A Publication of WTVP

Many small business owners are nearing retirement age; therefore, transferring their business to the next generation, whether to family members, employees or outsiders, is a growing concern. Numerous challenges can present themselves that range from how to finance the transaction to how to ensure a successful transition with existing customers, vendors and employees. Of course, owners also want to receive a fair return for the business they built as they enter retirement.

Employee Stock Ownership Plans (ESOPs) offer many attractive benefits to corporations and their owners. At the same time, ESOPs are strictly regulated to protect employees. For example, the value of ESOP shares that are not publicly traded must be determined at least annually by a qualified independent appraiser. These regulations equal increased costs to administer the ESOP, which means that ESOPs are not for every company, particularly very small businesses with few employees.

Essentially an ESOP is a retirement plan for employees. It is similar to a 401(k) plan which substantially invests all of its assets in company stock. The stock is held in a trust under the control of a trustee appointed by the board of directors, and participants are usually allocated stock based on compensation. The shares of stock must vest before employees are entitled to receive them (usually based on year of service, or in some plans, the shares vest immediately). In addition to shares of stock, participants can receive cash dividends.

It is estimated that approximately 11,000 ESOPs exist in the United States, with assets of approximately $600 billion covering over eight million employees. Research has shown that giving employees a significant stake in their companies can improve employees’ attitudes toward their companies, and that these improved attitudes can translate into bottom-line improvements.

Tax Benefits
The tax issues involving ESOPs are very complex and beyond the scope of an article of this size; however, two of the major benefits will briefly be discussed.

First, principal (and interest) payments on loans used to acquire stock are tax-deductible, subject to certain conditions. Thus, the company (through the ESOP) can purchase stock from the retiring owner dollar for dollar. This benefit exists because the company makes contributions to the ESOP (which are tax-deductible up to certain limits), and then the ESOP uses these contributions to repay the debt.

A second major tax benefit of an ESOP involves the selling shareholder. The owner can defer payment of capital gains taxes if all three of the following conditions are met:

1. The stock has been owned for more than three years,
2. The proceeds are reinvested in qualified replacement securities (generally stock or bonds issued by domestic corporations) within certain time restraints, and
3. The ESOP owns at least 30% of the outstanding company shares immediately after the transaction.

Plan fiduciaries, which may include trustees, administrators, sponsors and certain directors or managers, must take special care to act in the best interest of participants. Failure to do so exposes fiduciaries to potential damage claims for breach of fiduciary duty and may result in hefty excise taxes on insiders deemed to have engaged in prohibited transactions (e.g. selling stock to the plan at inflated prices). Great care must be taken if the selling shareholder will remain as trustee of the ESOP.

An ESOP is prohibited from paying more than “adequate consideration” for the employer’s stock. A plan’s fiduciaries, therefore, must determine the fair market value of the shares in good faith based on a prudent investigation. While a professional valuation is critical, the fiduciaries’ duties go beyond simply hiring an appraiser. Fiduciaries should be familiar with the unique issues involved in ESOP valuations, engage only qualified valuation professionals and work closely with those professionals to ensure that all relevant factors are properly considered.

The most effective way for ESOP fiduciaries to fulfill their duties is to obtain the advice of qualified independent financial advisors. This advice may extend to a number of areas, from opining on the fairness of proposed ESOP transactions to assisting in the negotiation of loan terms for a leveraged ESOP.

Special Valuation Concerns
In general, valuation methods for ESOP stock are consistent with established guidelines for determining fair market value in other settings. But there are some significant differences:

• ESOPs are required to give participants put options (the right to sell the stock back to the employer). An appraiser needs to analyze the impact of such rights on the stock’s marketability. The effect on value will depend on the features of the put options in question (especially payment terms) as well as the corporation’s financial ability to meet its repurchase obligations.
• Leveraged ESOPs raise additional valuation issues concerning the impact of the ESOP debt itself on the value of the corporation’s stock.

To protect themselves from liability, ESOP fiduciaries should engage a valuation professional with the appropriate skills and experience to accurately value the ESOP shares. But they should not stop there. To ensure that the valuation will hold up in court, they should establish written parameters for the work—including fees, timeframes and valuation standards. It is also critical to ensure full disclosure at all levels. Valuators analyze historical information to arrive at an informed conclusion about the future, based on management’s performance. For an accurate valuation, management must be candid about the company’s plans and expectations for the future.

While not for every company, ESOPs offer many benefits to corporations. However, these benefits come at the cost of strict regulation and exposure to liability, particularly for plan fiduciaries. When investigating whether an ESOP might be feasible for your company, be sure to enlist the help of qualified professionals. IBI