Succession Planning with an Employee Stock Ownership Plan

by Eric D. Altholz, Vice Chair of Verrill Dana’s Employee Benefits and Executive Compensation Group and A. Robert Ruesch, Chair, Chair of Verrill Dana’s Construction Law Group

According to the National Center for Employee Ownership, there are roughly 7,000 true employee stock ownership plans (“ESOPs”) nationwide, covering about 13.5 million employees and holding assets of approximately $1.2 billion.  More than 15% of those plans are sponsored by construction companies.  We are currently experiencing a major spike in ESOP activity nationally driven in large part by the desire of Baby Boomers to pull cash out of their businesses and retire.  That is why any discussion of succession planning for a successful company is likely to include consideration of an ESOP.

Construction companies are especially well-suited to ESOP transactions because the sons and daughters of the founder may have no interest in carrying on a challenging business, third party purchasers are often hard to find, and founders tend to feel strongly connected to their long time employees.   For the right business owner, the establishment of an ESOP may unlock the door to financial independence.  But like any significant business decision, it’s critical for the owner to understand the moving parts and feel well informed about the subject before getting too far down the road.

What is an ESOP and what are some of the benefits of having one?

An ESOP is a tax-qualified, defined contribution retirement plan – governed by the Internal Revenue Code and the federal Employee Retirement Income Security Act of 1974 (“ERISA”) – that is designed to invest primarily in the stock of the sponsoring corporation (or a parent or subsidiary of the sponsoring corporation).  It is that feature – the hardwired investment in employer stock – that sets ESOPs apart from ordinary defined contribution plans and drives the key financial benefits of the plan.

Stock may be contributed by the employer or it may be purchased by the ESOP from the shareholders of the corporation using cash provided by the corporation.  This transfer of stock to the ESOP allows a corporation and its owners to facilitate the reduction (or even elimination) of corporate level taxes, address succession planning issues, and deliver a meaningful cash-out event for business owners.  At the same time, ESOPs provide unique benefits for eligible employees and can be a powerful tool for developing a strong “employee ownership” culture.

Two Critical Concepts to Understand

Two critical concepts affect the basic operation of an ESOP.  First, unless the ESOP holds a sufficient amount of employer stock to begin receiving dividends, the sole source of cash for the ESOP will be contributions from the employer.  Annual cash contributions will be required to pay debt service if the ESOP borrows money – typically from the employer, using money it borrowed from a third party lender – to fund an initial stock purchase and to fund future stock purchases or repurchases from the accounts of terminated employees.  Second, even though ESOPs benefit from special rules and exceptions, they are still subject to many of the same federal tax rules that govern the operation of other defined contribution plans, such as 401(k) plans.  One such rule limits the amount contributed to an ESOP annually by the employer to 25% of the total compensation paid to the employees participating in the plan.  Both the need to contribute cash and the 25% contribution limit play a major role in determining whether the personal financial goals of a business owner can be realized.

Building a Team and Exploring an ESOP

Most business owners embrace the mantra: “keep it simple.”  Unfortunately, that rule is hard to follow when it comes to the exploration of an ESOP.  The establishment of an ESOP – and a sale of stock to an ESOP – has many moving parts and generally requires the involvement of a well-chosen team of advisors.  In most transactions, that team will include: (1) an ESOP consultant; (2) a qualified, independent valuation firm; (3) legal counsel familiar with ESOPs; and (4) an accounting firm familiar with ESOPs.  (A couple of other team members – a trustee and a plan recordkeeping firm – will have to be added later in the process.)

Selling Stock to the ESOP

These days, most new ESOPs are set up specifically to purchase all (or a large percentage of) the company stock from current owners.  The key question in determining the viability of the stock sale – the question that the ESOP consultant will answer – is how much stock can the ESOP purchase.  If the owner wants to sell stock to the ESOP, the ESOP will likely have to borrow the money from the company (which loan ultimately will have originated with a bank) in order to pay cash to the selling shareholder, or the ESOP can pay the purchase price in the form of a promissory note.  Of course, the ESOP might pay a portion of the purchase price in cash (with money borrowed from the company) and pay the remainder in the form of a promissory note.  Recall that either way the company will have to be able to make annual contributions to the ESOP sufficient to cover the debt service.

Where an ESOP is “leveraged” through the borrowing of money, the stock held by the ESOP will be pledged as security for the loan and allocated to participant accounts only as the loan is paid down.  If the loan is to be amortized over many years, it will take a long time before the financial benefits of stock ownership can be realized by plan participants.

After the valuation has been completed, the purchase price has been set, and the financing arrangements have been made, the stock sale itself can be documented and implemented and a plan will be established concurrent with the stock sale.  The key documents in the transaction typically will include: (1) an ESOP plan document that meets the formal requirements of the Internal Revenue Code and ERISA; (2) a summary plan description, explaining the ESOP to employees; (3) a stock purchase agreement; (4) a loan agreement and promissory note between the company and the ESOP; (5) a promissory note issued by the ESOP to each selling shareholder; (6) a trust agreement, between the company and the trustee of the ESOP trust; and (7) an administrative services agreement with the ESOP record keeping firm.

Other Legal Compliance Issues

Because an ESOP is a tax-qualified retirement plan, it must be maintained in accordance with the qualification requirements of the Internal Revenue Code and the requirements of ERISA.  This means, among other things, that: (1) the company will have to obtain an independent valuation every year in order to confirm the value of the stock and allocate stock to participant accounts; (2) a Form 5500 that includes audited financial statements for the plan will have to be filed with the U.S. Department of Labor each year; (3) a record keeping firm will have to be engaged to handle basic plan administrative tasks; and (4) a prudent fiduciary governance structure – including a plan administrative committee and an independent trustee – must be established in order to ensure that the fiduciary standards of ERISA are consistently applied by those charged with overseeing the administration of the plan.

A business owner must tackle many issues before making a decision to establish an ESOP.  But in most cases, a properly implemented ESOP can deliver a significant financial advantage for a business owner and meaningful benefits of ownership to employees.

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