People often think if an ESOP owns shares in a company, it has to be the only shareholder. This is not the case and more often than not, the ESOP is but one of several shareholders. An ESOP sale is most often used in combination with other ownership-transition strategies to maximize the tax efficiency and opportunities for the seller, the successor management team and the employees. Thus, it is as common for an ESOP’s ownership to change many times during its life as it is to stay the same.
ESOPs Increasing Share Ownership
In many situations, the ESOP is used for a specific purpose and a transaction is designed to accomplish that objective. Some companies limit the ESOP’s ownership so that key leaders hold a majority interest after the senior leadership exits the business. When employees leave the company and are cashed out of the ESOP, their shares are either redeemed by the company and contributed back to the ESOP, or simply repurchased by the ESOP itself. Therefore, the ESOP’s ownership is the same before the distribution as after.
For company owners seeking to transition their ownership gradually, tendering stock to the ESOP in stages is a common strategy which increases the ESOP’s ownership over time. An owner might sell 30% to the ESOP initially and once that transaction is finished, sell another block to the ESOP. This approach allows the owner to explore other options for the remainder of their shares while knowing there’s a ready buyer in the ESOP, as needed. Thus, they may continue selling to the ESOP, sell the rest to management or decide to sell the entire company outright. Selling one block of stock to an ESOP does not obligate an owner to ever sell more but also provides that opportunity if they choose.
Company owners seeking to sell all of their stock are quite interested to learn that they can create a tax free corporation using the ESOP. This tax advantage not only increases cash flow therefore the rate of debt repayment, but also creates a competitive advantage among its peers by taking out a large cost (taxes) from its service or product. This tax benefit is created by selling all shares to the ESOP – a tax exempt trust and electing to be taxed as an S-corporation - flow through entity. Each year when the ESOP gets its attribution of profits (100%) the federal and most state bills are zero.
ESOPs Decreasing Share Ownership
What goes up can also come down, and so it is with ESOP ownership as well. When a block of stock is sold to an ESOP, some owners plan on reducing its ownership over time. As employees leave the company, their ESOP stock accounts redeemed by the companyand held in treasury or reissued to others. This is a typical strategy for family-owned businesses as well as those where the owner wants to both create a benefit for their employees but also reward and incentivize their key leaders. As the ESOP’s ownership goes down, all things equal, the non-ESOP shareholders’ interests go up. This can work quite nicely if planned and managed carefully.
An ESOP can also be ‘bought down’. Some companies implement an ESOP initially to buyout a shareholder and like the idea of creating an employee benefit at the same time. These companies often redirect existing retirement funds for the ESOP stock purchase thus minimizing the marginal cost to buyout the shareholder. After the ESOP has paid for its stock, an existing owner or key non-shareholder executive might make a direct offer to buy back shares from the ESOP. In this case, the ESOP exchanges stock for cash and its ownership decreased. The buyer now owns a larger percentage of the company and the employees have a liquid benefit.
Finally, the most common reason for completely eliminating an ESOP’s ownership is the sale of the business. In these cases, whatever the amount of stock owned by the ESOP is either purchased directly in a stock purchase or liquidated by its sponsor company in an asset sale. In each case, the company stock assets in the ESOP are converted to cash which is then distributed to the participants or rolled over into a new plan. The ESOP itself is then either terminated or merged into an existing defined contribution plan. If the ESOP is still indebted for its stock purchase, it exchanges the unpaid for shares for debt relief and keeps the gain from the sale.
Using an ESOP is a flexible technique for making a market in company stock. It can be used in any number of ways for a myriad of reasons. If you have an interest in discussing you situation, don’t hesitate to call Jim Higgins or Bob Massengill. We’d be pleased to share our thoughts.