often-aging entrepreneur out of a business while setting up a way to attract, reward and retain a company's workers. To accomplish this, an ESOP trust is established to buy stock from the owner. The seller doesn't have to relinquish his entire holdings, but he has to sell at least a 30 percent stake in the business in order to defer his capital gains. The other requirement is that the company be a C corporation. Not surprisingly, most companies must obtain financing to buy the owner's shares. First, the company obtains a bank loan and lends this money to the ESOP trust, which then uses the cash to purchase the owner's shares. The company guarantees the loan, which is based on the company's credit, not the individual's credit. If the company's credit falls short of the needed financing, the seller may provide a guarantee, but that is rare.

By law, an owner can't make a killing on an ESOP; the sale of stock must be based on the company's fair market value, which is determined by an outside expert, such as an independent valuation consultancy. Some owners never seriously consider an ESOP because they believe they can pocket more money through other alternatives, like selling the company outright or through an initial public offering. “If you are looking to put a company in a competitive bidding situation to maximize value, an ESOP is not a good solution,” says Kim Abello, a managing director at Duff & Phelps, a leading independent financial-advisory firm. “Instead you should take the company to market and solicit bids.”

In fact, ESOPs typically appeal to owners who are interested in rewarding the employees that helped them build the business. ESOPs are also often used as a supplement to a firm's 401(k) or other retirement plan. They can be ideal for individuals who shudder at the prospect of someone else running the company, or worse, carving it up into expendable pieces that can be sold to the highest bidder. “It isn't just a financial transaction for them. What they are wanting to do is create an ownership culture,” Nelson says. They want their employees to think like owners and reward them like owners. It's not just a spread-sheet exercise.”


What's an ideal ESOP prospect? The most promising candidates are often privately held firms that have enjoyed a history of profitability. If a company isn't a good investment for workers, then a trustee will balk at buying the stock for an ESOP. Among the best candidates for putting ESOPs to good use are service-oriented companies, like engineering, architectural and health care firms, where brainpower represents the bulk of the expenses. In contrast, Fahey says, “Companies that thrive on highly entrepreneurial or closely controlled decision-making tend to be less ideal candidates from a cultural perspective.”

Owners who do pursue ESOPs are also attracted by powerful federal income tax incentives. ESOP contributions are tax deductible for the company, and earnings within ESOPs are not taxable. Principal and interest are deductible on ESOP loans. Some of the tax benefits will vary depending on whether the firm is a C or S corporation. Owners, who sell at least 30 percent of their company shares in C corporations can defer capital-gains taxes on the sale by purchasing domestic securities with the sale proceeds. Since a C corporation pays federal income taxes on its earnings, some of the ESOP tax benefits are more meaningful to C corporation ESOPs.

In contrast, an S corporation will generally pay no federal corporate income taxes. Rather the earnings are taxed at the shareholder level. If an ESOP owns 100 percent of an S corporation, it would enjoy at least a 35 percent advantage over competitors because of its ability to sidestep most federal taxes. “For each $1 million in earnings, the S corporation ESOP would have at least an additional $350,000 to reinvest in growth opportunities, pricing flexibilities on its products or to diversify its retirement-plan holdings,” Fahey says.

If an owner sells stock to a C corporation ESOP and defers the capital-gains taxes, then the cash from the sale must be invested in domestic stocks and bonds. This is obviously where you can play an important role in diversifying your client's new liquid assets. An owner must roll his cash into so-called qualified replacement property, which excludes some standard investments. While investing in domestic stocks and corporate debt is fine, steering money into mutual funds is not. Also off limits are government and municipal bonds, as well as any overseas investments. A way exists, however, to avoid these investment restrictions: using floating rate notes, which are AAA-rated bonds with a low variable coupon. An individual can borrow against the floating rate notes at low rates to invest in any type of portfolio.


If ESOPs have so many good qualities, why do so many entrepreneurs stay away? Quite simply, people don't understand ESOPs. “There are a number of myths surrounding ESOPs and most of those myths are perpetuated by those who don't understand them,” says William O'Brien, senior vice president of O'Brien Financial Strategies Group at Wachovia Securities in Itasca, Ill.

What gives a lot of business owners the willies is the specter of employees running the show. They fear they must abdicate power to these newfound owners who will eagerly raise their salaries, fatten their benefits and begin flying first class on business trips. “This is a big hang-up,” says Philip Harriman at Lebel & Harriman in Falmouth, Maine. “People think that employees will run the company, which is not the case.“

In reality, the employees, regardless of the number of company shares they own, will not have a direct say in the daily operations. The ESOP doesn't affect a company's management operations. The company will rely upon a trustee, selected by its board of directors, who represents the workers when votes are required. Only in rare cases, such as the sale of the company or its recapitalization, would workers typically get a direct say. And even then the trustee may override the workers' vote in some cases. Sometimes a chief financial officer or other executive from the company will serve as the trustee. But many experts urge firms to stick with an institutional trustee to avoid employee distrust.

Regardless of voting issues, employee ownership can instill in workers a greater desire to boost a company's profitability. Abello says she's seen plenty of examples of this phenomenon in her many years of valuing ESOP companies. A secretary at an ESOP-owned insurance brokerage firm, for instance, found a cheaper supplier of quality paper. Her initiative saved the company $500,000 a year. At another firm, the management team wanted to fire a woman who was a poor employee, but her co-workers protected her because she was popular. When the company became employee-owned, however, a consensus formed to terminate her. Clearly, the ESOP is one way to focus one's employees.

ESOP Primers

If you'd like to learn more about ESOPs, two excellent resources are The National Center for Employee Ownership ( and The ESOP Association ( If you work at a wirehouse, you may be able to rely on in-house experts to help your client decide whether an ESOP is feasible. Seek advice from individuals who have been involved in at least one successful ESOP. A first step for some reps may be to consult with a lawyer or tax advisor with ESOP experience.

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